This post was originally published on Forbes Jun 24, 2015
If you ever looked closely at a K-1 from a partnership, you might have noticed Section K - Partner's share of liabilities at year end. The liabilities come in three flavors - nonrecourse, qualified nonrecourse and recourse. If you haven't ever paid any attention to those numbers, it is just as well. Most likely they don't matter that much and on any given K-1, there is a very good chance that they are wrong. Almost nobody cares.
ISSUE For purposes of determining if a limited liability company taxed as a partnership has cancellation of debt income under § 61(a)(12) or gains from dealings in property under § 61(a)(3) upon foreclosure of its property, do the regulations under § 752 determine if the indebtedness is recourse or nonrecourse to the partnership§
CONCLUSION The regulations under § 752 do not determine if a debt is recourse or nonrecourse to a partnership for purposes of determining whether, upon foreclosure of the property, the partnership has cancellation of debt income under § 61(a)(12) or gains from dealings in property under § 61(a)(3).
Notes are at the center of the controversy in this case. Notes do not contain express language providing that they are recourse or nonrecourse to Taxpayer. Notes also do not expressly state whether Taxpayer, as borrower, would be unconditionally and personally liable for repayment if the collateral securing Notes was insufficient to fully repay the outstanding balance on Notes with interest. Section 8.16 of the Loan Agreement contains an affirmative covenant that Taxpayer is contractually bound to maintain its status as a SPE. Taxpayer also entered into several loan Amendments and Reaffirmations with Affiliate, which specifically provided that Taxpayer, as borrower, executed and delivered to Lender Assignments and Spreaders to the Deed of Trust, Assignment of Leases and Rents, Security Agreements and Fixture filings. Notes are expressly governed by California law. Since Notes constitute junior debt, Corporation and Affiliate did not receive any proceeds from the Year 2 non-judicial foreclosure.
The regulations under § 752 are limited to determining the partners' basis in the partnership. The definition of a recourse liability found in § 1.752-1(a)(1) is limited to issues under § 752, rather than a definition intended to extend to issues under §§ 61 and 1001. The primary authority for this conclusion is found in the regulatory text of § 1.752-1(a) which states, prefacing the definition of “recourse liability,” “nonrecourse liability,” “related person,” and “liability,” that the definitions found in this paragraph apply “for purposes of § 752.” In addition, the § 1.752-1(a)(1) definition of “recourse liability” does not even extend to all of Subchapter K. For instance, the regulations concerning the allocation of deductions that are attributable to nonrecourse liabilities found under § 704, define “nonrecourse liabilities” in a way that may encompass liabilities classified as “recourse” under § 752. Specifically, § 1.704-2(b)(4) defines “partner nonrecourse liability” as: [A]ny partnership liability to the extent the liability is nonrecourse for purposes of § 1.1001-2, and a partner or related person (within the meaning of § 1.752-4(b)) bears the economic risk of loss under § 1.752-2 because, for example, the partner or related person is the creditor or guarantor.
The determination of whether the loan in the instant case is recourse or nonrecourse for § 1001 purposes requires a factual analysis of the operating and loan documents and any relevant state law. We defer to your office and the examining agent to conduct this factual analysis; this memorandum does not reach a conclusion as to whether Notes are recourse or nonrecourse.