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.
Nice To Have Regulations
Of course, sometimes it does make a difference and sometimes people do care, just because if they are putting numbers in boxes, they want the numbers to be the right numbers. It is a point of professional pride. Anyway back in the day when I was still working full-time, doing a lot less actual work than I do now, but having a lot more aggravation, the way a lot of the people in my office dealt with getting those numbers right was by asking me. In an effort to encourage professional growth, I would often point the questioner to the regulations promulgated under Code Section 752. The Table of Contents to the regulations is considerably longer than the Code Section, but that's the way it goes in the partnership area which is something of an arms race between scoundrels designing bogus tax shelters and the writers of regulations.
At any rate, it was nice to have those regulations, because sometimes it is important how the liabilities are allocated among the partners and what flavor the liabilities are. One situation where it is important whether liabilities are recourse or nonrecourse is when property is foreclosed. If the liability is recourse, the balance is considered proceeds of sale to the extent of the fair market value of the property and the balance is income from the discharge of indebtedness. If the liability is nonrecourse, it is all proceeds of the sale. Which one is better?
Well that depends. A solvent partner would prefer that the liability be nonrecourse, since having it be all sales proceeds increases capital gain or decreases capital loss. An insolvent partner prefers recourse, since the income from the discharge of indebtedness can be excluded.
Regulations Have Limits
So it's really nice that we have those regulations under Section 752 to give us guidance on whether the liabilities are nonrecourse or recourse. Only in CCA 201525010, the Chief Counsel tells us that we don't. Here is the high point.
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).
The partnership had received 1099-A from the bank that had estimated the value of the property at less than the balance on the loan and that had been fine with the partners who were able to exclude debt discharge income because of insolvency. The paperwork was, however, less than crystal clear.
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.
I hate when that happens. The taxpayers wanted to use the 752 regulations to sort it out. Chief Counsel says no.
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.
Kicking The Question Back
So are the notes in this case recourse or nonrecourse? The Chief Counsel doesn't give an answer.
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.
There is some further discussion that indicates that they might lean toward nonrecourse though.
Blood From A Stone?
Kind of ironically I just read a post by Keith Fogg on the varying compromise standards among Chief Counsel, IRS and DOJ. The Chief Counsel office does not consider collectibility in deciding whether to compromise on issue. Note, here, that the taxpayers were insolvent and the field is being told to look harder for a possibly larger assessment. So it goes.