Tax News
CCA 201525010: CODI, recourse v nonrecourse liabilities and tax uncertainties
June 22, 2015
CCA 201525010 offers a useful insight and a cautionary tale regarding the unpredictability of certain recourse v. non-recourse liability issues in the partnership context. The issues which are the topic of the CCA arise primarily in the private equity fund context, and more often in the real estate context. What are the issues? When a project is held by an entity treated as a partnership and has some sort of financing, there is a substantive tax question regarding whether this financing is recourse or non-recourse for tax purposes. This determination could have various implications. For example, it has an impact on the investors’ outside tax basis. It could also have a significant impact if the deal goes sour. Specifically, the impact in the latter case pertains to whether the investors will have CODI or amount realized at the time the properties are foreclosed. Sometimes CODI treatment may be disadvantageous (i.e. it could at least theoretically cause a whipsaw of ordinary income/capital loss) and in some cases may be advantageous (i.e. the investors may be able to rely on a Sec. 108 CODI exclusion such as insolvency).

Now, the recourse v. non-recourse liability rules for Subchapter K purposes are by no means easy to digest. The bulk of those rules are contained in Sec. 752, 704 and the underlying regs. That said, with the exception of certain exculpatory liability issues, the Subchapter K rules, while complicated, are workable. What throws a wrench in all of this, however, is that there is no consistency among the definitions under Sec. 752, 704, and Sec-s. 61/1001. Thus, a liability for Sec-s 61/1001 purposes (i.e. the operative sections with respect to CODI) may be recourse but nonrecourse, for say, Sec. 752 purposes. This type of issue creates complexity and uncertainty. The CCA exemplifies this problem.

In CCA 201525010 the taxpayer funded a real estate deal through a 3 member LLC treated as a partnership for tax purposes. The deal imploded and the lenders foreclosed on the project. The taxpayer treated the foreclosure income as CODI based on the reasoning that the underlying debt was recourse and since the borrower was the LLC, the Sec. 752 rules governed.  The tax benefit from this treatment arose from the taxpayer's reliance on the 108(a)(1)(B) exception and a Sec. 108(b) NOL offset.  Ultimately the LLC was audited and the IRS agent argued that the LLC debt could be treated as nonrecourse.  The result in that case would have been amount realized taxed at capital gains instead of ordinary income CODI subject to a Sec. 108 exception.  Chief Counsel did not rule whether the debt was recourse or non-recourse. It sent the agent back for fact development. The key fact that presented a problem in this case was that the debt did not impose an unconditional personal liability on the LLC. However, Chief Counsel pondered that such liability is not necessary and under the facts, the debt may nonetheless be recourse to the entity because of certain pledges, general assignment of rights, and guarantees.  More importantly, however, the IRS ruled that 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). In ruling so, the IRS pointed out that taxpayers cannot interpret Fn 35 of the Great Plains case for the proposition that whether a debt is recourse or nonrecourse at the partnership level for Sec. 1001 purposes is determined by whether the partners personally guarantee the debt at the partner level. As the IRS put it succinctly, such interpretations are erroneous.

What implications to the industry after all of this? The implication is that the CCA offers an advance warning to investors, and particularly real estate investors.   Investors should heed the differences in the definitions of a recourse and nonrecourse liability for purposes of the various Code sections (namely, 704, 752, and 61/1001). Investors should specifically draft their documents bearing in mind these differences and model the impact of the recourse v. nonrecourse issue upfront. The tax hit from an adverse determination could be significant, penalties notwithstanding. Also, investors who may have been reading Great Plains as the taxpayer did in the CCA may want to abandon this type of reading unless they want to place their bets in court. The CCA can be found here.
Leave a Reply
You must be logged in to post a comment.
Tags: CODI, recourse liabilities, nonrecourse liabilities, Sec. 752