Partner guarantee shifts basis and at-risk treatment

Plain-English summary

An LLC taxed as a partnership acquired, renovated, and held hotel properties, while a separate manager handled daily hotel operations. One member personally guaranteed partnership notes, and another member claimed losses on the theory that the debt remained qualified nonrecourse financing. Chief Counsel concluded that the guarantee made the debt recourse under section 752 because the insolvency and bankruptcy-related triggers were not so remote that the payment obligation should be ignored. The hotel investment activity qualified as holding real property, but the personal guarantee meant the debt no longer qualified as nonrecourse financing under section 465 for the non-guaranteeing members. The operating agreement's optional capital calls, loans, ownership dilution, and possible later allocation agreement did not make those members personally liable because they had no mandatory obligation to fund the guarantee. If they actually become required to pay in the future, their payments may then be treated as partnership contributions.

Ruling snapshot

• Question: How does one partner's guarantee affect debt allocation, qualified nonrecourse financing, and the other partners' at-risk amounts?
• Outcome: The debt is recourse to the guarantor, and the non-guarantors receive neither debt basis nor at-risk treatment from the guaranteed amount.
• Key authorities: IRC §§ 465, 704, 722, and 752; Treas. Reg. §§ 1.465-27 and 1.752-2

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201606027
           Release Date: 2/5/2016
           CC:PSI:B03:WMKostak
           POSTF-116879-15

 UILC:     465.01-01, 465.04-01, 704.06-00, 752.06-01

  date:    October 23, 2015

     to:   William D. Richard
           Attorney (Seattle, Group 1)
           (Small Business/Self-Employed)

  from:    James A. Quinn
           Senior Counsel, Branch 3
           (Passthroughs & Special Industries)


subject:   Guarantee of Qualified Non-Recourse Financing

           This memorandum responds to your request for assistance dated August 13, 2015.
           This advice may not be used or cited as precedent.


           LEGEND

           X            = --------------------------------------
                                -----------------------
           Y            = -----------------------------------------------------
           Z            = -------------------------------------------------------------------
           A            = ------------------
                                ------------------------
           B            = ------------------
           C            = --------------------
           Country      = ---------
           n1           = ---
           n2           = ---
           n3           = ---
           n4           = ---
           n5           = ---------------
           n6           = ---
           n7           = --
POSTF-116879-15                                    2

n8          = -----------
n9          = ---
n10         = -----------
n11         = ---
n12         = -----------------
n13         = ---------------
n14         = ---------------
n15         = ---------------
n16         = ---------------
Date        = -------------------------
Year1       = --------------------------------
Year2       = --------------------------------
Year3       = --------------------------------

                                                 ISSUES

    1. If one partner guarantees a partnership’s obligation to satisfy a promissory note
     in the event of, among other events, the partnership admitting in writing that it is
     insolvent or unable to pay its debts when due, or its voluntary bankruptcy or
     acquiescence in an involuntary bankruptcy, does this guarantee preclude the
     promissory note from qualifying as a nonrecourse obligation of the partnership
     under § 752 of the Internal Revenue Code (“Code”) and regulations promulgated
     thereunder?
    2. If the partnership’s sole business activity involves acquiring existing hotels,
     renovating them, installing personal property appropriate to improve the
     properties’ utility as hotels, and holding and maintaining the premises, but does
     not include the hotels’ day-to-day operations, does this business activity qualify
     as an “activity of holding real property” within the meaning of § 465(b)(6)(A)?
    3. If a partner guarantees partnership debt that otherwise had met the requirements
     of qualified nonrecourse financing within the meaning of § 465(b)(6), are the
     other non-guarantor partners entitled to treat the obligation as qualified
     nonrecourse financing within the meaning of § 465(b)(6) and regulations
     promulgated thereunder or otherwise at risk with respect to the guaranteed
     obligation?
    4. If the partnership operating agreement provides that, in the event that the
     guaranteeing partner makes a payment under a guarantee, the guaranteeing
     partner has the right to call for the non-guaranteeing partners to make capital
     contributions and, if they fail to do so, treat ratable portions of the payment as
     loans to those partners, adjust their fractional interests in the partnership, or
     enter into a subsequent allocation agreement under which the risk of the
     guarantee would be shared among the partners, is this provision sufficient to
     make the non-guaranteeing partners personally liable with respect to the
     guaranteed obligation for the purposes of §§ 752 and 465?
POSTF-116879-15                              3

                                     CONCLUSIONS

        1. If a partner guarantees an obligation of the partnership and the guarantee is
      sufficient to cause the guaranteeing partner to bear the economic risk of loss for
      that obligation within the meaning of § 1.752-2(b)(1) of the Income Tax
      Regulations, the guaranteed debt is properly treated as recourse financing for
      purposes of applying the basis allocation rules of § 752. For this purpose, certain
      contingencies such as the partnership admitting in writing that it is insolvent or
      unable to pay its debts when due, its voluntary bankruptcy, or its acquiescence in
      an involuntary bankruptcy, after taking into account all the facts and
      circumstances, are not so remote a possibility that it is unlikely the obligation will
      ever be discharged within the meaning § 1.752-2(b)(4) that would cause the
      obligation to be disregarded under § 1.752-2(b)(3).
        2. Where the partnership’s sole business activity includes acquiring existing hotels,
      renovating them, installing personal property appropriate to improve the
      properties’ utility as hotels, and holding and maintaining the premises, but does
      not include the hotels’ day-to-day operations, the partnership is engaged in an
      “activity of holding real property” within the meaning of § 465(b)(6)(A).
        3. When an individual partner guarantees a partnership obligation, the amount of
      the guaranteed debt no longer meets the definition of “qualified nonrecourse
      financing” under § 465(b)(6)(B), and the amount of the guaranteed debt will no
      longer be includible in the at-risk amount of the other non-guaranteeing partners,
      if the guarantee is bona fide and enforceable by creditors of the partnership
      under local law.
        4. To the extent the guaranteeing partner has the right under the partnership
      operating agreement to call for the non-guaranteeing partners to make capital
      contributions and, if they fail to do so, treat ratable portions of the payment as
      loans to those partners, adjust their fractional interests in the partnership, or
      enter into a subsequent allocation agreement under which the risk of the
      guarantee would be shared among the partners, this right generally will not be
      sufficient to make the non-guaranteeing partners personally liable with respect to
      the guaranteed obligation for the purposes of §§ 752 and 465.

                                         FACTS

       X is a limited liability company electing to be taxed as a partnership. Its
members are A, an individual who owns n1% of the profits and equity interest in X; B,
an individual who owns n2% of X; and C, an individual who owns the remaining n3% of
X. A, B and C each owns more than 10% of the profits and equity of X. X directly or
indirectly owns a number of corporate subsidiaries (hereinafter “the subsidiaries”).

       Section 7.5 of the Amended and Restated Operating Agreement of X (“Operating
Agreement”) contains a number of provisions with respect to additional capital
contributions to X.
POSTF-116879-15                              4

       Section 7.5(a) of the Operating Agreement states that, except as otherwise
provided for therein or mutually agreed upon by the Members, no Member shall be
obligated to make capital contributions to X.

        Section 7.5(b) of the Operating Agreement states that in the event additional
capital is needed for X’s business, C, or an affiliate (the “Lender”) may elect to loan
funds to X for its business purposes (“C loans”). Such C loans shall be made on
commercially reasonable terms and conditions, and the Members agree that such loans
shall bear interest at a rate equal to n4% per annum, compounded annually. Such
loans shall be an obligation of X and, at the option of the Lender, may be repaid prior to
any distributions to the Members. C or its affiliates shall have no obligation to make C
loans to X. If C elects to make C loans to X, A and B shall be given the opportunity to
make similar loans in accordance with their respective ownership percentage interests
in X. If C makes any C loans to X, C may at any time convert such C loans into
additional capital.

       Section 7.5(c) of the Operating Agreement states that in the event that C
determines in his sole discretion that additional capital is needed for X’s operations in
addition to the initial capital contributions (as set forth in Section 7.2 of the Operating
Agreement) and C loans under section 7.5(b) above, if any, C may elect to make
additional capital contributions to X. If C elects to contribute additional capital, A and B
shall be given the opportunity to make similar additional capital contributions in
accordance with their respective ownership percentages in X. C’s additional capital
shall not exceed an amount which would cause C’s adjusted contribution amount at any
point to exceed $n5.

       Section 7.5(d) of the Operating Agreement states that in the event C’s adjusted
contribution amount exceeds $n5 and C determines in his sole discretion that additional
capital is needed for X’s business in addition to the initial capital contributions, any C
loans under section 7.5(b), and C’s additional capital contributions under section 7.5(c)
(but excluding guarantee contributions, which are subject to section 7.5(e)), the
Members shall contribute their ownership percentage interest of the required capital to
X within 20 days of receiving notice from C of the amount of required additional capital
(the “Demand Notice”). If a Member fails to contribute an amount required pursuant to
this section 7.5(d) (a “Defaulting Member”) within 20 days of receipt of a Demand Notice
from C, then C may elect one or more of the following remedies:

       (i)    C may elect to loan to X the amount that a Defaulting Member failed to
              contribute which loan shall be treated as a loan to the Defaulting Member
              and which shall bear interest at the rate of n6% per annum compounded
              annually from the date of the advance until the date the loans are paid in
              full, and shall be payable out of any distributions to the Defaulting Member
              (which payments will be applied first to accrued interest on the loans and
              then to the outstanding principal balance of such loans). If C elects to
              make such a loan, the other non-defaulting members shall be given a
POSTF-116879-15                            5

             similar opportunity to make similar loans in accordance with their
             respective ownership percentage interests in X; or
      (ii)   C may elect to adjust the ownership percentage interest of each
             Defaulting Member by n7% for each $n8 a Defaulting Member failed to
             contribute, and the ownership percentage interest of the Members who
             contributed their proportionate share in response to the Demand Notice
             (the “Contributing Members”) shall increase n7% by each $n8 the
             Defaulting Member failed to contribute, which increase in the ownership
             percentage interest of the Contributing Members shall be allocated among
             the Contributing Members based on the existing ownership percentage
             interests held by the Contributing Members. However, a Defaulting
             Member shall have the right to negate an adjustment of ownership
             percentage interests under this section 7.5(d)(ii) pursuant to the provisions
             of section 7.5(g).

       Section 7.5(e) states that in the event any Member makes a Guaranty
Contribution, the other Members shall contribute their ownership percentage interest of
the Guaranty Contribution to X (and X shall return a portion of the Guaranty Contribution
to the Member making such Guaranty Contribution) within 20 days of receiving written
notice from the Member making the Guaranty Contribution of the amount of the
Guaranty Contribution and the amount due from such Members (the “Guaranty
Contribution Demand Notice”). If a Member fails to contribute the amount required
pursuant to this section 7.5(e) (a “Guaranty Contribution Defaulting Member”) within 20
days of receipt of the Guaranty Contribution Demand Notice, then the Member making
the Guaranty Contribution may elect one of the following remedies:

      (i)    The Member making the Guaranty Contribution may elect to loan to X the
             amount of the Guaranty Contribution Defaulting Member failed to
             contribute, which loan shall be treated as a loan to the Guaranty
             Contribution Defaulting Member and which shall bear interest at the rate of
             n9% per annum, compounded annually from the date of the Guaranty
             Contribution until the date the loan is repaid in full, and shall be payable
             out of any distributions to the Guaranty Contribution Defaulting Member
             (which payments shall be applied first to accrued interest on the loans,
             and then to the outstanding principal balance of the loans). If the Member
             making the Guaranty Contribution elects to make such a loan, the other
             non-defaulting Members shall be given a similar opportunity to make
             similar loans in accordance with their ownership percentage interest; or
      (ii)   The Member making the Guaranty Contribution may elect to adjust the
             ownership percentage interest of the Guaranty Contribution Defaulting
             Member by n7% by each $n10 a Guaranty Contribution Defaulting
             Member failed to contribute, and the ownership percentage interests of the
             Members who contributed their proportionate share in response to a
             Guaranty Contribution Demand Notice (the “Guaranty Contribution
             Contributing Members”) shall increase n7% by each $n10 the Guaranty
POSTF-116879-15                               6

              Contribution Defaulting Member failed to contribute, which increase in the
              ownership percentage interest of the Guaranty Contribution Contributing
              Members shall be allocated among the Guaranty Contribution Contributing
              Members. However, a Guaranty Contributing Defaulting Member shall
              have the right to negate an adjustment of ownership percentage interests
              under this section 7.5(e)(ii) pursuant to the provisions of section 7.5(g).

         Section 7.5(f) of the Operating Agreement states that at any time when A or B
has an adjusted contribution amount in relation to the combined amount of all Members’
adjusted contribution amounts which is less than the ownership percentage interest of A
or B, either A or B may make voluntary capital contributions to X, which capital
contributions will be used to repay the capital contributions of the Members who have
adjusted capital amounts in relation to the combined amount of all Members’ adjusted
contribution amounts which are greater than such Member’s ownership percentage
interest. Similarly, at any time C has made a C loan under section 7.5(b) or a default
loan under section 7.5(d)(i), the creditor under such loan may repay such loan (with
interest) at any time and thus discontinue the interest accrual thereunder. Finally, if the
Members receive commissions or other fees generated in connection with the
facilitation of a transaction in which X has an interest, and if C has an adjusted
contribution amount which is greater than n11% of the combined amount of all
Members’ adjusted contribution amounts, C can require all Members to contribute the
net after-tax proceeds from such commissions and fees to the capital of X (with such
net after-tax amount calculated based on all foreign, national, state and local taxes
associated with such commissions and fees).

         Section 7.5(g) of the Operating Agreement states that a Member may negate the
dilution of its ownership percentage interest under section 7.5(d)(ii) or section 7.5(e)(ii)
if, within 12 months of the date of the Demand Notice or the Guaranty Contribution
Demand Notice, as applicable, the defaulting Member or Guaranty Contribution
Defaulting Member contributed to X the amount which would be due under section
7.5(d)(ii) or section 7.5(e)(ii) if the failure of such Member to make a contribution was
treated as a loan under such sections. Under such circumstances, the dilution shall be
negated, the prior contributions shall be treated as loans in accordance with section
7.5(d)(i) or section 7.5(d)(ii) [sic], as applicable, and such loans shall be repaid from the
amounts contributed by the Defaulting Member or Guaranty Contribution Defaulting
Member.

        Section 7.7 of the Operating Agreement states that in the event any Member
shall fail to contribute any cash or property when due hereunder, such Member shall
remain liable therefor to X, which may institute proceedings in any court of competent
jurisdiction in connection with which such Member shall pay the costs of such collection,
including reasonable attorneys’ fees. Any compromise or settlement with a Member
failing to contribute cash or property due hereunder may be approved by the Manager.

       Section 7.9 of the Operating Agreement states that in the event X’s financing or
other X undertakings whereby any Member of X elects or is required to become
POSTF-116879-15                                   7

personally obligated (including execution of guarantees of indebtedness, non-recourse
carve-out guarantees, environmental indemnities, etc.), the Members agree to enter into
a contribution agreement pursuant to which all Members agree to allocate the risks of
such personal obligations in accordance with their ownership percentage interests in X.1

        A senior promissory note was executed in Year1 by some (but not all) of the
subsidiaries of X as co-borrowers (“the senior promissory note”). The purpose of the
funds borrowed under the senior promissory note (and the “mezzanine financing”
discussed below) included acquiring and renovating real property used in the activity of
Z and financing its operation. The senior promissory note is secured by a security trust
agreement under the laws of Country; the security covers property constituting the
activity of Z. The activity of Z includes the acquisition and renovation of two hotel
properties in Country; the installation of furniture, fixtures, and equipment appropriate to
improve the properties’ use as hotels; and holding the hotel properties. Another entity
(also owned by A, B, and C) is responsible for managing the hotel properties; it hired a
hotel management company to conduct the day-to-day operation of the hotels
comprising Z. Starting in Year1 and continuing through Year3, X owned the hotel
properties used in the activity of Z.

       The senior promissory note provides that Y will provide $n12 as of the date of
closing, and will provide up to $n13 between the date the loan transaction closes and
the date that the obligations under the senior promissory note mature.

       C executed three personal guarantees of the senior promissory note, each
subject to different terms. The first guarantee, entitled “Guaranty of Recourse
Obligations,” executed on Date, provides that C “hereby unconditionally, absolutely and
irrevocably, as a primary obligor and not merely as a surety, guarantees to Lenders the
punctual and complete payment of the entire amount of the Guaranteed Obligations
upon demand by [Y, as agent for the Lenders]” (the “First Guarantee”). Section 1(b) of
the First Guarantee provides that the term “Guaranteed Obligations” means, among
other things, the entire outstanding principal amount of the Loan, together with all
interest thereon and all other amounts due and payable under the Loan Documents in
the event that:

      (1) the co-borrowers fail to obtain the lender’s consent before obtaining
subordinate financing or transfer of the secured property,

       (2) any co-borrower files a voluntary bankruptcy petition,

        (3) any person in control of any co-borrower files an involuntary bankruptcy
petition against a co-borrower,


1
  The taxpayer has not provided the examining agent with a separate contribution agreement and, for
purposes of this analysis, we are assuming that no separate contribution agreement has been entered
into pursuant to section 7.9 of X’s Operating Agreement.
POSTF-116879-15                               8

       (4) any person in control of any co-borrower solicits other creditors to file an
involuntary bankruptcy petition against a co-borrower,

       (5) any co-borrower consents to or otherwise acquiesces or joins in an
involuntary bankruptcy or insolvency proceeding,

       (6) any person in control of any co-borrower consents to the appointment of a
receiver or custodian of assets, or

        (7) any co-borrower makes an assignment for the benefit of creditors, or admits
in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they
come due.

       The second guarantee, entitled “Required Amortization Guaranty,” provides that
C, “as a primary obligor and not merely as a surety,” guarantees the punctual and
complete payment of all required amortization payments under the promissory note, but
in an amount not to exceed $n14. The required amortization payments represent
amounts required to be paid as necessary to maintain minimum yields on the underlying
obligation.

       The third guarantee, a completion guarantee, provides that C will guarantee part
of the $n13 “as a primary obligor and not merely as a surety.” In addition, the third
guarantee provides that C will personally guarantee repayment of any amounts
expended to complete the renovation of Z. C’s liability under the third guarantee will not
be subject to, or limited by, any non-recourse provisions contained in the promissory
note.

       Also in Year1, some (but not all) of the subsidiaries of X executed two other
promissory notes (“the Z mezzanine notes”) in addition to the senior promissory note
described above. The co-borrowers on the Z mezzanine notes are the same co-
borrowers on the senior promissory note. The Z mezzanine notes are secured by
security trust agreements under the laws of Country; the security covers property
constituting the activity of Z. The Z mezzanine notes provide that Y will provide $n15
and $n16 for the first and second Z mezzanine notes, respectively. Both of the Z
mezzanine notes are subject to guarantees (“Guaranty of Recourse Obligations” and
“Required Amortization Guaranty”) substantially similar to the first and second
guarantees of the senior promissory note described above.

       In Year2, the parties to the senior promissory note and the Z mezzanine notes
amended the terms of the notes, deleting and releasing some co-borrowers from the
notes. The loan modification agreements explicitly recites that all of the guarantees in
effect with respect to the notes remain in effect. As of the end of Year3, none of the
members of X have been called upon to make an additional capital contribution or a
Guaranty Contribution to X in accordance with X’s Operating Agreement, although C
made a loan to X that remains outstanding.
POSTF-116879-15                                 9

        In Year3, A claimed a pass-through loss for the current year as well as a pass-
through net operating loss (NOL) deduction from X. A claims that he is entitled to the
net operating loss deduction without limitation, because the business activity that
generated the loss was funded with “Qualified Non-Recourse Financing” within the
meaning of § 465(b)(6), and that C’s First Guarantee for this debt should be disregarded
for this purpose under § 1.752-2(b)(4) and § 1.465-27(b)(4)(i) because the First
Guarantee is a “contingent” liability. There are no other amounts for which A could be
considered at-risk with respect to the business activity of X within the meaning of
§ 465(b). Your request for advice asks whether A’s deduction is allowable in Year3 in
light of the basis limitations of § 704(d) and the at-risk limitations of § 465.



                                    LAW AND ANALYSIS

Section 752 Basis

       Section 704(d) provides that a partner’s distributive share of partnership loss
(including capital loss) shall be allowed only to the extent of the adjusted basis of such
partner’s interest in the partnership at the end of the partnership year in which such loss
occurred. Any excess of such loss over such basis shall be allowed as a deduction at
the end of the partnership year in which such excess is repaid to the partnership.

       Section 722 provides that the basis of an interest in a partnership acquired by a
contribution of property, including money, to the partnership shall be the amount of such
money and the adjusted basis of such property to the contributing partner at the time of
the contribution increased by the amount (if any) of gain recognized under § 721(b) to
the contributing partner at such time.

       Section 752(a) provides that any increase in a partner’s share of the liabilities of
a partnership, or any increase in a partner’s individual liabilities by reason of the
assumption by such partner of partnership liabilities, shall be considered as a
contribution of money by such partner to the partnership.

         Section 1.752-2(a) provides that a partner’s share of a recourse partnership
liability equals the portion of that liability, if any, for which the partner or related person
bears the economic risk of loss. The determination of the extent to which a partner
bears the economic risk of loss for a partnership liability is made under the rules in §§
1.752-2(b) through (k).

         Section 1.752-2(b)(1) provides generally that, except as otherwise provided, a
partner bears the economic risk of loss for a partnership liability to the extent that, if the
partnership constructively liquidated, the partner or related person would be obligated to
make a payment to any person (or a contribution to the partnership) because that
liability becomes due and payable and the partner or related person would not be
POSTF-116879-15                              10

entitled to reimbursement from another partner or person that is a related person to
another partner. Upon a constructive liquidation, all of the following events are deemed
to occur simultaneously --
    (i)     All of the partnership’s liabilities become payable in full;
    (ii)    With the exception of property contributed to secure a partnership liability
            (see § 1.752-2(h)(2)), all of the partnership’s assets, including cash, have a
            value of zero;
    (iii)   The partnership disposes of all of its property in a fully taxable transaction for
            no consideration (except relief from liabilities for which the creditor’s right to
            repayment is limited solely to one or more assets of the partnership);
    (iv)    All items of income, gain, loss, or deduction are allocated among the partners;
            and
    (v)     The partnership liquidates.

       Section 1.752-2(b)(3) provides that the determination of the extent to which a
partner or related person has an obligation to make a payment under § 1.752-2(b)(1) is
based on the facts and circumstances at the time of the determination. All statutory and
contractual obligations relating to the partnership liability are taken into account for
these purposes, including (i) contractual obligations outside the partnership agreement
such as guarantees, indemnifications, reimbursement agreements, and other
obligations running directly to creditors or other partners, or to the partnership; (ii)
obligations to the partnership that are imposed by the partnership agreement, including
the obligation to make a capital contribution and to restore a deficit capital account upon
liquidation of the partnership, and (iii) payment obligations (whether in the form of direct
remittances to another partner or a contribution to the partnership) imposed by state
law, including the governing state partnership statute. To the extent that the obligation
of a partner to make a payment with respect to a partnership liability is not recognized
under § 1.752-2(b)(3), § 1.752-2(b) is applied as if the obligation does not exist.

       Section 1.752-2(b)(4) provides that a payment obligation is disregarded if, taking
into account all the facts and circumstances, the obligation is subject to contingencies
that make it unlikely that the obligations will ever be discharged. If a payment obligation
would arise at a future time after the occurrence of an event that is not determinable
with reasonable certainty, the obligation is ignored until the event occurs.

        As a threshold matter, a bona fide guarantee that is enforceable by the lender
under local law generally will be sufficient to cause the guaranteeing partner to be
treated as bearing the economic risk of loss for the guaranteed partnership liability for
purposes of § 1.752-2(a). For purposes of § 1.752-2, we believe it is reasonable to
assume that a third-party lender will take all permissible affirmative steps to enforce its
rights under a guarantee if the primary obligor defaults or threatens to default on its
obligations. In this case, we view the “conditions” listed in section 1(b) of the First
Guarantee as circumstances under which the lender may enforce the guarantee to
collect the entire outstanding balance on the loan, beyond an actual default by X on its
obligations. As such, we do not believe these “conditions” are properly viewed as
POSTF-116879-15                                      11

conditions precedent that must occur before Y is entitled to seek repayment from C
under the guarantee.2 In addition, we believe it is reasonable to assume that one or
more of these conditions, more likely than not, would be met upon a constructive
liquidation of X under § 1.752-2(b)(1). Accordingly, we believe that these “conditions”
do not fall within the definition of “contingencies” as intended by § 1.752-2(b)(4).

       For these reasons, we conclude that, for the purposes of §§ 704(d) and 752, and
§ 1.752-2(a), the promissory notes described above are recourse partnership liabilities
allocable to the guaranteeing partner (C), and not to either A or B.

Section 465 At-Risk Amount

       Section 465(a)(1) (by reference to § 465(c)(3)(A)) allows losses incurred by an
individual engaged in a trade or business activity or an activity for the production of
income only to the extent of the amount by which the individual is at risk (within the
meaning of § 465(b)) for such activity at the close of the taxable year.

       Section 465(b)(1) includes in a taxpayer’s amount at risk for an activity (A) the
amount of money and the adjusted basis of other property contributed by the taxpayer
to the activity, and (B) amounts borrowed with respect to such activity (as determined
under § 465(b)(2)).

       Section 465(b)(2) includes amounts borrowed for use in an activity in a
taxpayer’s at-risk amount to the extent that he (A) is personally liable for the repayment
of such amounts, or (B) has pledged property, other than property used in such activity,
as security for such borrowed amount (to the extent of the net fair market value of the
taxpayer’s interest in such property). No property shall be taken into account as
security if such property is directly or indirectly financed by indebtedness which is
secured by property described in § 465(b)(1).

      Section 465(b)(4) provides that, notwithstanding any other provision of § 465, a
taxpayer shall not be considered at risk with respect to amounts protected against loss
through nonrecourse financing, guarantees, stop loss agreements, or other similar
arrangements.

       Section 465(b)(6)(A) includes in a taxpayer’s amount at risk the taxpayer’s share
of any qualified nonrecourse financing which is secured by real property used in such
2
  According to the submission, it appears the taxpayer may assert that the various events listed in section
1(b) of the First Guarantee, upon the occurrence of which the First Guarantee will become immediately
due and payable for the entire outstanding balance of the loan, are the only events under which the First
Guarantee will become due and payable. It appears to us that a failure of X to repay the loan, by itself,
likely would be sufficient to trigger the First Guarantee, as evidenced by the first sentence of section 1 of
the First Guarantee. Assuming, arguendo, that the taxpayer’s assertion is correct, we nevertheless
believe that the likelihood that X or any other co-borrower will ever meet any one of these conditions, in
the aggregate, is not so remote a possibility that would cause the obligation to be considered “likely to
never be discharged” within the meaning of § 1.752-2(b)(4).
POSTF-116879-15                              12

activity. Section 465(b)(6)(B) defines qualified nonrecourse financing as any financing
(i) which is borrowed by the taxpayer with respect to the activity of holding real property,
(ii) which is borrowed by the taxpayer from a qualified person or represents a loan from
any Federal, State, or local government or instrumentality thereof, or is guaranteed by
any Federal, State, or local government, (iii) except to the extent provided in
regulations, with respect to which no person is personally liable for repayment, and (iv)
which is not convertible debt.

       Section 465(b)(6)(C) requires, in the case of a partnership, a partner to
determine its share of partnership qualified nonrecourse financing on the basis of that
partner’s share of partnership liabilities incurred in connection with such financing
(within the meaning of § 752).

       Section 465(e)(1) requires taxpayers to include in gross income the amount by
which zero exceeds a taxpayer’s amount at risk in any activity at the close of any
taxable year. An amount equal to the amount so included in gross income shall be
treated as a deduction allocable to such activity for the first succeeding taxable year.

          Section 1.465-27(b)(1) defines qualified nonrecourse financing, for purposes of
§ 465(b)(6), as financing (i) which is borrowed by the taxpayer with respect to the
activity of holding real property; (ii) which is borrowed by the taxpayer from a qualified
person or represents a loan from any federal, state, or local government or
instrumentality thereof, or is guaranteed by any federal, state, or local government;
(iii) for which no person is personally liable for repayment, taking into account § 1.465-
27(b)(3), (4), and (5); and (iv) which is not convertible debt.

       Section 1.465-27(b)(2)(i) provides that, for a taxpayer to be considered at risk
under § 465(b)(6), qualified nonrecourse financing must be secured only by real
property used in the activity of holding real property. For this purpose, however,
property that is incidental to the activity of holding real property will be disregarded. In
addition, for this purpose, property that is neither real property used in the activity of
holding real property nor incidental property will be disregarded if the aggregate gross
fair market value of such property is less than 10 percent of the aggregate gross fair
market value of all the property securing the financing.

       Section 1.465-27(b)(3) provides that if one or more persons are personally liable
for repayment of a portion of a financing, the portion of the financing for which no
person is personally liable may qualify as qualified nonrecourse financing.

         Section 1.465-27(b)(4) provides that for purposes of § 465(b)(6), the personal
liability of any partnership for repayment of a financing is disregarded and, provided the
requirements contained in § 1.465-27(b)(1)(i), (ii), and (iv) are satisfied, the financing
will be treated as qualified nonrecourse financing secured by real property if (i) the only
persons personally liable to repay the financing are partnerships; (ii) each partnership
with personal liability holds only property described in § 1.465-27(b)(2)(i) (applying the
POSTF-116879-15                              13

principles of § 1.465-27(b)(2)(ii) in determining the property held by each partnership);
and (iii) in exercising its remedies to collect on the financing in a default or default-like
situation, the lender may proceed only against property that is described in
§ 1.465-27(b)(2)(i) that is held by the partnership or partnerships (applying the principles
of § 1.465-27(b)(2)(ii) in determining the property held by the partnership or
partnerships).

       Generally, a limited partner, in a limited partnership organized under state law,
who guarantees partnership debt is not at risk with respect to the guaranteed debt,
because the limited partner has a right to seek reimbursement from the partnership and
the general partner for any amounts that the limited partner is called upon to pay under
the guarantee. The limited partner is “protected against loss” within the meaning of
§ 465(b)(4) unless or until the limited partner has no remaining rights against the
partnership or general partner for reimbursement of any amounts paid by the limited
partner. To the extent that a general partner does not have a right of contribution or
reimbursement under local law against any other partner for the debts of the
partnership, the general partner is at risk for such debts under § 465(b)(2). The general
partner’s right to subrogation, reimbursement, or indemnification from the partnership’s
assets (and only the partnership’s assets) does not protect the general partner against
loss within the meaning of § 465(b)(4).

        In the case of an LLC, all members have limited liability with respect to LLC debt.
In the absence of any co-guarantors or other similar arrangement, an LLC member who
guarantees LLC debt becomes personally liable for the guaranteed debt and more
closely resembles a general partner with respect to the guaranteed debt. If called upon
to pay under the guarantee, the guaranteeing member may seek recourse only against
the LLC’s assets, if any. As in the case of a general partner, a right to subrogation,
reimbursement, or indemnification from the LLC (and only the LLC) does not protect the
guaranteeing LLC member against loss within the meaning of § 465(b)(4). Therefore,
in the case of an LLC treated as a partnership or disregarded entity for federal tax
purposes, we conclude that an LLC member is at risk with respect to LLC debt
guaranteed by such member, but only to the extent that

              (1) the guaranteeing member has no right of contribution or
                  reimbursement from other guarantors,

              (2) the guaranteeing member is not otherwise protected against loss
                  within the meaning of § 465(b)(4) with respect to the guaranteed
                  amounts, and

              (3) the guarantee is bona fide and enforceable by creditors of the LLC
                  under local law.

       As a general rule, LLC members may not include liabilities of the LLC in their at-
risk amounts unless the members are personally liable for the debt as provided by
POSTF-116879-15                             14

§ 465(b)(2)(A). Further, under § 465(b)(4), taxpayers are not at risk with respect to
amounts protected against loss through nonrecourse financing. Section 465(b)(6)(A)
creates an exception to these rules when a liability meets the definition of qualified
nonrecourse financing. Under § 465(b)(6)(B)(iii), a liability is qualified nonrecourse
financing only if no person is personally liable for repayment. When a member of an
LLC treated as a partnership for federal tax purposes guarantees LLC qualified
nonrecourse financing, the member becomes personally liable for that debt because the
lender may seek to recover the amount of the debt from the personal assets of the
guarantor. Because the guarantor is personally liable for the debt, the debt is no longer
qualified nonrecourse financing as defined in § 465(b)(6)(B) and § 1.465-27(b)(1).
Further, because the creditor may proceed against the property of the LLC securing the
debt, or against any other property of the guarantor member, the debt also fails to
satisfy the requirement in § 1.465-27(b)(2)(i) that qualified nonrecourse financing must
be secured only by real property used in the activity of holding real property.

       It should be noted that this conclusion generally will not be affected by a
determination that the guarantee is a “contingent” liability within the meaning of § 1.752-
2(b)(4). Instead, the question is simply whether the guarantee is sufficient to cause the
guarantor to be considered personally liable for repayment of the debt, based on all the
facts and circumstances, within the meaning of § 465(b)(6)(B)(iii). In this case, we
believe the First Guarantee is sufficient for this purpose.

       When the debt is no longer qualified nonrecourse financing due to a guarantee of
that debt, the non-guaranteeing members of the LLC who previously included a portion
of the qualified nonrecourse financing in their amount at risk and who have not
guaranteed any portion of the debt may no longer include any amount of the debt in
determining their amount at risk. Any reduction that causes an LLC member’s at-risk
amount to fall below zero will trigger recapture of losses under § 465(e). The at-risk
amount of the LLC member that guarantees LLC debt is increased, but only to the
extent such debt was not previously taken into account by that member, the
guaranteeing member has no right of contribution or reimbursement from other
guarantors, the guaranteeing member is not otherwise protected against loss within the
meaning of § 465(b)(4) with respect to the guaranteed amounts, and the guarantee is
bona fide and enforceable by creditors of the LLC under local law.

       In this case, we conclude that, for the purposes of § 465(b)(6)(B)(iii) and § 1.465-
27(b)(1)(iii), the First Guarantee described above is sufficient to cause the guaranteeing
partner, C, to be considered personally liable for the guaranteed debt obligations of X.
Accordingly, the guaranteed debt obligations of X will no longer qualify as “Qualified
Non-Recourse Financing” within the meaning of § 465(b)(6)(B) and § 1.465-27. A and
B, as non-guaranteeing members of X, will not be considered at-risk with respect to any
such amounts as a consequence of the First Guarantee.

Guarantor’s Remedies Under Section 7.5(e) of the Operating Agreement
POSTF-116879-15                             15

       The taxpayer has presented an alternative argument that, even if the First
Guarantee is respected as a full and bona fide guarantee that will cause C to be treated
as personally liable for the guaranteed debt of X for purposes of § 1.752-2(a) and
§ 465(b)(6)(B)(iii), section 7.5(e) of X’s Operating Agreement nevertheless operates to
cause A and B to be treated as personally liable (i.e., to bear the ultimate economic risk
of loss for purposes of § 752, and to be payors of last resort in a worst case scenario for
purposes of § 465) with respect to their proportionate share of the guaranteed debt,
because A and B are obligated under that provision to reimburse C in proportionate
amounts for any payments that C makes under the guarantees. For the reasons
discussed below, we disagree with this contention.

       Section 1.752-2(b)(4) provides that a payment obligation is disregarded if, taking
into account all the facts and circumstances, the obligation is subject to contingencies
that make it unlikely that the obligations will ever be discharged. If a payment obligation
would arise at a future time after the occurrence of an event that is not determinable
with reasonable certainty, the obligation is ignored until the event occurs.

       Section 1.752-2(b)(5) provides that a partner’s or related person’s obligation to
make a payment with respect to a partnership liability is reduced to the extent that the
partner or related person is entitled to reimbursement from another partner or a person
who is a related person to a partner.

         Section 1.752-2(b)(6) provides that for purposes of determining the extent to
which a partner or related person has a payment obligation and the economic risk of
loss, it is assumed that all partners and related persons who have obligations to make
payments actually perform those obligations, irrespective of their actual net worth,
unless the facts and circumstances indicate a plan to circumvent or avoid the obligation.

       Section 1.752-2(j)(1) provides that an obligation of a partner or related person to
make a payment may be disregarded or treated as an obligation of another person for
purposes of § 1.752-2 if facts and circumstances indicate that a principal purpose of the
arrangement between the parties is to eliminate the partner’s economic risk of loss with
respect to that obligation or create the appearance of the partner or related person
bearing the economic risk of loss when, in fact, the substance of the arrangement is
otherwise. Circumstances with respect to which a payment obligation may be
disregarded include, but are not limited to, the situations described in §§ 1.752-2(j)(2)
and (j)(3).

        Section 1.752-2(j)(3) provides that an obligation of a partner to make a payment
is not recognized if the facts and circumstances evidence a plan to circumvent or avoid
the obligation.

       Section 465(b)(3)(A) provides that, except as otherwise provided in regulations,
for purposes of § 465(b)(1), amounts borrowed shall not be considered at risk with
respect to an activity if such amounts are borrowed from any person who has an
POSTF-116879-15                             16

interest in such an activity or from a related person to a person (other than the taxpayer)
having such an interest.

      Section 465(b)(4) provides that, notwithstanding any other provision of § 465, a
taxpayer shall not be considered at risk with respect to amounts protected against loss
through nonrecourse financing, guarantees, stop loss agreements, or other similar
arrangements.

       With respect to § 465, no temporary or final regulations exist that provide rules
for determining when taxpayers will be considered personally liable with respect to
partnership debt subject to guarantees, including guarantees that may contain certain
reimbursement rights. Nevertheless, the following case law provides helpful guidance in
applying § 465.

        In Pritchett v. Comm’r, 85. T.C. 581 (1985), rev’d and remanded, 827 F.2d 644
(9th Cir. 1987), the taxpayers were limited partners in an oil and gas drilling operation,
and they claimed deductions for losses in excess of their cash contributions to the
partnership. The taxpayers argued that under the partnership agreement, they were “at
risk” for partnership liabilities held by a drilling company that was responsible for
developing the oil and gas fields. Under the contract the creditor would receive a
portion of profits from the drilling operation. While general partners were the only
parties personally liable, under the partnership agreement the general partners were
given the right to call on the limited partners to make a capital contribution if the notes
issued by the partnership remained unpaid upon their maturity date. The Service
argued that the liability was contingent and that the taxpayers were only at risk once
general partners called upon them to make a contribution. The Tax Court agreed with
this analysis. Upon appeal, the Ninth Circuit held that the contractual obligations of the
limited partners under the partnership agreement made them ultimately responsible for
the debt. While the Commissioner argued that the liability was contingent simply
because the general partners could elect to not make the cash calls, the Ninth Circuit
did not agree. The Ninth Circuit determined that the cash calls were mandatory under
the partnership agreements and that “economic reality” dictated that the general
partners would make the calls.

       In Melvin v. Comm’r, 88 T.C. 63 (1987), aff’d, 894 F.2d 1072 (9th Cir. 1990), the
general partnership in which the taxpayer was a partner invested in a limited
partnership. In payment for its limited partnership interest, the general partnership paid
$35,000 cash and agreed to make additional capital contributions of $70,000. The
obligation to make the additional capital contributions was evidenced by a $70,000
recourse promissory note. The taxpayer’s share of the note was $50,000. The limited
partnership obtained a $3,500,000 recourse loan from a bank and pledged partnership
assets to the bank, including the $70,000 note along with other limited partner notes, as
security. These notes were subsequently physically transferred to the bank. The court
concluded that the taxpayer was at risk on the $3,500,000 loan to the extent of his pro
rata share thereof. In reaching it conclusion the court reasoned that “a partner will be
regarded as personally liable within the meaning of § 465(b)(2)(A) if he has the ultimate
POSTF-116879-15                              17

liability to repay the debt obligation of the partnership in the event funds from the
partnership’s assets are not available for that purpose. The relevant question is who, if
anyone, will ultimately be obligated to pay the partnership’s recourse obligations if the
partnership is unable to do so. It is not relevant that the partnership MAY be able to do
so. The scenario that controls is the worst-case scenario, not the best case.” Melvin,
88 T.C. at 75 (citations omitted).

        We believe that Pritchett and Melvin stand for the proposition that the relevant
inquiries when dealing with guarantees of partnership debt, for purposes of § 465, are
whether the guarantee causes the guaranteeing partner to become the “payor of last
resort in a worst case scenario” for the partnership debt, given the “economic realities”
of the particular situation, and whether the guarantor possesses any “mandatory” rights
to contribution, reimbursement, or subordination with respect to any other parties, as a
result or consequence of paying on the guarantee, that would cause these other parties
to be considered the “payors of last resort in a worst case scenario” with respect to that
debt.

       We do not agree with the taxpayer’s interpretation of X’s Operating Agreement.
We do not believe section 7.5(e) of the Operating Agreement imposes a mandatory
payment obligation on A and B to make additional contributions to X if C is called upon
to pay on C’s personal guarantees. Rather, section 7.5(e) permits C to call for
additional capital from A and B, but if A and/or B chooses not to contribute additional
capital, C’s remedies are limited to the remedies identified in paragraphs (i) and (ii) of
that section. As a result, we do not believe the Operating Agreement gives C the right
to bring an action against A and B to require them to contribute additional capital to X if
they choose not to. Further, because we believe C’s remedies are limited to
paragraphs (i) and (ii) of section 7.5(e) if C calls for additional capital contributions from
A and B if C is required to pay on C’s personal guarantee, we believe section 7.7 of the
Operating Agreement is not applicable. In addition, because a separate contribution
agreement was not entered into by the parties, section 7.9 is also inapplicable.
Accordingly, because neither remedy available to C under section 7.5(e) requires A or B
to make additional contributions to X if C is called upon to pay on C’s personal
guarantees, we conclude that A and B do not bear the ultimate economic risk of loss for
the guaranteed debt of X for purposes of § 752.

        Moreover, for purposes of § 465, we believe the facts of this case are
distinguishable from those in Pritchett. Since X’s Operating Agreement does not require
A and B to make additional capital contributions to X, it does not appear that “economic
reality” would dictate that X or C must require A and B to make additional contributions
to X if C is required to pay on C’s personal guarantees. Accordingly, we conclude that
A and B are not “payors of last resort in a worst case scenario,” as discussed in
Pritchett and Melvin, and A and B are not currently at risk with respect to the
guaranteed debt of X for purposes of § 465.
POSTF-116879-15                                  18

      It appears that the taxpayer interprets X’s Operating Agreement as giving C an
enforceable right to require A and B to make additional contributions to X, in addition to
the specific remedies provided in paragraphs (i) and (ii) of section 7.5(e) of the
Operating Agreement. As noted above, we do not agree with this interpretation of the
Operating Agreement. Nevertheless, even if the taxpayer’s interpretation of the
Operating Agreement is ultimately determined to be correct, we still conclude that the
taxpayer is not allocated basis under § 752 and is not at risk under § 465 with respect to
the guaranteed debt.

        We reach this conclusion because we view the requirement for A and B to make
additional capital contributions to X as a contingent liability within the meaning of
§ 1.752-2(b)(4). Because C may choose alternate remedies that would not cause A or
B to be viewed as bearing the ultimate economic risk of loss for the guaranteed debt of
X, we believe these alternate remedies are properly viewed as contingencies that make
it unlikely that any payment obligations of A or B would ever be discharged. In addition,
we believe these remedies may also be viewed as future events that cause the payment
obligations of A and B to be “not determinable with reasonable certainty” and cause the
obligations to be ignored until A and B are actually required to make payments to X, for
purposes of § 1.752-2(b)(4).3

        In addition, for purposes of § 465, even if we view C as having an enforceable
right to require A and B to make additional contributions to X in addition to the other
remedies available in section 7.5(e) of X’s Operating Agreement, we believe that the
facts of this case would continue to be distinguishable from those in Pritchett. In this
case, C has been provided with alternate remedies under section 7.5(e) of X’s
Operating Agreement if A and B choose not to make additional contributions to X under
this provision. As a result, it appears that the requirement for A and B to make
additional contributions under this provision is not a “mandatory” requirement, since C
may elect to use these alternate remedies rather than have X enforce the Operating
Agreement under the default provision of section 7.7. Therefore, it does not appear that
“economic reality” would dictate that X or C must enforce the Operating Agreement
under section 7.7 in a court proceeding against A and B in such circumstances.
Accordingly, we conclude that A and B are not “payors of last resort in a worst case
scenario”, as discussed in Pritchett and Melvin, and therefore A and B are not currently
at risk with respect to the guaranteed debt of X for purposes of § 465.

       We would further note that, to the extent that C may elect to use the remedy
described in section 7.5(e)(i) of X’s Operating Agreement, in which C may treat the

3
  We believe that one or more arguments may also be made under §1.752-2(j) in this case, depending on
further factual development.
POSTF-116879-15                             19

amount of a Guaranty Contribution that a defaulting member failed to contribute as a
loan to the defaulting member, such “loan” would appear to be subject to the related-
party rule of § 465(b)(3)(A). Under the remedy of section 7.5(e)(i), A and B would be
viewed as borrowing money from C with respect to the activity of X, at a time when C
also possesses an ownership interest in the activity. Accordingly, A and B would not be
considered at risk with respect to such amounts pursuant to § 465(b)(3)(A) under this
scenario.

       Of course, if a payment obligation does arise in the future which requires A and B
to make a payment to X, A and B would properly be viewed as making contributions to
X at that time, for purposes of §§ 722, 704(d) and 465(b)(1)(A).

        In conclusion, because A and B do not have a mandatory obligation to make
additional capital contributions to the X, regardless of which interpretation of X’s
Operating Agreement is ultimately determined to be correct, A and B do not bear the
ultimate economic risk of loss for purposes of § 752, and A and B are not the payors of
last resort in a worst case scenario for purposes of § 465.

         CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

        This writing may contain privileged information. Any unauthorized disclosure of
this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.
POSTF-116879-15                          20




     Please call (202) 317-6852 if you have any further questions.



                                              _________________________
                                              James A. Quinn
                                              Senior Counsel, Branch 3
                                              Office of Associate Chief Counsel
                                              (Passthroughs & Special Industries)