Understanding Partner Loans: Recourse Or Nonrecourse?

Whether a loan from a partner is recourse or nonrecourse has significant implications for the borrower, particularly in the event of default. Recourse debt allows the lender to seek repayment from the borrower's other assets if the loan is not repaid, whereas nonrecourse debt limits the lender's recourse to the collateral or secured property. In the context of partnerships, the nature of the loan as recourse or nonrecourse depends on various factors, including the type of partnership, the partner's level of ownership, and the applicable tax regulations. Understanding these factors is crucial for partners to assess their potential liability and manage their financial risks effectively.

Are loans from partners recourse or nonrecourse?

Loans from LLC members

When it comes to loans from LLC members, there are a few things to consider in determining whether they are recourse or nonrecourse. Firstly, it's important to understand the difference between the two types of liabilities. Recourse liabilities are those for which the lender has a right to seek repayment from the borrower in the event of default. On the other hand, nonrecourse liabilities limit the lender's remedy to the collateral or security provided for the loan, meaning they cannot pursue the borrower personally for repayment.

In the context of LLC member loans, the general rule is that if a member or related person makes a loan to an LLC, it is typically categorized as a recourse loan for basis purposes, even if it would be considered nonrecourse if the lender were unrelated to the LLC. This type of loan is called a member nonrecourse loan. The member who is the lender or affiliated with the lender bears all the economic risk of loss and is allocated 100% of the liability.

However, there are exceptions and special rules that apply in certain situations. For example, if a member's interest in the LLC's income or loss is relatively low (typically 10% or less), and the loan meets the criteria for qualified nonrecourse financing, then a de minimis rule may apply. In this case, the loan would be treated as a true nonrecourse liability, and the liability would be allocated accordingly.

Additionally, the nature of the loan (recourse or nonrecourse) can vary depending on the specific provisions and regulations being considered. For instance, a liability could be classified as recourse under one provision, such as Section 1001, but as nonrecourse under another, such as Section 752, which focuses on the rights of the lender against the partners rather than the partnership.

It's worth noting that the classification of these loans can have significant implications for tax purposes, and the specific regulations and rules may change over time. Therefore, it's always important to consult the most up-to-date legal and financial advice when dealing with loans from LLC members to ensure compliance with the relevant laws and regulations.

Qualified non-recourse financing

In the context of loans from partners, the term "recourse" refers to the legal right of a lender to seek compensation from the borrower in the event of default. If a loan is non-recourse, it means that the lender cannot seek compensation from the borrower beyond the initial collateral (usually the property purchased with the loan).

Now, qualified non-recourse financing refers to financing for which no one is personally liable for repayment. It is borrowed for use in an activity of holding real property and is loaned or guaranteed by a federal, state, or local government, or is borrowed from a "qualified person". Qualified persons include any person or entity actively and regularly engaged in the business of lending money, such as a bank or a savings and loan association.

For a taxpayer to be considered at risk under Section 465(b)(6), qualified non-recourse financing must be secured only by real property used in the activity of holding real property. This means that the taxpayer is considered at risk with respect to their share of any qualified non-recourse financing that is secured by real property used in such an activity.

In the context of partnerships, the at-risk rules apply at the individual partner level. However, not all partners are subject to these rules. Determinations concerning partnership assets, investments, transactions, and the nature of liabilities necessary to determine the amounts at risk in an activity are made at the partnership level.

Additionally, it's important to note that including "bad boy" provisions in loan agreements is a common practice to protect the lender in the commercial real estate finance industry. These provisions state that a non-recourse loan will become recourse if the borrower engages in certain acts, such as declaring bankruptcy.

Recourse liabilities

The classification of a liability as recourse or nonrecourse for purposes of Section 1001, which governs real estate transactions, differs from the classifications used for partnership purposes. For example, a mortgage may be considered "recourse" to a partnership for Section 1001 purposes if the lender can pursue the partnership for any remaining deficiency if the property value drops below the loan balance. However, this does not mean it is recourse for Section 752 purposes, which focuses on the rights of the lender against the partners rather than the partnership.

In the context of partnerships, recourse liabilities refer to situations where a partner bears the economic risk of loss and is personally liable for partnership debts. This typically applies to general partners in a general partnership. If a partner guarantees a loan or is the one who made the loan to the partnership, a nonrecourse mortgage may be treated as recourse to that particular partner.

For instance, consider a scenario where an individual, I, purchases real estate from an unrelated seller for $10,000, paying $1,000 in cash and giving a $9,000 purchase mortgage note on which they have no personal liability. The seller can only seek repayment from the property itself. At a later point, when the property is worth $15,000, I sells it to a partnership in which they are a general partner. The partnership finances the purchase with a $15,000 mortgage note, which includes the $9,000 obligation to the original seller. In this case, the liability is a recourse liability to the extent of $6,000 because I, as the creditor, bears the economic risk of loss for that amount.

Another example involves Partnership AB, which borrows $100 on a recourse basis to buy an asset for $200. In this case, any limited partners are not personally liable for the debts of the partnership unless they enter into a DRO (debt-related obligation) or personally guarantee the debt. On the other hand, general partners are personally liable for the partnership's debts. Therefore, the liability is treated as recourse to the general partner(s) who are personally responsible for the loan under state law.

Additionally, when it comes to LLCs, members are generally not liable for the debts of the partnership, and all liabilities, whether recourse or nonrecourse at the partnership level, are considered nonrecourse liabilities for Section 752 purposes. However, if a partner makes a loan to the LLC, it is typically categorized as recourse for basis purposes, and the lender member bears all economic risk associated with the loan.

Non-recourse liability

In the context of partnerships, if a partner or related person guarantees a loan that would otherwise be a non-recourse loan, it may be considered a recourse liability for that partner. This is specifically outlined in the US Law Code, which states that if a partner guarantees a loan that would be considered qualified non-recourse financing, it becomes a recourse liability for that partner.

For example, consider a partnership where one partner, let's call them Partner A, guarantees a loan for the partnership. If the partnership defaults on the loan, the lender can only seek repayment from the partnership's assets and cannot pursue Partner A's personal assets. In this case, the loan is a non-recourse liability for Partner A.

It's important to note that non-recourse loans may have stricter terms, higher interest rates, and other conditions compared to recourse loans. This is because non-recourse loans pose a higher risk for the lender, as their recovery options are limited solely to the collateral. Traditional banks often avoid making non-recourse loans due to this increased risk.

Tax avoidance

The classification of loans as either recourse or nonrecourse has important implications for tax avoidance. The Internal Revenue Code (IRC) and related regulations provide the framework for determining whether a loan is recourse or nonrecourse, with specific considerations for partnerships.

Recourse vs. Nonrecourse Loans

IRC Section 752 defines a recourse partnership loan as one in which a partner or related person bears the economic risk of liability. In contrast, a nonrecourse partnership loan is a liability where no partner or related person assumes the economic risk of loss; instead, the lender bears this risk. This distinction is crucial when determining the tax consequences for partners in the event of loan forgiveness or foreclosure on collateral property.

Partners in a partnership may attempt to utilise the insolvency exception, which allows them to exclude cancelled debt income from their tax returns if the partnership loan is recourse. This strategy, however, is not applicable for nonrecourse loans. Additionally, the classification of a loan as recourse or nonrecourse is not solely dependent on its labelling; the IRS considers the facts and circumstances surrounding the loan.

To avoid adverse tax consequences, it is essential to provide clear documentation and guarantees regarding loan repayment. In the example of a partnership taxpayer who borrowed funds to purchase collateral property, the loan documents did not specify whether the loan was recourse or nonrecourse, nor did they establish personal liability for repayment if the collateral was insufficient. To address this, individual partners provided separate, unconditional guarantees to repay the loan, demonstrating their commitment to fulfilling their financial obligations.

In the context of LLC member and member affiliate loans, several scenarios can impact the classification of debt as qualified nonrecourse financing. For instance, if a member owns 20% or more of the lender or guarantor of an LLC liability, the transaction may be scrutinised for tax avoidance intentions. If tax avoidance is deemed the primary purpose, the member will be treated as holding the lender or guarantor's position to the extent of their ownership interest.

Furthermore, direct member nonrecourse loans and nonrecourse loans from member affiliates are subject to specific timelines. Direct member nonrecourse loans incurred, assumed, or materially modified after March 1, 1984, fall under the de minimis rule, while the same rule applies to nonrecourse loans from member affiliates for debts after January 29, 1989.

Understanding the distinction between recourse and nonrecourse loans is essential for partners in a partnership to navigate their tax obligations effectively. By correctly classifying loans, partners can make informed decisions to minimise tax liabilities and avoid adverse tax consequences. Clear documentation, guarantees, and compliance with regulations are key aspects of successful tax planning in this context.

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