Contribution of debt guarantee for capital interest in LLC

Syndicated Real Estate deal. Partner A guaranteed the loan in exchange for a capital interest in the LLC. Partner A will not provide any services and did not contribute anything else to the partnership outside the guarantee.

Is the receipt of a capital interest in exchange for a loan guarantee taxable to partner A? My research suggests that the loan guarantee may qualify as intangible property and also for nonrecognition treatment. On the flip side, the guarantee may be treated as a capital continuation and Partner A would have basis.

Thoughts?

Partner A will not provide any services .... Or is the loan guarantee itself a service?

I suppose that’s the question but what’s stopping it from being considered intangible property?

I haven't found a lot either way. I'm just having difficulty thinking of a guarantee as property.

This law firm informal memo takes 21 pages to discuss guarantee fees, and the bulk of the discussion is not directly on point, but where it is, it gives reasoning and authorities both ways. THE TAX CLUB How Could This Possibly Be? We Don't ... - Dechert LLP
https://www.dechert.com/content/.../Tax ... 20Club.pdf
May 21, 2014 - The treatment of guarantee fees has a long and tortured history ... I can't provide a link but it's findable. It's a cahed PDF file.

TAM 9020002 concludes in part that

Based solely on the information submitted, it is held as follows:
(1) Section 83 of the Code does not apply to the issuance of warrants to Guarantor because the warrants were not issued "in connection with the performance of services", within the meaning of section 83(a).

Written Determination 8508003 partly concluded

Unlike bona fide interest income, the income here is not a passive return on capital; it is compensation for the act of serving as guarantor of a loan. Compensation for services rendered is not investment income within the meaning of section 163(d)(3)(B).

but its focus was whether it was investment income, not whether it was property.

An article in The Tax Lawyer, https://www.jstor.org/stable/20771688?r ... b_contents, (may have to register to read it), says at one point "The Service has ruled that for purposes of Section 482 guarantees provided by a parent corporation for loans provided to its subsidiaries should be treated as services." One or two paragraphs later: "The position that guarantees are services has been discredited by the courts for good reason."

And even if it's a service, what is its value and when is it taxed?

(removed)

Thanks Nilodop. This article from the Tax Advisor makes it seem like you can “contribute” loan guarantees as intangible property though citations seem to be lacking: https://www.thetaxadviser.com/issues/20 ... 14-im.html

Dave: great citations, thank you.

Would the situation change if an agreement was made before hand, such as structuring a letter of intent, that detailed the loan guarantee of The partner and the associated value?

I think the basis issue raised in #6 is a digression from our question of whether the guarantee itself is property for section 721 or 351 purposes.

If Partner A had received cash in exchange for the guarantee, would you treat the transaction as a sale of an asset by A? If no, should A’s receipt of a partnership interest instead change the treatment to A?

I think the basis issue raised in #6 is a digression from our question of whether the guarantee itself is property for section 721 or 351 purposes.

Since you object to my post, I've removed it.

If Partner A had received cash in exchange for the guarantee, would you treat the transaction as a sale of an asset by A?. If it's not a payment for services, then yes. But what is the nature of the asset and what is its holding period?

Since you object to my post, I've removed it.. I didn't think I was objecting; rather just saying it was a different issue than the one we are dealing with.

I just got around to reading the Centel case. https://casetext.com/case/centel-comm-c ... al-revenue. And the TA article linked in #7. And I think I can narrow the issue somewhat more specifically.

The opinion in Centel held that section 83 did not apply to the issuance of warrants to shareholders who received them

... in consideration of, or in recognition of, the increased risks assumed by Davis, Grey, and Electric under the personal guarantees, performance guarantees, and subordinations.

. The court also said

The personal guarantees, performance guarantees, and subordinations were essentially an assumption of additional financial risk on the part of Davis, Grey, and Electric in their role as shareholders or investors. We think these are shareholder/investor actions to protect their investment in Telephone and as such do not constitute the performance of services and do not arise "in connection with the performance of services" within the meaning of section 83.

And in a footnote the court added

Sec. 83 does not apply to the warrants in the present case because they were not transferred in connection with the performance of services. Here the warrants were not compensatory, but were issued in recognition of something akin to contributions to capital. Thus, neither sec. 83 nor sec. 61 applies.

For the record, I don't agree with the opinion because it does not comport with what seems to me to be the real economics of what happened in their facts. I still want to know the nature of the asset contributed. But it's some support for OP not to report the income

So, all of that, if it's the ultimate authority, leads us to conclude that the guarantee is "akin" to property, which in OP's facts would mean Partner A has no taxable income and no tax basis in his partnership interest, and the partnership has no tax basis to expense or capitalize. Which also leads us to ask Smktax's question in #9.

Then we come to the TA article, which has this section.

Contribution of Debt Guarantees
Many LLCs request that members guarantee loans or make other similar financial guarantees. Often the LLC will treat such arrangements as a full or partial capital contribution. This creates some issues of timing and valuation that should be addressed in the operating agreement or other written agreement between the LLC and the member. The LLC should also consider paying members who guarantee loans a guarantee fee.

In Seminole Thriftway, Inc., 42 Fed. Cl. 584 (1999), the court held that the deductibility of guarantor payments was generally dependent on (1) the reasonableness of the fees; (2) whether businesses of the same type and size customarily paid guarantor fees to their owners; (3) whether the owners demanded compensation for signing as guarantors; (4) the absence of equity distributions to the owners, even though the payer’s profitability permitted such distributions; and (5) the proportional relationship between the amount of the guarantor payment and the owner’s share of equity.

. That also avoids Smktax's question.

Wouldn’t the same logic apply in the case of an LLC?

No, not at all. A partner would get basis credit for allocable debt.

And even if it's a service, what is its value and when is it taxed?

I think it would come down to valuation, but the metric might be any capital that was shifted to the guaranteeing partner.

OP speaks of a capital interest, but it’s unclear if he’ll be getting a credit to his book capital account or not. If he’s not, and the paperwork says there is no shift, then a strong case can be made that it’s not a capital interest.

I didn't think I was objecting

Yes, you were. You said that it was a "digression from our question of whether the guarantee itself is property for section 721 or 351 purposes."

I have more to contribute to this discussion, but I think I'll keep my thoughts to myself since anything I would say will be objected to.

Sorry you feel that way. Do note that one of our most technically competent members has commented on your (since deleted) post.

The underlying asset is real estate. Partner A is essentially providing the balance sheet needed to obtain the loan but will have no participation outside of providing the guarantee.

I'm still not clear on how to treat this.

Assume A, B, and C form an LLC. B and C materially participate in the real estate activity and collectively hold a 25% capital interest and a 0% profits interest. A does not participate at all but guarantees the debt and A holds a 5% capital interest and a 0% profits interest.

The remaining 70% capital interest and 100% profits interest is held by a group of limited partners that invested capital to acquire the LLC's real property assets.

While A holds a 5% capital interest, his capital account is $0. A will instead be paid out on the back-end when the real estate and LLC are liquidated in several years.

Per Centel, A has contributed property, not services, in exchange for his 5% capital interest. As a result, the receipt of capital interest is not taxable to C at issuance.

Is that right?

What happens if A is allocated book capital? Would that result in tax as a "guarantee fee"?

I wanted to bump this.

I'm still not clear on how to treat this.

You need to pull and post the relevant portions of the OA, including the allocation provisions, distribution provisions and the cap table at the back, which speaks to what everyone contributed.

In isolation, if we look at what you posted, we have B and C [and let’s also say A] contributed capital, but they have a 0% profits interest. On one level, that makes very little sense. They have no upside opportunity. The only possible upside you mention relates to A, where he will be paid “on the back-end.”

What you likely have here is the following: On a value basis, capital contributions are pro-rata between the GP’s and the LP’s. “General Partners” kick-in $30k for an initial 30% interest. Investors (Limited Partners) kick-in $70k for an initial 70% interest. All the investors can lose is their capital. The GP’s, or at least Mr. A, bears the biggest risk in that he guaranteed the entire loan. I am not sure if B&C indemnified A for a portion of the loan or not.

If things are set up this way, what usually happens is that allocations and distributions go pro-rata, based on the 30/70 split. There might also be a provision that calls for a preferred return (on capital, not of capital), of X% of unreturned capital to the investor LP’s. This usually involves a special allocation of profit (or gross income) to the investor LP’s.

At some point, the idea is that the investors have had all of their invested capital returned to them. At which point, the 30/70 flips the other way. This is where A, B and C realize their upside potential. Often, the investors get their unreturned capital returned to them by way of some type of liquidity/sale event. And once their previously unreturned capital is returned, whatever cash is left gets distributed 70/30 in favor of A, B and C. Because of this flip, commonly referred to as a “promoted” interest, you have a carried interest for A, B and C.

Here are some numbers:

GP’s contribute $30k for 30%.
LP’s contribute $70k for 70%.
Pretend all $100k is spent and all capital accounts are $0.
Then we sell the project for $150k.
The first $100k of profit goes $30k to GP’s and $70k to LP’s, to get everyone back to where they started. We distribute the $100k accordingly, bringing capital accounts back down to $0k. At this point, the investors have been repaid their capital. They have no “unreturned capital” at this point. Now the flip comes into play. With respect to the remaining $50k of cash, A, B and C collectively get 70% of it. The investors get 30% of it.

There are a wide variety of lifetime scenarios that could be at play. If this is rental property, you might have cash flow, and distributions of that cash flow, over time. It might also be that if this is something like a condo complex, individual units are sold, which provide cash flow, that might get distributed. In other words, it’s possible that initial unreturned capital gets whittled down over time, such that a back-end large sale event isn’t the sole transaction that gets capital/cash back to the investors.

It’s also possible that the economic arrangement isn’t pro-rata. It really might be that GP’s put in $30k, but they only share in losses once the LP’s capital accounts are driven to zero, or to the lowest level possible. But that’s not too typical. If I’m an LP, and capital contributions were pro-rata at inception, and then we have losses, I’d want some of those losses to be borne pro-rata from the get-go and until the flip happens, assuming the flip does happen.

What I haven’t addressed is A’s guarantee situation. If A really does have a 5% capital interest, and the cap table says he contributed nothing, there might be a taxable capital shift from B and C to A (or from ALL other partners to A). But I don’t know if that’s the intent. It’s likely not the intent of the LP’s. Thus, it might just be that the cap table ascribes some value to A’s guarantee, that makes the OA cap table work. In other words, B and C put in $20k, A is deemed to contribute value of $5k and the LP’s put in $70k. I’m not sure. If that is the case, then we simply have a forward 704c contribution by A, assuming we agree not to tax it, and that there is no shift, and it will be respected as a contribution of “property.”

In a nutshell, I think there’s way more to this situation that the way you’re framing it up. See my first sentence above.

Thanks Jeff. The underlying asset is a large rental property that the GP will operate for 5-7 years.

All of that makes sense but in this case the GP did not contribute an amount equal to 30% of the total monies contributed. What do you do in that case?

What if the 70% LPs contributed $100k for their 70% stake while B and C collectively contribute $10k (closing costs) for their 25% stake in the GP and A contributes a loan guarantee for a 5% stake in the GP?

A, B, and C only have a capital interest for the time being but will receive a profits interest after the LP's have had their capital returned at some later point in time.