This article is written to explain the two terms and where recourse is most commonly found in business. As an owner or manager of a small business operation, you need to understand the two terms and the variables involved in their respective use. In addition, there are other tools the small business owner can use to avoid or eliminate recourse when borrowing money. Finally, I’ll touch base on the tax meanings and how the Internal Revenue Service interprets these types of loans.
Recourse and Nonrecourse
The term ‘Recourse’ means to have the right to seek damages for failure to perform. In the financial arena, it is a guarantee from a party to pay on a loan if in the regular course of activity the preferred party fails to the pay the debt. This significantly reduces the risk to the lender as there is more than one party to make the loan payments and pay back the principle. This term is most often used in the business world. In the personal area of loans (home mortgages, auto and recreational equipment loans) the ‘Personal Guarantee’ is used to seek recourse for failure to pay the loan.
In effect, a guarantee is a personal level financial term and recourse is a business level term. This doesn’t mean the guarantee isn’t used at the business level; actually it is often used as a tertiary level of performance. Here the lender gets the business to sign on the loan, uses the collateral as a secondary form of repayment and then the owner(s) sign a personal guarantee in case of default.
‘Nonrecourse’ is a term meaning to rely on the collateral as the only backup source of repayment for a debt. Very few institutions offer these types of loans. However, they do exist and the most common form is in larger commercial developments and multi-family housing. In this area of business, the lender uses other tools to ensure repayment or protect the loan. An example of a tool is the lender requiring greater initial investment into the project by the borrower. Other tools include annual audits, requiring replacement reserves (money set aside in a trust account to repair the property or make note payments for a period of time in case of default) and controlling distributions/payments to the investors until the loam value is a certain percentage of the asset’s fair market value.
Common Forms of Recourse Loans
In almost all cases related to recourse loans there is a third party that has something to gain by having the loan made. In the construction industry, the ultimate buyer gains by having the contractor get a loan to build the project. Here, the buyer is the recourse on that construction loan. This is actually normal in construction. In addition, in really large project construction, the project is exclusive to the particular buyer and therefore, the lender will want some form of assurance of complying with the contract to ultimately buy the project. Examples of this include construction of fishing vessels, marine equipment, cranes, communication towers; commercial construction (shopping centers, office complexes, high-rise buildings) and customized manufacturing equipment.
As this relates to the economic world of small business, it happens more frequently than what small business owners realize. The following are several examples of how recourse is used in the small business realm:
- In the RV industry, the dealer is concerned about making the sale. The unit resides on the lot and is financed by a floor plan. In effect the lender is using the RV as the sole backup of payment. The initial sale is the primary source of the loan payment. In a typical sale, the unit is finance by a new lender and the floor plan lender is paid his amount related to that unit. The dealership is interested in getting the customer financed to complete the sale. Many lenders provide the conditions to the dealer for what they will allow as loans (the conditions of the customer to include their credit score, sources of earnings, personal financial status etc.). Sometimes lenders provide three different types or levels of loans to the dealer. The top notch loan is for the best customer and the lender offers no requirement for recourse back to the dealer. The secondary levels have higher rates for the customer but still no recourse back to the dealer. The third level loans have a higher interest rate but the lender only requires a certain minimum interest rate and the difference between what the lender requires and what the customer pays is called the spread. Most often it is less than 1% interest rate difference. The dealership earns this spread as the payments are made by the customer. So each month, a little portion of the customer’s payment is deposited into a special trust account owned by the dealership but controlled by the lender. If there are no problems with the customer making their payments, upon full repayment of the loan, the dealership receives the money in the special account. If the customer fails to make the payment, the dealership will lose the cash built up in the account and upon completing the repossession process, any unpaid balance is paid by the dealership.
In this example, the third party is the dealership. They brought a customer to the lender and of course desire the lender to fund the purchase. Without the loan, the dealership has no sale and of course no profit to show for its activity. So it is in the best interest of the dealer to accept recourse. In many of these types of deals, the dealership is OK with the recourse because if the unit is repossessed, the unit comes back to their lot as additional inventory. So in some cases, it isn’t a total loss. Often the profit made on the deal is so much more than the cost associated with paying off the balance in a repossessed unit.
- Technology is one industry that has changed dramatically in the last twenty years. The problem with this industry is that the value of the purchased equipment decreases very quickly because newer technology is developed quickly and nobody is interested in the old technology within a couple of years. Often, technology changes around 100% in less than 18 months. In effect, it is almost totally new in one and half years. But to purchase a lot of equipment for an office, the buyer needs the loan to be financed over an extended period of time like 36 months. For the lender, the equipment has little value as the secondary form of payment as collateral for a loan. So these financing institutions require recourse on the loan from the businesses’ owners. If the owners are other businesses, then using recourse is appropriate. However, if the owners are individuals, then the financing institutions can use personal guarantees as a substitute for recourse. Essentially the personal guarantee acts as the form of recourse.
- In farming, many farmers use the co-opt form of operations to reduce costs. They basically share the large pieces of equipment used on farms. The Co-Opt purchases a large piece of equipment such as a combine and the Co-Opt allocates the loan payments to the members. The lender often requires the individual farms as members to sign for recourse for their respective percentage of the Co-Opt. Many of these farms are incorporated so the corporation signs the recourse document. Sometimes the lender even requires personal guarantees from the ranking members.
Did you find the underlying thread that binds them? A third party is the signer of the recourse document and also benefits from the loan. The benefit includes making a sale, getting financing on risky collateral, or reducing the costs of operations. These are just some of the economic reasons to use recourse in debt.
How to Eliminate Recourse Debt
To eliminate recourse to you as an owner, remember the reason why the lender needs the recourse. The lender is uncomfortable with the asset as collateral in case of default. In effect, they know the collateral has a high volatility in value upon repossession. Therefore, they seek recourse in case the asset’s value is less than the balance of the unpaid loan. The problem with all this is that most likely the loan was made by your business. They are concerned that your business will default and the collateral will have inadequate value to pay off the balance of the loan. So they seek recourse by you (Personal Guarantee) as an individual or the owner of another business entity to make good on the loan.
So the key is the volatility of value in the underlying asset. To eliminate recourse, you need the risk associated with the asset to be low or nonexistent. There are several tools available to reduce the issue of volatility in value:
- Make a higher down payment on the asset during purchase. In effect you reduce the volatility by assuming more of the upfront risk associated with the market changes. Instead of paying 20% down, pay 50%. I realize that this may be burdensome on the cash position of the company, but you will need to exchange one existing benefit to gain a different benefit.
- Shorten the term of the loan. This reduces risk to the lender significantly. Instead of 36 months on a note, shorten this to 24 months and the lender will have greater comfort in getting paid back sooner.
- Provide other collateral as security for the loan. Provide collateral that has little volatility such as vehicles or real estate. Additional collateral reduces risk to the lender.
- Probably the best tool is to have a great business operation. Years of positive information provides the greatest comfort to a lender. The better your business performance and financial information, the less likely lenders will require recourse when lending money.
Recourse Debt as Defined by the Internal Revenue Service
This term is interpreted differently by the IRS than by the banking industry. You wouldn’t think so, but the IRS is not concerned with collateral value, they are mostly concerned with the risk aspect of the loan. The secret is the effect to the taxpayer at the end of the day. If the taxpayer is assuming the risk of the investment, then the IRS is willing to allow the losses from that investment to be used as a deduction on the taxpayer’s Form 1040. This is where the ‘At – Risk’ rules of investments come into play. If the taxpayer is willing to assume the risk for default on the loan, then they are entitled to the tax savings associated with the risk. To the IRS this is no different than having paid in the actual cash associated with the investment. In effect the taxpayer is liable anyway, so any losses associated with the asset can be deducted from the tax return and a cash benefit in the form of reduced taxation is gained.
If the debt is nonrecourse, then the taxpayer hasn’t assumed any risk and therefore is limited in losses to the amount invested associated with that asset in case of default.
For partnership types of operations (traditional partnerships and the newer limited liability companies filing Form 1065) Section 752 of the Code governs the at risk rules related to recourse loans. If the partner has to make good on the loan or contribute capital to the partnership to cover the outstanding portion of the loan, then this value is considered at risk and therefore losses associated with this risk are deductible on the taxpayer’s return.
For further help and understanding you should read Publication 925 related to the Passive Activity At-Risk Rules.
Several times in the history of the tax code, Congress has actually allowed a taxpayer to take their respective share of the ‘Non-Recourse’ debt as a deduction. Think about this for a minute, the taxpayer can take a deduction for more than what he invests in the business. So if a business has investors contribute $500,000 and then takes out a loan for $1,500,000 then the aggregated investment is $2,000,000. Congress has allowed the investors to take their respective share of the $1,500,000 loan and their own share of contributed capital as a deduction related to the investment for tax purposes. If I were reading this for the first time, I would ask: ‘What idiot thought of this?’
Remember the tax code actually has two goals. One, raise revenues to fund the operations of the government, and two, entice the taxpayer to make social changes by providing tax incentives to achieve these social changes. The best example of a social change occurred in the late 70’s when Congress was intent on getting the people of the country to reduce energy consumption. Congress provided tax incentives to get society to reduce their respective energy consumption in the household. Remember getting a write-off to install insulation? Other examples include allowing mortgage interest as a deduction via itemized deductions and so on. Mortgage interest deductions spurred Americans to own homes thus creating jobs in the residential construction industry.
Well, as this relates to nonrecourse debt, Congress wanted more multi-family housing (apartment complexes) in the United States back in the late 60’s. By allowing an investor to take his initial investment and the nonrecourse debt share related to that real estate investment, Congress was successful. Actually over 5,000 complexes were constructed back in the 70’s and 80’s to affect social change. The lenders were mostly government institutions such as the Farmer’s Home Administration or HUD. So the code allowed the investor to take those losses associated with the deprecation on the real estate tied to the non-recourse debt purchased portion as a deduction on their tax return. Many investors were allowed to have a negative basis in the investment thus saving significant tax dollars on their personal side.
In general, the IRS doesn’t allow nonrecourse financing of asset purchases as a deductible loss in case of a loss. Only those losses associated with recourse debt are allowed on the taxpayer’s return. There are lots of restrictions and rules but in general, this is the guiding concept used in the Code.
Summary – Recourse and Nonrecourse Loans
It is essential for the business owner to understand the difference between recourse and nonrecourse loans. It is better to have a nonrecourse loan as the lender cannot seek you out at the personal level to ensure payment of the debt. However, this is a risk issue and the question at the end of the day is ‘Who assumes the ultimate risk of nonpayment on the loan?’ I provided several examples of how nonrecourse debt is used in business and how it even benefits the signer of the recourse document. There are slight advantages related to the Internal Revenue Code related to having assumed the recourse position in debt. In the long run, it is generally better to not have recourse in your portfolio of business operations. To truly prevent or eliminate this, you need to have a great operation that generates a lot of cash. Good business is the best way to reduce risk to all parties. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.