IRS Chief Counsel Describes
When Guarantors Are At Risk
for Tax Purposes
By Thomas R. Vance and Robert E. Dallman
Thomas R. Vance and Robert E. Dallman discuss the impact
of an important and new IRS announcement relating to the
“at-risk rules.”
©2013 T.R. Vance and R.E. Dallman
Thomas R. Vance and Robert E. Dallman are attorneys in the Milwaukee offi ce of Whyte Hirschboeck Dudek S.C.
T
he at-risk rules are an additional hurdle that certain taxpayers must overcome before deducting otherwise valid losses for tax purposes. By way of background, Congress enacted the “at-risk rules” in Code Sec. 465 to limit certain taxpayers’ losses from activities to the amount of the taxpayer’s investment in those activities.1 If theat-risk rules apply, a taxpayer may deduct a loss from an activity only to the extent to which the taxpayer is considered economically “at risk” for the activity.2
IRS Chief Counsel’s Offi ce recently advised that a member of an LLC (who guarantees the debt of the LLC) may be “at risk” with respect to the guaranteed debt at the time the guarantee is executed (as opposed to when the member makes a payment on the guar-antee).3 The Chief Counsel Advice (CCA) applies to
LLCs treated as partnerships or as disregarded entities and also provides insight on the treatment of general and limited partnerships.
The CCA resolves an issue that has arisen in many audits of LLC members; namely that two Proposed Treasury Regulations provide confl icting rules for when similar guarantees increase the amount at risk for owners of entities treated as in partnerships for tax purposes. This update addresses the signifi cance
of the CCA to LLC members and the implications it may have for owners of general partnerships, limited partnerships, and S corporations.4
Rules That Limit
the Use of Losses
Taxpayers have to consider three sets of rules in de-termining whether a loss will be allowed:
1. Basis Limitations. The owners of entities treated as partnerships for tax purposes and shareholders of an S corporation may claim losses from their entities only to the extent they have basis in their ownership interests.5
2. At-Risk Limitations. Taxpayers can claim losses only to the extent that they are at risk within the meaning of Code Sec. 465.
3. Passive Losses. Losses from passive activities are used only to the extent allowed by the Code Sec. 469 passive activity loss rules.
Each set of rules must be applied in the order listed above.6 For example, if a partner in a partnership has a
loss that exceeds the partner’s basis in her partnership interest, that loss is disallowed regardless of whether the partner has a suffi cient amount at risk to justify the loss. If the partner has suffi cient basis, she must also have suffi cient economic risk for purposes of Code Sec. 465 or the loss will be suspended. Once the loss is supported by suffi cient basis and amount ment in those axpayer m o the ex econom ay ded ent to ally “ e uc wh t r t a lo ch k” oss he or Taxp te 1 ayer ning Basis
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on l s T th il id ss he ow ree sets of be allow ers of e rules d: ities t n de ea at- ru l risk ’ con 2 paye ti er is vity es nv ty ns nv ppl om xp xp he he t-r paye taxp taxp isk r m an paye ers’ paye paye rule n ac er is losse er’s i er s i s ap ctivit con on der de fice r guar ecen ante tly a es that risk, it is then analyzed under the passive activity rules of Code Sec. 469.7
As a practical matter, taxpayers encounter the limitations imposed by basis and passive losses more often than the at-risk rules. This may be because a taxpayer’s amount at risk in an entity is often the same as or close to her amount of basis in that entity. However, certain debts (which increase basis) do not always increase the amount at risk, and these rules remain a trap for those who are caught unaware.8
Taxpayers Subject
to the At-Risk Rules
The at-risk rules only apply to certain taxpayers. These are individuals and any C corporation for which (at any time during the last half of the year) 50 percent of the value of its outstanding stock is owned by fi ve or fewer individuals.9
While the at-risk rules do not apply to general part-nerships, limited partpart-nerships, LLCs or S corporations as entities, they do apply to the owners of those enti-ties. The owners must have suffi cient amounts at risk in their entities to deduct any losses fl owing from them.
Activities Subject to
the At-Risk Rules
The at-risk rules apply to any activity engaged in as a trade or business or for the production of income, including the activity of holding real property.10
There are exceptions from this broad rule for certain equipment leasing engaged in by closely held corpo-rations and active businesses carried on by qualifi ed C corporations.11
Generally, each activity engaged in by a taxpayer is treated as a separate activity for purposes of the at-risk rules. While some activities may be grouped together, losses generated by one activity or group may not be deducted against income generated by a different activity or group.12
Amounts Considered At Risk
A taxpayer’s amount at risk includes cash contribu-tions and certain amounts borrowed with respect to the activity.13 The amount at risk in any activity is alsoincreased by the net income from that activity and decreased by any loss allowed under Code Sec. 465.14
Debts of the entity increase a taxpayer’s amount at risk only if (1) the taxpayer is personally liable for
repayment or has pledged property (other than prop-erty used in the activity) as security for the borrowed amounts, and (2) the taxpayer is not protected against loss by nonrecourse fi nancing, guarantees, stop loss agreements or other similar arrangements.15
Certain debt satisfi es the two-prong test and increases an owner’s amount at risk. An owner may borrow money directly and contribute it to an entity, and that contribution will increase the amount at risk in the entity.16 A similar increase in the amount at risk may
be achieved if an owner lends money to an entity.17
However, such structures may not be desirable because the owner would be primarily liable for the debt.
As discussed in the CCA, for other borrowed amounts, the fi rst prong (i.e., personally liable stan-dard) is generally determined by analyzing whether the taxpayer is ultimately liable for repayment as the “payor of last resort.”18 For the second prong (i.e., the
protected against loss standard), three circuit courts (Second, Eighth and Eleventh) consider whether (based on the “economic realities” as of the end of the tax year) the taxpayer is protected from loss by any ar-rangement. The Sixth Circuit applies the same “payor of last resort” analysis as is used for the fi rst prong.
The CCA addressed a taxpayer within the jurisdic-tion of the Seventh Circuit (taxpayers in Wisconsin, Indiana and Illinois), which has not ruled on the proper test for the second prong. However, Chief Counsel expressed the belief that the Seventh Circuit would view the “economic realities” standard with more approval and applied it to the facts at issue.
Confl ict in Proposed
Regulations
Though seemingly mentioned as an aside, the CCA resolves what has been a major concern for taxpay-ers. The Proposed Regulations provide confl icting instructions for how to treat the guarantee of partner-ship debt by a partner for purposes of Code Sec. 465. The resolution of the confl ict by the CCA is important to the many entities treated as partnerships for tax purposes, including general partnerships, limited partnerships and LLCs.
There are two relevant Regulations—both issued in 1979 and both still proposed.19 The fi rst is
Pro-posed Reg. §1.465-6(d), which states that:
If a taxpayer guarantees repayment of an amount borrowed by another person (primary obligor) for use in an activity, the guarantee shall not increase
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the taxpayer’s amount at risk. If the taxpayer re-pays to the creditor the amount borrowed by the primary obligor, the taxpayer’s amount at risk shall be increased at such time as the taxpayer has no remaining legal rights against the primary obligor. Under this Proposed Regulation, taxpayers are not considered at risk based on the mere execution of a guarantee of a second taxpayer’s debt. The guaran-tor’s amount at risk only increases upon payment of the guarantee.
The second relevant Regulation is Proposed Reg. §1.465-24(a)(2)(i), which states that:
[w]hen a partnership incurs a liability in the con-duct of an activity and under state law members of the partnership may be held personally liable for repayment of the liability, each partner’s amount at risk is increased to the extent the partner is not protected against loss.
This Proposed Regu-lation would increase a partner’s amount at risk upon execution of a personal guarantee of partnership debt to the extent the guarantor is not protected against loss. It does not require (as a pre-requisite to increasing the
amount at risk) that the guarantor actually pay any amount on the guarantee or satisfy all its legal rights against the primary borrower.
It is very common for owners of entities (which are treated as partnerships for tax purposes) to provide guarantees of their partnerships’ debt. The inconsis-tent treatment of such guarantees by the Proposed Regulations has made it diffi cult for many taxpayers to determine the proper tax treatment and is often a source of consternation if the treatment is audited.
The CCA is one step forward in providing taxpay-ers (and IRS Agents, etc.) with clarity on this issue. However, (as discussed below) it is unclear to what extent IRS personnel will heed the advice.
The CCA
Facts
The CCA addressed the question of whether a tax-payer’s amount at risk increased when the taxpayer
(“T”) guaranteed the debt of an LLC (“S”) that was wholly owned by an LLC (“P”) that was, in turn, wholly owned by T. Initially, T, P and two brother/ sister S corporations (also wholly owned by T) were co-guarantors. Then, the debt was modifi ed so that T became a co-borrower with S, but under state law, T was only an “accommodation party.”20 So, S
remained primarily liable for the debt and had no right to contributions from T.
Two-Prong Test for Debt
As discussed above and noted in the CCA, the debt of an entity generally only increases its owners’ amount at risk in the entity if (1) the owner is per-sonally liable for repayment, and (2) the owner is not protected against loss. To satisfy the fi rst prong, T had to be the payor of last resort in the worst-case scenario. After the debt was modifi ed, T met that prong because, in the worst-case scenario, the promissory note would be payable in full and the lender would be unable collect from the primary borrower, S. The lender would then seek payment in full from T, as co-bor-rower, before looking to other guarantors.
To satisfy the second prong, the economic realities at the end of the year would have to indicate that T was not protected from loss. The CCA held that the indem-nifi cation of T by S (as principal borrower) did not protect T from loss because under the worst case scenario S is assumed unable and unwilling to pay. After the debt was modifi ed, T (as co-borrower) was at risk for full payment.
Comparison to General Partners
The CCA reasoned that an LLC member who guar-antees the debt of the LLC is placed in a similar economic position as a general partner with respect to the guaranteed debt. A general partner is at risk for the full amount of claims against the partnership unless the general partner has a right to contribution or reimbursement against any other partner. A general partner’s amount at risk is therefore increased for any debt of the partnership.
A member of an LLC (who guarantees a debt of the LLC) is (in the worst-case scenario) directly liable for that debt and cannot seek reimbursement from the
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e th in alities at year w cate th the e uld h T w nd o v s erso t gu d onal hi incr i uisit t te to t at r eb ant e ( re ant nst oe qu ar xte xte pro tner ent t ent t tecte es no uisit rship he g he g ed a ot req te to p de guara guara again quire incr as a asinsi or s wer. atisfy all iother LLC members (unless they are also guaran-tors). The Chief Counsel determined that it would be “incongruent” for an LLC member in a similar economic position as a general partner to have a different amount at risk.
Even Disregarded Entities May Limit
the Amount at Risk
While indemnification by the primary borrower, S, did not limit T’s amount at risk, indemnification by any other party could have. The CCA explained that even entities disregarded as separate from T (i.e., P and the two S corporations) could provide protec-tion from loss within the meaning of Code Sec. 465(b)(4). Accordingly, whether a guarantor (like T before the debt was modified) is protected from loss by a disregarded entity will depend on an analysis of the “economic realities” as of the end of the year.
Limiting the Application of
Proposed Reg. §1.465-6(d)
The CCA acknowledges that its conclusion might appear to confl ict with Proposed Reg. §1.465-6(d) (1979). However, the CCA advised that the applica-tion of that Proposed Regulaapplica-tion should be limited to general partnerships and limited partnerships because those were the entities primarily in existence at the time the regulation was promulgated.
In so doing, the CCA reaffi rmed that a limited partner of a limited partnership does not increase her amount at risk by guaranteeing the debts of the partnership. A limited partner would still have recourse to the general partner for reimbursement so the limited partner would be protected from loss. This was true when the regula-tions were proposed and is still true today.
However, the CCA is also clear that since an LLC does not have a general partner to which a guaran-tor could look for reimbursement, the Proposed Regulation does not apply to that kind of owner-ship. As discussed below, the teaching of the CCA is helpful to taxpayers evaluating their amounts at risk in many entities.
Allocating At-Risk Amounts
Using Guarantees in an LLC
To illustrate how the reasoning in the CCA could apply to an LLC, assume the following:An LLC has executed a promissory note in favor of a bank with the face amount of the note
be-ing $1 million. The LLC has fi ve members, and each owns 20 percent of the outstanding member interests of the LLC.
At the request of the bank, each member execut-ed a joint and several personal guarantee in an amount equal to the then-outstanding principal balance of the note.
In the fi rst year, there were no principal payments on the debt by the LLC; in the second year, there were $100,000 of principal payments by the LLC on the note.
The at-risk amount for each guarantor at the end of the fi rst year and at the end of the second year is $200,000 and $180,000, respectfully.
No member is at risk for 100 percent of the out-standing principal balance, because (pursuant to the terms of the joint and several guarantee) each member is indemnified by the other members to the extent of the other members’ ownership in-terests. In other words, each member is protected from loss on the 80 percent of the debt for which the member could seek reimbursement from the other members. Conversely, there is no limit to the risk on the 20 percent of the debt for which the member cannot seek reimbursement from other members.
Allocating At-Risk Amounts
Using Guarantees in
General Partnerships
The CCA provides some insight into the effect of debt held by a general partnership on its partners. Recall that the two-prong test for debt to increase the amount at risk would require the partner to (1) be personally liable for repayment, and (2) not be protected from loss. As discussed in the CCA, general partners are directly liable for all the debts of the entity such that those debts could increase the partners’ amount at risk. However, the amount at risk for any single partner is limited by the right that partner has to seek reimbursement from the other partners.
The Tax Court has agreed that bona fi de guarantee agreements can allocate specifi c at-risk amounts to specifi c partners.21 In Abramson, each partner
guaranteed a particular amount of debt and the guarantee provided that neither the partnership nor any other partner would pay that amount. The guarantee was also clear that the liable partner s primarily in s promulga affi rmed th oes not ed. at a lim rease p nc e er a pa mou ner nt
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The CCA suggests an alternative arrangement that would permit a specifi c partner to assume the amount at risk for a particular debt while the entity remains the primary borrower. The CCA determined that, when T became a co-borrower accommoda-tion party with S, T became the payor of last resort (i.e., ahead of the other guarantors). Since T was only an accommodation party, S remained primar-ily liable for the debt.
While this structure effectively placed T ahead of other guarantors, more may be required to effec-tively place one general partner ahead of another. In an LLC, the members would not be personally liable for unpaid LLC debt, and the LLC members (who did not guarantee the debt) would not indem-nify the guarantor-member. However, in a general partnership, if the partnership defaults, the general partners are all still liable for the partnership’s debt, and each general partner may seek reimbursement from the others.
Since co-borrowers are usually jointly and sever-ally liable, a lender may demand payment from either. Where a general partner is a co-borrower with the partnership and the partnership defaults, the lender may pursue payment from either the partner or the partnership. If the lender pursues the partnership, the other general partners may have to make payments on the debt. Under general part-nership law, they would only be entitled to seek reimbursement from the co-borrower to the extent of her interest in the partnership. The co-borrower is thus protected from loss.
In addition, the co-borrower would have a right to indemnifi cation from the other general partners for any payments she makes as a co-borrower. Again, this limits the co-borrower’s potential loss and her amount at risk.
To effectively allocate an amount at risk to a general partner, the agreements between the parties should protect the other general partners from liability (to the lender and the co-borrower). If properly structured, such agreements should create the necessary “eco-nomic realities” so that the co-borrower is effectively allocated the amount at risk.
Allocating At-Risk Amounts
Using Guarantees in
Limited Partnerships
In a limited partnership, there is at least one gen-eral partner and at least one limited partner. At-risk amounts for partnership debt would be allocated among general partners in a manner similar to the partners in a general partnership. If there is only one general partner, that partner is the only one personally liable for partnership debts and would be the only partner allocated at-risk amounts from partnership debt, absent other economic realities (e.g., a limited partner that is also a co-borrower).
The CCA specifi cally notes that the mere guar-antee of partnership debt by a limited partner will not alter that partner’s amount at risk because the limited partner’s loss is limited by the right to seek reimbursement from a general partner. Still, it may be possible (as discussed above) to shift some amount of risk from the general partner(s) to that limited partner while leaving the partnership as the primary borrower. In other words, if the agreements create the right “economic realities,” the limited partner may be allocated the amount at risk by becoming a co-borrower.
Allocating At-Risk Amounts
Using Guarantees in
S Corporations
The CCA did not address the implications of guar-antees of corporate debt by shareholders of an S corporation. Conceptually, the shareholders of an S corporation face the same economic risk of loss as members of an LLC. The shareholders, like members of an LLC, are generally shielded from the entity’s li-abilities and there is no general partner from whom to seek reimbursement. It should follow that the effect of guarantees and related agreements should be the same for S corporation shareholders as it would be for members of an LLC. As noted in the CCA, taxpayers with congruent economic risk should receive congru-ent treatmcongru-ent under the at-risk rules.
Unfortunately for S corporation shareholders, the Proposed Regulations for the atrisk rules specifi -cally allocate the at-risk amount from S corporation debt in the same manner as the debt is allocated for purposes of basis.22 The only loans that provide
an S corporation shareholder with basis are loans are usually j may deman al partner d the p d pay is a co nersh an me -b p d s nt fr rr efau om wer ts
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specifi city of the rules for allocation of S corporation debt, the principals of the CCA may not apply to these entities despite any “incongruent” results.
Even if guarantee of debt could increase a share-holder’s amount at risk, it is likely of little use to the shareholder. Recall that a taxpayer must have suffi cient basis in her stock (or loans to the corporation) to take a loss before considering whether there is a suffi cient amount at risk to take the loss. Courts have long held that guarantees of corporate debt do not increase the shareholder’s basis in the S corporation.24 In fact, the
Tax Court has held that where a taxpayer-shareholder is a co-borrower (effectively an accommodation party) with the S corporation, the S corporation did not owe a debt to the taxpayer-shareholder and the shareholder, therefore, was not entitled to any basis from the loan.25
Thus, it may not matter if the amount at risk supports a loss since it is likely already suspended for lack of basis.
At-Risk Recapture
The concept of “recapture” is usually associated with depreciation recapture (which is triggered by property being sold in a taxable transaction).
However, at-risk recapture presents another poten-tial trap for taxpayers.
Losses cannot by themselves reduce the at-risk amount below zero because losses in excess of the amount at risk are suspended.26 However,
distribu-tions and reducdistribu-tions in entity debt could reduce a taxpayer’s amount at risk below zero.
If a taxpayer’s amount at risk falls below zero, the negative at-risk amount must be included in income for the year.27 Such amount is then treated as a loss
suspended under the at-risk rules and carried forward until it can be recognized.28 Essentially, a taxpayer is
re-quired to recapture deductions previously taken when the amount at risk no longer supports those deductions.
Conclusion
The IRS announcement is important even though the at-risk rules are often eclipsed by basis limitations and the passive activity rules. The CCA brings needed clarity to the treatment of guarantees of LLC debt by members. Unfortunately, it does not directly address guarantees by partners of general partnerships or limited partnerships although as discussed above, it provides some guidance for these entities.
E
NDNOTES 1 See S. REP. NO. 938, 94th Cong., 2d Sess. 47(1976).
2 Code Sec. 465(a)(1).
3 CCA 201308028 (Nov. 14, 2012). 4 This will not address: (1) whether an
obliga-tion to make a capital contribuobliga-tion to the company (as opposed to a direct obligation to the creditor) increases that taxpayer’s at-risk amount based on Proposed Reg. §1.465-22(a), Cf. J.E. Pritchett, 85 TC 580, Dec. 42,449 (1985), with J.E. Pritchett, CA-9, 87-2 USTC ¶9517, 827 F2d 644, 647 and Hubert Enterprises, Inc., 95 TCM 1194, Dec. 57,351(M), TC Memo. 2008-46, on
remand from, CA-6, 2007-1 USTC ¶50,494, 230 FedAppx 526, aff’g in part, vac’g in part,
and rem’g in part, 125 TC 72, Dec. 56,145
(2005); (2) whether the creditor has an inter-est in the activity other than as a creditor, e.g.,
Pritchett, id., 827 F2d, at 647; or (3) whether
the fact that the obligation may not become due for many years in the future suggests that it should not increase the amount at risk
M.W. Melvin, 88 TC 63, 73–74, Dec. 43,632
(1987); Pritchett, id., 827 F2d, at 647.
5 Code Secs. 704(d) and 1366(d). 6 Reg. §1.469-2T(d)(6).
7 A loss disallowed by the at-risk rules is
ignored for purposes of the passive activity
loss rules and is carried forward until it is allowable under Code Sec. 465 in a later year. Then, it is subject to the passive activity loss rules of Code Sec. 469 in the later year based the facts as they were in the year the loss was generated. Reg. §1.469-2T(d)(1), (8).
8 For example, nonrecourse debt may increase
basis, but it does not increase the amount at risk (except in the circumstances specifi ed in Code Sec. 465(b)(2)(B) and in the case of qualifi ed nonrecourse fi nancing in Code Sec. 465(b)(6)). Also, basis may arise from debt owed to persons with an interest in the activ-ity (and related persons), but such debts may not increase the at-risk amount. Most relevant to this discussion, a debt that increases basis does not increase the at-risk amount to the extent the borrower is protected from loss within the meaning of Code Sec. 465(b)(4).
9 Code Secs. 465(a)(1) and 542(a). Stock
own-ership is determined under the constructive stock ownership rules of Code Sec. 544, as modifi ed by Code Sec. 465(a)(3).
10 Code Sec. 465(c)(3). 11 Code Sec. 465(c)(4) & (7).
12 See Code Sec. 465(d). An analysis of the
rules for the identifi cation and grouping of activities provided in Code Sec. 465(c)(2) & (3) is beyond the scope of this article.
13 Code Sec. 465(b)(1). 14 Proposed Reg. §1.465-22(c).
15 Code Sec. 465(b)(2) & (4). Certain
quali-fi ed nonrecourse quali-fi nancing is treated as an amount at risk. Generally, qualifi ed nonre-course fi nancing is borrowed with respect to the activity of holding real property from a qualifi ed lender. See Code Sec. 465(b)(6).
16 The amount at risk does not increase if the
lender has an interest in the activity other than as a creditor. See Code Sec. 465(b)(3); Proposed Reg. §1.465-8.
17 Proposed Reg. §1.465-10. The Proposed
Regulations would allocate partnership or S corporation debt under the at-risk rules in the same manner as it is allocated to provide basis in those entities.
18 Initially, courts were not uniform in this regard.
cf. Pritchett, supra note 4, 827 F2d 644, with, Pritchett, supra note 4, 85 TC 580 (1985).
19 It is noted that Proposed Regulations have
“no force or effect” (unlike Temporary or Final Regulations). F.B. Offerman, 55 TCM 955, 964, Dec. 44,809(M), TC Memo. 1988-236.
20 In the context of debt, an “accommodation
party” executes a note without receiving a direct benefi t from the agreement. The ac-commodation party is gratuitously lending its good name to the co-borrower to induce
ng., 2d Sess. 47 2). all yea los ru wa . T rule s a ble un n, of C der Cod s subject ode Sec Sec. o t 46 465 in assive n the la is ter ty ar C P C fi ed R po e Sec. nonrec 22 ) .465 g. 65(b)(2) & se fi nanc c). ). Certa is trea n q d addre s will not a 8 94 1). No 8, 94 Co CC S See (19 S R ee S. R 976). ode Se CA 20 N EP. NO ec. 46 13080 938 O. 938 65(a)(1 028 (N v. 14 ) 1 oblig ta osed ation ye Reg
the lender to lend the money. The lender may enforce agreement against the accom-modation party, but the co-borrower does not have a right to contribution.
21 See E.D. Abramson , 86 TC 360, Dec. 42,919
(1986) (court reviewed).
22 Proposed Reg. §1.465-10(c).
23 Code Sec. 1366(d); T. Gleason, 92 TCM 250,
Dec. 56,616(M), TC Memo. 2006-191.
24 See, e.g., E.T. Sleiman, Jr., CA-11, 99-2 USTC
¶50,828, 187 F3d 1352, aff’g, 74 TCM 1270, Dec. 52,372(M), TC Memo. 1997-530; D. Leavitt Est., CA-4, 89-1 USTC ¶9332,
875 F2d 420, aff’g, 90 TC 206, Dec. 44,557 (1988); but cf. E.M. Selfe, CA-11, 86-1 USTC
¶9115, 778 F2d 769 (cited in Sleiman at
1359 for an “unusual sets of facts” showing that the true borrower was the shareholder).
25 In R.J. Reser, 70 TCM 1472, Dec. 51,032(M),
TC Memo. 1995-572, aff’d on this point, CA-5, 97-1 USTC ¶50,416, 112 F3d 1258, 1264. 26 Code Sec. 465(a)(1).
27 Code Sec. 465(e); Proposed Reg. §1.465-3(c). 28 Code Sec. 465(e)(1)(B).
