The at-risk rules are an additional hurdle that

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1 IRS Chief Counsel Describes When Guarantors Are At Risk for Tax Purposes By Thomas R. Vance and Robert E. Dallman September 2013 Thomas R. Vance and Robert E. Dallman discuss the impact of an important and new IRS announcement relating to the at-risk rules. The 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 the at-risk rules apply, a taxpayer may deduct a loss from an activity ty only to the extent ent to which the taxpayer is considered economically at trisk for the activity. 2 IRS Chief Counsel s Office fice recently advised that a member of an LLC (who guarantees antees 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 guarantee). 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 conflicting 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 significance Thomas R. Vance and Robert E. Dallman are attorneys in the Milwaukee office of Whyte Hirschboeck Dudek S.C. 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 ayer have to consider three sets of rules in determining whether a loss will be allowed: 1. Basis Limitations. itation 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 At-Risk Limitations. Taxpayers can claim losses only to the extent that they are at risk within the meaning of Code Sec 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 sufficient amount at risk to justify the loss. If the partner has sufficient basis, she must also have sufficient economic risk for purposes of Code Sec. 465 or the loss will be suspended. Once the loss is supported by sufficient basis and amount TAXES THE TAX MAGAZINE 2013 T.R. Vance and R.E. Dallman 31

2 When Guarantors Are at Risk for Tax Purposes at risk, it is then analyzed under the passive activity rules of Code Sec 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 five or fewer individuals. 9 While the at-risk rules do not apply to general partnerships, limited partnerships, LLCs or S corporations as entities, they do apply to the owners of those entities. The owners must have sufficient amounts at risk in their entities to deduct any losses flowing from them. Activities ies Subject to the At-Risk Rules The at-risk rules apply to any activity ity engaged ed in as a trade or business s or for the production of income, including activity of holding property. 10 ng the fhold real perty There are exceptions from this broad rule for certain equipment leasing engaged ed in by closely held corporations and active businesses ses carried on by qualified 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 contributions and certain amounts borrowed with respect to the activity. 13 The amount at risk in any activity is also increased by the net income from that activity and decreased by any loss allowed under Code Sec Debts of the entity increase a taxpayer s amount at risk only if (1) the taxpayer is personally liable for 32 repayment or has pledged property (other than property used in the activity) as security for the borrowed amounts, and (2) the taxpayer is not protected against loss by nonrecourse financing, guarantees, stop loss agreements or other similar arrangements. 15 Certain debt satisfies 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 first prong (i.e., personally liable standard) 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 arrangement. The Sixth Circuit applies the same payor of last resort analysis as is used for the first prong. The CCA addressed a taxpayer within the jurisdiction 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 esse the belief that the Seventh Circuit would view the economic om realities standard with more approval al and applied it to the facts satis issue. Conflict in Proposed Regulations Though seemingly mentioned as an aside, the CCA resolves what has been a major concern for taxpayers. The Proposed Regulations provide conflicting instructions for how to treat the guarantee of partnership debt by a partner for purposes of Code Sec The resolution of the conflict 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 first is Proposed Reg (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

3 September 2013 the taxpayer s amount at risk. If the taxpayer repays 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 guarantor s amount at risk only increases upon payment of the guarantee. The second relevant Regulation is Proposed Reg (a)(2)(i), which states that: [w]hen a partnership incurs a liability in the conduct 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 Regulation would increase a partner s amount at risk upon execution of a personal guarantee of partnership rship debt to the extent ent the guarantor ant is not protected ed against loss. It does not require e (as a prerequisite to increasing the tatri or s 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 inconsistent treatment of such guarantees by the Proposed Regulations has made it difficult 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 taxpayers (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 taxpayer s amount at risk increased when the taxpayer The IRS announcement is important even though the atrisk rules are often eclipsed by basis limitations and the passive activity rules. ( 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 modified 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 personally liable for repayment, and (2) the owner is not protected against loss. To satisfy the first prong, T had to be the payor of last resort in the worstcase scenario. After the debt was modified, 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-borrower, before looking to other guarantors. To satisfy the second prong, the economic realities at the end of the year would have to indicate that Tw was not protected from loss. The CCA held that the indemnification 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 modified, T (as co-borrower) was at risk for full payment. Comparison to General Partners The CCA reasoned that an LLC member who guarantees 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 TAXES THE TAX MAGAZINE 33

4 When Guarantors Are at Risk for Tax Purposes other LLC members (unless they are also guarantors). 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 protection 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 (d) The CCA acknowledges that its conclusion might appear to conflict with Proposed Reg (d) (1979). However, the CCA advised that the application of that Proposed Regulation should be limited to general eral partnerships and limited partnerships p because those were the entities primarily in existence at the time the regulation was promulgated. In so doing, the CCA reaffirmed that a limited partner of a limited ited partnership rsh does not increase her amount at risk by yguaranteeing the debts of the partnership. A limited partner would still have recourse to the general partner for reimbursement so the limited ited partner would be protected from loss. This was true when the regulations 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 guarantor could look for reimbursement, the Proposed Regulation does not apply to that kind of ownership. 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 34 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 being $1 million. The LLC has five members, and each owns 20 percent of the outstanding member interests of the LLC. At the request of the bank, each member executed a joint and several personal guarantee in an amount equal to the then-outstanding principal balance of the note. In the first 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 first 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 outstanding 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 interests. 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 an 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 fide guarantee agreements can allocate specific at-risk amounts to specific 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

5 September 2013 had no right to seek reimbursement from the other partners. In light of this case and the CCA, such an arrangement should satisfy both prongs of the test to support the amount and allocation of risk. However, Abramson contemplates a situation where the partner is primarily liable on the debt, which may not be desirable for that partner. The CCA suggests an alternative arrangement that would permit a specific 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 accommodation 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 primarily liable for the debt. While this structure effectively placed T ahead of other guarantors, more may be required to effectively 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 indemnify 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 row are usually jointly and sever- ally liable, a lender may demand d payment from either. Where a general partner is a co-borrower with hthe epa partnership and the partnership pdefaults, the lender may pursue payment from either the partner or the partnership. p. If the lender pursues the partnership, the other general partners may have to make payments on the debt. Under general partnership 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 indemnification 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 economic 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 general 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 specifically notes that the mere guarantee 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 loc At-Risk Amounts Using Guarantees in S Corporationsoratioon The CCA did not address the implications of guarantees 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 liabilities 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 congruent treatment under the at-risk rules. Unfortunately for S corporation shareholders, the Proposed Regulations for the at-risk rules specifically 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 TAXES THE TAX MAGAZINE 35

6 When Guarantors Are at Risk for Tax Purposes from the shareholder to the corporation. 23 Given the specificity 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 shareholder s amount at risk, it is likely of little use to the shareholder. Recall that a taxpayer must have sufficient basis in her stock (or loans to the corporation) to take a loss before considering whether there is a sufficient 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 potential 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, distributions and reductions 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 required 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. 1 See SR S. REP. NO. 938, th Cong., 2d Sess. 47 (1976). 2 Code Sec. 465(a)(1). 3 CCA CA (Nov. 14, 2012). 2). 4 This will not address: (1) whether an obligation to make a capital contribution to the company (as opposed to a direct obligation to the creditor) increases that taxpayer s at-risk amount based on Proposed osed Reg (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 , on remand from, CA-6, 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 interest 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 Code Secs. 704(d) and 1366(d). 6 Reg T(d)(6). 7 A loss disallowed by the at-risk rules is ignored for purposes of the passive activity ENDNOTES 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 ty loss rules of Code Sec. 469 in the later year based the facts as they were in the year the loss was generated. Reg T(d)(1), (8). 8 For example, nonrecourse debt may increase basis, but it does not increase the amount at risk (except in the circumstances specified in Code Sec. 465(b)(2)(B) and in the case of qualified nonrecourse financing in Code Sec. 465(b)(6)). Also, basis may arise from debt owed to persons with an interest in the activity (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 ownership is determined under the constructive stock ownership rules of Code Sec. 544, as modified 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 identification 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 (c). 15 Code Sec. 465(b)(2) & (4). Certain quali- fied nonrecourse financing is treated as an amount at risk. Generally, qualified nonrecourse financing is borrowed with respect to the activity of holding real property from a qualified 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 Proposed Reg 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 In the context of debt, an accommodation party executes a note without receiving a direct benefit from the agreement. The accommodation party is gratuitously lending its good name to the co-borrower to induce 36

7 September 2013 the lender to lend the money. The lender may enforce agreement against the accommodation 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 (c). 23 Code Sec. 1366(d); T. Gleason, 92 TCM 250, Dec. 56,616(M), TC Memo 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 ; 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 , aff d on this point, CA- 5, 97-1 USTC 50,416, 112 F3d 1258, Code Sec. 465(a)(1). 27 Code Sec. 465(e); Proposed Reg (c). 28 Code Sec. 465(e)(1)(B). This article is reprinted with the publisher s permission from the TAXES THE TAX MAGAZINE, a month ly journal published by CCH, a part of Wolters Kluwer. Copying or dis tri bu tion without the pub lish er s per mis sion is prohibited. To subscribe to the TAXES THE TAX MAGAZINE or other CCH Journals please call or visit CCHGroup.com. All views expressed in the articles and col umns are those of the author and not necessarily those of CCH. TAXES THE TAX MAGAZINE 37