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Interpretation of At-Risk Rules on LLC Debt Guarantees Could Mean Recapture Income for Some LLC Members. (Parker Tax Publishing April 24, 2014)

The at-risk rules under Code Sec. 465 are important in determining the tax effect of numerous transactions because they limit a taxpayer's loss from most activities to the amount at risk in the activity. In 1977 and 1979, the IRS issued a slew of proposed regulations under the at-risk rules, which are still in proposed form today. In 1985, 1998, and 2004, the IRS issued a limited number of final at-risk rules. Thus, most of the regulations that guide taxpayers on the consequences of the at-risk rules were issued more than 30 years ago. None of the at-risk rules address the effect of the rules on limited liability companies (LLCs) or their members.

Under the proposed regulations, a partner is not considered at risk for the guarantee of a partnership debt until the partner repays the debt and has no rights of reimbursement from anyone else. However, there is an exception to this rule. A partner's at-risk amount for an activity is increased by the partner's share of any qualified nonrecourse financing that is secured by real property used in the activity. A partner determines its share of qualified nonrecourse financing on the basis of that partner's share of partnership liabilities incurred in connection with such financing.

Earlier this month, the Office of Chief Counsel surprised practitioners by concluding that an LLC member is considered at risk with respect to LLC debts guaranteed by the member regardless of whether the member waives any right to reimbursement or indemnification from the LLC. The ruling in AM 2014-003 directly contradicts the proposed regulations. The Chief Counsel's Office also concluded that when an LLC member guarantees qualified nonrecourse financing of an LLC, the amount of the guaranteed debt no longer meets the definition of "qualified nonrecourse financing," and the amount of the guaranteed debt will no longer be includible in the at-risk amount of the other non-guarantor members of the LLC.

Practice Tip: While this is good news for the LLC member guaranteeing the debt, it can be detrimental to the other LLC members. Where the debt is no longer includible in the at-risk amount of the non-guarantor LLC members, at-risk recapture income could be triggered, thus leaving a substantial and unexpected tax liability.

At-Risk Rules Relating to Debt Guarantees

Generally, under Code Sec. 465(b)(1) and (2), a taxpayer is at-risk for amounts contributed to an activity and amounts borrowed for use in the activity, to the extent the taxpayer is personally liable for repayment of the debt or has pledged certain property as security for the debt. However, under Code Sec. 465(b)(4), a taxpayer is not considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or other similar arrangements.

Under Prop. Reg. Sec. 1.465-6(b), a partner is not at risk with respect to any partnership liability to the extent the partner would be entitled to contributions from other partners if the partner were called upon to pay the partnership's creditor, because to that extent, the partner is protected against loss.

Generally, a limited partner in a limited partnership organized under state law, who guarantees partnership debt is not at risk with respect to the guaranteed debt because the limited partner has a right to seek reimbursement from the partnership and the general partner for any amounts that the limited partner is called upon to pay under the guarantee. Thus, the limited partner is protected against loss within the meaning of Code Sec. 465(b)(4) unless and until the limited partner has no remaining rights against the partnership or general partner for reimbursement of any amounts paid by the limited partner.

Under Prop. Reg. Sec. 1.465-6(d), a taxpayer who guarantees repayment of an amount borrowed by another person (i.e., the primary obligor) for use in an activity, is not at risk with respect to the amount guaranteed. If the taxpayer repays to the creditor the amount borrowed by the primary obligor, the taxpayer's amount at risk is increased at such time as the taxpayer has no remaining legal rights against the primary obligor.

As previously noted, there are special rules for qualified nonrecourse financing. Under Code Sec. 465(b)(6), in the case of an activity of holding real property, a taxpayer's amount at risk includes the taxpayer's share of any qualified nonrecourse financing that is secured by real property used in that activity. Qualified nonrecourse financing is defined as any financing (1) that is borrowed by the taxpayer with respect to the activity of holding real property, (2) that is borrowed by the taxpayer from a qualified person or represents a loan from any federal, state, or local government or instrumentality thereof, or is guaranteed by any federal, state, or local government, (3) except to the extent provided in regulations, with respect to which no person is personally liable for repayment, and (4) that is not convertible debt. In the case of a partnership, a partner is required to determine its share of partnership qualified nonrecourse financing on the basis of that partner's share of partnership liabilities incurred in connection with such financing.

If at the close of any tax year a taxpayer's amount at risk in an activity is less than zero, Code Sec. 465(e) requires the taxpayer to include the amount of the excess in gross income. The amount required to be included in gross income, however, is limited to losses allowed in previous years that have not already been recaptured. The recaptured amount is treated as a deduction attributable to the activity in the following tax year.

LLC Member Guarantees of LLC Debt

In AM 2014-003, the Chief Counsel's Office noted that, unlike a partnership where a limited partner has a right to seek reimbursement from the partnership and the general partner when called upon to pay under a guarantee, an LLC member who guarantees LLC debt becomes personally liable for the guaranteed debt and is in a position akin to a general partner in a partnership who has no right of reimbursement. If called upon to pay under the guarantee, the guaranteeing LLC member may seek recourse only against the LLC's assets, if any. As in the case of a general partner, a right to subrogation, reimbursement, or indemnification from the LLC (and only the LLC) does not protect the guaranteeing LLC member against loss within the meaning of Code Sec. 465(b)(4).

Therefore, the Chief Counsel's Office concluded that, in the case of an LLC treated as a partnership or a disregarded entity for federal tax purposes, an LLC member is at risk with respect to LLC debt guaranteed by such member without regard to whether the LLC member waives any right to subrogation, reimbursement, or indemnification against the LLC, but only to the extent: (1) the guaranteeing member has no right of contribution or reimbursement from persons other than the LLC, (2) the guaranteeing member is not otherwise protected against loss within the meaning of Code Sec. 465(b)(4) with respect to the guaranteed amounts, and (3) the guarantee is bona fide and enforceable by creditors of the LLC under local law.

LLC Member Guarantees of LLC Qualified Nonrecourse Financing

With respect to LLC member guarantees of LLC qualified nonrecourse financing, the Chief Counsel's Office concluded that, because the guarantor is personally liable for that debt, the debt is no longer qualified nonrecourse financing. Further, because the creditor may proceed against the property of the LLC securing the debt, or against any other property of the guarantor member, that debt also fails to satisfy the requirement that qualified nonrecourse financing must be secured only by real property used in the activity of holding real property.

Because the debt is no longer qualified nonrecourse financing, the Chief Counsel's Office stated, the nonguaranteeing members of the LLC who previously included that portion of the qualified nonrecourse financing in their amount at risk and who have not guaranteed any portion of that debt can no longer include that amount of the debt in determining their amount at risk. Any reduction that causes an LLC member's at-risk amount to fall below zero will trigger recapture of losses under Code Sec. 465(e). The at-risk amount of the LLC member that guarantees LLC debt is increased, but only to the extent (1) such debt was not previously taken into account by that member, (2) the guaranteeing member has no right of contribution or reimbursement from persons other than the LLC, (3) the guaranteeing member is not otherwise protected against loss with respect to the guaranteed amounts, and (4) the guarantee is bona fide and enforceable by creditors of the LLC under local law. (Staff Editor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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