Volume 23 Issue 3 -- May/June 2011
It is quite common for LLC members
to guarantee loans advanced to their LLC. While a member’s guaranty
usually means that the amount of the guaranteed debt is included in the
member’s basis in his or her LLC membership interest, does that mean
that the member can take loss deductions against that debt? Many tax
professionals may be surprised to learn that the answer is usually “No.”
While the same issues arise in
traditional partnerships, because of the popularity of LLCs and the
fact that they differ in certain significant ways from traditional
partnerships, we will focus our attention on LLCs that are taxed as
partnerships.
Suppose that Abe, Beth, and Corey
form an LLC called Risky Ventures (“RV”). Each member puts in $10,000
in cash. RV obtains a $100,000 loan from a bank for working capital
which only Beth personally guarantees. In the first year, RV has a net
loss of $45,000, which is allocated equally among the members. What
portion of this loss is deductible?
Under the partnership tax basis
rules, Beth’s guaranty of the loan allows her to include the entire
amount of the loan in her basis, whereas the other members may not
include any portion of it in their basis computations.
Hence, Abe and Corey’s basis is $10,000 each, meaning that
they can each deduct only $10,000 of loss.
Because the $100,000 of debt is
included in Beth’s basis, her basis in her membership interest is
$110,000. Can she deduct all of her $15,000 share of the loss?
The answer depends upon the
at-risk rules. The at-risk rules are the second of three deduction
hurdles that an LLC member must surmount in order to deduct losses. The
first, which we already mentioned, is the basis limitation. The third,
which we will ignore in this newsletter, is the passive loss rule.
The at-risk rules limit the amount
of any deduction by an LLC member to the “amount at risk.” While one
might think that because the guaranteed loan is included in Beth’s
basis under the partnership basis rules, she must also be considered at
risk for that amount, but that is often not the case. The Proposed
Regulations under IRC § 465 say
If a taxpayer guarantees repayment
of an amount borrowed by another person (primary obligor) for use in an
activity, the guarantee shall not increase 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.
The reason for this result is that under the
law of most states, as between the
guarantor and the primary debtor, the guarantor is considered only
secondarily liable for the debt. If the guarantor has to pay when the
primary debtor defaults, by law in most states a guarantor usually has
a right to recover from the primary debtor any amounts that the
guarantor pays.
For example, if RV defaults and
Beth has to pay off the $100,000 loan, she has a right to recover
$100,000 from the LLC itself. This right to recover from the LLC,
unless contractually modified or eliminated, prevents the guarantor
from being considered “at risk” for the amount of the debt. In reality,
this right to recover from the LLC often has questionable value, but
that is another issue, perhaps, for another newsletter.
Such questions often arise in
conjunction with an LLC’s
K-1s, which show a member’s share of LLC debt as “recourse” or
“nonrecourse.” We are ignoring the somewhat specialized concept of
“qualified nonrecourse indebtedness.” If a debt is listed as “recourse”
on a member’s K-1, does that mean the member is at-risk for that
amount?
Under the laws in most states, a
loan made to an LLC is generally “nonrecourse” as to the members,
unless the member has guaranteed it. A member may include guaranteed
debt in the member’s basis in her LLC interest, but that does not mean
that the member is at risk for that amount.
Unfortunately, the IRS fails to make clear precisely which
concept of
“recourse” applies for purposes of the K-1.
Probably,
the IRS intended “recourse” on the
K-1 to cover only those debts that are included in the member’s
basis. As a result, a liability that is marked “recourse”
on a member’s K-1 need not be an amount at risk.
For example, RV issues a K-1 to
Beth that shows she has a $100,000 share of a “recourse” liability, but as we have
seen Beth is not “at risk” for the guaranteed debt. As a result, a debt
may be listed as “recourse” but an LLC member cannot tell whether she
is at risk for that amount merely by looking at her K-1.
If you have further questions about this subject, please contact the Tax & Business Professionals.
[In 2013,
in internal guidance, the IRS appeared to softened its position on
this issue in situations where there is a sole guarantor who is not
otherwise protected against loss.]
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
Return to Newsletter List
Return to Content Index
Home Page