On February 20, 2020, the Tax Court issued a Memorandum Opinion in the case of Bordelon v. Commissioner (T.C. Memo. 2020-26). The issues presented in Bordelon v. Commissioner were (1) whether the petitioner-husband’s personal guarantee of a loan established sufficient amounts “at risk” under IRC § 465 to permit deduction of a loss related to a wholly-owned LLC in 2008; and (2) whether petitioner-husband’s personal guarantee of a second loan increased his basis in a second wholly owned LLC under IRC § 704(d), thereby establishing sufficient “at risk” amounts under IRC § 465 to entitle him to deduct in 2011 his share of suspended losses from 2008.
Between a Rock and a Hard Place in Bordelon v. Commissioner
Rock Bordelon was in the healthcare business. His name wasn’t Peter, and he did not simply go by “Rock.” No, dear reader, the name his momma gave him was Rock. It’s likely that he had siblings, perhaps River and Tree, but sadly the Tax Court is silent on his kith and kin.
Rock wholly owned a hospital management company AHM, a C corporation in 2008 and 2009 and an S corporation in 2010 and 2011, all four years being in issue in the petitioners’ consolidated cases. Rock also wholly owned Many LLC, which, in and of itself is a stupid name, but even stupider when the Tax Court explains that Many is not a number, but a town in the bayou. Many LLC and AHM purchased the Many Hospital in 2008 for $9.9m, funded by a USDA loan, which Rock personally guaranteed.
Rock also owned a 90.2% interest in Kilgore LLC, which owned and operated a hospital in Kilgore, Texas, with the other 9.8% interests being owned by a third-party individual and LLC. Kilgore took out a $550,000 loan, for which Rock executed a promissory note, secured by collateral including Rock’s home. Rock also personally guaranteed the Kilgore loan. Both guarantees provided that the lenders could proceed against Rock (as if one could proceed against Rock) without proceeding against any other obligor. With a hint of whimsy, Judge Gustafson observes that Rock’s “liability under the guarantees was unlimited, and his obligations continuing.”
Rock reported the income and expenses of Many LLC on his Schedule C, claiming a $1.6m loss in 2008, a $176,000 loss in 2009, a $191,000 profit in 2010, and a profit of $1.9m in 2011. Kilgore LLC reported its income and expenses on a Form 1065 (U.S. Return of Partnership Income). Rock reported a loss of $2.7m in 2008 on Schedule E (Supplemental Income and Loss) of which $2.2m related to Kilgore LLC. In 2009, he reported $14,000 in income, and zero income or loss in 2010 and 2011.
The IRS examined Rock’s returns (the visual of this is just fantastic), determined a deficiency in 2008, 2009, 2010, and 2011, and timely mailed a statutory notice of deficiency (SNOD) to the petitioners. In particular, the SNOD for 2008 disallowed almost $1m of Rock’s $1.6m loss related to Many LLC on the grounds that he had not demonstrated that he was “at risk” to the extent of the reported loss.
The IRS also disallowed the deductions claimed for the Schedule E losses related to Kilgore LLC for 2008 on the grounds that Mr. Bordelon did not have a sufficient adjusted basis in that entity to claim the deductions. Rock cried foul. He and his faithful bride, Mrs. Rock, timely filed petitions with the Tax Court seeking redetermination of the deficiencies.
Section 465 Principles – The “At Risk” Rules
For certain taxpayers (including individuals and certain closely held corporations), who are engaged in certain activities (including each activity engaged in by the taxpayer in carrying on a trade or business or for the production of income), IRC § 465 generally limits loss deductions to the amount for which the taxpayer is considered “at risk”. IRC § 465(a), (c)(3)(A). If losses are disallowed under IRC § 465, then the losses are suspended and carried forward to the first succeeding taxable year (subject to the same “at risk” limitations) or to each year thereafter until the losses can be deducted. IRC § 465(a)(2).
A taxpayer’s amount “at risk” for an activity generally includes both the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and any amounts borrowed with respect to such activity. IRC § 465(b)(1). Amounts borrowed are considered to be “at risk” only to the extent that the taxpayer is either personally liable for the repayment of such amounts, or has pledged property (other than property used in the activity) as security for the borrowed amount, and then only up to the fair market value of the taxpayer’s interest in the pledged property. IRC § 465(b)(2).
A taxpayer will not be considered “at risk” with respect to any amount that is protected against loss (more on this below). IRC § 465(b)(4). The “at risk” rules provide that amounts that a taxpayer previously deducted as losses are recaptured as income in subsequent years, if and when the amounts are no longer “at risk,” which is to say, when the amount at risk falls below zero. IRC § 465(e).
Personal Liability for “At Risk” Rules
IRC § 465 does not address if a taxpayer-guarantor is considered “personally liable” for the amounts the taxpayer borrowed and guaranteed, but other cases have determined that IRC § 465 does consider some guarantees to result in personal liability.
Historically, the Tax Court has held merely executing a guarantee is insufficient to establish personal liability for purposes of IRC § 465(b)(2)(A). See Brand v. Commissioner, 81 T.C. 821, 828 (1983). This is because with most guarantees, the guarantor-taxpayer can seek reimbursement from the primary obligor of the debt. If the guarantor-taxpayer can seek reimbursement, this does not fit within Congress’ intent with respect to the personal liability provisions of IRC § 465(b)(2)(A). See Brand, 81 T.C. at 828.
As the Tax Court observes with regard to Rock’s guarantees, not all guarantees are created equal. For example, in the case of Abramson v. Commissioner, 86 T.C. 360, 376 (1986), the Tax Court held that if a guarantor is directly liable on a debt (meaning that there is no primary obligor with recourse liability for the debt from whom the guarantor-taxpayer can seek reimbursement), then the guarantor-taxpayer would not have any “meaningful right to reimbursement” and would, therefore, be ultimately and solely liable for the debt. This type of guarantee can be easily distinguished from the guarantee in Brand and would, therefore, qualify as “personal liability” pursuant to IRC § 465(b)(2)(A). Compare Brand, 81 T.C. at 828 with Abramson, 86 T.C. at 376; see also Thornock v. Commissioner, 94 T.C. 439, 452-453 (1990).
Bright Line Rule for Personal Liability Pursuant to IRC § 465(b)(2)(A)
A guarantor’s personal liability for purposes of the “at risk” rules of IRC § 465(b)(2)(A) depends on whether or not the guarantor has the “ultimate liability” for the debt. See Melvin v. Commissioner, 88 T.C. 63, 75 (1987), aff’d, 894 F.2d 1072 (9th Cir. 1990). To answer that question, the Tax Court considers the “worst-case scenario” and then identifies the “obligor of last resort” based on the substance rather than the form of the transaction. Id. The Tax Court asks, in essence, if there are no funds to repay the debt and all of the assets of the activity or business are worthless, who would the creditor look to for repayment? In the case at hand, they would look no further than Rock.
Right to Reimbursement – Protection Against Loss for “At Risk” Rules
Similar to the question of “ultimate liability” under a guarantee, for purposes of IRC § 465(b)(4), a taxpayer will not be considered “at risk” as to any amounts that are protected against loss (whether through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements). As with the determination of “ultimate” personal liability under IRC § 465(b)(4), under IRC § 465(b)(2)(A) the IRS looks to whether the guarantor-taxpayer has a right to reimbursement from any other source (usually a primary obligor). See Melvin v. Commissioner, 88 T.C. 63 (applying IRC § 465(b)(4)); Brand, 81 T.C. at 828 (applying IRC § 465(b)(2)(A)). If the guarantor-taxpayer has a right to reimbursement, he will not be “ultimately liable” for such protected amounts and will, therefore, not be considered “at risk” as to the reimbursable liability.
A Closer Look at Brand and Melvin
In Brand, 81 T.C. at 828, the Tax Court stated that if a guarantor is entitled to reimbursement as to a debt, Congress did not intend to provide the guarantor-taxpayer with the benefits of the “at risk” rules, because the guarantor-taxpayer will not be “personally” or “ultimately” liable for the repayment of such debt. Id. (citing IRC § 465(b)(2)(A)).
Brand involved guarantees by limited partners for amounts in excess of their initial capital contributions. Id. at 823-825. The limited partners personally guaranteed the debts of the partnership, but, under the partnership agreement, the limited partners had the right to seek reimbursement from the general partner. As such, the Tax Court determined that because the limited partners (the guarantors) had the right to reimbursement to any amounts paid toward the debt in excess of their respective initial capital contributions, it was the general partner who was “ultimately” on the hook for repayment. Therefore, the limited partners risk was, you guessed it, limited, and the limited partners were consequently not “at risk.” Id. at 828.
Similarly, in Melvin, 88 T.C. at 71, the Tax Court observed that a taxpayer’s obligation to repay a debt is only a “secondary liability” when the taxpayer-debtor has a right of reimbursement against the primary obligor. In such case, the taxpayer-debtor will not be treated as “at risk” as to the repayment obligation under the terms of IRC § 465(b)(4).
Right to Reimbursement must be “Certain” and “Meaningful”
In both Brand and Melvin, the taxpayer’s right to reimbursement kyboshed the argument that the taxpayer was “at risk” with regard to its repayment obligation. The Tax Court in Bordelon observed, however, that the right of reimbursement must be “certain” and “meaningful” in order to violate the “personal liability” component of the “at risk” rules.
To that end, when a guarantor’s right to reimbursement lies against a primary obligor that has limited liability, such as a corporation or an LLC, and there is no “definite or fixed” or “certain and meaningful” recourse obligation for the underlying debt, then the right to reimbursement is less meaningful and thus there may indeed be risk that rises to the level of IRC § 465(b)(2)(A).
Bright Line Rule
When evaluating a guarantor’s loss protections (including reimbursements from primary obligors), the Tax Court will look at the facts and circumstances of each loan and repayment arrangement to determine (a) whether there is a right to reimbursement held by the guarantor against a “primary obligor,” and (2) whether the substance of the right is definite, fixed, certain, and meaningful. In other words, the Tax Court will consider the “realistic possibility” that, in the event that the bottom drops out on the loan and repayment is required, it is the guarantor who would ultimately be liable for repayment, and, therefore, subject to “economic loss” thereby satisfying the “at risk” provisions of IRC § 465(b)(2)(A). See Levien v. Commissioner, 103 T.C. 120, 126 (1994), aff’d without published opinion, 77 F.3d. 497 (11th Cir. 1996); Miller v. Commissioner, T.C. Memo. 2006-125.
What is lost in the shuffle of the discussion of the “at risk” rules of IRC § 465 is a far more fundamental question that underpins the very jurisprudence of the Tax Court. Although this case ultimately hinged on whether Rock-qua-guarantor was “personally liable” (as the term is used in this context), Judge Gustafson dodged a real bullet here.
The “ultimate liability” theory makes absolute practical sense and appears to fall well within the lines of original Congressional intent. However, one question remains for another day: what would Judge Gustafson have done if IRS Counsel had moved to dismiss the consolidated petitions on the grounds that paper covers Rock? The day the Tax Court decides that issue will be a halcyon day indeed.Add to favorites