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Personal Liability under the “At Risk” Rules under IRC § 465

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.”[1] For purposes of the at risk rules, a loss is defined as the excess of allowable deductions (before application of IRC § 465) allocable to an activity to which the at-risk rules apply over the income received or accrued by the taxpayer during the taxable year from that activity.[2] 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.[3]

Congressional Rationale

Congress enacted the at-risk rules in order to limit a taxpayer’s ability to use devices such as nonrecourse financing to generate tax losses in excess of the taxpayer’s economic risk. Although the main intended goal of IRC § 465 was to curb the abusive use of tax shelters caused by nonrecourse financing,[4] application of the at-risk rules is not limited to tax shelter activity.[5]

Amount at Risk

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.[6] 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.[7]

A taxpayer will not be considered “at risk” with respect to any amount that is protected against loss (more on this below).[8] 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.[9]  Generally, each activity engaged in by a taxpayer is treated as a separate activity for purposes of the at-risk rules. Losses generated by one activity may not be deducted against income generated by a separate activity. There are, however, circumstances under which a taxpayer is allowed to aggregate activities for purposes of applying the at-risk rules.

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. In Brand v. Commissioner, the Tax Court has held merely executing a guarantee was insufficient to establish personal liability for purposes of IRC § 465(b)(2)(A),[10] as (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).[11]

Not all guarantees, however, are created equal.

For example, in the case of Abramson v. Commissioner,[12] 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 did 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).[13]

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.[14] 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.[15] 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).[16] 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.[17]

A Closer Look at Brand and Melvin

Brand involved guarantees by limited partners for amounts in excess of their initial capital contributions.[18] The Tax Court observed in Brand 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.[19] Although the limited partners in Brand personally guaranteed the debts of the partnership, under the partnership agreement, they had the right to seek reimbursement from the general partner. As such, the Tax Court determined that it was the general partner who was “ultimately” on the hook for repayment.[20]  Therefore, the limited partners risk was (as their name suggests) limited, and they were consequently not “at risk.”

Similarly, in Melvin,[21] 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).[22]

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.[23] 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).[24]

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).[25]


Footnotes:

[1] IRC § 465(a)(1); Bordelon v. Commissioner, T.C. Memo. 2020-26; IRC § 465(a), (c)(3)(A).

[2] IRC § 465(d).

[3] IRC § 465(a)(2).

[4] See S. Rep. No. 938, 94th Cong., 2d Sess. 47 (1976). See also Pritchett v. Commissioner, 827 F.2d 644 (9th Cir. 1987), rev’g and rem’g 85 T.C. 580 (1985).

[5] See, e.g., Peters v. Commissioner, 77 T.C. 1158 (1981).

[6] IRC § 465(b)(1).

[7] IRC § 465(b)(2).

[8] IRC § 465(b)(4).

[9] IRC § 465(e).

[10] See Brand v. Commissioner, 81 T.C. 821, 828 (1983).

[11] Id.

[12] 86 T.C. 360, 376 (1986)

[13] C.f. 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).

[14] See Melvin v. Commissioner, 88 T.C. 63, 75 (1987), aff’d, 894 F.2d 1072 (9th Cir. 1990).

[15] Id.

[16] See Melvin, 88 T.C. at 75 (applying IRC § 465(b)(4)); Brand, 81 T.C. at 828 (applying IRC § 465(b)(2)(A)).

[17] Id.

[18] Id. at 823-825.

[19] 81 T.C. at 828 (citing IRC § 465(b)(2)(A)).

[20] Id. at 828.

[21] 88 T.C. at 71.

[22] Id.

[23] T.C. Memo. 2020-26 at *22.

[24] Id.

[25] Id. at *22-*23; see also 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.

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