LLCs and the sec. 465 at-risk rules with DROs.

Does a limited liability company (LLC) operating agreement, with a deficit restoration obligation (DRO) enforceable under state law, increase members' amounts considered at-risk? Under Sec. 465, a taxpayer's deductible loss is generally limited to the amount at-risk; for any given activity, this includes cash contributions, adjusted basis of property contributed to the activity and amounts borrowed as to it. Under Sec. 465, the taxpayer includes the amounts borrowed in determining at-risk basis to the extent he or she is personally liable for repayment or has pledged assets not used in the activity as security for them.

For example, an LLC secured a bank debt; the security agreement provided that in addition to specific equipment, general intangibles and funds arising out of the LLC's activities or related to it are collateral. For purposes of the loan agreement, the LLC operating agreement would contain a DRO enforceable under state law. As a result, creditors could force a member to repay the debt from individual assets, through a garnishment proceeding.

Field Service Advice (FSA) 1999-993 involved an analogous situation. It concluded:

[i]n the case of a limited partner, the litmus
test for inclusion of debt in their amount at
risk is the extent to which the limited partner
bears ultimate personal liability for amounts
borrowed by the partnership ... [citing Callahan,
98 TC 276 (1992)]. In Pritchett ... 85
T.C. 581 (1985), rev'd and remanded 827
E2d 644 (9th Cir. 1987), a limited partnership
executed a recourse note in connection
with a turnkey drilling arrangement. Only
the general partners were personally liable
under the note. However, the limited partnership
agreement provided that in the event
the note was not paid in full at maturity, the
limited partners would be personally obligated,
if called upon by the general partners, to
make additional capital contributions to the
partnership to cover the deficit. The Tax
Court concluded that the limited partners
were contingently obligated to make future
contributions only in the event partnership
revenues were insufficient to satisfy the note
at maturity and the general partners exercised
their discretion to make the cash call.

The Ninth Circuit reversed the Tax
Court. Although the Ninth Circuit agreed
that the limited partners were not directly
and personally liable to the creditor, the
court emphasized that the critical inquiry
was whether the partner was the obligor of
last resort. See also Bennion ... 88 T.C. 684
(1987) ... The Ninth Circuit also made it
clear, however, that if the limited partnership
agreement had created only contingent
obligations on the part of the limited partners
the amounts at risk would not increase.
On the facts of Pritchett, the Ninth Circuit
concluded that the liability of the limited
partners was "unavoidable, hence not contingent."
See also Melvin ... 88 T.C. 63
(1987), aff'd 894 E2d 1072 (9th Cir.
1990) ...

Based on the holding in FSA 1999-993, it would appear that LLC members should be considered at-risk for LLC liabilities within the meaning of Sec. 465 if, under state law, the LLC operating agreement contains a DRO provision that places members in a position to bear the economic risk of loss for a loan if the LLC cannot repay its debt obligations.

FROM JOHN L. WRIGHT, CPA, MST, GAITHER RUTHERFORD & CO., LLP (AN INDEPENDENT MEMBER OF THE BDO SEIDMAN AllIANCE), EVANSVILLE, IN