Tax court says taxpayer not at risk for DRA.

Deficit restoration agreements (DRAs) are widely used to increase basis to use partnership losses or maintain basis when capital accounts have been taken below zero. There has been substantial legal precedent in this area; this has laid the groundwork for DRAs to be a viable option for holding partners liable for a portion of the partnership's liabilities, giving them basis and allowing them to take current-year losses. Many taxpayers have relied on that precedent while drafting DRAs and using the at-risk basis created thereby. The Tax Court recently decided a case involving a limited liability company (LLC), in which it ignored prior cases in the area. This decision has created confusion as to whether the use of DRAs will continue to provide at-risk basis.

Hubert Enterprises

In Hubert Enterprises, Inc., 125 TC 72 (2005), aff'd in part, vact'd and rem'd in part, 6th Cir. (4/27/07), the Tax Court ruled in favor of the IRS on three separate issues; whether the:

1. Parent corporation could claim a business bad debt deduction on its transfer of funds to an LLC controlled by the same group of individuals that controlled the corporation;

2. Taxpayer could aggregate leasing activities into a single activity when the leases had commenced in different years; and

3. Taxpayer could use a DRA that made the LLC members liable for the entity's otherwise recourse obligations to deduct current-year equipment-leasing activity losses.

The first and second issues are not discussed in detail in this item. As to the first issue, the court concluded that the funds transferred from the parent to the LLC should be characterized as a capital contribution instead of a loan, because the loan was unsecured, at a low interest rate and for an unstated period. The court applied the 11 factors from Roth Steel Tube Co., 800 F2d 625 (6th Cir. 1986), which determine whether a funds transfer between entities should be characterized as debt or equity. The court decided that there were insufficient debt factors present and that an unrelated third party would not have made the same loan to the LLC. Thus, the court sided with the Service.

On the second issue, the court again held for the IRS, ruling that the leasing activities could not be aggregated into a single activity. The taxpayer had argued that under Sec. 465(c)(2)(B)(i),the activities could be aggregated. Generally under Sec. 465(c)(2), leasing activities involving Sec. 1245 property cannot be aggregated for purposes of the at-risk rules. However, an exception for S corporations and partnerships (Sec. 465 (c)(2)(B)(i)) states that all activities with respect to Sec. 1245 properties that are leased or held for lease, and placed in service in any tax year of a partnership or an S corporation, shall be treated as a single activity. The court, citing prior cases and interpretations of Sec. 465(c) (2)(B)(i) by commentators, held that the word "any" in this case means "one" tax year; the taxpayer's interpretation was that "any" meant "all" tax years. Because the taxpayer entered into the leases at issue in different tax years, it could not aggregate the leasing activities.

The court's decision in the third issue is perhaps the most troubling. It was also the issue the court analyzed the least.

Facts Related to DRAs

The taxpayer, Hubert Enterprises, Inc. (HEI), had several subsidiaries. In 1998, one of its subsidiaries and an affiliated company formed a Wyoming LLC (LCL) to conduct equipment-leasing activities. LCL's two members were Hubert Commerce Center, Inc. (HCC), an HEI affiliate, and HBW, Inc., an HEI subsidiary.

LCL's ownership consisted of 100 membership units. During LCL'S 1998 tax year, HBW received 99 of those units for a $9,900 capital contribution; HCC received the last unit for a $100 capital contribution. On April 30, 1998, HBW and LCL also executed as a contribution to LCL's capital an assignment in which HBW transferred to LCL all of HBW's rights, title and interest in its leases, subject to existing loans.

Section 4.2 of LCUs operating agreement stated, "No Member shall be liable as suchfor the liabilities of the Company." On March 28, 2001, the LCL operating agreement was amended and restated in its entirety (revised LCL operating agreement), effective retroactively to Jan. 1, 2000. The revised agreement is construed under Wyoming law, and only the parties who signed it (and their successors in interest) have any rights or remedies under that agreement. The revised agreement stated that neither HBW nor HCC was required to make any additional capital contribution to LCL. It also stated:

7. 7 Deficit Capital Account Restoration. If any Partner has a deficit Capital Account following the liquidation of his, her or its interest in the partnership, then he, she or it shall restore the amount of such deficit balance to the Partnership by the end of such taxable year or, if later, within 90 days after the date of such liquidation, for payment to creditors or distribution to Partners with positive capital account balances.

In 2000 and 2001, neither HBW nor HCC liquidated its interest in LCL.

The Arguments

The taxpayer argued that, although there were no liquidations of LCL's partnership interests during the years at issue and no partner was required to repay a deficit capital account, the deficit capital account restoration provision in LCL's operating agreement exposed LCL members to liability for their respective share of LCL's recourse debt. Thus, to the extent of a deficit in their respective capital accounts, each partner would be at risk for LCL's underlying liabilities. Sec. 465 would limit the ability to use the passthrough losses to both the contributions to LCL and the share of LCL's debt.

The Service argued that the deficit restoration provision was not operative during the relevant years, because it required that an LCL member first liquidate its interest in LCL, an event that never occurred during the years at issue. The IRS argued that the provision, if operative, did not make the members liable for LCL's recourse obligations, in that a third-party lender did not, under the revised LCL operating agreement, have the right to force the members to abide by any obligation that LCL failed to honor.

The Decision

The court held that the LCL members were not at risk for any of the disputed amounts. Its reasoning was as follows:

Congress enacted section 465 to limit the use of artificial losses created by deductions from certain leveraged investment activities. Such losses may be used only to the extent the taxpayer is at risk economically. Generally, the amount at risk includes (1) the amount of money and the adjusted basis of property contributed to the activity by the taxpayer and (2) borrowed amounts for which the taxpayer is personally liable. Sec. 465(b).

The aspect of petitioners' dispute with respondent's application of the at-risk rnles rests on whether LCL's members may take into account any part of LCL's recourse obligations. We agree with respondent that they may not. The recourse notes signed by LCL were not personally guaranteed by LCL's members, and applicable State (Wyoming) law provides that the members of a limited liability company are not personally liable for the debts, obligations, or liabilities of the company. See Wyo. Stat. Ann. sec. 17-15-113.... The agreements of LCL also contain no provisions obligating its members to pay LCL's debts, obligations, or expenses. Because LCL's members did not assume personal liability for the notes, the members are not at risk under section 465(b)(1)(B) and (2)(A) with respect to LCL's recourse obligations. Cf. Emershaw v. Commissioner, 949 F.2d 841 (6th Cir. 1991), affg.T.C. Memo. 1990-246.

Petitioners seek a contrary result, focusing on the deficit capital account restoration provision in section 7.7 of the revised LCL operating agreement. Petitioners argue that this provision made LCL's members personally liable for LCL's recourse obligations for purposes of applying the at-risk rules. We disagree. As observed by respondent, section 7.7 contains a condition that must be met before the deficit capital account restoration obligation arises. In accordance with that condition, an LCL member must first liquidate its interest in LCL before the member has any obligation to the entity. Neither HBW nor HCC liquidated its interest in LCL during the relevant years.

Did the Tax Court Get It Right?

Although many cases have addressed whether a taxpayer is considered to be liable for the debts of another, the Tax Court cited only one: Emershaw. That decision, however, does not seem to support the conclusions reached by the court. In Emershaw, the court adopted a concept of "payor of last resort" to determine who would bear the ultimate risk of loss. This concept assumes a worst-case scenario. Applying this concept to Hubert, the court should have concluded that the DRA would have forced the members to pay LCL's liabilities, because all the entity's assets would have been written down to zero, creating large deficits in the members' capital accounts, which would be required to be restored on liquidation of the entity. Although the court correctly pointed out that this was a contingent situation, the entirety of the at-risk rules is based on the contingent situation of who bears the economic risk of loss if one occurs. Under Sec. 465, a general partner is considered to be responsible for all the recourse debts of the general partnership, even though the partnership as of the end of any particular year has sufficient assets to pay the debts. Based on Sec. 465's intent to limit the ability to deduct losses to those who bear the economic risk and on the precedent established in prior cases, it would appear that the Hubert court got it wrong.

What to Do Now?

On appeal, the Sixth Circuit vacated the Tax Court's decision as to the DRA's effect on the at-risk amount under Sec. 465 and remanded the case to the Tax Court. Until this issue is settled, DRAs should be avoided (or used prudently) as a means of establishing at risk basis. If a DRA must be used, a taxpayer can take several steps to differentiate its facts from those of Hubert. First, with respect to the entity's organization, the taxpayer should seek to organize its LLC to permit modification of the applicable law via the operating agreement's provisions. Second, the operating agreement should specifically provide that a member is not liable for the entity's debts, except as provided for in the operating or a separately created agreement. Third, the operating agreement should not preclude creditors from benefiting from the provisions of a DRA or other similar arrangement. Fourth, the operating agreement should not limit a restoration to only on liquidation. Although the existence of these additional facts cannot guarantee that the Tax Court will rule in taxpayers' favor, they allow taxpayers to distinguish their cases from Hubert. This, along with a more thorough argument by the taxpayer as to precedent, should force the court to perform a more thorough analysis of the law. Perhaps then the court will reach the right decision.

FROM JENNIFER TAPIA, COHEN & COMPANY, CLEVELAND, OH.