At-risk rules - Sec. 465 prop. regs.
Prop. Kegs. Sec. 1.465-7(a) allows for an increase in at-risk basis for a partner's loan to a partnership. Conversely, Prop. Kegs. Sec. 1.465-6(d) does not permit an increase in at-risk basis for a guarantee of partnership nonrecourse debt. However, the increase in at-risk basis is permitted when the partner is required to make payment on the debt. This treatment is inconsistent with the more lenient rules in Kegs. Sec. 1.752-2(d) (2), which allow guarantees of nonrecourse debt to increase at-risk basis. The inconsistency is currently unresolved. To be protected trader both regulations, practitioners should follow the tests outlined in Abramson, 86 TC 360 (1986), Gefen, 87 TC 1471 (1986), and Bennion, 88 TC 684 (1987), which allowed for an increase in at-risk basis for guarantees:
1. That were absolute and unconditional.
2. For which there was no right of subrogation, contribution or reimbursement from the entity or other owner.
3. For which the guarantor bore ultimate responsibility for the debt (or a portion thereof), if the entity defaulted.
Partners are not at risk to the extent they are protected against losses. For example, Prop. Kegs. Sec. 1.465-6 looks through to the ultimate legal rights to determine whether at-risk basis should be disallowed. If a partner has the legal right to sue other partners for reimbursement or is entitled to a contribution from them, the partner will not be at risk. Prop. Kegs. Sec. 1.465-6(e) provides an example.
Example (1). A, an individual, borrows $6,000 from a bank for use in an activity described in Sec. 465(c)(1).A is not personally liable for repayment of the loan but, rather, pledges as security, assets not used in the activity with a $6,000 net fair market value (FMV). However, a third party, B, guarantees A that A's entire loss from the activity will be repaid to A by B. Because A is protected against loss on the loan, A's at-risk amount is not increased as a result of the entire transaction.
The original at-risk rules applied only to the activities listed under Sec. 465(c)(1), which include (1) holding, producing or distributing motion picture films or video tapes; (2) farming; (3) leasing Sec. 1245 property; (4) exploring for, or exploiting, oil and gas resources; or (5) exploring for, or exploiting, geothermal deposits (as defined in Sec. 613(e)(2)) as a trade or business or for the production of income. The Revenue Act of 1978 extended the at-risk rules to all activities of carrying on a trade or business (by adding Sec. 465(c)(3)). Strong lobbying lead to real estate activities being excluded from the at-risk rules, until the Tax Reform Act of 1986 applied them to real estate placed in service after 1986.
Interest "Other than as a Creditor"
Under Sec. 465(b)(3)(B)(i), partners will not get at-risk basis when borrowing from a lender who has an interest (described below) other than as a creditor. This applies to (1) loans for which the borrower is personally liable for repayment, (2) nonrecourse loans secured by assets with a readily ascertainable FMV and (3) nonrecourse loans secured by assets without a readily ascertainable FMV. When the borrower is personally liable for repayment and nonrecourse loans are secured by assets == with a readily ascertainable FMV, a lender will be deemed to have an interest other than as a creditor if it has an interest in the activity's capital or net profits. Lenders related to a person with an interest other than as a creditor are also prohibited from being at-risk. "Related person" is defined in Secs. 52(b), 267(b) and 707(b)(1). In applying these sections, 10% ownership interest is substituted for 50%. Regs. Sec. 1.465-8 (b)(4) offers examples.
Example (1). A, the owner of a herd of cattle, sells it to partnership BCD, which pays A $10,000 and executes a $30,000 note payable to A. Each of the three partners, B, C and D, assumes personal liability for repayment of the amount owed. In addition, BCD enters into an agreement with A, under which A is to take care of the cattle for BCD in return for 6% of BCD's net profits. Because A has an interest in the net profits of BCD's farming activity, A is deemed to have an interest in the activity other than that of a creditor. Accordingly, amounts payable to A for use in that activity do not increase the other partners' at-risk amount, even though they assume personal liability for repayment.
Example (2). The facts are the same as in Example (1) above, except that instead of receiving 6% of BCD's net profits, A receives 1% of the gross receipts. A does not have a capital interest in BCD. A's interest in the gross receipts is not deemed an interest in net profits. Because B, C and D assumed personal liability for the amounts payable to A, and A has neither a capital interest nor an interest in the net profits, A is not deemed to have an interest in the activity other than that of a creditor as to the $30,000 loan. Accordingly, B, C and D are at-risk for their share of the loan if the other provisions of Sec. 465 are met.
For nonrecourse loans secured by assets without a readily ascertainable FMV, a person will be deemed to have an interest other than as a creditor if he or she stands to receive financial gain from the activity. This includes persons receiving compensation for services for the activity (i.e., promoters).
Until the final regulations were issued, Sec. 465(b)(3)(B)(i)'s interest-other-than-as-a-creditor rules had limited application. In 1990, however, the Tax Court ruled in Alexander, 95 TC 467, that this section applies only to the original activities listed in Sec. 465(c)(1) (as noted above).
In response to Alexander, Kegs. Sec. 1.465-8 was issued specifically to apply the Sec. 465(b)(3) rules to Sec. 465(c)(1) and (3) activities. Sec. 465(c)(3) includes activities that are (1) engaged in by a taxpayer in carrying on a wade or business, or for the production of income and (2) not described in Sec. 465(c)(1).The final regulations are effective for amounts borrowed after May 3, 2004.
Tax advisers need to pay careful attention to these at-risk rules when determining partner deductions and when applying basis for guarantees, to ensure they are following the tests applied in the various court cases mentioned. Care should also be given to properly address whether at-risk applies when there is (1) a lender with an interest other than as a creditor and (2) loss protection by legal right or agreement.
FROM ELIZABETH KOZENKO, CPA, MT, COHEN & COMPANY, LTD., AKRON, OH
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|Title Annotation:||deductions in excess of basis resulting in taxable gains|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 2005|
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