IRC section 465 generally limits loss deductions to the amount for which the taxpayer is
considered “at risk.” A taxpayer is considered at risk in an activity to the extent of:
1) The amount of money and the adjusted basis of other property contributed by the taxpayer
to the activity, and
2) The amounts borrowed with respect to such activity.
Amounts borrowed are considered to be at risk only to the extent that the taxpayer:
1) Is personally liable for the repayment of such amounts, or
2) Has pledged property, other than property used in such activity, as security for such
borrowed amount.
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A taxpayer is not considered at risk with respect to amounts protected against loss
through non-recourse financing, guarantees, stop loss agreements, or other similar arrangements.
If the taxpayer is not at risk for the amount of loss, then the loss is suspended
and carried forward to the first succeeding tax year in which the taxpayer is at risk.
The taxpayer in this case owned an LLC treated as a disregarded entity, with income and
expenses reported on Schedule C, Profit or Loss From Business. The LLC was formed to
purchase and own a hospital in Louisiana. To make the purchase, the taxpayer borrowed
money from a bank. The LLC was listed as the borrower. As security for the loan, the
hospital and its equipment was listed as collateral. The taxpayer also executed a personal
guarantee for the loan.
The taxpayer deducted losses incurred by the business. The IRS disallowed the loss because
it claimed the personal guarantee that the taxpayer executed did not actually put
him at risk to the extent of the disallowed deductions. To be at risk, the taxpayer must be
personally liable for repayment of the loan.
As a general matter, the tax court has ruled that merely executing a guarantee is insufficient
to establish personal liability because the guarantor would generally be entitled to
seek reimbursement from the primary obligor. However, not all guarantees are created
equal. When a guarantor is directly liable on a debt and there is no primary obligor bearing
recourse liability for the debt, then the guarantor would not have any meaningful
right to reimbursement and would thus be ultimately liable for the debt.
A guarantor’s personal liability for purposes of IRC section 465 depends on whether or
not the guarantor has the ultimate liability for the debt. To answer that question, courts
consider the “worst-case scenario” and then identify the “obligor of last resort” based
on the substance of the transaction. If there are no funds to repay the debt and all of
the assets of the activity or business are worthless, to whom would the creditor look for
repayment?
The IRS argued that under Louisiana law, a member of an LLC is not personally liable for
the debts of the LLC. The court stated the taxpayer became liable for the debt not because
he was a member of the LLC, but because he executed a personal guarantee for the debt.
The IRS also argued that the taxpayer was not personally liable for purposes of IRC section
465 because Louisiana law provides that “a surety who pays the creditor is entitled
to reimbursement from the principal obligor.”
The court stated that for purposes of IRC section 465, we presume the worst-case scenario.
A circumstance in which the primary obligor, the LLC, would be worthless and thus unable
to reimburse the taxpayer for any amounts paid on account of his guarantee. The taxpayer,
as the sole owner of the LLC, would still bear the economic responsibility for such reimbursement
in substance. Any reimbursement to which the taxpayer might theoretically be
entitled would be due to him from his own 100% owned entity. The taxpayer would ultimately
be paying the debt, and the fact that he might then be entitled to seek reimbursement
from himself would not render him any less at risk.
The IRS also argued that the loan was substantially collateralized, that it was not likely
that the taxpayer would ever be called on to make payments pursuant to his guarantee,
and that he did not in fact ever do so. The court stated these facts do not undermine his
personal liability under IRC section 465. The worst-case scenario analysis does not consider
whether a payment from the guarantor was every actually required or likely would
be required. Thus, the court ruled the taxpayer was personally liable and thus “at-risk”
for the losses.
In contrast, if this taxpayer were the sole shareholder of an S corporation,
the personal loan guarantee would not be enough to establish basis for
deducting S corporation losses. For an S corporation, the personal loan
guarantee only increases basis when the shareholder actually re-pays the
loan.
