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'TIS THE SEASON FOR AT-RISK BASIS...

December 15, 2004

In a world of change, we find security in the traditions of the holiday season. We embrace the parties, the excitement of children, wrapping presents, and making sure we have enough basis in our pass-through entities to deduct our losses.

Yet change comes, even to hallowed traditions like basis-shifting. The IRS changed an important rule this year that makes it harder for many of us to use our losses.

THE BACKGROUND

Owners of "pass-through" entities -- partnerships and S corporations -- only get to deduct losses if they have "basis" in their ownership interests. Basis starts with your purchase price. Owners of pass-throughs increase their basis for their shares of income from the entity and for any capital contributions they make. Their basis is reduced by their shares of losses, deductions and distributions.

Pass-through owners also can get basis from debt. Partners can get basis from borrowings made by the partnership from partners or third parties; S corporation owners can get basis from loans they make directly to their corporations.

Basis gets attention this time of year because you need to have it by year-end to deduct this year's losses. Pass-though owners wanting to deduct their losses sometimes may have to make contributions or loans to their passthroughs at year-end to get their needed basis.

AT-RISK RULES: SOME BASIS IS MORE EQUAL THAN OTHER BASIS

Not all basis allows you to deduct losses. If your basis is not "at-risk," the tax law keeps you from using the losses until you dispose of the activity, or until you obtain "at-risk" basis. The at-risk rules are a relic of the tax shelter wars of the 1980s, but they still lurk today, dangerous and often overlooked.

To have "at-risk" basis, you need real money in the game. If you get your basis from a "non-recourse" loan - where the creditor can only repossess its collateral to satisfy the loan, but cannot proceed further against the debtor - you are normally not at risk. (A special exception applies to third-party real estate loans).

RELATED PARTY LOANS: BE VERY AFRAID

The at-risk rules go another step. If you borrow money from a lender who has "an interest in the activity," or who is "related to a person (other than the borrower)" with an interest in the activity, the losses will not be considered "at-risk." These related-party rules formerly only applied to a few activities, including farming and equipment leasing. The Treasury extended them to all activities for amounts borrowed after May 3, 2004.

A CAUTIONARY TALE FROM CENTRAL IOWA

Larry Van Wyk, a farmer from Monroe, Iowa, got a taste of the dangers of the at-risk related-party loan rules back when farmers were their primary target. He owned an S corporation farm 50-50 with his brother-in-law, Keith Roorda. On December 24, 1991, Larry borrowed $700,000 from Keith. The loan was fully-recourse, so the brother-in-law could proceed ruthlessly against Larry in the event of non-payment. Larry used about $250,000 to repay money he owned the S corporation and loaned the remainder to increase his basis to enable him to deduct losses.

Unfortunately, Larry's brother-in-law had "an interest in the activity" - he owned half of it. This made the deduction not "at-risk," even though no loan from a brother-in-law is without risk in a very real sense. The efforts of some of the finest tax attorneys west of the Mississippi were unavailing; the Tax Court agreed with the IRS, and Larry lost his losses.

WHO'S RELATED?

If you borrow from somebody who co-owns an activity with you, the borrowing will not be at-risk. You will not be at risk if you borrow from your co-owner's ancestors, descendents, siblings or spouse. Nor will you be at-risk if you borrow from a business owned 10% or more by your co-owner.

Also, an "interest in an activity" can extend beyond co-ownership. In some cases a person who does business with an activity can be considered to have "an interest in the activity"; so also may an employee.

In short, if you aren't getting your funds from an unrelated party, like your friendly community bank, or from your own assets, you need to be very careful. This is especially true in borrowings among family members.

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