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OBLIGATION TO CONTRIBUTE CAPITAL MAY NOT MAKE YOU 'AT-RISK'

February 29, 2008

The "at-risk" rules of Section 465 are one of the more obscure land-mines of the the tax law. These rules were enacted in 1976 as one of the earliest attempts to attack tax shelters. The "passive loss" rules enacted ten years later were much more effective, but the at-risk rules were never repealed, and they continue to trip up taxpayers, as a Tax Court case yesterday illustrates.

Hubert Enterprises was a C corporation that owned 99% of an LLC named "LCL." The LLC borrowed money to purchase and lease out equipment. Because owners of an LLC aren't personally liable for debts, this debt would normally be considered "non-recourse," and therefore not "at-risk." The partners would then be unable to deduct losses attributable to their partnership basis arising from the debt.

To get around this, the LLC had a "capital account deficit restoration obligation," or "DRO." The LLC operating agreement required Hubert to restore a capital account deficit under some circumstances. They took the position that this made them "at-risk" to the extent of the obligation. The Tax Court disagreed:

Under the DRO, HBW's obligation is limited to restoring the amount of any deficit in its capital account. However, the amount of that deficit, if in fact one occurs, is not necessarily the same amount as HBW's proportionate share of LCL's recourse debt. Moreover, as just noted, the revised operating agreement does not require LCL to pay any or all of the restored deficit to creditors; it allows LCL to distribute any restored funds to members with positive capital account balances.

The Moral? If you want to be "at-risk" on LLC debt, a deficit-restoration obligation may not do the trick. The LLC member should arrange be directly on the hook by agreement with the lender, ideally as guarantor of last-resort.

Note: special rules apply to real estate loans. Not all real-estate loans require personal liability to be considered "at-risk."

Cite: Hubert Enterprises Inc. v. Commissioner; T.C. Memo. 2008-46

Related: 'TIS THE SEASON FOR AT-RISK BASIS

Tags: at-risk rules.

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