Generally, an LLC member’s amount at risk is the sum of:
Cash contributed to the LLC
The cumulative adjusted basis of other property contributed to the LLC
The member’s share of LLC recourse debt on the measurement date
The member’s share of any other LLC debt for which the member is ultimately liable on the measurement date, and
The member’s share of any LLC qualified nonrecourse debt
Because of the limited liability afforded to LLC members, members may not be able to include any of the LLC’s debt in their amount at risk under items 3 or 4 above. Members can include a portion of the LLC’s debt in their amount at risk only under the following situations:
A member or members elect to assume liability for LLC debts under a state statute that allows such an assumption
The member is a former general partner in a partnership that converted to LLC status, and state law requires the member to remain liable for recourse debts incurred prior to the conversion
The member has a financial responsibility to make contributions to the LLC that are available to the LLC’s creditors (e.g., because of a capital contribution obligation or an obligation to return a prohibited distribution), or
The member is the creditor with respect to an LLC debt or has the ultimate responsibility for payment of the debt
The amount at risk is reduced by the cumulative allocation to the member of LLC taxable losses and deductions. A member’s amount at risk should be increased by the member’s cumulative share of LLC income and gains and reduced by any cumulative distributions to the member.
Example. Calculating a member’s amount at risk:
An LLC is formed for geothermal exploration and is classified as a partnership for federal tax purposes. The LLC has three equal members, A, B, and C. The LLC was formed in year 1 with capital contributions of $200,000 each by B and C. A contributed earthmoving equipment that had a $200,000 fair market value (FMV) and an adjusted basis of $100,000. The LLC borrowed $3 million under a recourse note from the bank to purchase a tract of land for exploration. The LLC reported losses in year 1 of $180,000 and in year 2 of $300,000. The calculation of each member’s amount at risk at the end of year 2 is shown in the table “LLC Members’ Amounts At Risk,” below.
The members cannot increase their amounts at risk by any portion of the LLC debt because they have no economic risk with respect to the debt (see Prop. Regs. Sec. 1.465-24(a)(1)). Under state law, even though the debt is recourse to the LLC, the members’ limited liability protects them from any obligation to fund the debt — in the event of a default, the creditor can attach only the LLC’s assets. Given no change in the debt structure of the LLC and no additional contributions or distributions to or from the LLC in future years, B and C would each be able to deduct $40,000 of additional LLC losses. A can deduct only $40,000 of the year 2 LLC loss allocated to him because of his limited amount at risk — he can deduct no subsequent losses from the LLC until his at-risk amount increases.
Including LLC debt in a member’s amount at risk
Generally, a member’s amount at risk is increased for the amount of debt related to the at-risk activity for which the member is ultimately liable. This creates a stricter standard for allocating recourse debt to members who guarantee LLC debt than is used in either the basis determination rules or the Sec. 704(b) allocation rules. The following list addresses the specific rules for determining whether borrowed amounts can be included in a member’s amount at risk.
Member loans: A member’s amount at risk is increased by the amount of any loans made by the member to the LLC to the extent that the member’s basis in the LLC interest would be increased under Sec. 752 (see Prop. Regs. Sec. 1.465-7). Consequently, the amount of a recourse or nonrecourse loan made by a member is typically included in the member’s amount at risk.
Member guarantees: See the discussion of loan guarantees below.
Recourse debts that become nonrecourse: Recourse debts, if any, that become nonrecourse upon the occurrence of some event or the lapse of time are amounts at risk during the recourse period — if they are motivated by business reasons and are consistent with normal commercial loan practices (see Prop. Regs. Sec. 1.465-5). An LLC will seldom have recourse debt.
Protection against loss: Members are not considered to be at risk for borrowed amounts (or for contributions of cash or property) to the extent that they are protected against loss by agreement among the members or by operation of law.
Interest other than as a creditor: Amounts borrowed by an LLC from a lender with an interest other than that of a creditor (or from a lender related to a person (other than the borrower) who has an interest other than as a creditor) are not considered amounts at risk. Consequently, except to the extent provided in regulations, amounts borrowed by a member from the following persons are not at risk: (1) another member; (2) anyone who has an equity or profits interest in the activity; or (3) a person who is related to such other member or person with an equity or profits interest in the activity.
Pledged property: Members are at risk to the extent of the FMV of property they have pledged to secure LLC debt unless the pledged property is used in the at-risk activity (see Sec. 465(b)(2)(B)).
Impact of loan guarantees
Taxpayer’s guarantees of debt are not included in the amount at risk until the taxpayer actually pays the guaranteed amounts and has no right to reimbursement. The current IRS position is that the guarantee of nonrecourse debt (most LLC debt is nonrecourse debt or exculpatory debt that is recourse to the LLC but nonrecourse to the members) does not create an amount at risk for deducting losses. However, the Tax Court has been more willing to look at the economic issues involved in deciding whether at-risk amounts should be increased for nonrecourse debt guarantees. Three Tax Court cases, Abramson, 86 T.C. 360 (1986); Gefen, 87 T.C. 1471 (1986); and Bennion, 88 T.C. 684 (1987), have permitted an increase in at-risk amounts for guarantees by partners or members in LLCs classified as partnerships if:
The guarantee is absolute and unconditional;
There is no right of subrogation, contribution, or reimbursement from the entity or any other owner; and
The guarantor bears the ultimate responsibility for the debt, or a portion of the debt, if the entity defaults in a worst-case scenario. The worst case scenario is essentially equivalent to the hypothetical transaction described in Regs. Sec. 1.752-2(f), Example (1), where all of the entity’s assets, including cash, are deemed to be worthless and each owner’s responsibility for the various entity obligations is measured by the true economic risk each member bears.
If the debt is qualified nonrecourse financing, the member’s amount at risk is increased by the amount guaranteed to the extent that (1) the debt was not previously taken into account by that member; (2) the guaranteeing member has no right of contribution or reimbursement from persons other than the LLC and is not otherwise protected against loss within the meaning of Sec. 465(b)(4); and (3) the guarantee is bona fide and enforceable by LLC creditors.
Amounts borrowed from related taxpayers
A member’s amount at risk may be increased by amounts borrowed from a person that is related to the member, unless the related person has an interest in the activity other than as a creditor or borrowed the money on a nonrecourse basis. However, a member’s amount at risk cannot be increased by amounts borrowed from a person who is related to a person (other than the member) that has an interest in the activity other than that of a creditor. The rules of Secs. 267(b) and 707(b)(1) define a related party under the at-risk rules, except that 10% is substituted for 50% when referring to ownership percentages (Sec. 465(b)(3)(C)). Additionally, persons engaged in businesses under common control (as defined in Secs. 52(a) and (b)) are considered to be related.
Calculating basis can be complex, and accuracy is essential. Give us a call to discuss your specific situation, and we will provide professional insight, and the information you need to succeed.
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