2014-Issue 40—“Villainy, thy name is Taxpayer!” is what the IRS might wail if we all lived in a world encompassing a Shakespearean tragedy. Thankfully, we don’t. But nonetheless, the IRS is continually bedeviled by certain artful taxpayers, for whom the world is not enough, seeking to exploit perceived loopholes in order to unfairly reduce their tax burdens.
Over the years, Congress has counterattacked along several avenues, and relevant to this article is one such weapon in its arsenal: the At Risk rules of Section 465, which are discussed below. Once hailed as the Prince that was Promised of the Internal Revenue Code, the At Risk rules have long since been relegated to a footnote of tax history, arguably having been subsumed by the passive activity loss rules of Section 469.
But not everything has come up Milhouse. Though subsumed, they were never repealed, and therefore much like a lion that waits in the tall grass for an unwitting gazelle to wander into its kill zone, the At Risk rules have transformed into a trap for the unwary taxpayer, and they are patient...and hungry.
This edition of Tax Advisor Weekly explores the history of the At Risk rules and their application to modern-day transactions.
Fighting Chaos With Chaos
To understand the At Risk regime, a detour must first be taken through the partnership tax rules. A partner in a partnership generally may deduct losses that are allocated to him from such partnership on his income tax return only to the extent of his tax basis in his partnership interest, pursuant to Section 704(d). The calculation of a partner’s tax basis in his partnership interest is complicated and outside the scope of this article, but suffice to say that, broadly speaking, a partner’s tax basis in his partnership interest includes the taxpayer’s allocable share of the partnership’s liabilities. Therefore, as a very simplistic example, if a partnership with two equal partners borrows $100, each partner’s respective partnership tax basis increases by $50.
One other definitional matter before we dive in. To apply the At Risk rules, one must understand the difference between “recourse” and “nonrecourse” debt. These are precise legal terms governed by state law, but in general, when debt is recourse in nature, that means that if the debtor defaults on the obligation, the creditor may pursue the debtor’s personal assets in order to satisfy it. When debt is nonrecourse in nature, the debtor’s personal assets are off limits to the creditor in the event of default.
The loss limitation rules under Section 704(d), as described above, were viewed as insufficient to combat various perceived abuses being committed by certain vintages of primordial tax shelters, particularly in situations where taxpayers received substantial tax deductions from various trades or businesses where they were deemed to not bear sufficient economic risk to justify receiving such tax benefits. Therefore, in 1976 Congress enacted the At Risk rules as part of the broader Tax Reform Act. The eponymously-named At Risk rules introduced the requirement of being “at risk” with respect to a trade or business in order to recognize any corresponding tax benefits that emanate from such trade or business. Note that the At Risk rules apply only to individuals and corporations that are classified as personal holding companies for U.S. federal income tax purposes.
Broadly speaking, a taxpayer is at risk with respect to a trade or business to the extent the taxpayer has contributed money or property to the trade or business, or the trade or business has incurred debt for which the taxpayer is personally liable (i.e., recourse debt). Note that a taxpayer is not, by definition, at risk with respect to nonrecourse debt, since creditors cannot pursue a taxpayer’s personal assets in the event of default with respect to a nonrecourse obligation.
The practical application of the At Risk rules to partnerships, which were a primary target of such rules, is, in effect, the creation of two tax bases in the partnership interest for a partner to track: one tax basis as calculated under Section 704(d), and the other tax basis as calculated under the At Risk rules. These two numbers will not always line up perfectly. Remember above, where we noted that a partner’s tax basis in his partnership interest includes the partner’s allocable share of the partnership’s debt? If a partnership has both recourse and nonrecourse debt, then a partner’s tax basis in his partnership interest as computed under Section 704(d) will generally be greater than the partner’s tax basis as computed under the At Risk rules, because the Section 704(d) tax basis includes the partner’s allocable share of both recourse and nonrecourse debt, while the At Risk tax basis only includes recourse debt.
As one simplistic example of the effect of the At Risk rules, if Partner A, an individual, is a partner in a partnership and receives a loss allocation from the partnership that exceeds Partner A’s At Risk tax basis, but does not exceed Partner A’s Section 704(d) tax basis, Partner A is nonetheless limited to recognizing the loss on Partner A’s individual income tax return only up to an amount equal to Partner A’s At Risk tax basis. Theoretically, as a result of the application of these rules in this example, Partner A has been limited from recognizing tax benefits that do not correspond to the economic risk that Partner A bears, and the integrity of the federal fisc has been preserved. Theoretically.
Qualified Nonrecourse Financing — the Exception That Swallowed the Rule
At the behest of the real estate industry, Congress included an exception within the At Risk rules for so-called “qualified nonrecourse financing,” which is debt that has the following characteristics:
- It is borrowed by the taxpayer with respect to the activity of holding real property;
- It is borrowed by the taxpayer from a qualified person or represents a loan from any federal, state or local government or instrumentality thereof, or is guaranteed by any federal, state or local government;
- No person is personally liable for the repayment of such debt; and
- It is not convertible debt.
When debt meets the aforementioned requirements, it is generally deemed to be at risk for purposes of the At Risk rules, and as such in the context of a partnership, the partners would receive an increase to their At Risk tax basis with respect to such debt, notwithstanding the fact that for state law purposes the debt, by its own terms, is nonrecourse in nature.
This exception to the At Risk rules contributed to the perception that such rules failed to impose a measure of fairness within the federal income tax system. In effect, by enacting the exception for qualified nonrecourse financing, Congress may very well have been hoisted by its own petard. This, and the metastasis of a burgeoning tax shelter industry, eventually led to Congress invoking the nuclear option by enacting the passive activity loss rules of Section 469.
From Congress With Love: The Passive Activity Loss Rules
The passive activity loss rules, which were enacted as part of the Tax Reform Act of 1986, were a more direct, and more successful, action by Congress to address the perception of widespread avoidance by taxpayers through the generation of artificial losses from tax shelters and other trades or business for which they did not bear sufficient economic risk. In this case though, rather than nibble around the edges as it had arguably done in enacting the At Risk rules, Congress went for the jugular. The passive activity loss rules focus on the source and character of losses rather than on the taxpayer’s wherewithal to recognize such losses, which is considerably more vulnerable to manipulation. Although a detailed discussion of the passive activity loss rules is outside the scope of this article, suffice to say that, broadly speaking, the rules operate to prevent taxpayers from offsetting their income from so-called non-passive activities (i.e., trades or businesses for which they are viewed as having real “skin in the game”) with losses from so-called passive activities, which are generally defined as trades or businesses in which the taxpayer does not materially participate.
It's worth mentioning that it is quite difficult for losses from real estate to be characterized as non-passive under the passive loss rules, meaning that, in practice, the qualified nonrecourse financing exception discussed above is now only useful to taxpayers if they have other passive income to offset such losses.
The Gift That Keeps on Giving
One of the main pitfalls of the At Risk rules is that there is only limited guidance explaining the application of these rules to real-life situations. Based on its actions (or really lack thereof), one might even be led to believe that the IRS had forgotten about them altogether. This is not the case. Tax lore is littered with instances of taxpayers obliviously meandering into the At Risk rules, and the IRS gleefully springing the trap. In fact, more than 30 years after the enactment of the At Risk rules, taxpayers are still being stung by their application, as evidenced by Zeluck v. Commissioner, 103 TCM (CCH) 1537 (2012).
Nobody Expects the At Risk Rules!
In Zeluck, the taxpayer contributed $310,000 to a partnership in 2001 in the form of $110,000 in cash and a $200,000 note that matured on December 31, 2009. The taxpayer also guaranteed a note that was issued by the partnership up to an amount equal to the note he contributed, giving him an initial At Risk tax basis of $310,000 ($110,000 of cash plus $200,000 of guaranteed debt). In 2001 and 2002, the taxpayer was allocated losses from the partnership that practically eliminated his At Risk tax basis, and in 2003 the partnership terminated. After the partnership terminated, no attempt was made to enforce payment of the taxpayer’s note or the partnership’s note. Moreover, the taxpayer never made any principal payments on his note, and even failed to make certain interest payments.
The IRS argued that the taxpayer’s guarantee of the partnership’s note became meaningless in 2003 in connection with the termination of the partnership, and therefore he ceased to be at risk for the $200,000. Since at the time of the partnership’s termination the taxpayer’s At Risk tax basis was already zero, the loss of the guarantee’s status as at risk resulted in the taxpayer’s At Risk tax basis being reduced from zero to negative $200,000, requiring him to recapture the difference as additional taxable income pursuant to a somewhat obscure provision of the At Risk rules. The Tax Court agreed, and there was no rejoicing.
Alvarez & Marsal Taxand Says:
To characterize the At Risk rules as a paper tiger may lead to one’s own undoing. Although Congress may have hoped that these rules would level the playing field with respect to the federal income tax system, the road to hell is always paved with good intentions — and casualties. The lack of guidance regarding the At Risk rules merely creates a trap for the unwary taxpayer, and because they are still relevant to a wide variety of transactions, the best course for taxpayers would be to tread lightly.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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