Losses Weren’t Always Bad
Most tax advisers are aware that, prior to the Tax Reform Act of 1986 (the “TRA”),[i] the Code placed few limitations on the ability of an individual taxpayer to use deductions from a particular activity to offset income from other activities.
In the absence of such limitations, taxpayers with substantial positive income could sharply reduce their income tax liability by investing in partnerships engaged in activities that generated deductions[ii] – basically, a non-economic return on the taxpayer’s investment.
Congress Made It Less Palatable
Many of you will recall that the TRA sought to limit a taxpayer’s ability to realize the benefit of such non-economic returns by enacting the passive loss rules[iii] and by extending the at-risk rules to real estate activities.[iv]
In the years that followed, these rules, as well as others that address a taxpayer’s ability to utilize “tax losses,” have been revised in various ways,[v] most recently by the Tax Cuts and Jobs Act (“TCJA”).[vi]
Specifically, the TCJA introduced the excess business loss rules,[vii] eliminated a taxpayer’s ability to carry back its net operating losses (“NOLs”), and limited the use of loss carryovers for a taxable year to 80 percent of the taxpayer’s taxable income for such year. However, the TCJA also permitted NOLs to be carried forward indefinitely.[viii]
Don’t Forget the Basis Limitation
Of course, before any of the at-risk, passive loss, excess business loss, and NOL limitation rules can be applied – in that order – to an individual partner of a loss-generating partnership, the partner must first demonstrate that they had sufficient basis in their partnership interest – so-called “outside basis” – at the end of the partnership’s taxable year in which the losses were realized or to which the losses were carried.[ix]
The underlying reason for this limitation on loss deductions is clear if one considers that a partner’s outside basis generally represents their unrecovered investment in the partnership – i.e., the amount for which the partner is at economic risk.
A recent decision[x] of the U.S. Tax Court involved a taxpayer who failed to carry the burden of establishing that he had sufficient outside basis to allow him to utilize his distributive share of a partnership’s losses. It also illustrates the lengths to which some taxpayers will go to secure an unwarranted tax benefit. Although the taxable years in question preceded the TCJA, the Court’s analysis is nonetheless instructive.
LLC-A
Taxpayer owned a 99% membership interest in LLC-A and his spouse owned the remaining 1% interest.
LLC-A’s operating agreement did not state that its members were liable for the LLC’s debts, and it did not provide for mandatory cash calls by or to its managers or members. The operating agreement did not provide for a capital deficit restoration obligation.
The LLC’s operating agreement did not require its members to contribute additional capital to the LLC in excess of the “Maximum Capital Contribution” listed in the operating agreement. Its members were required to make their maximum capital contribution upon receipt of a notice from a “majority in interest” of the LLC’s members.
Taxpayer owned a “majority in interest” in the LLC during the periods in question. Maximum Capital Contribution amounts, when requested by the “majority in interest,” were to be paid in installments “determined exclusively by the Managers, in their reasonable discretion as needed for [the LLC’s] business.” The operating agreement listed Taxpayer’s Maximum Capital Contribution as $166,667. The record did not show whether he ever made that contribution.
Taxpayer gave LLC-A a purported promissory note for $2.7 million, stating that he would pay $2.7 million to the LLC on or before December 31, 2030, with interest accruing at an annual rate of 4.75% (“Taxpayer’s Note”). The note was neither secured nor collateralized. The note did not include a repayment schedule but did allow repayment to be extended beyond the year 2030 without notice.
LLC-A filed Forms 1065, U.S. Return of Partnership Income, for the years in question but it did not report Taxpayer’s Note on Schedules L, Balance Sheets per Books, for any of those returns.
LLC-B
During the years in question, LLC-A owned a 20% membership interest in LLC-B, which it acquired in exchange for a promissory note of $2.7 million, payable with interest at 4.75% per annum (“LLC-A’s Note”). The terms of the note were the same as those of the Taxpayer’s Note. LLC-A also received a $300,000 credit in its member’s capital account for prior services that it had provided to LLC-B. Neither LLC-A nor Taxpayer made any payment on the LLC-A Note.
LLC-B’s operating agreement stated that its members were not personally liable for any judgment, decree, or court order against LLC-B, or for the debts, obligations, liabilities, or contracts of the company.
LLC-A was not required to make any capital contribution to LLC-B in addition to the $2.7 million note. LLC-B’s operating agreement required that the managing member make additional capital contributions as needed for the LLC’s business. LLC-A was not a managing member of LLC-B during the years in question.
LLC-B’s operating agreement provided that members could not make voluntary capital contributions to the LLC. It did not provide for mandatory cash calls to its members (other than the managing member). It provided that its members had no capital deficit restoration obligation.
LLC-B filed a Form 1065 for each of the years in question. The returns reported notes receivable as Schedule L assets.
The Loan
Lender, LLC-B, and the LLC’s managing member executed a loan agreement by which Lender agreed to lend a specified sum to LLC-B and its managing member (the “Loan”).
The borrowers were jointly and severally liable for the Loan. Any payment on the Loan was credited to the Loan as a whole and not allocated among the borrowers. Neither LLC-A nor the Taxpayer was personally liable for the Loan. None of LLC-B, LLC-A, or the Taxpayer made any payment on the Loan.
In the event of a default on the Loan, collection was not limited to the collateral specified in the loan agreement. Lender, however, was not entitled to directly collect on the Loan against LLC-A’s or the Taxpayer’s assets. Neither LLC-A nor the Taxpayer pledged any of their assets as collateral or security for the Loan, and neither was a guarantor of the Loan. Neither the LLC-A Note nor Taxpayer’s Note was ever pledged as collateral or security for the Loan; nor was either of those notes mentioned in any of the Loan documents.
Taxpayer’s Returns
On his tax returns for the subject years, Taxpayer claimed significant deductions for NOL carryovers. The NOLs resulted from passthrough losses, including losses realized by LLC-A and by LLC-B, that Taxpayer deducted on his tax returns for the years in question, the excesses of which were carried forward as NOLs.
Thus, LLC-A issued Taxpayer Schedules K-1 for each of the subject taxable years reporting ordinary losses, which Taxpayer reported on Schedule E of Form 1040, Supplemental Income and Loss. To the extent that this loss for a year exceeded Taxpayer’s income for that year, Taxpayer added that excess to the NOL that he carried forward from the preceding taxable year and carried forward the resulting sum to the succeeding taxable year.
IRS Disagreed
The IRS disallowed these deductions on Taxpayer’s returns, determining in the notices of deficiency that Taxpayer (1) failed to substantiate the existence or the amounts of the claimed NOLs, and (2) failed to substantiate he had sufficient basis in his LLC-A membership interest to deduct the claimed NOLs.[xi]
The Court’s Opinion
Taxpayer then petitioned the Tax Court to review the IRS’s determination; specifically, to consider whether Taxpayer could deduct the NOL carryover that was claimed on his tax returns.
NOLs
The Code allows a taxpayer to deduct NOLs for a taxable year.[xii] The amount of the NOL deduction equals the aggregate of the NOL carryovers and NOL carrybacks to the taxable year. An NOL is defined as the excess of deductions over gross income, computed with certain modifications.[xiii]
An unused NOL is “carried to the earliest of the taxable years to which . . . such loss may be carried.”[xiv] Any excess NOL that is not applied in one year is carried to the next earlier year.[xv]
A taxpayer who claims an NOL deduction bears the burden of establishing both the existence of the NOL and the amount that may be carried over to the year involved.
The NOLs claimed by Taxpayer correlated to a loss from LLC-B for one of the subject years. The parties agreed that LLC-B realized those losses but disputed whether Taxpayer could claim any deduction with respect to such losses for the subject years.
LLC-A was a member of LLC-B for the above-referenced loss year, and LLC-B allocated to LLC-A its distributive share of LLC-B’s loss. LLC-A then allocated its loss (which included the LLC-B loss in its computation) to Taxpayer, who reported the loss on their tax return for such year.
The IRS disallowed these deductions. Taxpayer had the burden of demonstrating that the disallowance was wrong.
LLC-B Losses
According to the Court, Taxpayer had to prove three points to overcome the IRS’s disallowance of the deductions with respect to the LLC-B loss:
- First, Taxpayer had to prove that LLC-A had a sufficient outside basis in its LLC-B membership interest to deduct the loss allocated to LLC-A.[xvi]
- Second, Taxpayer had to prove that he had a sufficient outside basis in LLC-A to deduct the losses that LLC-A allocated to him.
- Third, Taxpayer had to prove that he was at risk with respect to LLC-B’s activities.[xvii]
The Court stated that it would sustain the IRS’s determination if Taxpayer failed to establish any of these three points.
Outside Basis
A partner’s distributive share of a partnership loss is allowed as a deduction to the partner only to the extent of the adjusted basis of the partner’s interest in the partnership at the end of the partnership year in which the loss occurred.[xviii]
If the loss allocated to a partner exceeds the partner’s outside basis, the excess amount may not be deducted by the partner. Instead, the disallowed loss deductions are carried forward by the partner to subsequent taxable years until the partner has sufficient outside basis to absorb the losses.[xix]
A partner’s basis in a partnership interest, referred to as outside basis, is determined by looking at (1) the basis of any property[xx] that the partner contributed (or is deemed to have contributed) to the partnership, (2) any increase or decrease based on the partner’s share of the partnership’s income, loss, deductions, or credits, (3) any partnership distributions (including deemed distributions), and (4) the partner’s share of partnership liabilities.[xxi]
Significantly, a partner’s contribution of their own promissory note to a partnership in which they are a partner does not increase the partner’s outside basis because the partner has a zero basis in the note.[xxii]
The amount of a partnership liability that is included in a partner’s basis depends on whether the liability is characterized as recourse or as nonrecourse.[xxiii]
A partnership liability is a recourse liability to the extent that a partner or related person bears the economic risk of loss as to the liability.[xxiv] Economic risk of loss (or the lack thereof) can result from statutes, the partnership’s governing documents,[xxv] or outside contracts.[xxvi]
A partner bears economic risk of loss to the extent that, if the partnership constructively liquidated, the partner or a related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner.
For purposes of the constructive liquidation, the regulations deem the following events to occur simultaneously: (1) all partnership liabilities become payable in full, (2) all partnership assets that do not secure a partnership liability have a value of zero, (3) all partnership property is disposed of in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor’s right to repayment is limited solely to one or more assets of the partnership), (4) the partnership’s income, gain, loss, and deductions are allocated among the partners, and (5) the partnership liquidates.[xxvii]
A partner’s share of a recourse liability equals the portion of that liability for which the partner or a related party bears the economic risk of loss.
LLC-A’s Outside Basis in LLC-B
At one point, LLC-B and its managing member borrowed money from Lender to finance operations. Taxpayer had to prove that the Loan gave LLC-A a sufficient basis in LLC-B for LLC-A to deduct its share of the LLC-B loss. The parties agreed that there was no other capital contribution, transaction, or activity that would provide LLC-A with an outside basis in LLC-B.
The Loan was a recourse liability of LLC-B since its managing member would bear the economic risk of loss as to that liability. Its members, including LLC-A, would generally not be liable for the company’s debts and would have no obligation to pay the Loan should LLC-B’s assets be insufficient to satisfy the liability. LLC-B’s operating agreement reiterated the members’ protected status: “No Member, by virtue of his or its status as a Member, shall be bound by or be personally liable . . . for the debts, obligations, liabilities or contracts of the Company.” The operating agreement provided that, with the exception of the managing member, “[n]o Member shall be required to contribute any additional capital to the Company” and that “[e]xcept to the extent of its share of minimum gain or non-recourse debt minimum gain [neither of which is applicable here] . . . no Member shall have a Deficit Restoration Obligation.”[xxviii]
In contrast to the other members, LLC-B’s managing member would have an obligation to pay the Loan in the event of LLC-B’s constructive liquidation. The managing member was a borrower on the Loan, jointly and severally liable for the full amount of debt pursuant to the loan agreement. In the event of a constructive liquidation, when all LLC-B’s liabilities became payable, its assets had no value, and all its property was disposed of for no consideration, the managing member alone would be responsible for payment of the Loan; moreover, it would not be eligible for reimbursement from any of the other partners. Additionally, as LLC-B’s managing member, it could be obligated to contribute additional capital.
Based on the foregoing, the Court concluded that LLC-A acquired no basis in LLC-B on account of the Loan. Accordingly, LLC-A had no outside basis in LLC-B throughout the years in question.
Taxpayer’s Outside Basis in LLC-A
Likewise the Court found that Taxpayer had no outside basis in LLC-A throughout the subject years. The parties agreed that Taxpayer’s claim to any basis in LLC-A had to stem from Taxpayer’s Note, the LLC-A Note, and/or the Loan.
In cases of tiered partnerships with recourse liabilities, the liabilities of a lower-tier partnership allocated to the upper-tier partnership (the lower-tier partnership’s member) equal the amount of economic risk of loss the upper-tier partnership bears with respect to the liabilities and any other liabilities for which the partners of the upper-tier partnership bear the economic risk of loss.[xxix]
The Court concluded that neither LLC-A (the upper-tier partnership) nor Taxpayer bear any economic risk of loss as to an LLC-B liability. Taxpayer did not acquire any outside basis in LLC-A from the Loan. Neither did the Taxpayer Note or the LLC-A Note provide either of them with any basis.
Accordingly, Taxpayer did not have any outside basis in LLC-A during the subject years and, so, was not to claim the deductions reported on his tax returns.
Alternatives?
What is a partner to do when faced with the prospect of insufficient outside basis and the resulting inability to claim a deduction for their distributive share of a partnership’s loss?
Every situation is different, but there are several options to consider.
- A cash contribution is obvious, as is a loan of cash to the partnership, or the payment of a partnership debt. A contribution of other property (including a third-party note) would do the trick, but only to the extent of the partner’s basis in the contributed property (not its fair market value).
- If a partner owns another business entity, the partner may be able to cause that entity to make a loan to the partnership, thereby generating additional outside basis.
- A partner may consider borrowing money from a third party and then contributing or lending it to the partnership, provided a willing lender can be found.
- In addition, a partner’s personal guarantee or assumption of a partnership liability to a third party may generate outside basis, but the partner may not be in a position to utilize these options.
- The partner who purchases a partnership interest from another partner, even for an installment note, will receive a cost basis in such interest against which partnership losses may be deducted.
- Finally, the acceleration of partnership income or the deferral of deductions or distributions may assist in giving the partner outside basis for purposes of absorbing losses.
In reviewing the available alternatives, it will behoove a partner facing the possible disallowance of loss deductions to consult with their tax adviser. Before committing to any course of action, however, it is imperative that the alternative also make sense from a business perspective.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Pub. L. 99-514.
[ii] Tax shelters.
[iii] IRC Sec. 469. The passive loss rules limit deductions from passive trade or business activities. These loss rules apply to individuals, estates and trusts, and closely held corporations. A passive activity is a trade or business activity in which the taxpayer (a) owns an interest, but (b) does not materially participate. A taxpayer is treated as materially participating in an activity if they are involved in the operation of the activity on regular, continuous, and substantial basis.
[iv] IRC Sec. 465.
[v] Sometimes for better, other times for worse, depending on one’s perspective.
[vi] Pub. L. 115-97.
[vii] IRC Sec. 461(l). The excess business loss rules limit the ability of an individual taxpayer – including an individual partner in a partnership – to apply their losses from an operating business (including a partner’s distributive share of partnership business loss) for a taxable year against, for example, their investment income for such year. The amount of such loss that is disallowed for a year is treated as part of the taxpayer’s net operating loss (“NOL”) carryforward in subsequent years.
[viii] IRC Sec. 172.
[ix] IRC Sec. 704(d).
[x] Bryan v. Commissioner, T.C. Memo 2023-74 (filed June 20, 2023).
[xi] In the event the Court determined that Taxpayer had sufficient basis, the IRS also argued that Taxpayer did not substantiate he was at risk so as to be allowed to deduct the claimed NOLs and, failing which, the IRS argued Taxpayer did not substantiate that he materially participated in the activity or activities generating the losses so as to be allowed to deduct the claimed NOLs. (The IRS later conceded that Taxpayer had materially participated in the activities generating the NOLs disallowed as deductions for certain of the years in question.)
This post does not discuss the at risk or passive activity loss rules because the Taxpayer’s ability to utilize the losses claimed was resolved by the Court’s finding that Taxpayer did not have sufficient basis in the LLC membership interests.
Just as an aside, an individual taxpayer’s loss deduction from certain activities is generally limited to the aggregate amount for which the taxpayer is at risk for that activity at the close of that year. A taxpayer is at risk with respect to a particular activity to the extent of (1) money and adjusted basis of property he contributed to the activity and (2) amounts borrowed with respect to the activity for which the taxpayer is personally liable for repayment or has pledged property (other than property used in the activity) as security for the loan. See IRC Sec. 465.
[xii] IRC Sec. 172(a).
[xiii] IRC Sec. 172(c) and Sec. 172(d).
[xiv] IRC Sec. 172(b)(2).
[xv] Absent an election under pre-TCJA IRC Sec. 172(b)(3), an NOL for any taxable year first had to be carried back two years and then carried forward over 20 years. See pre-TCJA IRC Sec. 172(b)(1)(A), (2), (3).
[xvi] IRC Sec. 704(d).
[xvii] It was conceded that Taxpayer materially participated in the LLCs’ activities. IRC Sec. 469.
[xviii] IRC Sec. 704(d). Of course, the at-risk, passive loss, excess business loss, and NOL limitation rules have to be satisfied before the deduction is utilized to offset income.
[xix] Reg. Sec. 1.704-1(d). That said, it is possible that the partner will never be in a position to utilize these suspended losses.
[xx] Stated differently, the taxpayer’s unrecovered investment in the property.
[xxi] IRC Sec. 705, 722, 733, 752.
[xxii] Similarly, a partner’s capital account is not increased with respect to a note issued by that partner until there is either a taxable disposition of the note by the partnership or the partner makes principal payments on the note.
[xxiii] Reg. Sec. 1.752-1(a) (defining recourse and nonrecourse liabilities);.Reg. Sec. 1.752-2(a); 1.752-3(a).
State law characterization of a liability, as well as the characterization of the liability by the parties thereto, is not conclusive.
[xxiv] Reg. Sec. 1.752-1(a)(1).
[xxv] Which may require a capital contribution under certain circumstances involving a partnership liability.
[xxvi] Reg. Sec. 1.752-2(b)(3).
[xxvii] Reg. Sec. 1.752-2(b).
[xxviii] These provisions of the operating agreement were consistent with Reg. Sec. 1.752-2(b)(3)(ii).
[xxix] Reg. Sec. 1.752-2(i).
