Keeping It Real
Contrary to what has long been an all-too-popular belief,[i] there is a method to the Code. That is not to say that no part of it is arbitrary, or that none of its provisions are tainted by political dealings, or that it cannot be improved. After all, it is the product of human beings[ii] and, as such, it is bound to reflect our mistakes and weaknesses – many of which are part and parcel of the trial-and-error process by which our system of taxation has evolved and been developed. By the same token, it is often amended in response to, and as a counter against, various manifestations of those weaknesses.
So, what is this “method” referred to above? Setting aside the Code as a tool for generating revenue,[iii] social engineering,[iv] behavior modification,[v] etc., one of the Code’s most important functions is to ensure that the benefits it bestows, and the burdens it imposes, are realized only by those taxpayers who have an economic “entitlement” to them.
For example, in computing taxable income for a taxable year, the Code permits a taxpayer to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.[vi] However, various rules have been developed to ensure that the tax consequences of a given transaction match the economic consequences of the transaction.[vii] Among these, for example, are the so-called “at-risk” limitations, which are designed to prevent a taxpayer from deducting losses in excess of the taxpayer’s actual economic investment in an activity.[viii]
Under the at-risk rules (“ARR”), a taxpayer’s deductible losses from an activity for a taxable year are limited to the amount the taxpayer has placed at-risk – the amount the taxpayer could actually lose – in the activity. The initial amount at-risk is generally the sum of (i) the taxpayer’s cash contributions to the activity, (ii) the adjusted basis[ix] of other property contributed to the activity, and (iii) amounts borrowed for use in the activity with respect to which the taxpayer has personal liability or has pledged as security for repayment property not used in the activity.[x] This amount is generally increased each year by the taxpayer’s share of income from the activity, and is decreased by the taxpayer’s share of losses and withdrawals from the activity.[xi]
A recent decision of the U.S. Tax Court provided a helpful illustration of how these rules are applied.[xii]
During the years at issue, Taxpayer was in the healthcare business. As part of the business, Taxpayer owned a medical services company (“Service-Co”) which provided management services to hospitals, outpatient facilities, rehabilitation facilities, and medical clinics. Service-Co was a corporation[xiii] and Taxpayer owned all of Service-Co’s issued and outstanding shares of stock.
In addition to Service-Co, Taxpayer owned all of the membership interests of Hospital LLC, which Taxpayer formed to purchase and own a hospital (“Hospital”).[xiv] Hospital LLC was a single-member limited liability company that was treated as a disregarded entity for Federal tax purposes during the relevant years.[xv]
In July 2008, Taxpayer used Hospital LLC and Service-Co to purchase Hospital for $9.9 million. Taxpayer funded the purchase using a development loan (“Hospital Loan”) obtained from Bank.
Bank granted the Hospital Loan under a Federal program overseen by Agency that provided banks with a government guarantee on loans for certain development projects; however, as a condition for such loans, Agency required borrowers to execute personal guarantees for the full loan amount; $9.9 million in this instance.
The Hospital Loan was structured so that Hospital LLC and Service-Co were identified as the co-borrowers. Taxpayer executed a corresponding promissory note on behalf of Hospital LLC and Service-Co that reflected a payment schedule, a maturity date, and collateral consisting of Hospital facilities and equipment. Taxpayer also executed Agency’s required personal guarantee that made him directly liable to Bank for the full amount of the Hospital Loan and any amounts due for as long as the Hospital Loan was outstanding.
The guarantee created strict obligations for Taxpayer regardless of any obligations of the borrowers (Hospital LLC and Service-Co). Under the terms of the personal guarantee, Bank was not required to seek payment from any other source before demanding payment from Taxpayer. The guarantee also clearly stated that Agency was “not a co-guarantor” on the Hospital Loan and that Taxpayer had “no right of contribution” from Agency with respect to the guarantee. Furthermore, the guarantee provided that if Agency paid any amounts on the Hospital Loan to Bank, those amounts would become a debt owed by Taxpayer and subject to all remedies Agency could employ to recover the debt. There were no other guarantors to the Hospital Loan, and it remained outstanding through the years at issue.
Tax Returns and IRS Exam
For 2008, Taxpayer reported the income and expenses of Hospital LLC on a Schedule C, “Profit or Loss From Business”,[xvi] of their Form 1040 and claimed the corresponding loss deduction related to Hospital LLC.
The IRS reviewed the return, determined a deficiency, and timely[xvii] mailed Taxpayer a notice of deficiency (“NOD”). The NOD disallowed almost $1 million of Taxpayer’s claimed loss deductions related to Hospital LLC on the grounds that Taxpayer had not demonstrated that they were “at-risk” to the extent of the reported loss.[xviii]
The Taxpayer timely filed petitions with the U.S. Tax Court.[xix] The issue for decision before the Court was whether the personal guarantee that Taxpayer executed in 2008 left Taxpayer “at-risk” under Section 465 of the Code to the extent of the $1 million of loss deductions Taxpayer claimed related to Hospital LLC.[xx]
For individuals and certain closely held corporations engaged in carrying on a trade or business or for the production of income, Section 465 of the Code generally limits loss deductions to the amount for which the taxpayer is considered “at-risk”.[xxi] If losses are disallowed under Section 465, then the losses are suspended and carried forward to the first succeeding taxable year (subject to the same “at-risk” limitations), or to each year thereafter until the losses can be deducted.[xxii]
A taxpayer’s amount at-risk for an activity generally includes: “(A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and (B) amounts borrowed with respect to such activity”.[xxiii] In general, amounts borrowed are considered to be at-risk only to the extent that the taxpayer: “(A) is personally liable for the repayment of such amounts, or (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the net fair market value of the taxpayer’s interest in such property).”[xxiv] Furthermore, “a taxpayer shall not be considered at-risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.”[xxv]
With regard to the Hospital LLC deductions, the IRS contended that the personal guarantee that Taxpayer executed in 2008 did not actually put Taxpayer at-risk to the extent of the disallowed deductions. The personal guarantee would qualify under section 465(b)(1)(B), if at all, only as an “amount borrowed”. Thus, Taxpayer had to show: (1) that they were “personally liable” for the Hospital Loan and (2) that they was not “protected against loss.”
The ARR do not specifically address whether a guarantor is considered “personally liable” (and, therefore, potentially “at-risk”) for amounts borrowed, but the courts have generally determined that some guarantees do result in personal liability. As a general matter, the mere execution of a guarantee is insufficient to establish personal liability for purposes of the ARR. The reason is that in the case of a typical guarantee, if the guarantor were required to pay on the underlying debt, the guarantor would generally be entitled to seek reimbursement from the primary obligor.
However, as the Court explained, “not all guarantees are created equal”; when a guarantor is directly liable on a debt and there is no primary obligor bearing recourse liability for the debt, then the guarantor would not have any meaningful right to reimbursement, and thus would be ultimately liable for the debt.
Accordingly, a guarantor’s personal liability for purposes of the ARR depends on whether or not the guarantor has the ultimate liability for the debt.
To answer that question, the Court considered the “worst-case scenario” and then identified the “obligor of last resort” based on the substance of the transaction. The Court asked: If there were no funds to repay the debt, and all of the assets of the activity or business were worthless, to whom would the creditor look for repayment?
The Court was persuaded that Taxpayer bore the “ultimate liability” with respect to the Hospital Loan. In 2008, Taxpayer obtained a $9.9 million loan through two of their wholly owned entities, Hospital LLC and Service-Co. The loan was part of Agency’s lending program that required Taxpayer to personally guarantee the full amount of the loan, and Taxpayer executed the guarantee in 2008. There were no other guarantors to the loan. The guarantee created a direct liability against Taxpayer that would have permitted Bank to pursue Taxpayer directly without any action against Hospital LLC or Service-Co if either of them defaulted on the loan.
The only other viable option for Bank to pursue in the event of Hospital LLC’s or Service-Co’s default would have been to seek loss payments from the Agency through its lending program, in which case Taxpayer would have incurred a debt obligation subject to the full recourse actions available to the Federal government for any such payments. In either case, Taxpayer would have been ultimately liable for the debt, either to Bank or to Agency.
The IRS argued that, under State law, a member of an LLC was not personally liable for the debts of the LLC. The Court rejected this, stating that Taxpayer became liable for Hospital LLC’s debt not because they were a member of the LLC but because they executed a personal guarantee for that debt.
The IRS also argued that Taxpayer was not personally liable for purposes of the ARR because State law “provides that a surety who pays the creditor is entitled to reimbursement from the principal obligor.” That is, the IRS asserted that, if Taxpayer made payments on the Hospital Loan, Taxpayer then would have a right to reimbursement from the primary obligors: Hospital LLC and Service-Co. To evaluate this argument, however, the Court invoked the principle that “for purposes of these rules, we presume the worst-case scenario – a circumstance in which the primary obligors” (Hospital LLC and Service-Co) would be worthless and thus unable to reimburse Taxpayer for any amounts paid on account of Taxpayer’s guarantee.
Moreover, the Court continued, even if it looked to Hospital LLC and Service-Co (whether or not deemed defunct or insolvent) as the obligors responsible in form for any such reimbursement, it could not ignore the fact that Taxpayer, as the sole owner of Hospital LLC and Service-Co, would still bear the economic responsibility for such reimbursement in substance. In other words, any reimbursement to which Taxpayer might theoretically be entitled would be due to him from their own 100-percent-owned entity. Taxpayer would ultimately be paying the debt, and the fact that Taxpayer might then be entitled to seek reimbursement from themselves would not render Taxpayer any less at-risk.
The IRS stressed that the Hospital Loan was substantially collateralized, that it was not likely that Taxpayer would ever be called on to make payments pursuant to their guarantee, and that Taxpayer did not in fact ever do so.
But these facts did not undermine Taxpayer’s personal liability under the ARR. The Court also observed that the IRS did not cite any authority for the relevance of these propositions.
Thus, as to the Hospital Loan, the Court found Taxpayer “personally liable” for purposes of the ARR.
Protected Against Loss?
The Court next considered whether Taxpayer was “protected against loss” for purposes of the ARR,[xxvi] noting that “a taxpayer shall not be considered at-risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.” The Court stated that a guarantor who had a right to reimbursement from a primary obligor was not, as a general rule, considered to be at-risk.
The Court explained: “Since a guarantor is entitled to reimbursement from the primary obligor, it is clear that Congress did not intend that a guarantor of a loan is personally liable for repayment of the loan within the meaning of” the ARR. In other words, if a guarantor were required to pay an amount on the underlying debt beyond their initial contribution, then they would have a right to reimbursement from the principal obligors, and the guarantor’s risk would be limited.
However, the Court stated that a guarantor’s right to reimbursement would limit their risk only if the facts indicated a certainty as to the reimbursement; i.e., the right to reimbursement was meaningful. Conversely, when a guarantor’s right to reimbursement was against a primary obligor that has only limited liability, and there was no definite or fixed recourse obligation for the underlying debt, then the right to reimbursement would be less meaningful and, so, there may indeed be risk.
Accordingly, when evaluating a guarantor’s loss protections (including reimbursements from primary obligors), the Court indicated that it looks at the facts and circumstances to determine not only whether there is a right to the reimbursement, but whether the substance of the right is meaningful. In other words, one must consider the “realistic possibility” that the guarantor would ultimately be subject to “economic loss” if called upon to make payments on account of the guarantee.
The Court then applied both the “worst case scenario” and the “realistic-possibility” analyses to Taxpayer’s guarantee.
In determining whether Taxpayer was personally liable, the Court presumed that the primary obligors (Hospital LLC and Service-Co) were worthless and unable to pay the amount owed under the Hospital Loan. If that presumption were maintained as to the primary obligors, and one then turned to the question of whether there was a realistic possibility of reimbursement, it was clear that Taxpayer would not be protected against loss for purposes of the ARR because Taxpayer’s right to reimbursement would be against the worthless entities with no means to repay Taxpayer for any amounts contributed.
Taxpayer executed a personal guarantee in 2008 for Hospital Loan. Under that guarantee, Taxpayer became directly liable to Bank for the full amount of the debt if the obligors defaulted. There was no other guarantor on the debt, nor was there a definite or fixed right to any contribution from other members of Hospital LLC or from Service-Co on account of the debt. Indeed, Taxpayer was the sole owner of these entities and the only person with unlimited liability for the Hospital Loan. Even if one disregarded a worthlessness determination when considering Taxpayer’s realistic possibility of economic loss, the Court could not disregard that, in substance, Taxpayer was the only one involved with respect to the liability for the Hospital Loan, the corresponding promissory note, and the personal guarantee.
Accordingly, the court found that Taxpayer was personally liable, not protected against loss, and ultimately at-risk under the Hospital Loan during 2008 so as to be entitled to deduct the losses related to Hospital LLC that were claimed on the Taxpayer’s 2008 return.
Good to Be At-Risk (?)
Not really, not if you can avoid it, or at least contain its consequences. A calculated risk is something else – it may be the price one must pay to be in business and, hopefully, to realize a worthwhile return on one’s investment[xxvii] of capital, time and effort.
Yes, losses may be generated along the way, but at least you’ll have the comfort of knowing that you may deduct those losses for purposes of determining your taxable income. Of course, I’m being somewhat facetious.[xxviii] A loss is still a loss, though a tax deduction may remove some of the sting, and thereby encourage a taxpayer to take a chance on a new project or business.[xxix]
The ARR, however, are only one step in the gauntlet of rules that are aimed at limiting a taxpayer’s ability to use the losses from one business to offset the income from another.[xxx]
A business owner would be well-served to consult with their tax adviser if they expect their new venture will be generating losses, at least initially. A familiarity with the ARR, as well as with the Code’s other loss-limitation rules, will enable the business owner and their advisers to select[xxxi] the appropriate entity through which to operate the new business or venture, and to structure the capitalization thereof, including financing, in a way that will allow the owner to maximize the use of any losses for tax purposes and, thereby, to reduce the net economic effect of such losses.
[i] Thanks to whoever, at the moment, benefits from perpetuating it.
[ii] Not philosopher kings, though we could use a few wannabes in Washington.
[iii] Its primary function.
[iv] For example, the charitable contribution deduction [IRC Sec. 170, Sec. 2055, Sec. 2522], or the credit for low income housing [IRC Sec. 42].
[v] For example, the denial of most deductions for cannabis business [IRC Sec. 280E], or the treatment of spouses as a single economic unit for most income and transfer tax purposes [IRC Sec. 1041, Sec. 2056, Sec. 2523].
[vi] IRC Sec. 63, Sec. 162.
[vii] The IRS and the courts will gauge a tax position on the basis of its economic reality. Thus, they will often look for the independent non-tax business reason for a transaction. In the realm of partnership allocations, they will look for the substantial economic (non-tax) effect of an agreement to share profits and losses.
[viii] IRC Sec. 465.
[ix] I.e., the unreturned investment – not the appreciated fair market value; only the amount by which the taxpayer has come out of pocket.
[x] We ignore the special case of real property and qualified nonrecourse financing. Ah, real estate – an example of our weaknesses? Or an attempt to encourage certain behavior? Some combination of both.
[xi] The amount that has been taxed to the taxpayer, but which they have not withdrawn from the business, thereby leaving it “at-risk” in the business.
[xii] Bordelon v. Comm’r, T.C. Memo. 2020-26.
[xiii] It was treated as a C corporation for Federal tax purposes during 2008 and 2009 and as an S corporation beginning in 2010.
[xiv] Yes, a for profit hospital – one that operates to provide a return for its investors. Approximately 25% of the non-federal hospitals in the U.S. are for profit. https://nonprofitquarterly.org/how-do-nonprofit-and-for-profit-hospitals-differ-its-complicated/
[xv] Reg. Sec. 301.7701-3.
[xvi] Because Taxpayer owned 100% of Hospital LLC, and because the latter was disregarded for tax purposes, Taxpayer was treated as owning all of LLC’s assets and liabilities, income and expenses. In other words, Taxpayer was treated as a sole proprietor with respect to Hospital LLC’s business. Accordingly, the profits and losses from this business were reported on Sch. C of Taxpayer’s Form 1040.
[xvii] See IRC Sec. 6501 – the statute of limitations for the assessment of a tax deficiency.
[xviii] Consequently, Taxpayer had the burden of showing that they were at risk for the Hospital Loan
The IRS did not determine that Hospital LLC did not actually incur the expenses underlying those losses. Rather, the only dispute was Taxpayer’s entitlement to deductions for those losses under the at-risk rules.
[xix] IRC Sec. 6213. The 90-Day Letter.
[xx] There were other issues that we are not addressing in this post.
[xxi] IRC Sec. 465(a), (c)(3)(A).
[xxii] IRC Sec. 465(a)(2).
[xxiii] IRC Sec. 465(b)(1).
[xxiv] IRC Sec. 465(b)(2).
[xxv] IRC Sec. 465(b)(4).
[xxvi] IRC Sec. 465(b)(4).
[xxvii] One’s putting at risk.
[xxviii] Compare the idea of saving taxes by making a charitable contribution of cash. Unless you really intend to benefit a charity, your only savings, generally speaking, is equal to the amount of the contribution multiplied by your effective tax rate. You’re still out the cash, though it didn’t cost you as much as it otherwise would have if the charitable contribution deduction had not been available.
[xxix] The Code’s role in encouraging certain behavior.
[xxx] In determining their taxable income for a taxable year, the shareholders of an S corporation and the partners of a partnership are allocated their share of the pass-through entity’s losses for such year. However, there are a number of rules that limit the ability of these owners to deduct these losses.
As a threshold matter, the aggregate amount of losses taken into account by a shareholder or partner for a taxable year cannot exceed, (i) in the case of an S corporation, the sum of the shareholder’s adjusted basis for his stock, plus his adjusted basis of any corporate indebtedness owed to the shareholder, and, (ii) in the case of a partnership, the adjusted basis of such partner’s interest in the partnership. Any excess for which a deduction is not allowed in a taxable year is carried forward.
Any pass-through loss that is allowed under the above “basis-limitation rule” must also be tested under the “at-risk” rules and, then, the “passive activity” loss rules before it may be utilized by a shareholder or partner in determining his taxable income. A loss that is disallowed under either of these rules is “suspended” and is carried forward indefinitely to succeeding taxable years until the taxpayer has more amounts at risk, or realizes more passive income, or disposes of their interest in the pass-through entity.
The Tax Cuts and Jobs Act imposed yet another limitation on a non-corporate taxpayer’s ability to utilize a pass-through loss against other income – whether it is realized through a sole proprietorship, S corporation or partnership – which is applied after the basis-limitation, at-risk, and passive loss rules. Specifically, for taxable years beginning after December 31, 2017 and before January 1, 2026, the excess business losses of a non-corporate taxpayer are not allowed for the taxable year.
[xxxi] All other things being equal.