Originally published on Forbes.com May 5th, 2014
It has been in the news of late that GAO does not think IRS has been looking closely enough at large partnerships. Follow-up stories indicate that maybe the IRS will be looking at them more. A recently released memo (AM 2014-003) issued internally last summer hints at what they might start looking at and I find it rather scary for lots of high-net-worth individuals. The memo was from Associate Chief Counsel Curt Wilson to Division Counsel for the Large Business] and International Division. It concerns how debt guarantees affect the amount at-risk] (Code Section 465). The memo points both to a planning opportunity and a trap for the unwary. Something tells me IRS might be more interested in the latter. I have to warn you that this is a bit tax geeky, so I will give you just a bit of background.
Background
One way of looking at much tax legislation for the last half-century is as something of a war against tax shelters. The war has resulted in a lot of collateral damage in the form of complicated rules that people who are not really trying to get away with anything can run afoul of. One way I have explained the whole confusing mess is by laying out the series of hoops that you have to jump through in a very specific in order to post a negative number on your return. The third and fourth hoops in my analysis are basis and at-risk. People often confuse these two. The confusion is at its worst in the partnership area. Based on chief counsel memos I have seen, the confusion exists even inside the IRS.
The reason that the partnership form is the entity of choice for tax sheltering is that you have basis in your share of the partnership’s liabilities. Basis is the third hoop you have to jump through to post a negative number on your return. (The first two, which I will not be discussing are the activity being for profit (Section 183) and the allocation of loss to you being valid (Section 704))Having basis also allows you to take cash out of the entity without recognizing gain.
At-risk is the next hoop. There is more to it than this, but generally “at-risk]” will track basis pretty closely until you get to liabilities. In order for a liability to give you “at-risk” basis it has to be a recourse liability. In other words, you can’t just turn over the keys and be done with it you have to be, well, at risk, for the entire balance. Certain types of non-recourse “qualified non-recourse” will also get you “at-risk” basis . When you own stock in an S corporation it is possible for you to be literally at risk, through a debt guaranty without having basis, since, unlike a partnership, you do not have basis in a share of the S corporation’s liabilities.
The Ominous Memo
Limited liability companies can be taxed as either partnerships or corporations. The entity gets to choose. Mr. Wilson’s memo addresses what happens when an LLC member guarantees the liabilities of an LLC. I didn’t find anything surprising in the memo other than that the Division Counsel of the Large Business and International Division needed to ask these questions.
First The Planning Opportunity
The first thing is that when a member guarantees non-recourse liabilities of the LLC, the member gains at-risk basis, but only to the extent that the member has no right of contribution or reimbursement, is not otherwise protected against loss and the guaranty is bona fide and enforceable by creditors of the LLC under local law. Although this is not surprising, it is good to see it in black and white. Further, it does present a planning opportunity to affect the timing of losses. The trade payables of an LLC will create regular basis, but not at-risk basis to the members. A strategic guaranty to a key supplier might allow the stream of losses to be turned on for one of the members. Of course if the LLC goes under, that member might have reason to regret that move.
The Trap
As Mr. Wilson, with one hand, gives us an opportunity, with the other he points out a trap. When a member, let’s call him George, guarantees qualified nonrecourse indebtedness, he may get additional at-risk basis. Remember George will already have been deemed at-risk for some of the qualified non-recourse indebtedness. The trap is not for George, though. The trap is for some other member, let’s call him Norman. Because of George’s guaranty, the debt is no longer qualified non-recourse indebtedness. So Norman (and maybe some other members) have their at-risk basis reduced. This could be very nasty since 465(e) provides for recapture of losses when the amount at risk drops below zero.
Why This Might Be Ominous
You learn about your share of a partnership’s liabilities from Box K of Form 1065. More often than not, those numbers will not affect your tax liability. That is good news, because also more often than not the numbers are wrong. Either liabilities are wrongly classified or the amount has not been properly allocated among the partners. If the partnership is subject to TEFRA, you are stuck with the incorrect characterization.
I know that the Box K numbers are frequently wrong because I have been involved in preparing both a large number of partnership returns and a large number of complicated individual returns that include a lot of K-1s. My various crews have not always been fanatically meticulous about Box K, but I have always kept a close eye on it, particularly when I know it can make a difference to the partners. When on the receiving end of K-1s, I have seen many that are blatantly wrong. It is very easy to get them wrong, hard to get them right and it usually does not make a difference, particularly since the IRS has not been paying much attention to them.
Thanks to the GAO report, it seems likely that the IRS will be looking more closely at large partnerships. Years ago, I might have thought that those partnerships must have returns that were done in a technically proficient manner since they were done by large national firms, if not the Big 4. Then I spent 17 months working for a not quite Big 4 firm.
The standard engagement letter for a partnership indicated that preparation of the return did not include making sure that capital accounts were being properly maintained (That was a special service performed by a national team. The kid running it was a genius. That’s why I loved working for a national firm.) The only problem was that getting a special team to deploy (That is what they literally called it) was very expensive and most clients were not up for it. So the standard engagement letter was saying, in effect, “If you want us to do your return right, you have to pay extra”.
So my fear is that lots of Normans are going to get blindsided by adjustments starting in a couple of years.
You can follow me on twitter @peterreillycpa.
Afternote
Although, this memo is ominous enough, what will really start worrying me is when they start taking a close look at Code Section 752 which is where the allocation of basis from liabilities, regardless of at-risk takes place. In our example above, Norman might not be all that concerned about having losses denied by the at-risk rules, if he was unable to jump through the next hoop, the passive activity loss rules. What if the partnership made a distribution to Norman and he did not recognize gain since he had basis from liabilities? George’s guaranty will also cause those liabilities to shift away from Norman for regular liability purposes possibly triggering a gain. That would be really nasty.