LLCs and the Sec. 465 At-Risk Rules with DROs

Does a limited liability company (LLC) operating agreement, with a deficit restoration obligation (DRO) enforceable under state law, increase members amounts considered at-risk? Under Sec. 465, a taxpayers deductible loss is generally limited to the amount at-risk; for any given activity, this includes cash contributions, adjusted basis of property contributed to the activity and amounts borrowed as to it. Under Sec. 465, the taxpayer includes the amounts borrowed in determining at-risk basis to the extent he or she is personally liable for repayment or has pledged assets not used in the activity as security for them.

For example, an LLC secured a bank debt; the security agreement provided that in addition to specific equipment, general intangibles and funds arising out of the LLCs activities or related to it are collateral. For purposes of the loan agreement, the LLC operating agreement would contain a DRO enforceable under state law. As a result, creditors could force a member to repay the debt from individual assets, through a garnishment proceeding.

Field Service Advice (FSA) 1999-993 involved an analogous situation. It concluded:

[i]n the case of a limited partner, the litmus test for inclusion of debt in their amount at risk is the extent to which the limited partner bears ultimate personal liability for amounts borrowed by the partnership[citing Callahan, 98 TC 276 (1992)]. In Pritchett85 T.C. 581 (1985), revd and remanded 827 F.2d 644 (9th Cir. 1987), a limited partnership executed a recourse note in connection with a turnkey drilling arrangement. Only the general partners were personally liable under the note. However, the limited partnership agreement provided that in the event the note was not paid in full at maturity, the limited partners would be personally obligated, if called upon by the general partners, to make additional capital contributions to the partnership to cover the deficit. The Tax Court concluded that the limited partners were contingently obligated to make future contributions only in the event partnership revenues were insufficient to satisfy the note at maturity and the general partners exercised their discretion to make the cash call.

The Ninth Circuit reversed the Tax Court. Although the Ninth Circuit agreed that the limited partners were not directly and personally liable to the creditor, the court emphasized that the critical inquiry was whether the partner was the obligor of last resort. See also Bennion...88 T.C. 684 (1987)The Ninth Circuit also made it clear, however, that if the limited partnership agreement had created only contingent obligations on the part of the limited partners the amounts at risk would not increase. On the facts of Pritchett, the Ninth Circuit concluded that the liability of the limited partners was unavoidable, hence not contingent. See also Melvin88 T.C. 63 (1987), affd 894 F.2d 1072 (9th Cir. 1990)

Based on the holding in FSA 1999-993, it would appear that LLC members should be considered at-risk for LLC liabilities within the meaning of Sec. 465 if, under state law, the LLC operating agreement contains a DRO provision that places members in a position to bear the economic risk of loss for a loan if the LLC cannot repay its debt obligations.

From John L. Wright, CPA, MST, Gaither Rutherford & Co., LLP (An Independent Member of the BDO Seidman Alliance), Evansville, IN