At-Risk Final Regs. on “Disqualifying Interests”

Sec. 465 final regulations broaden the scope of the at-risk rules for loans from lenders with a “disqualifying interest” in the activity. Effective after May 3, 2004, amounts borrowed for use in essentially any activity will not increase the taxpayer’s amount at risk, regardless of the taxpayer’s personal liability for repayment, if the lender also has an interest in the activity other than that of a creditor (a disqualifying interest). The rules also apply if the lender is related to any person (other than the taxpayer) who has a disqualifying interest in the activity.

The final regulations apply to any individual or closely held corporation otherwise subject to the Sec. 465 at-risk rules; however, taxpayers who invest in passthrough entities may be affected the most, because they are likely to use borrowed funds to increase their at-risk basis for purposes of deducting allocated losses.

Overview

Prior to the issuance of the final regulations, Sec. 465(b)(3) (added in 1978) prohibited increasing an at-risk amount when funds were borrowed from lenders with disqualifying interests in the activity. However, at the time of passage, that provision applied only to activities enumerated in Sec. 465(c)(1) (motion pictures, farming, equipment leasing and the exploration/exploitation of oil and gas resources or geothermal deposits). For this ban to apply to “all other activities,” the IRS was instructed to provide regulations. Proposed regulations (REG-209377-89) were finally issued in July 2003; final regulations were issued in April 2004 (TD 9124). Prior to that time, taxpayers engaging in any activity other than those enumerated in Sec. 465(c)(1) could increase their at-risk amount by borrowing funds from anyone, as long as the taxpayer/borrower was personally liable for loan repayment or had pledged assets as security. As was mentioned, the enumerated activities have been subject to Sec. 465(b)(3) all along.

Disqualifying Interests

General rules: Under Regs. Sec. 1.465-8(b)(1), if a borrower is either personally liable for repayment of a loan or has secured it with assets with a readily ascertainable fair market value (FMV), a lender is deemed a person with an interest in the activity other than that of a creditor if he or she has either a capital interest in the activity or an interest in the activity’s net profits. For this purpose, Regs. Sec. 1.465-8(b)(2) provides that a lender has a capital interest in an activity if he or she is entitled to a distributable share of the assets on the activity’s liquidation. Owners of interests in passthrough entities (i.e., partnerships and S corporations) are deemed to have capital interests in the entity’s activities.

According to Regs. Sec. 1.465-8(b)(3), a lender who does not possess incidents of ownership in an entity’s assets, but has an interest in its net profits, is also deemed to have a disqualifying interest. For example, if any part of an employee’s or independent contractor’s compensation is determined with reference to the activity’s net profits, that person will be deemed to have an interest in the activity’s net profits.

Under Regs. Sec. 1.465-8(d), when a borrower secures a nonrecourse loan with assets without a readily ascertainable FMV, the lender will be deemed to have a disqualifying interest in the activity if he or she stands to receive financial gain (other than interest) from the activity or from the sale of interests therein. For example, a person who receives compensation for (1) services rendered in connection with the activity’s organization or operation or (2) the sale of interests in the activity, such as the promoter, is deemed to have an interest in the activity other than that of a creditor.

Because a lender can have a disqualifying interest in an activity either directly or indirectly, tax advisers must also keep in mind the rules that cause a lender to be “related” to a party who has an interest in an activity other than as a creditor. According to Sec. 465(b)(3)(C), for this purpose, Secs. 52(a) and (b), 267(b) and 707(b)(1) apply. By including the language “other than the taxpayer,” a taxpayer is permitted under the Code to borrow from family members or entities in which he or she has an ownership interest and increase his or her at-risk amount, as long as the lender does not have a direct or indirect disqualifying interest in the activity (other than the relationship with the taxpayer).

Loans protected against loss: Under Regs. Sec. 1.465-20, amounts borrowed after May 3, 2004, from a lender who has a disqualifying interest in an activity or is related to someone (other than the taxpayer) with a disqualifying interest, will be treated in the same manner as borrowed amounts protected against loss. Loans are generally deemed protected against loss when the borrower has no personal liability and has not pledged security. Even before the final regulations were issued, loans protected against loss did not increase a taxpayer’s at-risk amount.

Deducting Losses

A taxpayer’s ability to deduct losses from an activity is limited to the amount of investment in the activity that is at risk, otherwise known as the “at-risk basis.” A taxpayer is generally at risk and, thus, has at-risk basis in an activity to the extent of money or property contributed, amounts borrowed for use in the activity or to acquire an interest in the activity (to the extent the taxpayer is personally liable for repayment or has pledged assets for security), and the net income has been allocated to the taxpayer, but has not been distributed. Losses passed through to the owner of a limited liability company (LLC) or an S corporation and disallowed as a current deduction due to insufficient at-risk basis, are carried forward indefinitely until the taxpayer’s at-risk basis is increased. Making contributions and loans to the entity, as well as future net income allocations, can increase at-risk basis.

While losses are deferred, rather than disallowed, under the at-risk rules, the time value of money makes a deduction in the year of the loss more valuable than a deferral of the deduction. Thus, to maximize a taxpayer’s ability to deduct losses currently, the final regulations’ provisions must be followed closely.

Example 1: X owns 70% of Y, an LLC. X’s daughter, D, borrows money from X to acquire a 10% ownership interest in Y. Under Regs. Sec. 1.465-8(a), D’s at-risk basis in Y does not increase by the amount she borrowed from X, because X has a disqualifying interest in Y. As D makes payments to X on the loan, her at-risk basis in Y will increase.

Example 2: The facts are the same as in Example 1, except that D borrows from X to start an LLC with an unrelated person. The funds D borrowed from X would increase her at-risk basis in the LLC, as X does not have a disqualifying interest in that entity.

Conclusion

Regs. Sec. 1.465-8 and -20 apply Sec. 465(b)(3) to generally all activities carried on as a trade or business or for the production of income. For some taxpayers, these regulations will be seen as welcome guidance; for others, they will put an end to the practice of borrowing from another partner or S shareholder (usually, a majority owner) to acquire an interest in the same activity. When the same individuals or families are involved in several closely held entities, tax advisers should advise caution when borrowing funds to acquire or expand interests in an entity (especially if allocated losses are expected).

From B. Carol Howard, CPA, R J Pile, LLC, Indianapolis, IN