Special rules apply for allocating basis from loans made or guaranteed by limited liability company (LLC) members or affiliates of members. The following discusses how loans made or guaranteed by members or member affiliates generally must be allocated 100% to the member who makes or guarantees the loan (or whose affiliate makes or guarantees the loan).
Allocating Debt Owed to Members and Member Affiliates
If a member or related person (i.e., a member affiliate) makes a loan to an LLC, it is generally categorized as recourse for basis purposes (Regs. Sec. 1.752-2(c)). This is true even if the loan would be characterized as nonrecourse if made by an unrelated person. This type of liability is called a member nonrecourse loan. The lender member or member affiliated with the lender is deemed to bear all economic risk of loss with respect to the loan. As a result, the lender member or member affiliated with the lender is allocated 100% of the liability for basis purposes. A similar rule applies to guarantees of nonrecourse debt by a member or member affiliate.
As discussed in the previous paragraph, nonrecourse loans from members or member affiliates are generally allocated 100% to the lender member (or member related to the lender). However, a de minimis rule applies to member (or member affiliate) nonrecourse loans if (1) such member's interest in each and every item of income, gain, loss, deduction, or credit is 10% or less over the life of the LLC, and (2) the loan constitutes qualified nonrecourse financing under the at-risk rules. If both criteria are met, member nonrecourse loans are treated as true nonrecourse debt that is allocated based on the three-tier system described in Regs. Sec. 1.752-3(a).
The determination of whether a debt is qualified nonrecourse financing for purposes of this de minimis rule is made without regard to the type of activity for which the debt is used (i.e., it need not be held in connection with real estate activities). The intent of this rule is to allow the allocation of basis to nonlender members for nonrecourse loans owed to a member (or member affiliate) who is predominantly a creditor of the LLC rather than a member. For direct member nonrecourse loans, this rule applies to debt incurred, assumed, or materially modified on or after March 1, 1984. With respect to nonrecourse loans from member affiliates, the de minimis rule applies to post–January 29, 1989, debt.
Example 1: An individual, M, and F Inc. form an LLC in 2009 to acquire and operate a small grocery store. The LLC is classified as a partnership for federal taxes. M contributes $9,500 cash, and F contributes $500 cash. F then loans the LLC $100,000 to purchase a building for the store. F is actively engaged in the business of lending money, and the loan is commercially reasonable and is on the same terms as a loan F would make to an unrelated party. The loan is secured only by the store building. Under the LLC's operating agreement, M and F share all LLC items, including income, losses, and credits, on a 95/5 basis.
Under the general rule for nonrecourse loans directly from LLC members or member affiliates, F would be deemed to bear all economic risk of loss for the loan under Regs. Sec. 1.752-2(c)(1). As a result, the entire $100,000 liability would be allocated to F for basis purposes. However, because F 's interest in each item of the LLC's income or loss is 10% or less, and the loan meets the definition of qualified nonrecourse financing under Sec. 465(b) (6)(B), the de minimis rule applies. Therefore, the liability is allocated as a true nonrecourse liability under Regs. Sec. 1.752-3.
Impact of Member Affiliate Loans
As stated previously, the character of a liability as recourse or nonrecourse (and the determination of the members' shares of the liability for basis purposes) depends not only on the relative rights and obligations of the members but also on those of persons related to members, i.e., member affiliates. In determining basis, the rights and obligations of these member affiliates are attributed to the related members. This means that a loan from a member affiliate is treated as if it is owed to the member related to the lender. The related member is treated as having 100% of the economic risk of loss and is allocated all the liability for basis purposes. However, the de minimis rule already discussed may apply.
The definition of member affiliates (i.e., parties that are related to members) is critical because such relationships may cause a nonrecourse loan to be treated as recourse. This treatment results in an allocation of 100% of the basis from the loan to the member affiliated with the lender. In general, a person is affiliated with a member if such person (1) is not another member in the same LLC and (2) shares with the member one of the relationships described by the related-party rules of Sec. 267(b) or the controlled partnership rules of Sec. 707(b)(1), subject to certain modifications set forth in the regulations (Regs. Secs. 1.752-1(a)(3) and 1.752-4(b)).
These relationships, as modified, are as follows:
- Members of the same family, including spouses, ancestors, and lineal descendants.
- An individual and a corporation of which more than 80% (by value) of the outstanding stock is owned directly or indirectly by or for the individual.
- Two corporations that are members of the same controlled group.
- A grantor and a fiduciary of the same trust.
- Fiduciaries of trusts with the same grantors.
- A fiduciary of a trust and a beneficiary of another trust—if the same person is the grantor of both.
- A fiduciary of a trust and the beneficiary of that trust.
- A fiduciary of a trust and a corporation if more than 80% (by value) of the stock is owned directly or indirectly by or for the trust, or by or for a grantor of the trust.
- A person and a tax-exempt organization controlled directly or indirectly by that person or by his or her spouse, ancestor, or lineal descendant.
- A corporation and an LLC (or partnership) when the same persons own more than 80% (by value) of the corporation's stock and more than 80% of the capital or profits interests in the LLC (or partnership).
- Two S corporations if the same persons own more than 80% (by value) of the stock of both corporations.
- An S corporation and a C corporation if the same persons own more than 80% (by value) of the stock of both corporations.
- An LLC (or partnership) and a person that owns, directly or indirectly, more than 80% of the capital or profits interests in the LLC (or partnership).
- Two LLCs (two partnerships, or an LLC and a partnership) in which the same persons own, directly or indirectly, more than 80% of either the capital or the profits interests in both LLCs (both partnerships, or both the LLC and the partnership).
The constructive ownership rules of Sec. 267(c) apply in determining whether these relationships are present.
If a person is related to more than one member, the person is deemed to be related only to the member with the greatest percentage of related ownership at the time of the determination. If two or more members have the same percentage of related ownership with a person and no other member has a greater percentage, the basis of the related person's loan or guaranteed loan is allocated equally among those members (Regs. Sec. 1.752-4(b)(2)).
Example 2: B, A, and P form L LLC to acquire and operate a resort hotel. L is classified as a partnership for federal taxes. B, A, and P each have a onethird interest in L and each contributes $100,000 to the LLC. L purchases the hotel building and land with the $300,000 cash and a $3 million nonrecourse loan from T, Inc., a C corporation. P owns 45% of T 's stock (by value), his son owns 40%, and the remaining 15% is owned by an unrelated party.
T and P are related parties as defined in Regs. Sec. 1.752-4(b). P directly owns 45% of T 's stock value and indirectly owns an additional 40% (because under the constructive ownership rules of Sec. 267(c), P is considered to own the stock owned by his family, including his son). Under the related-party rules, as modified by Regs. Sec. 1.752-4(b), an individual and a corporation are related parties when more than 80% (by value) of the corporation's outstanding stock is owned directly or indirectly by or for the individual. Since P is deemed to own 85% of T 's outstanding stock, P and T clearly meet the definition of related parties.
Because of this relationship, the otherwise nonrecourse loan to L will be treated as recourse. This results in an allocation of 100% of the basis from the loan to P, the member affiliated with the lender.
Note: Because the percentage threshold for affiliation between a member and an entity is set fairly high by the regulations (i.e., 80%), it was anticipated that taxpayers would attempt to take advantage of the rules by having members own slightly less than 80% of an affiliated entity. Therefore, if a member owns 20% or more of the lender or guarantor of an LLC liability, the transaction will likely be scrutinized to determine if its principal purpose is tax avoidance. If a tax avoidance purpose is found, the member will be treated as holding the entity's position as lender or guarantor to the extent of the member's ownership interest in the entity (Regs. Sec. 1.752-4(b)(2)(iv)).
Favorable Wrapped Debt Rule
Often an LLC nonrecourse liability owed to a member or member affiliate is wrapped around a second nonrecourse liability owed to an unrelated creditor. The second liability is referred to as wrapped debt. In such cases, the LLC wraparound liability is treated as owed to the unrelated creditor to the extent of the amount of the underlying wrapped debt (Regs. Sec. 1.752-2(c)(2)). This results in the wrapped debt being treated as a true nonrecourse liability that can be allocated to all members for basis purposes.
Example 3: K owns an apartment building he originally purchased for $450,000. The building is subject to a $375,000 nonrecourse mortgage K obtained from an unrelated lender when he purchased the property. In 2009, K agrees to form J LLC with his friend W . J is classified as a partnership for federal taxes. Each member has a 50% interest in J . J will own and operate the apartment building. J buys the building from K for $475,000, with $75,000 of the purchase price paid in cash. The remaining $400,000 is financed by a nonrecourse promissory note secured by the property and owed to K . J 's $400,000 note to K (the wraparound note) will wrap around K 's existing $375,000 nonrecourse note (the wrapped note). The wrapped note will remain in place and continue to be secured by a first lien on the building. K will continue to service the $375,000 wrapped note with the interest and principal payments from J .
An LLC liability that is nonrecourse but owed to a member is a member nonrecourse debt. The creditor-member is deemed to bear 100% of the economic risk of loss with respect to such debts. However, if the liability wraps around an underlying true nonrecourse liability owed to an unrelated creditor, the LLC's wraparound note is treated as owed to the third-party creditor to the extent of the wrapped debt.
In this example, J 's $400,000 obligation wraps around an underlying $375,000 true nonrecourse obligation owed to an unrelated third party. As a result, $375,000 of the wraparound debt is allocated as a true nonrecourse liability because, in reality, neither K nor W bears any risk of loss for that amount. The remaining $25,000 of the nonrecourse wraparound debt is considered member nonrecourse debt and is allocated entirely to K, the member-creditor, because W has no personal risk of loss for that amount.
This case study has been adapted from PPC's Guide to Limited Liability Companies, 14th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2008 ((800) 323-8724; ppc.thomson. com ).
Albert B. Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.