Before the advent of LLCs, the at-risk rules were for the most part a poor stepchild when it came to loss limitations. If a partner could avoid application of the passive loss rules and the basis limitation rules, the at-risk rules seldom created a problem. Accordingly, the IRS and Treasury have made little effort to provide guidance in the at-risk area. The at-risk regulations are predominantly proposed and temporary regulations that have been on the books for many years without being finalized.
However, the at-risk rules may frequently limit the ability of LLC members to deduct losses. This is largely the result of the at-risk provision that denies members in LLCs taxed as partnerships at-risk basis for their share of LLC nonrecourse debts. Since all LLC debt is generally nonrecourse (either true nonrecourse or exculpatory), most LLC members can deduct only cash out-of-pocket LLC losses under the at-risk provisions. Treasury has indicated that it expects to review the at-risk rules and regulations in the near future.
The at-risk rules apply to individual taxpayers and closely held corporations under Sec. 465(a)(1). Consequently, an LLC itself is not subject to the at-risk rules. However, those rules are applied at the individual member level to losses passed through from the LLC.
The at-risk rules were designed to prevent the deduction of losses when the taxpayer is protected from suffering an actual out-of-pocket loss. When the at-risk rules were first enacted by Congress, the rules applied only to the following activities (Sec. 465(c)(1)):
- Exploring for or exploiting oil and gas resources;
- Holding, producing, or distributing motion picture films or videotapes;
- Leasing equipment; and
- Exploring for or exploiting geothermal deposits.
These five areas were considered at the time to be the most fertile ground for tax-shelter abuses. Then in 1978, Congress extended the at-risk rules to all other activities except real estate. Finally, as part of the Tax Reform Act of 1986, P.L. 99-514, the rules were extended to cover real estate activities in certain circumstances. The at-risk rules now apply to all activities engaged in as part of a trade or business or for the production of income (Sec. 465(c)(3)).
Note: The at-risk rules generally apply to losses incurred after December 31, 1986, with respect to the activity of holding real property that the taxpayer placed in service after that date. Under this general rule, as long as the real property used in the activity was placed in service prior to the end of 1986, the at-risk rules do not apply to post-1986 losses, even if the losses are attributable to nonrecourse financing incurred after 1986. However, in the case of a partnership or LLC interest acquired after December 31, 1986, these rules apply to all losses incurred after 1986 that are attributable to real property owned by the entity, regardless of when the entity placed the property in service.
Determining What Constitutes a Separate Activity
Since the determination of amounts at risk generally is made on an activity-by-activity basis, it is important to understand what constitutes a separate activity and what activities can or must be aggregated for at-risk purposes. (Activities for purposes of applying the at-risk rules may not be the same as activities defined by the passive loss regulations.)
The Code specifically treats each of the original five activities, except the leasing of tangible personal property, as a separate activity. This means that each project in each one of the five listed categories is treated as a separate activity (e.g., each film and each oil and gas property). An LLC involved in the activity of leasing tangible personal property must treat all leased assets placed in service in a single tax year as a single activity (Sec. 465(c)(2)(B)).
Members in an LLC can aggregate all activities conducted by the LLC in any of the original five at-risk activities except equipment leasing (Temp. Regs. Sec. 1.465-1T(a)). For example, if the LLC operates five oil wells, a member can aggregate them into one activity. If the LLC also distributes three films, the three films can be aggregated into one activity; however, the film activity and the oil well activity cannot be aggregated.
If a taxpayer is conducting activities other than the original five at-risk activities or real estate activities, and the activities constitute a single trade or business, they must be aggregated as one activity if either:
- The taxpayer actively participates in management of the trade or business; or
- The trade or business is carried on by a partnership, an LLC classified as a partnership, or an S corporation, and 65% or more of the losses for the tax year are allocable to persons who actively participate in the management of the trade or business (Sec. 465(c)(3)(B)).
Factors that indicate active participation include:
- Participating in decisions involving performing services for the trade or business;
- Actually performing services for the trade or business; and
- Hiring and discharging employees (this must include employees other than the manager) (Joint Committee on Taxation, General Explanation of the Revenue Act of 1978 (JCS-1-79), p. 131 (March 12, 1979)).
Handling Real Estate Activities
All real estate held by a taxpayer is considered a single activity. This rule does not apply to real estate held in connection with any other activity. In other words, if real estate is held in connection with an oil and gas activity or an active trade or business activity, it is included in that activity rather than in the activity of holding real property.
Aggregating At-Risk Activities
While a member in an LLC usually wants to treat activities as separate under the passive loss rules, it generally is preferable to aggregate activities for at-risk purposes. This provides the member with the largest “pool” of at-risk basis against which losses can be deducted.
Example: B and T form G LLC to operate several farming properties in the Midwest. G is classified as a partnership for federal taxes and operates three farms, X, Y, and Z. B’s share of the income and loss from each farm property for 2011 is shown in the exhibit. B’s amount at risk with respect to G at the end of 2011 is $12,000, with $4,000 allocated to each of the three farm activities. If G does not aggregate the three farm activities, each is treated as a separate at-risk activity. Because the losses passed through from X and Y exceed B’s at-risk basis in those activities, B cannot deduct $4,500 of the X loss and $500 of the Y loss.
If G aggregates the three activities, B has net income from the aggregated activity of $22,700, and no at-risk limitation applies.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 16th 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 2011 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.