Application of the Tax Basis and At-Risk Loss Limitations to Partners

Editor: Jon Almeras, J.D., LL.M.

Partners & Partnerships

Individuals who invest in partnerships need to be aware of the rules that limit the ability of a partner to deduct losses. Individual partners who have been allocated a distributive share of loss must satisfy three separate loss limitations before the loss can be used. The loss limitations, in the order in which they are applied, include: (1) the Sec. 704(d) basis limitation, (2) the at-risk limitation of Sec. 465, and (3) the passive loss limitation of Sec. 469 (Temp. Regs. Sec. 1.469-2T(d)(6)(i)). This item focuses on the application of the Sec. 704(d) basis limitation and the at-risk limitation for individual partners and does not discuss the application of the passive loss rules.

Loss Limitation Under Sec. 704(d)

Sec. 704(d) provides that a partner’s distributive share of loss is allowable to the extent of the partner’s adjusted tax basis in his interest in the partnership at the end of the partnership year in which the loss occurred. Any losses in excess of the partner’s tax basis are disallowed pro rata (Regs. Sec. 1.704-1(d)) and are carried forward indefinitely for as long as the partner remains in the partnership.

Sec. 705(a) generally provides that a partner’s adjusted basis in his interest in the partnership includes the amount of money and the adjusted basis of property contributed to the partnership increased by any gain recognized on the contribution. A partner’s adjusted basis is increased by the partner’s distributive share of taxable and tax-exempt income and decreased by the partner’s distributive share of partnership losses, nondeductible expenditures, and the amount of money and the adjusted basis of distributed property (see, e.g., Rev. Rul. 96-10 and Rev. Rul. 96-11).

A partner’s basis is further adjusted by the liability allocation provisions of Sec. 752. Sec. 752(a) provides that an increase in a partner’s share of the partnership’s liabilities, or any increase in a partner’s individual liabilities because the partner assumed those liabilities, is considered a contribution of money by the partner to the partnership. Sec. 752(b) provides that a decrease in a partner’s share of a partnership’s liabilities, or any decrease in a partner’s individual liabilities because the partnership assumed the partner’s individual liabilities, is considered a distribution of money to the partner by the partnership.

Example 1: Individual A is a general partner in partnership AB, which invests in a single activity. A has a $6,000 basis in his partnership interest and is allocated 50% of profits and losses. At the end of tax year X1, partnership AB has $10,000 of gross income and $30,000 of expenses, resulting in a $20,000 loss. A’s share of this loss is $10,000, and his tax basis (before taking into account his share of the loss) is $6,000.

Under Sec. 704(d), A has an allowable loss for the year of $6,000, and his tax basis is reduced to zero. Assume that the allocation to A in this example is valid because A has a deficit restoration obligation, which is an obligation to restore a deficit balance in a capital account. Deficit restoration provisions are used to comply with the requirement that partnership allocations have substantial economic effect (see Regs. Sec. 1.704-1(b)(2)). The excess loss of $4,000 is suspended and carried over.

The regulations under Sec. 704(d) dictate the order in which a partner’s tax basis is adjusted for purposes of determining the extent to which a partner’s distributive share of loss is deductible. A partner’s tax basis is first increased for items of income and then decreased for distributions. Then, a partner’s tax basis is decreased by the partner’s distributive share of losses from the current year and losses previously disallowed. Losses in excess of a partner’s remaining tax basis are limited under Sec. 704 (Regs. Sec. 1.704-1(d)).

For a partnership that distributes all of its taxable income, the ordering rules cause the continued deferral of carryover losses, provided additional capital is not contributed. If the partnership terminates or if a partner disposes of his entire interest while the partner’s loss is suspended under Sec. 704(d), the partner loses the loss. Partial dispositions of partnership interests, however, do not reduce the carry­over amount. (See Regs. Sec. 1.704-1(d)(1) and Sennett, 80 T.C. 825 (1983), aff’d per curiam, 752 F.2d 428 (9th Cir. 1985).)

Example 2: The facts are the same as Example 1. In the following year, X2, partnership AB has $10,000 of income. A’s distributive share of income is $5,000, and he receives a distribution of the same amount.

Under the ordering rules of Sec. 704(d), A may not deduct any of the $4,000 carryover loss, as his tax basis remains at zero following tax basis adjustments for his distributive share of income (+$5,000) and distribution received (−$5,000).

A partner seeking to use a loss suspended under Sec. 704(d) in a later year can increase the tax basis of his partnership interest by (1) contributing additional money or property, (2) receiving an allocation of partnership income, or (3) increasing his share of partnership liabilities. Partnerships that are temporarily not profitable and whose partners do not wish to contribute additional capital may choose to incur debt to facilitate the deduction of suspended losses.

Example 3: The facts are the same as Example 1, except that partnership AB assumed $8,000 of recourse debt, and A’s allocable share of the recourse debt is $4,000. Then A’s tax basis would increase from zero to $4,000 due to the increase in A’s share of partnership liabilities.

The tax basis increase would enable A to deduct the $4,000 carryover loss, reducing A’s tax basis to zero. The use of debt as a means to deduct the loss comes with a future cost. A subsequent reduction of a partner’s allocable share of partnership debt would be treated as a distribution of money potentially resulting in gain recognition if the partner did not have sufficient basis. If in year X3, partnership AB paid off the debt, A’s allocable share of partnership liabilities would decrease, and A would be deemed to have received a distribution of money in the amount of the decrease. If A’s tax basis still equaled zero at the time of the deemed distribution, A would recognize a gain of $4,000 under Sec. 731(a) attributable to the decrease in A’s share of partnership liabilities. Sec. 731(a)(1) provides that a partner does not recognize gain on a distribution from a partnership except to the extent that any money distributed exceeds the adjusted tax basis of the partner’s interest in the partnership before the distribution.

At-Risk Rules

For individuals, estates, trusts, and closely held C corporations, deductions of business- or investment-related losses from an activity for a tax year are limited to the amount the taxpayer is at risk. The amount at risk includes: (1) the amount of money and the adjusted basis of property contributed to an activity; (2) amounts borrowed with respect to the activity to the extent the taxpayer is personally liable for repayment or has pledged property, other than property used in the activity, as security for the borrowed amount; and (3) generally, amounts borrowed with respect to the activity of holding real property for which no person is personally liable for repayment (qualified nonrecourse financing) (see Sec. 465(b)). The amount at risk is also increased by the excess of items of income from an activity for the tax year over items of deduction from the activity for the tax year.

Unlike a partner’s tax basis, the amount at risk can go negative, although not from recognition of losses (Prop. Regs. Sec. 1.465-3(b)). The consequence of a negative at-risk amount is the potential for at-risk recapture, which is the recognition of previously deducted losses as income in a year in which a taxpayer’s amount at risk is negative, often as the result of a distribution. Recognition of at-risk recapture increases a partner’s amount at risk (Sec. 465(e)).

Example 4: The facts are the same as Example 1, except that in the following year, X2, partnership AB has no income or loss and has incurred $15,000 of nonrecourse debt. Under the liability allocation rules of Sec. 752, partner A’s allocable share of partnership nonrecourse debt is $7,500. A receives a $7,500 distribution from the partnership.

Although the liability allocation increases A’s tax basis from zero to $7,500 prior to the distribution, the allocation does not increase A’s amount at risk because A is not personally liable for his share of nonrecourse debt. The distribution reduces A’s amount at risk from zero to negative $7,500, and he is required to recapture and recognize as income the $6,000 loss previously deducted in year X1. The amount included in income is treated as a deduction allocable to the activity in the first succeeding tax year (Sec. 465(e)). A could have avoided recognition of income by guaranteeing a portion of the partnership’s debt equal to the amount of potential at-risk recapture. The at-risk rules apply on an activity-by-activity basis. Thus, a single partnership investment may have multiple activities, each of which would need to be accounted for separately by a partner under the at-risk rules.

“Loss” Defined for Purposes of At-Risk Rules

The at-risk rules do not limit the deductibility of all deductible expenses arising from an activity; rather, they limit the deductibility of losses. A “loss” is defined as the excess of otherwise allowable deductions allocable to an activity over income received from the activity for the tax year (Sec. 465(d)). This means that, even in a year in which a taxpayer’s at-risk amount is zero or negative, the taxpayer can still deduct expenses up to the amount of income from the same activity.

Example 5: The facts are the same as in Example 1. Assume that at the end of year X1, A’s at-risk amount is zero. In year X2, A’s share of items from partnership AB is shown in Exhibit 1.

A has a net loss of $4,000 for the year; therefore, his at-risk amount remains zero at the end of year X2. Although A is not at risk, A can deduct $3,000 of current-year expenses under the at-risk rules equal to the gross income from the activity. The rule permitting deductions to the extent of current-year income from the same activity applies even if a partner receives a distribution from the partnership in the same year that causes the partner’s at-risk amount to become negative.

A partnership may fund initial losses and/or distributions to its partners by incurring debt. The allocation of nonrecourse debt to a partner provides tax basis to avoid loss limitation under Sec. 704(d) and can facilitate tax-free distributions (subject to at-risk recapture); however, deductibility of those losses would still be limited under the at-risk rules. Losses suspended under the at-risk rules may become deductible in a year in which a partner does not have tax basis in his partnership interest. The deduction of the suspended losses in a subsequent year reduces the amount the taxpayer is at risk (Sec. 465(b)(5)).

Example 6: The facts are the same as in Example 1, except assume that, during year X1, partnership AB incurs $8,000 of nonrecourse debt and A’s allocable share of that debt is $4,000.

The $4,000 debt allocation would provide sufficient tax basis to enable A to satisfy Sec. 704(d) but would not prevent the suspension of the $4,000 loss under the at-risk rules. In year X2, the non­recourse debt is converted into recourse debt as to A. A’s share of income and expense items from partnership AB is shown in Exhibit 2.

At the end of year X2, A’s tax basis remains at zero, as all current-year items of gross income have been offset by items of expense and A’s share of liabilities has not changed. The debt conversion has increased A’s amount at risk to $4,000, thereby enabling A to deduct $4,000 of losses suspended under the at-risk rules and carried forward from year X1. Subsequent to the deduction of the $4,000 of suspended losses, A’s amount at risk is reduced to zero ($4,000 at risk less the $4,000 deduction).

Partnership Recourse Debt and Limited Partners/Members

A partnership’s incurring recourse debt does not necessarily result in a partner’s being deemed at risk for a ratable share of the debt. Limited partners and members of a limited liability company (LLC) generally are not considered at risk for partnership recourse debt, and the mere existence of a deficit restoration obligation (DRO) does not necessarily change this result. In Hubert Enterprises, T.C. Memo. 2008-46, supplementing 125 T.C. 72 (2005), aff’d in part and remanded, 230 Fed. Appx. 526 (6th Cir. 2007), the Tax Court considered whether a member of an LLC (treated as a partnership for tax purposes) could be considered at risk with regard to a proportionate share of the LLC’s liabilities because the LLC’s operating agreement contained a DRO. The DRO in Hubert Enterprises provided as follows:

Deficit Capital Account Restoration. If any Partner has a deficit Capital Account following the liquidation of his, her or its interest in the partnership, then he, she or it shall restore the amount of such deficit balance to the Partnership by the end of such taxable year or, if later, within 90 days after the date of such liquidation, for payment to creditors or distribution to Partners with positive capital account balances.

In determining the member was not at risk, the court applied the test used in the Sixth Circuit Court of Appeals that looks to whether the taxpayer is the payer of last resort. The court found that a default on the recourse debt would not enable the recourse creditor simply to turn to the member to satisfy the debt, and that a creditor could not compel the liquidation of a member’s interest so as to cause an additional contribution under the DRO.

The court concluded that the member of the LLC was not a payer of last resort because the member was not personally liable for repayment of any of the LLC’s debt within the meaning of Sec. 465(b)(2)(A). Thus, the member could not take into account its proportionate share of LLC debt in determining its amount at risk. After Hubert Enterprises, limited partners and LLC members intending to increase their amount at risk by taking into account partnership liabilities should guarantee a portion of the debt or pledge property in connection with the debt.

Disposition of Partnership Interests

Recognition of gain from the disposition of all or part of an activity, including gain from the disposition or liquidation of a partnership interest, is treated as income from the activity, thereby increasing a partner’s amount at risk (Prop. Regs. Sec. 1.465-66). This provision enables a partner to deduct losses previously suspended under the at-risk rules to the extent gain is recognized. This is an important distinction from the tax basis limitation under Sec. 704(d), in which gain from the disposition of a partnership interest does not increase a partner’s tax basis, and suspended losses therefore do not offset gain on disposition.

If a partner (transferor) with suspended at-risk losses disposes of a partnership interest in a nonrecognition transaction in which the basis of the transferee is determined in whole or in part by reference to the basis of the transferor, then the transferee increases its basis in the property by the amount of the transferor’s suspended at-risk losses (Prop. Regs. Sec. 1.465-67). This provision serves to preserve the tax benefit of the losses by allowing the transferee in a nonrecognition transaction to add the losses to its tax basis.

Example 7: Assume the same facts as Example 6 for year X1 so that, at the end of X1, A has suspended at-risk losses of $4,000. At the beginning of year X2, A and B each contribute their partnership interests to corporation D in exchange for 100% of the outstanding shares of corporation D in a non­recognition transaction under Sec. 351.

Under Sec. 358 and Prop. Regs. Sec. 1.465-67, corporation D would take a basis in partnership AB of the interest contributed by A equal to $4,000, which is the sum of (1) A’s basis in partnership AB ($0) and (2) A’s suspended at-risk losses ($4,000).

Conclusion

When a partner’s tax basis and at-risk amount have been substantially diminished, losses allocated to the partner may not be deductible, and distributions to the partner may result in income recognition under both Sec. 731 and Sec. 465(e). A partner may avoid these consequences by being aware of his tax basis and amount at risk and by taking measures to increase these amounts prior to the anticipated event. A partner’s tax basis and at-risk amount increase through the receipt of a share of partnership income. A partner may also increase tax basis and at-risk amount by contributing capital to the partnership or by guaranteeing a portion of partnership debt. Post–Hubert Enterprises, a DRO is no longer sufficient to deem a partner at risk with regard to partnership recourse debt in an LLC, and partners need to personally guarantee a portion of the LLC’s debt to be considered at risk.

EditorNotes

Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.

For additional information about these items, contact Mr. Almeras at (202) 758-1437 or jalmeras@deloitte.com.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.