IRS Guidance Shows Risks to Nonguarantor LLC Members

Editor: Valrie Chambers, Ph.D., CPA

LLCs & LLPs

As the limited liability company (LLC) form of business continues to proliferate, lending institutions are frequently requiring LLC members to personally guarantee the debts of these entities. The extent that such guarantees affect the amount of losses available to be deducted has been uncertain in the past, but recent IRS guidance clarifies the treatment of both the guarantor and the nonguarantor members. While the guidance generally benefits the guarantor member, it also highlights the potentially unknown effect on at-risk amounts for any members who have not personally guaranteed the debt.

Practitioners looking for guidance in this area previously had to look to regulations written well before the LLC form of entity became available under state law. Those rules focused on general partners versus limited partners and generally did not allow “limited partners” to treat personally guaranteed debt as “at risk” because, under state law, a limited partner has a right to seek reimbursement from the general partner and the partnership if the limited partner is called upon to pay the guarantee (see Sec. 465(b)(4)). However, in the case of an LLC, all members have limited liability for the LLC’s debt and generally do not have the ability to seek reimbursement from the LLC or other members.

To provide clarity on this topic, the IRS Office of Chief Counsel issued Legal Advice AM 2014-003 on April 4, 2014. The memorandum addresses the tax consequences under Sec. 465 of a member’s guaranteeing the debt of an LLC classified as a partnership (or a disregarded entity), the consequences when the debt of the LLC is classified as “qualified nonrecourse financing” under Sec. 465(b)(6)(B), and the consequences to other members of the LLC when a member guarantees qualified nonrecourse debt.

For an LLC member who guarantees an LLC’s debts, the memo indicates that the member will be treated similarly to a general partner who had personally assumed the partnership’s debt and who had no right of reimbursement from other members (such as the general partners used in the example in Prop. Regs. Sec. 1.465-24(a)(2)(ii)). In that situation, the member is considered to be “at risk” for the LLC debt guaranteed, regardless of whether the member waives any right to subrogation, reimbursement, or indemnification against the LLC, but only to the extent that the member has no reimbursement right from persons other than the LLC, the member is not otherwise protected against loss, and the guarantee is bona fide and enforceable by the LLC’s creditors under local law. The treatment is the same for LLCs treated as disregarded entities.

For LLCs owning real property, one exception to the general rule that nonrecourse debt would not be considered “at risk” was the treatment of “qualified nonrecourse financing.” To the extent allowed under Sec. 465(b)(6), LLC members generally can include LLC liabilities as amounts “at risk” if the debt meets four qualifications: The debt is held for the purpose of holding real property, it is borrowed from a “qualified” person (a bank), no person is personally liable for repayment, and the debt is not convertible debt. Therefore, losses from real estate LLCs were typically deductible by members to the extent of their share of the qualified nonrecourse debt.

The new memorandum clearly points out the risks to those LLC members if one of the other members guarantees the LLC debt. When the member makes the guarantee, the existing debts will no longer qualify as “qualified nonrecourse financing” because they fail the third leg of the test for qualification (i.e., a member is now personally liable to repay the debt).

Accordingly, the nonguaranteeing members of the LLC, who had previously included that portion of the qualified nonrecourse financing in their amount at risk and who have not guaranteed any portion of that debt, may no longer include that amount of debt in determining their amount at risk. If such a reduction causes a member’s at-risk amount to fall below zero, it will trigger immediate recapture of previously deducted losses under Sec. 465(e).

This creates a potential trap for both investors and practitioners who may not be aware of the guarantor status of members whose tax returns they may not see because those members are not clients of the preparer of the LLC’s income tax return. As more and more banks require personal guarantees from investors, it is critical that the practitioner obtain sufficient knowledge of these guarantees to properly classify the LLC’s liabilities and the amount each member will be considered to be “at risk” to the LLC.