Allocating LLC recourse debts

Under Regs. Sec. 1.752-2(a), limited liability company (LLC) members share recourse liabilities in the same proportions in which they bear the economic risk of loss with respect to the liability. In other words, members are allocated basis from recourse debt to reflect the way they would be legally obligated to bear the burden of discharging the liability if the LLC were unable to do so. Because of the limited liability characteristic of LLCs, members generally do not bear any economic risk of loss with respect to LLC liabilities.

However, loans made to the LLC or guaranteed by a member (or a member affiliate) generally are treated as recourse for the debt allocation rules. Also, an LLC may have recourse debt if its members elect to assume the LLC’s debt under state law, the LLC is a converted general partnership (the former general partners remain liable for debts incurred before the conversion), or the LLC members have a financial obligation (under state law) to make contributions that are available to LLC creditors.

To properly determine the members’ economic risk of loss with respect to an obligation to contribute capital or return a prohibited distribution, the practitioner should review the LLC’s articles of organization, the operating agreement, and the appropriate state LLC statute. Members with a deficit restoration obligation may, in certain situations, be allocated a share of LLC recourse debt.

Determining a member’s economic risk of loss

Under Regs. Sec. 1.752-2(b)(1), a member bears the economic risk of loss with respect to an LLC recourse liability to the extent that, after a no-value liquidation (see below), the member (or member affiliate) would be obligated to make a payment to another person or the LLC. This obligation is referred to as the member’s payment obligation. The member’s ability to actually satisfy the obligation (i.e., the member’s net worth) is generally irrelevant unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (Regs. Sec. 1.752-2(b)(6)) or if the member is a disregarded entity. In addition, the member (or member affiliate) is deemed to bear the economic risk of loss only to the extent he or she is not entitled to reimbursement from another member (or member affiliate).

IPO II, 122 T.C. 295 (2004), addressed the effects of guarantees by related owners and the impact of the “related partner exception” on the allocation of recourse debt. (The related-partner exception of Regs. Sec. 1.752-4(b)(2)(iii) provides that, notwithstanding the general definition of related persons, persons owning interests directly or indirectly in the same partnership are not treated as related for purposes of determining the economic risk of loss borne by each of them for the liabilities of the partnership.) In this case, an LLC classified as a partnership borrowed money on a recourse basis to purchase an airplane. The LLC was owned by an individual and an S corporation solely owned by the same individual. That individual also owned 70% and 63%, respectively, of two other corporations.

The loan the LLC took out to buy the airplane was guaranteed by the individual owner and those two nonmember corporations. The taxpayer argued that the S corporation member should be allocated a portion of the liability as a result of its relationship with one of the corporate guarantors through the individual owner. The court, however, held that under the related-partner exception, the relationship between the S corporation and the individual was severed for purposes of determining whether the S corporation bore an economic risk of loss for the LLC’s recourse liability.

No-value liquidation defined

A no-value liquidation is a hypothetical liquidation under the following circumstances (Regs. Sec. 1.752-2(b)(1)):

• All LLC assets (excluding only contributed property used solely to secure the repayment of a loan, but including cash) are assumed to be worthless;
• All LLC liabilities are assumed to be due and payable in full;
• The LLC disposes of its assets in a fully taxable transaction for no consideration (other than relief from liabilities for which the creditor’s right to repayment is limited solely to one or more LLC assets, i.e., nonrecourse debt (including exculpatory debt)); and
• The LLC allocates all items of income, gain, loss, and deduction among its members in accordance with the LLC operating agreement, state law, and applicable tax rules and then promptly liquidates.

Calculating a member’s payment obligation

The amount of a member’s payment obligation is adjusted if the member is not required to satisfy the obligation within a reasonable period of time after the LLC liability becomes due and payable (Regs. Sec. 1.752-2(g)(1)). A reasonable period of time for this purpose is defined as the later of the end of the year in which the member’s interest is liquidated or 90 days after the liquidation. If the member is not required to satisfy the payment obligation within this period, the obligation must be discounted using the appropriate applicable federal rate (AFR). A member’s payment obligation also includes the amount of the member’s money or other separate property directly or indirectly pledged to secure payment of an LLC liability (Regs. Sec. 1.752-2(h)).

Payment obligation limited to property

If a member’s payment obligation is limited to the value of certain property (e.g., property pledged to secure LLC nonrecourse debt or specific property the member is obligated to contribute), basis from that obligation is limited to the net fair market value (FMV) of the property at the time of the pledge or contribution (or its most recent valuation if the property’s FMV is not readily ascertainable) (Regs. Sec. 1.752-2(h)(3)). However, if the pledged property is an interest in the LLC itself, it is presumed to have a zero value for these purposes.

Example 1. Allocation of recourse debt when members are liable under state law: O Investors LLC, an LLC classified as a partnership, was formed in Illinois on Dec. 31. Under the state’s LLC statute, a member can assume liability for the debts of an LLC. J and D, individuals who are O’s members, elect upon formation to be responsible for the LLC’s debts. They also include a deficit capital account restoration clause enforceable by creditors in the LLC’s operating agreement. J and D each contribute $50,000 to O upon formation. The $100,000 of contributed capital plus the proceeds of a $400,000 recourse note are used to purchase an office building. Under the terms of the operating agreement, losses are allocated 70% to J and 30% to D. On Dec. 31, O has an office building with a tax basis of $500,000 and an outstanding recourse mortgage of $400,000. The LLC has no other debts or assets.

Under the no-value liquidation rules, the LLC’s assets are deemed worthless and disposed of in a fully taxable transaction, and all assets are deemed payable in full. Applying these rules, the LLC has a $500,000 loss on the disposition of the building. Under the terms of the operating agreement, the loss is allocated $350,000 to J and $150,000 to D. J’s capital account becomes a negative $300,000, while D’s capital account is a negative $100,000, as shown in the chart below.

After the hypothetical no-value liquidation, the deficit capital account restoration provision would require J to contribute $300,000 to the LLC and D to contribute $100,000. Consequently, J’s payment obligation and risk of loss is $300,000, and that amount of the LLC’s debt is includible in the basis of her LLC interest. D can include $100,000 of the recourse debt in the basis of his interest.

Example 2. Allocations of debt to members with capital contribution obligations: W LLC, classified as a partnership for federal tax purposes, has five members who each own 20% of the LLC’s capital and profits interests. The LLC was formed in a state that provides limited liability for LLC members in all circumstances. However, the state’s LLC Act provides that a member’s written obligation to make future capital contributions is binding on the member and enforceable by creditors. W has outstanding short-term debt of $250,000 that is recourse debt to the LLC. Each of the five LLC members has a written obligation to make an additional capital contribution of $10,000.

Because the members have an enforceable financial obligation of $50,000 to the LLC, $50,000 of the LLC’s recourse debt is allocable to the members ($10,000 each). The remainder of the short-term debt, $200,000, is exculpatory debt, since no partner is liable for the debt and it is not secured by specific LLC property. The $200,000 of exculpatory debt is nonrecourse debt and is allocated among the members based on the three-tier method for allocating nonrecourse debt.

Disregarded payment obligations

The determination of the extent to which a partner bears the economic risk of loss for an LLC recourse liability is made under the rules of Regs. Sec. 1.752-2. In 2016, the IRS issued Prop. Regs. Sec. 1.752-2(j)(3), which indicates that obligations of a member or related person to make a payment would not be recognized if the facts and circumstances indicate that there is a plan to circumvent or avoid the obligation. Prop. Regs. Sec. 1.752-2(j)(3)(ii) lists several nonexclusive factors that may indicate that there is a plan to avoid or circumvent a payment obligation (other than to restore a deficit capital account on the LLC’s liquidation). The presence or absence of a factor is based on all the facts and circumstances when the member (or related person) makes or modifies the payment obligation. The weight given to any factor depends on the particular case, and the presence or absence of a factor is not necessarily indicative of whether a payment obligation will be recognized. The factors are:

• The member (or related person) is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment;
• The member (or related person) is not required to provide (either when the payment obligation is made or periodically) commercially reasonable documentation regarding the member’s financial condition to the benefited party;
• The payment obligation’s term ends before the term of the LLC liability or the member (or related person) has a right to terminate it, if the purpose is to terminate the obligation before an event that would increase the guarantor’s or benefited party’s economic risk of loss (this factor is generally not present if the obligation terminates at an event that decreases economic risk of loss of the guarantor or benefited party (e.g., upon completion of a building project));
• There is a plan or arrangement in which an obligor with respect to the LLC liability (or a related person) holds (directly or indirectly) money or other liquid assets in excess of its reasonably foreseeable needs;
• The payment obligation does not permit the creditor to promptly pursue payment following a payment default on the LLC liability (or other arrangements indicate a plan to delay collection);
• In the case of a guarantee or similar arrangement, the terms of the LLC liability would be substantially the same had the member (or related person) not agreed to provide the guarantee; or
• The creditor or other party benefiting from the obligation did not receive executed documents with respect to the payment obligation from the member (or related person) before or within a commercially reasonable time after the obligation’s creation.

  Example 3. Guarantee disregarded as a payment obligation: In 2016, individuals A, B, and C form D LLC, which is classified as a partnership. Also in 2016, D receives a bank loan. Because none of the members are personally liable for the LLC’s loan, it is treated as nonrecourse debt for the Sec. 752 debt allocation rules. In 2018, A guarantees the entire amount of the loan. The bank did not request the guarantee, and the terms of the loan did not change as a result of the guarantee. A did not provide any executed documents with respect to his guarantee to the bank. The bank did not require any restrictions on asset transfers by A, and no such restrictions exist.

The following factors indicate a plan to circumvent or avoid A’s payment obligation: (1) He is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment, such as restrictions on transfers for inadequate consideration or equity distributions; (2) he is not required to provide (either at the time the payment obligation is made or periodically) commercially reasonable documentation regarding his financial condition to the benefited party; (3) the terms of the liability are the same as they would have been without the guarantee; and (4) the bank did not receive executed documents with respect to A’s payment obligation when it was created. Absent the existence of other facts or circumstances that would weigh in favor of respecting A’s guarantee, the proposed regulations say that these facts are evidence that a plan to circumvent or avoid the obligation exists, and A’s guarantee is not recognized. As a result, D’s liability continues to be treated as nonrecourse for the debt ­allocation rules.

Prop. Regs. Sec. 1.752-2(j)(3) will be effective when it is finalized, but taxpayers can rely on it for the period between Oct. 5, 2016, and the date the regulation is finalized (Prop. Regs. Sec. 1.752-2(k)(1)).  

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 23rd edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).