The at-risk rules of Sec. 465 originated with the enactment of the Tax Reform Act of 1976, P.L. 94-455. It was a time of 70% tax rates, when tax shelters were aggressively marketed to manipulate taxable income. Originally, the rules applied only to certain narrowly defined types of activities, but subsequent amendments expanded their scope to cover all trades or businesses and other income-producing activities (Sec. 465(c)(3)). The at-risk rules apply to individuals and closely held C corporations (Sec. 465(a)(1)). Notably, Treasury has never finalized the bulk of the regulations implementing Sec. 465; as a result, reliance on proposed regulations issued in 1979 is the norm and is assumed in this discussion.
What was the problem?
Prior to the enactment of Sec. 465, the only limitation on a partner's ability to deduct properly allocated losses was its outside tax basis in the partnership. The outside tax basis in a partnership includes a partner's share of both liabilities that the partner could be required to pay (recourse liabilities), as well as liabilities for which the partner bears no economic risk of loss (nonrecourse liabilities) (Sec. 752). The inclusion of nonrecourse debt in a partner's outside tax basis provided an opportunity for taxpayers to claim deductions far in excess of their economic losses. The at-risk rules reflect an attempt to curb this perceived abuse.
Calculating a partner's at-risk basis in a partnership
A taxpayer's initial amount at risk in an activity (sometimes referred to as an "at-risk basis") is calculated by combining the taxpayer's cash investment with any amount that the taxpayer has borrowed and is personally liable for (Sec. 465(b)). A taxpayer's amount at risk is measured annually at the end of the tax year (Sec. 465(a)(1)). At-risk basis is increased annually by any amount of income in excess of deductions, plus additional contributions, and is decreased annually by the amount by which deductions exceed income and distributions (Prop. Regs. Sec. 1.465-22(c)). For purposes of adjusting at-risk basis, income includes tax-exempt income, and deductions include nondeductible expenses. In a real estate context, an increase of qualified nonrecourse financing increases the taxpayer's basis.
Avoidance of at-risk rules
These annual adjustments to at-risk basis have led to the following question: Because at-risk basis is determined at the end of the tax year, could a partnership increase debt at the end of the year to increase the amount of deductions that partners could use? Prop. Regs. Sec. 1.465-4 states that this type of debt manipulation may not occur; however, if there is a valid business purpose for the debt, then certain facts and circumstances will be examined to determine whether an increase followed by a decrease in debt is allowed. These factors include the time between the increase and decrease of debt, what normal business practices dictate, and contractual agreements between the parties (Prop. Regs. Sec. 1.465-4(b)).
Differences between at-risk basis and tax basis
At-risk basis and tax basis are often confused because many of the same components are included in both calculations. A partner's initial tax basis in a partnership interest is defined by reference to various provisions throughout the Internal Revenue Code but generally includes the value of cash and the adjusted basis of other assets contributed to the partnership, plus the partner's share of partnership liabilities. At-risk basis is the cumulative result of a taxpayer's (1) contributions and distributions of cash and the adjusted basis of property contributed; (2) borrowings to the extent the taxpayer is liable for repayment or has pledged property, other than property used in the activity, as security for the borrowed amounts (recourse debts); (3) borrowings in connection with holding real property if no person is liable for repayment (qualified nonrecourse debts); and (4) the excess of passthrough items of income over deductions from the activity (Sec. 465(b) and Prop. Regs. Sec. 1.465-22). A partner shall not be considered personally liable for recourse debts if the partner is not considered the payer of last resort (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)).
What is an activity?
When originally enacted, Sec. 465 applied to taxpayer activities involving farming, oil-and-gas exploration, geothermal deposit exploration, motion picture film/videos, and leasing of Sec. 1245 property. Each of these activities was treated as a separate activity, even if multiple activities were structured in the same entity. Aggregation of certain activities is possible if specific tests are met with respect to the taxpayer's level of participation in the management of the trade or business carried on by a partnership or an S corporation.
Income and deductions are separated out, either by single activity or, if certain tests are met, by aggregated groups of activities (see, e.g., Sec. 465(c)(3)(B)). For each tax year, if the income received or accrued by the activity exceeds deductions allocable to the activity, then deductions are allowed and no at-risk limitation applies (Sec. 465(d)). If deductions exceed income, then deductions will be allowed to the extent that the taxpayer has at-risk basis in that activity. If the deductions are not allowed, they carry over to the next tax year, maintaining the same character as when originally incurred (Prop. Regs. Sec. 1.465-38(b)).
The character of income or deductions is irrelevant when determining whether a Sec. 465(d) loss exists but could have a significant impact when a loss is partially allowable in the current year and partially suspended. Prop. Regs. Sec. 1.465-38(a) provides rules for the ordering of allowable deductions, prioritizing the deduction of capital and Sec. 1231 losses over ordinary and tax-preferred losses. The instructions to Form 6198, At-Risk Limitations, however, indicate that losses of differing character are instead to be disallowed on a pro rata basis. This is consistent with guidance in Regs. Sec. 1.704-1(d)(2), regarding losses suspended due to basis limitations, and Temp. Regs. Sec. 1.469-2T(d)(6)(iii), concerning passive activity losses. Absent definitive authority, it could be reasonable (and would usually be more favorable) to apply the pro rata approach, given its applicability to other types of loss limitations. Deductions should be tracked according to the year they originated, with the earliest incurred being allowed first in subsequent years (Prop. Regs. Sec. 1.465-38(c)).
Recapture of prior-year losses
In certain situations, the recapture of previously recognized losses may be required (Sec. 465(e)). Frequent reasons for recapture are a change in the character of partnership debt or a reduction in the amount of debt. If a recourse debt is converted to a nonrecourse debt, the conversion will affect the at-risk basis calculation for the partners, both directly by the characterization shift (non-recourse debt does not provide at-risk basis) and indirectly by its effect on debt allocation. This can have surprising results. Recapture can also occur when the partnership makes distributions to the partners, reducing their amount at risk (Prop. Regs. Sec. 1.465-22). It is important to note that if a partnership has had income in excess of deductions throughout its existence (and, thus, has never had a Sec. 465(d) loss), there would be no recapture even if a partnership distribution reduces the at-risk basis below zero, because the taxpayer has no prior loss to recapture (Sec. 465(e)(2)).
Example: ABC Partnership began operation in 2016, has reported income in excess of deductions for 2016, 2017, and 2018, and at the end of 2018 has nonrecourse debt secured by transportation equipment. At the end of 2018, Partner B has an at-risk basis composed of a cash contribution of $50,000 and three years of his share of earnings totaling $10,000, for a total at-risk basis of $60,000, and a tax basis of $80,000 (including nonrecourse debt of $20,000). If the partnership distributes $70,000 to Partner B, the at-risk basis is reduced to ($10,000), while his tax basis is reduced to $10,000. Partner B has no Sec. 465(e) recapture because there have been no previously allocated losses.
At-risk discussion for specific industries
The proposed regulations also discuss specific rules relating to certain enumerated activities in Sec. 465. For example, Sec. 465(c)(1)(A) specifically discusses the holding, producing, or distributing of motion picture films or videotapes. An interesting application in the regulations is the apparent distinction between an individual directly involved in the trade or business of making multiple films, who must treat each film as a separate activity, compared to an individual who performs the same activity through a partnership, who could treat all films as one activity (Prop. Regs. Sec. 1.465-42).
Activities related to the leasing of Sec. 1245 property (generally, most depreciable personal property) also have special rules under the statute and accompanying regulations. Although each leased property must generally be treated as a separate activity (Sec. 465(c)(2)(A)(ii) and Prop. Regs. Sec. 1.465-44), they can be aggregated if held through a partnership or S corporation (Sec. 465(c)(2)(B)) or if the leased properties consist of an integrated unit under a single lease, such as parts of a single computer system (Prop. Regs. Sec. 1.465-44(c)(2)).
Proposed regulations as a guide
Although not finalized, the proposed Sec. 465 regulations provide significant guidance and detailed examples of the application of the at-risk rules. In addition to the general policy that, when no final regulations are available, the IRS Chief Counsel will not take a position harsher to the taxpayer than that available in proposed regulations (Internal Revenue Manual §188.8.131.52.2), the long-standing nature of these proposed regulations has resulted in a de facto reliance not usually afforded to other proposed guidance. Therefore, practitioners wanting to have a full grasp of the at-risk rules as they are implemented in practice would do well to devote time to the study of these proposed regulations.
Mo Bell-Jacobs, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.