Editor: Lori Anne Johnston, CPA, J.D.
There are four sets of rules that could disallow all or part of a partner's deduction of an allocable loss from a partnership. These rules and the order in which they apply are: first, the adjusted tax basis of the partnership interest under Sec. 704(d); second, the partner's amount at risk under Sec. 465; third, the passive activity loss rules of Sec. 469; and fourth, the excess business loss limitation of Sec. 461(l). This discussion focuses on the Sec. 465 at-risk limitation.
Starting with the basis limitation under Sec. 704(d), a partner's basis in its partnership interest can never be negative. If a loss exceeds basis, basis is reduced to zero, and the excess creates a loss carryforward. If a partnership distribution exceeds basis, basis is reduced to zero, and the excess creates taxable gain (Sec. 731). Unlike the basis rules, however, a partner's at-risk basis can go negative. If a loss exceeds the amount at risk, the amount at risk is reduced to zero, and the excess creates an at-risk loss carryforward. However, if a partnership distribution exceeds the amount at risk, the amount at risk becomes negative.
The mechanical rules
Example 1: In year 1, a partner contributes $100 to a partnership and is allocated a $300 loss and $400 of partnership liabilities. Assume in this example and the following examples that the liabilities do not create at-risk basis for Sec. 465. There is no basis limitation. Basis at the end of year 1 is $200. But Sec. 465 disallows $200 of the $300 loss. The amount at risk at the end of year 1 is zero, and a $200 at-risk loss carryforward is created.
Example 2:In year 2, the partner receives a distribution of $100. The partner is allocated no income or loss and $400 of partnership liabilities. Since the distribution did not exceed basis, no gain is recognized under Sec. 731. The partner's basis is reduced to $100 at the end of year 2. But the distribution causes the partner's amount at risk to go to negative $100. This creates the potential for income recapture of prior at-risk losses under Sec. 465(e). If there were no prior-year losses, no income recapture occurs, and the partner's at-risk basis is allowed to remain negative. If there were prior-year losses, income recapture is required, limited to the prior years' aggregate at-risk loss, reduced by any prior-year income recapture amounts.
In Example 2 there is an aggregate prior-year at-risk loss of $100 and no prior income recapture amounts. Thus, $100 of recapture income is recognized in year 2. Since the recapture income is at-risk income, the partner's amount at risk is restored to zero at the end of year 2. The $200 at-risk loss carryforward from year 1 is not deductible in year 2.
When recapture income is recognized, Sec. 465(e)(1)(B) provides that "an amount equal to the amount so included in gross income shall be treated as a deduction allocable to such activity for the first succeeding taxable year." This results in an increase to the at-risk loss carryforward equal to the recapture amount. Returning to Example 2, the $100 recapture will therefore increase the at-risk loss carryforward from $200 to $300 at the end of year 2.
Example 3: In year 3, the partner receives a distribution of $100. The partner is allocated no income or loss and $400 of partnership liabilities. Since the distribution did not exceed basis, no gain is recognized under Sec. 731. The partner's basis is reduced to zero at the end of year 3. The distribution causes the partner's amount at risk to go to negative $100. Since the prior years' aggregate at-risk loss of $100 was already completely recaptured, there is no recapture income in year 3. The amount at risk at the end of year 3 is negative $100. There is a $300 at-risk loss carryforward at the end of year 3.
The rules outlined above can be confusing. The reporting can be as well. Form 6198, At-Risk Limitations, and its instructions outline the reporting requirements. In Part I, current-year at-risk income or loss is calculated. In Part II, the individual's amount at risk, before consideration of the current-year at-risk income or loss, is determined. Part III is now largely obsolete as it deals with old Sec. 465 transition rules. Part IV performs the basic comparison of the current-year at-risk loss (if any), against the current amount at risk (if any), and applies the at-risk loss limitation (if any).
Part I and Part IV are fairly straightforward. One important item to remember in Part I is to include the prior-year disallowed at-risk loss (if any) and the amount of recapture income from the prior year as a deduction (if any), with the current-year amounts.
Form 6198, Part II
Line 6 is the first line in Part II, and it asks for "adjusted basis" on the first day of the tax year. Many practitioners refer to "regular tax basis" and "at-risk basis." According to an informal poll conducted by the authors, many practitioners try to report an individual's "at-risk basis" on line 6, and then treat Part II as a "roll-forward schedule" of the amount at risk. If there are errors embedded in the prior-year calculation of the amount at risk, then this approach will tend to roll forward the undetected errors.
According to the form instructions, Part II is an annually recurring "conversion" schedule. Line 6 reports the partner's "regular tax basis" (and not the "at-risk basis") at the beginning of the year. Then, via adjustments, the beginning-of-year basis is converted to the end-of-year amount at risk (before consideration of the current-year at-risk income or loss). The critical aspect of this approach is to identify any components of the partner's basis that do not qualify as amounts at risk. Those components are "stripped out" of the partner's basis on line 9 of Part II to arrive at the partner's amount at risk at the end of the year. This approach is more likely to detect prior-year errors when calculating the current-year amount at risk.
Tax reporting the examples
In the first example, Part I would report an at-risk loss of $300; Part II would report an amount at risk of $100; and Part IV would report a deductible loss of $100. In the second example, Part I would report an at-risk loss of $200, and Part II would report an amount at risk of negative $100. The individual would be required to report $100 of recapture income. Part IV would allow zero deductible loss. In the third example, Part I would report an at-risk loss of $300. Part II would report an amount at risk of negative $100. Part IV would allow zero deductible loss.
Amount at risk
If the Sec. 752 regulations classify a liability as "nonrecourse" to a partner, then it is extremely unlikely to be an amount at risk. If the Sec. 752 regulations classify a liability as "recourse" to a partner, then it is likely to be an amount at risk, but not in all situations. An example occurred 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). There, members of a Wyoming limited liability company (classified as a partnership for federal income tax purposes) agreed to the following deficit restoration obligation (DRO) provision in their LLC operating agreement:
7.7 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 ٩٠ days after the date of such liquidation, for payment to creditors or distribution to Partners with positive capital account balances.
Apparently in connection with the DRO, some of the LLC liabilities were classified as Sec. 752 "recourse" liabilities on the Form 1065 Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., to the partners. The Tax Court, in its memorandum decision, held that the partners (i.e., the LLC members) did not have sufficient personal liability to the creditors of the LLC under the DRO to treat the amounts as at-risk for Sec. 465 purposes. Since the Sec. 465 at-risk rules are not the same as the Sec. 752 debt-characterization rules, further analysis under Sec. 465 is often necessary.
For partnership loans, and for partner guarantees of partnership loans, a partner must be "personally liable" under Sec. 465(b)(2)(A), and not "protected against loss" under Sec. 465(b)(4), to be at-risk under Sec. 465. Nevertheless, if the borrowing is from a related party under Sec. 465(b)(3)(C), then the partner may not be at-risk under Sec. 465. Under Sec. 465(b)(3)(B), the related-party rules do not apply to a person who has an interest in the activity as a creditor, or, in the case of amounts borrowed by a corporation from a shareholder, a person who has an interest as a shareholder is not considered a related party.
A real estate carve-out
There is an important exception to the general rule that the amount at risk does not include certain nonrecourse debt for which no partners are personally liable. This rule generally allows an individual to be treated as at-risk for qualified nonrecourse financing if the borrowing is in connection with an activity of holding real estate and is secured by real property used in the activity (Sec. 465(b)(6)). Liabilities on Form 1065 Schedule K-1 identified as "Qualified nonrecourse financing" can thus be treated as at-risk for Sec. 465 purposes.
The aggregation issue
Some Code sections allow partners under the right circumstances to group or aggregate interests in partnerships (or S corporations). Examples include the Sec. 469 passive loss rules and the Sec. 199A qualified business income deduction rules. A similar issue arises under Sec. 465: Can taxpayers aggregate interests in partnerships (or S corporations) for Sec. 465 purposes?
Sec. 465(c)(3)(A) provides that the at-risk rules apply to each activity (1) engaged in by the taxpayer in carrying on a trade or business or for the production of income and (2) which is not already subject to the rules under Sec. 465(c)(1). Sec. 465(c)(3)(B) provides that, except as provided in Sec. 465(c)(3)(C), activities described in Sec. 465(c)(3)(A) that constitute a trade or business shall be treated as one activity if (1) the taxpayer actively participates in the management of such trade or business, or (2) such trade or business is carried on by 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)(C) provides that Treasury shall prescribe regulations under which activities described in Sec. 465(c)(3)(A) shall be aggregated or treated as separate activities. To date, no regulations have been promulgated under Sec. 465(c)(3)(C).
The government recently outlined its position on this issue in Chief Counsel Advice (CCA) 201805013. The government's position as articulated in that CCA suggests that, from its perspective, it would be difficult to argue that aggregating activities conducted across partnerships (or S corporations) is allowable for at-risk purposes.
A caution for clients
The takeaway from this discussion is that, if you have an individual client who owns an interest in a partnership that is not involved in real estate, and the client's outside tax basis capital account goes negative, then beware Sec. 465 and Form 6198.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.