The Sec. 465 at-risk rules are intended to prevent taxpayers from deducting losses in tax shelters and similar activities in excess of the actual amount of money they might lose if the activity was abandoned. The rules have no effect on profitable activities. These rules limit the losses allowed to certain closely held C corporations on investments in certain activities (Sec. 465(a)(1)).
For purposes of the at-risk rules, a closely held C corporation is a corporation in which five or fewer individuals own (directly or indirectly) at any time during the last half of the tax year more than 50% in value of the stock. For this purpose, a personal service corporation can be a closely held corporation.
The at-risk rules cover losses in farming; oil, gas, and geothermal exploration; equipment leasing; movie or videotape holding, production, and distribution; and all trade or business activities or activities for the production of income not already specified (Secs. 465(c)(1) and (3)). A corporation is considered at risk in an activity to the extent of: (1) cash contributed to the activity; (2) the adjusted basis of other property contributed; (3) amounts borrowed for use in the activity if the corporation is liable for repayment; and (4) amounts borrowed for use in the activity to the extent the corporation has pledged property other than property used in the activity as security for the borrowed amount (to the extent of the net fair market value of the corporation's interest) (Sec. 465(b)). The amount of loss a corporation may recognize from an activity is limited to the amount that is at risk for that activity at the close of the tax year (Sec. 465(a)(1)).
When applying the rules to amounts borrowed, one of the more difficult issues involves contingent or deferred obligations. Clearly, the mere guarantee by an investor of another's debt does not increase the amount at risk (Prop. Regs. Sec. 1.465-6(d)). But the extent to which contingent liabilities and deferred obligations increase the amount at risk is less clear. Prop. Regs. Sec. 1.465-6(c) states that when the taxpayer is liable for repayment based only on the occurrence of a contingency, the taxpayer is considered at risk if the likelihood of the contingency occurring is such that the taxpayer is not effectively protected against loss or if the protection does not cover all likely possibilities.
Example 1. At-risk amount based on contingent liability: M Corp., a closely held corporation, is engaged in the activity of farming. To finance farming operations for the current year, M borrows $100,000 from a bank. M pledges its corn crop for all future years as security for the loan. The loan agreement states that M is not liable for repayment of the loan beyond this collateral. However, the agreement contains one exception stating that M will be liable beyond this collateral if the crops are destroyed as the result of a flood. Flooding is generally not a concern in the area in which M operates.
M's amount at risk will not be increased unless flooding actually occurs and destroys the crops. The likelihood of flooding is so remote that M is essentially protected against loss. However, if the contingency (in this case flooding) does occur, M's amount at risk will be increased at the end of the year in which the flood loss occurs (Prop. Regs. Sec. 1.465-6(e), Example (3)).
A corporation is potentially subject to the at-risk limitations if a loss is incurred (either directly or via a partnership or other passthrough entity) in a business or production-of-income activity in which an investment was made in the form of:
- Amounts contributed to or used in the activity that are protected against loss by guarantee, stop-loss agreement, or similar arrangement (Sec. 465(b)(4); Prop. Regs. Sec. 1.465-6).
- Amounts borrowed, whether recourse or nonrecourse, for use in, or contribution to, the activity from a person who has an interest in the capital or profits of the activity (other than as a creditor) or who is related to a person (other than the taxpayer) who has such an interest in the activity (other than as a creditor) (Sec. 465(b)(3); Regs. Sec. 1.465-8).
Note: An exception exists for amounts a corporation borrows from its shareholder (Sec. 465(b)(3)(B)). The IRS issued regulations that apply Sec. 465(b)(3) to all trade, business, or income-producing activities of the taxpayer (Regs. Sec. 1.465-8). The regulations also clarify that a taxpayer's amount at risk can be increased by amounts borrowed from a related person who does not have a disqualifying interest in the activity and by amounts borrowed by a corporation from its shareholders. Also, qualified nonrecourse financing, if used in an activity of holding real property and secured by real property used in the activity, is not subject to the limitations of Sec. 465(b)(3).
- Nonrecourse loans (either within the activity or to acquire an interest in the activity) that are not secured by the taxpayer's own property (i.e., property not used in the activity) (Sec. 465(b)(6)).
In Moreno, No.6:12CV2920 (W.D. La. 5/19/14), the taxpayer (through his single-member LLC) was at risk for only 50% of the amount of debt he personally guaranteed. Amounts borrowed were used by the taxpayer's single-member LLC to purchase an aircraft that was leased to customers. The loan was secured by the purchased aircraft, by the taxpayer personally, and then by a guaranty from a corporation controlled by the taxpayer. The taxpayer, however, also had a right of reimbursement from the controlled corporation for half the amount if he ultimately was required to pay the obligation. The taxpayer was at risk with respect to the loan, except to the extent there was a right of reimbursement.
Aggregation of activities
Normally, a corporation must test each separate activity it holds an interest in to determine if it is at risk for that activity. If the corporation holds an interest in a partnership, however, separate activities may be combined that are of the same type (e.g., two farms or four oil-and-gas properties) and constitute one of the five activities originally subject to the at-risk rules (see Sec. 465(c)(2)(B) and Temp. Regs. Sec. 1.465-1T).
For a corporation to be allowed to combine like-kind activities other than the original five, the activities must constitute a single trade or business (Sec. 465(c)(3)(B)):
- In whose management the corporation's employees actively participate; or
- That is carried on by a partnership in which at least 65% of the losses for the tax year are allocable to partners actively participating in its management.
Example 2. Aggregating separate activities to meet the at-risk test: G Corp. is 100% owned by J. G has a 50% interest in two separate partnerships, one with a bowling alley and a second that is involved in computer sales. G's employees (along with those of the other 50% partner in each partnership) are actively involved in the management of both partnerships. G's amount at risk is positive for the bowling alley but negative for the computer sales partnership. If the two partnerships were combined, G would have a positive amount at risk of $10,000. The computer sales operation incurred a loss in the current year of which G's share was $13,000. G and the partnerships use a calendar year.
G is unable to claim any loss on its current-year return. G is not at risk with respect to the loss because its amount at risk in the computer sales partnership is negative. It is not allowed to aggregate its interest in the bowling alley with the computer sales partnership because they are separate trades or businesses (IRS Letter Ruling 9035005). Assuming the two sales partnerships qualified as a single trade or business, G could deduct $10,000 of the loss (its net positive amount at risk in the two partnerships).
This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Closely Held C Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2021 (800-431-9025; tax.thomsonreuters.com).