Tax Loss Planning: The At-Risk Rules

Are you purchasing a business or real estate that involves financing a business or investment that is likely to produce tax losses in the future? Or have you already made the purchase?

If so, there may be ways to ensure that you can take the loss in the future. To do so, you have to plan for several roadblocks. The at-risk rules are one such roadblock.

In Bordelon v. Commissioner, T.C. Memo. 2020-26, the court recently revisited whether personal guarantees can be used to satisfy the at-risk rules. The case is a must read for those whose losses could be limited by the at-risk rules.

Facts & Procedural History

The taxpayer formed a single member LLC to purchase a hospital. The LLC was taxed as a disregarded entity.

The hospital was funded with a $9.9 million agricultural development loan. The loan was made by a local bank that received a guarantee from the U.S. Department of Agriculture and Rural Development (“USDARD”) lending program. The USDARD loan required the taxpayer to execute personal guarantees for the full loan amount.

The loan was made to the taxpayer’s LLC and guarantee the taxpayer executed the USDRD guarantee that made him directly liable for the loan.

The taxpayer reported a $1.6 million and a $176,000 loss from the LLC in 2008 and 2009, respectively.

The IRS audited the taxpayer’s return and proposed to disallow the loss. The IRS asserted that the taxpayer was not at-risk for the loan and, therefore, the loss was not allowable in 2008 or 2009.

About the At-Risk Rules

The at-risk rules were one of several tax measures put in place to deal with illegal tax shelters. But the rules were modified so that they apply to any loss transaction.

The at-risk rules limit the amount of losses that individual and small businesses can take (including losses from S corporations, which the IRS is focusing its audit resources on). They do so by suspending the losses in any year that the taxpayer is not “at-risk” for the loss. This test is applied as of the last day of the tax year. Suspended losses roll forward and are evaluated each subsequent year under the at-risk rules.

The taxpayer is at-risk for an amount equal to cash and property contributed plus any amount that the taxpayer borrowed and is personally liable for with respect to the activity or pledged other assets as collateral for the debt. For amounts borrowed, the taxpayer cannot be protected against loss–such as by the use of nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.

So the question for the at-risk rules is whether the taxpayer is personally liable and there are no protections against loss.

Personal Liablity

The courts have said that executing a personal guarantee is not sufficient to create personal liability for purposes of the at-risk rules. The reasoning for this is that the taxpayer would then have a claim against the borrower and could be made whole by suing the borrower.

But this reasoning shows that some personal guarantees may be sufficient. Specifically, it would seem that the personal guarantee would be sufficient if it allows the lender to pursue the guarantor first and separately.

Those are the facts in this case:

Mr. Bordelon also personally guaranteed the Kilgore Loan on February 18, 2011. Mr. Bordelon’s guarantee of the Kilgore Loan was an absolute and unconditional guarantee of performance under the loan, entitling HFB to enforce its rights against Mr. Bordelon without proceeding against any other obligor on the underlying indebtedness. Mr. Bordelon’s liability under the guarantee was unlimited and his obligations continuing. 

In these cases, the court applies a two step test to determine liablity:

a guarantor’s personal liability for purposes of section 465(b)(2)(A) depends on whether or not the guarantor has the ultimate liability for the debt.8 See Melvin v. Commissioner, 88 T.C. 63, 75 (1987), aff’d, 894 F.2d 1072 (9th Cir. 1990). To answer that question, we consider the “worst-case scenario” and then identify the “obligor of last resort” based on the substance of the transaction. Id. We ask: If there are no funds to repay the debt and all of the assets of the activity or business are worthless, to whom would the creditor look for repayment? See id.

In applying these tests, the court concluded that the taxpayer bore the ultimate liability for the debt.

The IRS argued that Louisiana law allows a right to reimbursement for someone who pays the debt of another. The court noted that it applies the worst case scenario, meaning, it presumed that the LLC borrower was insolvent and not able to pay. Thus, the Louisiana law did not have any bearing on the at-risk analysis.

The court also noted that the taxpayer, as the sole owner of the LLC, would bear the economic responsibility for such reimbursement in substance. He “would ultimately be paying the debt, and the fact that he might then be entitled to seek reimbursement from himself would not render him any less at risk.”

Planning for At-Risk Tax Losses

These are common issues raised by the IRS on audit, so this case goes a long way to help taxpayers whose losses are being reviewed by the IRS.

This case shows how personal guarantees should be structured if the debt-financed business is likely to incur losses in the future. Personal guarantees may be worded to put the ultimate responsibility on the taxpayer. If not, then the borrower may be a single member LLC owned by the taxpayer. The arrangement should then be reviewed under the worst-case scenario analysis.

This tax planning in advance of the transaction, the risk of an IRS dispute can be mitigated. There are other planning options that may be available if done timely, such as making loans to the business. But timing matters with most of these options.