At Risk Limitation Affecting the Deductions Permitted to Members of Entities Taxed as Partnerships Based on Member Loans

One of the advantages of conducting business in a partnership or limited liability company taxed as partnership is the pass through of losses to members of the organization, which they are entitled to deduct against their other sources of income.  However, the ability to benefit from these losses is subject to two limitations.  First, a member may only deduct an amount that does not exceed the tax basis of his membership interest in the organization.  Any excess is deferred until he has sufficient basis to take a further deduction.  Second, he may not take a deduction for an amount that exceeds that for which he is at risk as set forth in §465 of the Internal Revenue Code (the “Code”).  This comment will describe the “at risk” limitation imposed by §465 of the Code and its effect on deductions that depend on basis derived from a related party loan.  As used in this comment the terms “organization” and “member” refer to organizations taxed as partnerships and to their members.

Section 465 was adopted in 1976 as part of an effort rein in excessive tax shelter activities.  Its purpose is to prevent taxpayers from taking deductions that exceed the amount of their actual loss from an investment.  Although §465 was initially aimed at specific targets, the provision was later amended to cover almost all business activities.

In general, funds borrowed from a bank or other sources will enable a member to increase his tax basis in the entity to the extent of his allocated share of the organization’s indebtedness.  This increased basis enables the member to deduct losses allocated to him in an amount that can exceed his contribution to the capital of the organization.  However, even if the member has sufficient basis to benefit from the full amount of an allocated deduction, he may not deduct an amount that exceeds the amount for which he is at risk under §465.

Treas. Reg. §1.465-8(b) imposes an important qualification on the ability of  a member of an organization to include in his amount at risk his share of a loan to the organization from a member having a capital interest in the organization or from a person related to that member.[1]  Thus, it would appear that no member, including a lending member, may benefit from deductions that depend on the inclusion of the lending member’s loan in determining the amount to which members are at risk.

However, Proposed Reg. §1.465-7(a) would change the foregoing result to allow only the lending member to increase his amount at risk to the extent that his basis is increased under Treas. Regs. §§1.752-2(a), (b).  Unlike Treas. Reg. §1.465-8(b), the foregoing regulations under §752, which govern member basis, allow only the lending member to increase his basis in an amount equal to his allocated share of the principal balance of his loan.  Although Proposed. Reg. §1.465-7(a) has never been formally adopted as a final regulation, it has been cited favorably by the U.S. Tax Court in Melvin v. Commr., 88 T.C. No. 63, 88, T.C. No. 5  n 7 (1987) and by the Internal Revenue Service in GCM 39488  7 (1986).  As a result, there is significant support of record for including a lending member’s share of basis in his loan in his amount at risk as well.

The foregoing sources, Melvin and GCM 39488 are all the references to Treas. Reg. 1.465-7(a) that your author has found.  There does not appear to be any guidance that specifically allows a member to base a deduction on Treas. Reg. §1.465-7(a).  However, in addition to the foregoing authorities, the first sentence of Treas. Reg. §1.752-2(a), states that in determining a partner’s basis in his interest “[a] member’s share of a recourse liability equals the portion of that liability, if any, for which the member bears the economic risk of loss (emphasis supplied).”  Treas. Reg. §1.752-2 (a) was adopted in 2006 two years after Treas. Reg. §1.465-8(b) and seems to reflect the current position of the Service with respect to the concept of at risk as well as basis.  BNA Portfolio 550 3rd at page 23 states that a lending member of a partnership is at risk as described in Proposed Reg. §1.465-7(a) without further citation or comment.  However, before taking a significant deduction in reliance on that regulation, it would be prudent to determine whether further guidance has been provided.  In any event, it seems unlikely that a penalty would be imposed if the deduction were taken by a lending member with respect to his share of his loan to an organization.

To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding U.S. tax penalties.


[1]  Treas. Reg. 1.465-8(b) also limits deductions based on loans from persons that derive income from a pass through entity and parsons related to them.

 

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