Regs. Sec. 1.704-2(b)(4) defines the term “partner nonrecourse debt” as “any partnership liability to the extent the liability is nonrecourse for purposes of §1.1001-2, and a partner or related person (within the meaning of §1.752-4(b)) bears the economic risk of loss under §1.752-2 because, for example, the partner or related person is the creditor or a guarantor.” A key issue is how deductions should be allocated that are funded by a general obligation of a limited liability company (LLC) if the obligation is guaranteed by or borrowed from a member and is recourse debt under Sec. 1001.
Treatment should be consistent with the general “tax follows economics” analysis on which Sec. 704(b) is based. In most cases, analyzing a general obligation of an LLC that is guaranteed by or borrowed from a member as if it were a partner nonrecourse debt may yield the most appropriate result, even though such a loan does not fall squarely within the definition of partner nonrecourse debt.
To understand Treasury’s intention behind Regs. Sec. 1.704-2(b)(4), it is helpful to look first to the legislative history of the statute. The preamble to the Sec. 704(b) and Sec. 752 temporary regulations, which the IRS released together in the same package, indicates that
[t]he coordination of these two sections reflects the fact that one of the principal purposes for including partnership liabilities in the bases of the partners’ interests in the partnership is to support the deductions that will be claimed by the partners for the items attributable to those liabilities. [T.D. 8237]
The preamble also indicates that the allocation of partnership liabilities equalizes the partnership’s inside basis with the partners’ outside basis, thereby allowing the partners that are allocated the deductions attributable to a partnership liability to be allocated the basis for that liability and enabling them to have enough tax basis to recognize the deductions on their tax returns. These statements make it clear that Treasury’s intention was for the deductions that are attributable to a specific liability to be allocated among the partners in the same manner as the liability itself.
This concept appears very straightforward, until the complexities of categorizing debt as recourse or nonrecourse under Secs. 752 and 1001 are layered on top of the liability classification as nonrecourse or partner nonrecourse and the deduction allocation rules of Sec. 704(b). To decipher the appropriate treatment for a general obligation of an LLC that is guaranteed by or borrowed from an LLC member, the classification of liabilities under Secs. 704(b), 752, and 1001 must be considered.
The first step in this analysis is to determine whether a particular liability is nonrecourse or recourse for purposes of Regs. Sec. 1.1001-2. Although there is little direct authority on this issue, it is generally thought that a liability is nonrecourse for purposes of Sec. 1001 if less than all the debtor’s assets are subject to the liability and recourse if all the debtor’s assets are subject to the liability. In this regard, it is important to distinguish between two related but different concepts—an asset’s being “subject to” a liability versus an asset’s “securing a liability.”
Being subject to a liability is a broader concept. An asset can be subject to a liability even though it does not secure the liability. An example is a mortgage on a personal residence. The creditor takes a perfected security interest in the house in the form of a mortgage; therefore, the house is securing the debt. The creditor’s rights do not end there, however, because the creditor can sue on the promissory note entered into in obtaining the loan to recover a deficiency not satisfied by the mortgage’s real estate. Therefore, the borrower’s other assets are subject to the loan. Accordingly, the loan would be viewed as recourse under Sec. 1001 because all the assets of the borrower are subject to the loan.
Many of the liabilities borrowed by an LLC from a member of the LLC are recourse liabilities under Sec. 1001 because typically the loan documents do not limit the lender’s recovery rights to specified assets. General obligations from an independent third-party creditor that are guaranteed by an LLC member are less common but fall into this same category. Such liabilities (member recourse loans) are not partner nonrecourse debt as defined under Regs. Sec. 1.704-2(b)(4), and since they are not nonrecourse liabilities under Regs. Sec. 1.704-2(b)(3), the rules outlined in Regs. Sec. 1.704-2 do not literally apply to them.
Because the allocation rules outlined in Regs. Sec. 1.704-2 do not apply to deductions that are financed by member recourse loans, deductions that are financed by these loans must be allocated in accordance with the general rules under Regs. Sec. 1.704-1. Given Treasury’s intention of coupling the allocation of debt-financed deductions with the allocation of the liability that is financing the deductions among partners, it appears the deductions that are financed by member recourse loans generally should be allocated to the lending or guaranteeing member. There are two different theories as to how these deductions should be allocated.
One suggested approach would be that by not subjecting the deduction attributable to a member recourse loan to the partner nonrecourse debt rules, the LLC is free to allocate these deductions pursuant to the general sharing ratio under the partnership agreement. This position leads to the possibility that deductions would be allocated to members other than the members who bear the economic risk of loss and who are not allocated the liability under Sec. 752.
The second approach would be to allocate the deductions attributable to a member recourse loan back to the lending or guaranteeing member under the fundamental concept that deductions must be allocated to the partner that bears the economic burden of the deductions. This approach appears in line with the legislative intent of Secs. 704(b) and 752 as well as with the fundamental principle of Sec. 704(b) that tax items must be allocated in a manner that reflects the economics. Generally, the economic risk of loss of the deductions attributable to a member recourse loan would be borne by the lending or guaranteeing member, thereby achieving conformity between Secs. 704(b) and 752. Therefore, unless it can be established that the economic risk has been shifted away from the guaranteeing or lending LLC member, the losses attributable to the debt should be allocated exclusively to that guaranteeing or lending member.
Generally, the second approach outlined above should achieve the correct economic answer in most cases. However, it may be possible to shift the economic risk of loss from the lending or guaranteeing member through the use of a properly drafted deficit restoration obligation (DRO) that shifts the economic risk of loss for both Secs. 704(b) and 752 to the member with the DRO. The application of a DRO in the context of an LLC is uncertain. In general, a DRO will not be incorporated into an LLC agreement, but if it is, it is important to distinguish between DROs that truly shift the economic risk of loss and those that do not.
A DRO in an LLC agreement has the potential to shift the economic risk of loss to the member with the DRO if the creditor has the right to enforce the DRO directly against the member with the deficit capital account who signed up for the DRO. In other words, is the DRO an asset of the LLC to which a creditor can look? The answer is a matter of state law (a legal question beyond the scope of this item). If the lender cannot enforce the DRO against the member, the DRO should be disregarded and the losses should be allocated exclusively to the lending or guaranteeing member, in effect treating it as if it were partner nonrecourse debt even though it does not fall within the definition of Regs. Sec. 1.704-2(b)(4).
Under Secs. 704(b), 752, and 1001, a liability could be categorized as recourse under one provision and as nonrecourse under another provision. In the case of member recourse loans, the liability does not fall squarely within the definition of partner nonrecourse debt under Regs. Sec. 1.704-2(b)(4). Although the Code and regulations are silent on this specific issue, under the fundamental principle of Sec. 704(b) tax items must be allocated in a manner that reflects the economics. Under this view, the losses attributable to the debt generally should be allocated exclusively to that guaranteeing or lending member in the same manner that losses funded by partner nonrecourse debt are allocated back to the guaranteeing or lending member.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.