Merely being a guarantor of a rather large outstanding partnership debt was not sufficient to allow a deduction for losses flowing through from a partnership in the case of Hargis v. Commissioner, TC Memo 2016-232.
The case involved a question of proving basis both in S corporations in which the husband was a shareholder and basis in LLCs taxed as partnerships in which the wife was a partner. The S corporation issue was fairly simple—the debts did not flow directly from the husband to the S corporation, so there was no basis provided by the debt.
But the partnership situation is different—a key difference between partnerships and S corporations is that a partner considers as part of his/her basis calculation the partner’s allocable share of partnership debt. How that debt is allocated to a partner depends on whether the debt is recourse (at least one partner has an economic risk of loss on the debt as provided for in Reg §1.752-2) or nonrecourse (where no partner has an economic risk of loss).
In this case, there were two partnerships, each with its own debts. The first partnership debt was described as follows in the opinion:
Brenda Hargis was a member of Melbourne Properties, LLC (Melbourne Properties), which received a loan of $2 million from Liberty Bank of Arkansas (Liberty Bank) in December 2005. Brenda Hargis, petitioner, and four other individuals signed guaranty agreements as security for the Liberty Bank loan.
The second partnership and debt were described as follows:
Brenda Hargis was also a member of Clay County, LLC (Clay County), which was one of seven coborrowers on a loan from Bank of Oklahoma in August 2009. The Bank of Oklahoma loan proceeds were for the purchase of the Corning nursing home property by Clay County and for the construction of a new facility on that property. The agreement did not state whether or how responsibility for the indebtedness was to be apportioned among the seven entities listed as coborrowers. Brenda Hargis, petitioner, and two other individuals signed as guarantors of the Bank of Oklahoma loan.
Neither debt specifically provided that the debts were to be recourse against the individuals. As well, the Bank of Oklahoma loan’s remedies in the case of nonpayment of the debt did not include actions against individual members of the LLC.
The K-1s that Brenda received from each partnership had no entries on the lines for her allocation of debt. Brenda argued, though, that since she was a guarantor on the debt of the first partnership and a co-borrower on the debt of the second, she clearly had enough basis to claim the flow through losses. After all, the bank could pursue any of the guarantors or any of the co-borrowers for the entire balance of the loan should the partnership fail to pay its debts.
Unfortunately for Brenda, the regulations aren’t quite that simple. It wasn’t clear that these were truly recourse debts at the partnership level though it seems likely they would so qualify. But even if the lender might look outside the partnership for payment and even take assets from Brenda to pay off the debt in the case of default, that doesn’t mean Brenda would necessarily be allocated any of the debt.
Reg. §1.752-2(a) defines a partner’s share of a recourse debt. Generally, it provides:
A partner's share of a recourse partnership liability equals the portion of that liability, if any, for which the partner or related person bears the economic risk of loss.
The definition of “economic risk of loss” is found in Reg. §1.752-2(b)(1) which initially provides that:
…[A] partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner.
The second clause is where Brenda runs into trouble—if she can seek reimbursement from other members of the LLC for some (or perhaps even all) of any amounts the bank could force her to pay, then that portion of the debt will not be considered as part of her basis calculation.
The basic calculation of her portion of the debt is calculated via a constructive liquidation calculation. As Reg. §1.752-2(b)(1) continues:
Upon a constructive liquidation, all of the following events are deemed to occur simultaneously:
(i) All of the partnership's liabilities become payable in full;
(ii) With the exception of property contributed to secure a partnership liability (see § 1.752-2(h)(2)), all of the partnership's assets, including cash, have a value of zero;
(iii) The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditors's right to repayment is limited solely to one or more assets of the partnership);
(iv) All items of income, gain, loss, or deduction are allocated among the partners; and
(v) The partnership liquidates.
To determine which partner is required to make a payment, Reg. §1.752-2(b)(3) provides that a determination is based on the facts and circumstances at the time of the determination and goes on to note:
All statutory and contractual obligations relating to the partnership liability are taken into account for purposes of applying this section, including:
(i) Contractual obligations outside the partnership agreement such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or to other partners, or to the partnership;
(ii) Obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership; and
(iii) Payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state law, including the governing state partnership statute.
Normally until a partner fails to fulfill his/her obligation, it is assumed that all partners will fulfill his/her obligations under those various agreements and under applicable law.
The fact that Brenda did not have a calculation of a deemed liquidation, nor evidence of how the various agreements and state law rules noted above would have impacted the amount she was deemed to be ultimately liable for in the worst-case liquidation scenario meant that Brenda could not show that any of the debt would have been allocated to her. Thus, the Tax Court sustained the IRS’s position that since Brenda had not shown any basis in her interest no loss deduction was allowed for the year in question.