AM 2014-003, LLC Debt and Member Guaranties

By Jorge Otoya, Bird Education Specialists in Taxation, LLC 

This AM was dated August 27, 2013, but released on April 4, 2014 and deals with the intersection of the at-risk rules of § 465 and LLC member guaranties.  Although this document does not have precedential effect, it does provide some insight into the IRS’s position on audit regarding the effect of LLC member guaranties on the at-risk basis of the members in the activity of an LLC.  AM 2014-003 tackles three queries:

Query 1: What happens under § 465 when an LLC member guaranties the debt of the LLC? 

Query 2: What if the LLC debt is “qualified nonrecourse financing”?

Query 3: What happens to the other members under Query 2 above?

Discussion (Query 1):

From a policy standpoint, if an LLC member guarantees the debt of the LLC (whether the LLC is treated as a partnership or a disregarded entity for federal income tax purposes), the member has assumed a real economic risk with respect to the guaranteed debt, assuming it is a “real” guarantee and that the member would not be entitled to some form of repayment if it had to come out of pocket as a result of the guarantee. 

But does this grant the member at-risk basis for section 465 purposes with respect to the guaranteed debt?  One would think from a policy perspective that the member should receive at-risk basis for its guarantee and treat a partnership liability for at-risk purposes consistent with the classification of such a liability as recourse under § 752. 

Proposed Treas. Reg. § 1.465-6(d) is potentially troubling in this regard.  It provides that a person is not at-risk for a guaranty with respect to an amount borrowed by another person, unless he actually comes out of pocket and has exhausted its legal rights against the primary obligor (the Guarantee Rule).  If the Guarantee Rule applies to members that guarantee LLC debt, this would mean that the guarantor member would not receive at-risk basis for such guarantee unless (i) he actually made a payment with respect to the guarantee; and (ii) exhausted his legal rights of subrogation against the LLC for his payment. 

As the AM indicates, in the partnership context, the example in Prop. Treas. Reg. § 1.465-24(a)(2)(ii) concludes that general partners include partnership debt in their amount at-risk because they are personally liable for such debt.  This treatment applies in the example even though general partners would have a legal recourse against the primary obligor who is the general partnership.   Although the general partners in the example are personally liable for the debt of the general partnership pursuant to state law they also have legal rights against the partnership if they had to make a payment to a partnership creditor.  Thus, they have the same recourse as a member who has guaranteed the debt of an LLC.  Interestingly, the general partners have not actually guaranteed the debt (and even though they are included in the relevant example, do not literally fall within the definition of the Guarantee Rule).  Nonetheless, from a policy perspective, it would not seem appropriate to treat taxpayers that have taken the same risk differently for at-risk purposes just because they are different types of owners.   

Indeed, in the AM, the IRS concludes as such…stating “a member who guarantees LLC debt becomes personally liable for the guaranteed debt and is in a position akin to the general partners...” and thus “a right to subrogation, reimbursement, or indemnification from the LLC (and only the LLC) does not protect the guaranteeing LLC member against loss within the meaning of § 465(b)(4).”  The IRS reasons that the Guarantee Rule was written prior to the proliferation of LLC Acts and thus it does not apply if an “LLC member guarantees LLC debt, the member has no rights of contribution or reimbursement, the guarantee is bona fide and enforceable by creditors of the LLC under local law, and the member is not otherwise protected against loss.”   This is not necessarily a great response for this taxpayer...

Discussion (Query 2 and 3):

Query 2 and 3 are essentially one in the same.  What happens to the members of an LLC when one of the members guarantees a debt that would otherwise qualify as qualified nonrecourse debt?  With respect to these queries, the IRS concludes that an LLC member guarantee of an LLC debt causes the debt to lose its qualified nonrecourse debt status because (i) the debt is no longer secured solely by real property but also by the assets of the guarantor; and (ii) a member is personally liable for repayment of the debt.  Accordingly, under the reasoning applied in Query 1, only the guarantor member receives at-risk basis.  

The other members do not receive at-risk basis with respect to this debt.  To the extent that such other member’s at-risk amount would decrease below zero, they would be required to pick up income.  This was the case for the taxpayer under audit that is the subject of this AM.  It seems that the audited taxpayers included the qualified nonrecourse debt in the at-risk basis of all of the members.  This is important because if there were deductions attributable to such debt, all of the members would have been allocated those deductions as well.   But under the AM, once the one member guarantees the debt, the debt (and any associated deductions) would be allocated solely to the guarantor. 

Observations:

What can the taxpayer do in this situation?  Query whether the taxpayer could avoid the income chargeback to the other members referenced in item 2, by arguing that the literal application of the Guarantee Rule applies.  Thus, the member guarantee has no effect on the qualified nonrecourse financing.  Typically, it is the policy of the IRS to follow its own proposed regulations on audit.   What do you think?