T he number of limited liability companies (LLCs) in the United States is increasing dramatically. Most choose to be taxed as partnerships and follow the normal partnership rules. However, some of those regulations must be adjusted as a result of the owners’ limited liability. Recently the Tax Court considered the special rules that apply to the allocation of liabilities to LLC members.
Gerald Forsythe owned 70% of Indeck Energy Services Inc. (IE), a C corporation, and owned 100% of Indeck Power Overseas Ltd. (IO), an S corporation. Forsythe and IO owned IPO II, an LLC; Forsythe owned 1% and IO the remaining 99%. IPO II purchased an airplane funded by a $9.4 million loan from Nationsbanc Leasing Corp. that Forsythe and IE guaranteed. The loan guarantee said neither of them would be entitled to reimbursement for any payments they made under the guarantee. Forsythe included the entire loan in his basis in IPO II since IE wasn’t a member of the LLC. The IRS concluded that part of the loan should be allocated to IO under the related-party rules and should be included in IO’s basis in IPO II.
Result. For the taxpayer. The Tax Court had to decide how to allocate an LLC’s liability. Under the general rule of IRC section 752, a recourse liability is allocated to the partner that bears the economic risk of loss. Normally a loan guarantee would not cause a guarantor to fall into this category because the guarantor would be entitled to reimbursement for any payments made. But in this case the guarantee agreement provided that Forsythe was not entitled to reimbursement and therefore he is treated as bearing the economic risk of loss. Several parties guaranteed the loan but only Forsythe was an owner of the LLC. Consequently the entire loan is allocated to him under the general economic risk of loss rule.
Although the second owner of the LLC, IO, does not bear direct risk of loss, the IRS argued it should be allocated part of the loan since it is a related party to Forsythe, who does bear the risk of loss. In this instance the nonguarantor/owner is related to the second guarantor. Under such circumstances the IRS says part of the liability should be allocated to that entity. Section 752 specifically provides for allocation of part of the liability to “related parties” if they meet the definition of that term under IRC sections 267 or 707(b).
However, section 752 contains an exception: Persons who own a direct or indirect interest in the partnership are not treated as related parties. According to the Tax Court, Congress put this exception in the law to prevent the allocation of a liability to a partner who does not bear the risk of loss from a partner that does. Since the IRS is attempting to allocate the liability away from a guarantor/owner who bears the risk of loss to one that does not, the exception to the related-party rules apply. The guarantor/owner and only the guarantor/owner includes the liability in its basis.
This case illustrates the requirement that a guarantor waive the right to reimbursement to qualify as bearing the economic risk of loss. It also shows how the exception to the related-party rule prevents allocation from one owner to another.
IPO II v. Commissioner, 122 TC no. 17.
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.