On remand from the Sixth Circuit, the Tax Court has held that a deficit restoration obligation (DRO) added to the operating agreement of a limited liability company didn’t allow its member to create recourse debt. Despite the DRO, the at-risk rules under IRC § 465 barred a current deduction because the member wasn’t personally liable for the repayment of that debt, the court said.
Hubert Holding Company (HHC) owned 99% of Leasing Company LLC (LCL), a Wyoming LLC classified as a partnership for federal income tax purposes. After LCL’s tax year ended on July 31, 2000, its operating agreement was amended to state that on liquidation of the company its members were required to satisfy the negative balances in their capital accounts, thereby imposing a DRO on the members. The reasoning for this amendment was that the effect of its DRO was to obligate the members to contribute capital equal to their pro rata share of LCL’s recourse indebtedness, thus creating an “at-risk” amount under section 465.
Under section 465(b)(2), a taxpayer is considered to be at risk for amounts borrowed if the taxpayer is “personally liable for the repayment of such amounts.” However, the Sixth Circuit, in analyzing this provision, has previously applied an Emershaw standard or “payer of last resort” test. (See Emershaw v. Commissioner, 68 AFTR2d 91-5894 (1991)). Emershaw, among other cases, considered whether the taxpayer realistically had a fixed and definite obligation to use personal funds to pay a debt in a worst-case scenario. Under this test, if a taxpayer is deemed to be a payer of last resort, the taxpayer is considered at risk for purposes of section 465.
In its remand decision, the Tax Court held that HHC was not a payer of last resort of LCL’s recourse debt and therefore not personally liable for the repayment under section 465(b)(2)(A). According to the Tax Court, HHC did not make an unconditional promise to contribute additional capital to LCL, because the DRO required HHC to contribute additional capital to LCL only if (1) HHC liquidated its interest in LCL and (2) had a deficit in its capital account at the time of liquidation. Thus, the operation of the DRO hinged on the liquidation of HHC’s interest in LCL, and, under Wyoming law, a creditor of LCL had no right to recover funds directly from HHC or to compel a liquidation of HHC’s interest in LCL to force a payment under the DRO.
The Tax Court further noted that the DRO did not require LCL to pay the restored deficit to creditors. In fact, under the terms of the LLC operating agreement, the DRO could be paid to members with positive balances in their capital accounts rather than to creditors. Second, the DRO would not apply to HHC if LCL liquidated and HHC had a positive capital account following a liquidation of its interest in LCL. Third, under the DRO, HHC’s obligation to restore was limited to the amount of any deficit in its capital account. However, this amount would not necessarily be the same amount as HHC’s proportionate share of any unpaid debt owed by LCL.
When the Tax Court applied the Emershaw standard, no comparison was made to Treas. Reg. § 1.752-2(b)(1), which is used to determine a partner’s share of partnership liabilities for section 752. Under section 752, the regulations impose a “constructive liquidation” test, which also entails a worst-case result in determining a taxpayer’s basis with respect to partnership recourse liabilities. Whether this comparison needs to be made in the future remains an open argument.
For years, many practitioners have believed that a partnership or operating agreement containing a qualified DRO would achieve some form of at-risk status for the taxpayer. While the results of the Tax Court in Hubert were not necessarily at-risk-friendly, they do provide taxpayers with a road map of what a well-crafted DRO must contain to render a taxpayer the payer of last resort.
Hubert Enterprises Inc. v. Commissioner, TC Memo 2008-46
By Steven C. Thompson, CPA, Ph.D.