Guarantor of LLC Debt: Additional Basis for Losses? Part 1 of a 2 part series
It is quite common for LLC members to guarantee operating loans that have been advanced to/or secured by their LLC. While a member’s guaranty usually means that the amount of the guaranteed debt is included in the member’s basis in his or her LLC membership interest, does that actually mean that the member can take loss deductions against that debt? Many tax professionals may be surprised to learn that the answer is generally “No.”
Suppose that members A, B, and C form an LLC called Rock Steady LLC. Each member puts in $10,000 in cash. The LLC elects to obtain a $100,000 loan from a local bank for working capital which only member B personally guarantees. In the first year, the LLC incurs a net loss of $45,000, which is to be allocated in accordance with the entity's operating agreement equally among the members. What portion of this loss is deductible by the members, if any?
Under the normal partnership tax basis rules found in I.R.C. Section 752, the losses sustained and allocated to the members is limited to their individual basis in their interest in the LLC. Additionally, B’s guaranty of the loan allows for the inclusion of the entire amount of the loan in B's basis, whereas the other members may not include any portion of the loan in their basis computations. Hence, members A and C are denied a basis increase and as such are limited as to the amount of loss each of them can deduct. In this case A and C cannot deduct more than $10,00 each.
Because the $100,000 of debt is included in B's basis, B's basis is increased. Does this mean that B's loss is fully deductible? The answer not only depends on the member's basis limitation, but also depends upon the at-risk rules under I.R.C. 465. The at-risk rules are the second of three rules that an LLC member must satisfy in order to fully deduct allocated losses. The first rule is the basis limitation. The third set of rules, which is not covered herein, is the passive loss rules under Code Section 469.
The at-risk rules, in essence, limit the amount of any loss deduction by an LLC member to the “amount the LLC member is at risk.” While one might think that because the guaranteed loan is included in B’s basis under the partnership basis rules, the member must also be considered at risk for that amount, but that is often not the case. That is because the rules under I.R.C. 465 say that if a taxpayer guarantees repayment of an amount borrowed by another person (ie. a primary obligor, which in this case, is the LLC) for use in an activity, the guarantee cannot increase his or her amount at risk. The taxpayer's amount at risk is not increased until such time as the taxpayer actually makes good on the guarantee.
The reason for this result is that under the law of most states, as between the guarantor and the primary debtor, the guarantor is considered only secondarily liable for the debt. If the guarantor has to make good the guarantee when the primary debtor defaults, then by law in most states a guarantor usually has a right to recover in a civil action from the primary debtor any amount that the guarantor paid. The right, then, to recover from the LLC prevents the guarantor from being considered “at risk” for the amount of the debt.
This question often arises in conjunction with an analysis of an LLC’s Schedule K-1s, the schedule which shows a member’s share of LLC debt as being either “recourse” or “non-recourse.” If a debt is listed as “recourse” on a member’s K-1, does that mean the member is at-risk for that amount? Under the laws in most states, a loan made to an LLC is generally “nonrecourse” as to the members, unless the members or a member guaranteed it. A member may include guaranteed debt in the member’s basis, but that does not mean that the member is at risk for that amount (1). However, recently the IRS and the courts have ruled that a member will be deemed to be at risk in the circumstance where there is a sole guarantor.
(1) the entity's debt may be listed as “recourse” on a schedule K-1 but a member cannot tell whether or not the member is at risk for that amount merely by looking at the K-1.