THE AT-RISK LOSS LIMITATION

GENERAL RULE: In addition to the other limitations on losses (viz., the passive income and loss rules and the adjusted basis limit) applicable to common pass-through entity taxpayers (i.e., S corporation shareholders, LLC members electing partnership treatment, and general or limited partners), losses from most activities are limited to amounts “at-risk.” In general, a taxpayer is at-risk in any activity for:

(1) The money and adjusted basis of property the taxpayer contributes to the activity; and

(2) Amounts the taxpayer borrows for use in the activity if:

a. the taxpayer is personally liable for repayment; or

b. the taxpayer pledges property (other than property used in the activity) as security for the loan.

(3) Qualified nonrecourse financing.

For purposes of the at-risk rules, a “loss” is defined as the excess of allowable deductions from the activity for the year (including depreciation or amortization allowed or allowable, disregarding the at-risk limits) over income received or accrued from the activity during the year. Income does not include income from the recapture of previous losses (see Recapture, below).

For partners (including limited partners and LLC members) and S corporation shareholders, there are three distinct loss limitations which limit the partner or shareholder’s share of losses distributed by the partnership or corporation. They are as numbered below in the order in which they must be applied:

(I) The adjusted basis of (a) the partner’s partnership interest (or the LLC member’s membership interest), or (b) the shareholder’s stock plus any loans the shareholder makes to the corporation;

(II) The at-risk rules; and

(III) The passive income and loss rules.

SCOPE OF APPLICATION: The at-risk limits apply to:

(I) Individuals (including partners, LLC members, and S corporation shareholders)

(II) Estates

(III) Trusts

(IV) Certain closely held corporations, excluding S corporations. A closely held corporation (“CHCorp”) is a non-S corporation more than 50% (by value) of the outstanding stock of which, at any time during the last half of the tax year, is owned directly or indirectly by or for five or less individuals. The IRS has very technical rules about how the 50% value amount is calculated.

1. What activities are subject to the at-risk rules?

Generally, all trades or businesses are subject to the at-risk rules. The Service explicitly defines the scope of covered activities as any of the following activities, if they are conducted as a trade or business activity or for the production of income:

(I) Holding, producing, or distributing motion picture films or videotapes.

(II) Farming.

(III) Leasing section 1245 property.

(IV) Exploring for, or exploiting, oil and gas.

(V) Exploring for, or exploiting, geothermal deposits (for wells started after 09/78).

(VI) Any other activity not included above that is carried on as a trade or business or for the production of income.

NOTE RE SECTION 1245 PROPERTY: Section 1245 Property. Section 1245 property is any property that is or has been subject to depreciation or amortization and is:

A. Personal property;

B. Other intangible property (other than a building or its structural components) that is:

(1) Used in manufacturing, production, extraction or furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services;

(2) A research facility used for the activities in (1); or

(3) A facility used in any of the activities in (1) for the bulk storage of fungible commodities,

C. A single purpose agricultural or horticultural structure; or

D. A storage facility (other than a building or its structural components) used for the distribution of petroleum.

2. What activities are not subject to the at-risk rules?

(1) NON-MINERAL REALTY IN SERVICE PRE-1987. The at-risk rules do not apply to the holding of real property (but not mineral property) placed in service before 1987. Nor do they apply to the holding of an interest acquired before 1987 in a pass-through entity engaged in holding real property placed in service before 1987. Personal property and services that are incidental to making real property available as living accommodations are deemed part of the activity of holding real property, and thus are included within the exception.

(2) CHCORP EQUIPMENT LEASING. Equipment leasing by a closely held corporation that is actively engaged in such leasing activity is a separate activity that is not subject to the at-risk rules. “Actively engaged” means that at least 50% of the closely held corporation’s gross receipts for the tax year are from equipment leasing. “Equipment leasing” refers to the leasing, purchasing, servicing, and selling of equipment that is § 1245 property; and the term does not include:

a. the leasing of master sound recordings and similar contractual arrangements for tangible or intangible assets associated with literary, artistic, or musical properties (like books, lithographs of artwork, or musical tapes); or

b. leasing activities related to motion picture films and videotapes, farming, oil and gas properties, and geothermal deposits.

c. Control groups. A controlled group of corporations is subject to special rules for this exclusion from covered activities. See IRC § 465(c).

(3) QUALIFIED CORPORATIONS EXCEPTION. Qualified corporations are not subject to the at-risk limits for any qualifying business. Each qualifying business is treated as a separate activity.

a. “Qualified corporation” means a closely held corporation (see closely held corporation Equipment Leasing exception, above) that is not:

i. A personal holding company;

ii. A foreign personal holding company; or

iii. A personal service corporation (defined per IRC § 269A(b), but substituting 5% for 10%).

b. “Qualifying business” means any activity if all of the following apply:

i. During the entire 12-month period tax year, the corporation had at least:

[A] one full-time employee whose services were in the active management of the business; and

[B] three full-time nonowner employees whose services were directly related to the business. “Nonowner” means one who does not own more than 5% (in value) of the outstanding stock at any time during the tax year. The rules of IRC § 318 are applicable, with the substitution in such rules of 5% for 50%.

ii. There are allowable business expense deductions and deductions relating to contributions to certain employee benefit plans, in the tax year, that exceed 15% of the gross income for such year.

iii. The business is not an excluded business, i.e.:

[A] equipment leasing businesses (see CHCorp Equipment Leasing, above); or

[B] any business involving the use, exploitation, sale, lease, or other disposition of master sound recordings, motion picture films, video tapes, or tangible or intangible assets associated with artistic, literary, musical or similar properties.

3. What is an “activity?”

A. Separation of Activities. In general, each item of activity – whether it is a motion picture, a piece of § 1245 property, a farm, oil or gas property, etc. – is a separate activity. Also, each investment that is not a part of a trade or business is treated as a separate activity. Partnerships and S corporations must treat all leasing of § 1245 property placed in service in any tax year as one activity.

B. Aggregation of Activities.

(1) Generally, all activities within a given category of covered activities (see categories I – VI, paragraph 2, above) are treated as one activity if:

a. the taxpayer actively participates in the management of the trade or business, or

b. The trade or business is carried on by a partnership or S corporation and 65% or more of its losses for the tax year are allocable to persons who actively participate in the management of the trade or business.

(2) Active Participation. Relevant factors in finding active participation include: making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees. Factors suggesting a lack of active participation include: lack of control in management and operations, having authority limited to discharging the manager, having an independent contractor manager rather than an employee manager.

4. How does a taxpayer calculate the amount at-risk in a given activity?

A. Generally. A taxpayer is “at-risk” in an activity to the following extent:

1. The amount of money and adjusted basis of property contributed to the activity; and

2. The amounts the taxpayer borrows for use in the activity provided:

[A] the taxpayer is personally liable for repayment, or

[B] the taxpayer pledges property (other than property used in the activity) as security for the loan.

B. Borrowed Amounts. Where property (other than property used in the activity) is pledged for a loan that is contributed to the activity, the amount considered at risk is the net fair market value of the taxpayer’s interest in the pledged property. “Net fair market value” means the fair market value on the date of the pledge less any prior or superior claims to which it is subject, except that no pledged property can be considered if it is directly or indirectly financed by debt that is secured by property contributed to the activity. Service rules provide that the taxpayer may increase his/her risk only once.

C. Exclusions for Related Persons. Even if the other requirements are met, a taxpayer is not at risk if the borrowed money came from a person having an interest in the activity or from someone related to a person (other than the taxpayer) having an interest in the activity.

(1) Exceptions from the Exclusion:

(a) Amounts borrowed by a corporation from its shareholders;

(b) Amounts borrowed from a person having an interest in the activity as a creditor; or

(c) An activity described in categories VI (see paragraph 2, above).

(2) Definition of Related Person. Related persons include the relationships below. Note that there are very technical rules regarding the meaning of direct or indirect ownership of the outstanding stock of a corporation (see Publication 925, at At-Risk Amounts).

(a) Members of a family, but only an individual’s brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants.

(b) Two corporations that are members of the same controlled group of corporations determined by applying a 10% ownership test.

(c) Fiduciaries of two different trusts, or the fiduciary and beneficiary of two different trusts, if the same person is the ancestor of both trusts.

(d) Tax exempt educational or charitable organization and a person who directly or indirectly controls it.

(e) A corporation and an individual who owns directly or indirectly more than 10% of the value of the outstanding stock.

(f)  A trust fiduciary and a corporation of which more than 10% in value of the outstanding stock is owned directly or indirectly by or for the trust or by or for the grantor of the trust.

(g) The grantor and fiduciary, or the fiduciary and beneficiary, of any trust.

(h) A corporation and a partnership if the same persons own over 10% in value of the outstanding stock of the corporation and more than 10% of the capital interest or the profits interest in the partnership.

(i)  Two S corporations if the same persons own more than10% in value of the outstanding stock of each.

(j)  An S corporation and a regular corporation if the same persons own more than 10% in value of the outstanding stock of each.

(k) A partnership and a person who owns directly or indirectly more than 10% of the capital or profits of the partnership.

(l)  Two partnerships if the same persons directly or indirectly own more than 10% of the capital or profits of each.

(m) Two persons who are engaged in business under common control.

(n) An executor of an estate and a beneficiary of that estate.

D. Other Considerations.

(1) Government Price Support Programs: Such programs do not reduce the taxpayer’s at-risk amounts, without agreements limiting costs.

(2) Effect of Increasing Amounts At-Risk in Subsequent Years. Allowable losses for a given year reduce the amount at-risk (but not below zero) effective at the beginning of the following year. Any loss in a given year greater than the current at-risk amount is “suspended,” and will not be allowed in later years unless and until the at-risk amount is increased. Suspended losses are treated as deductions for the activity in the following years, provided the at-risk amount effective for such year is greater than such suspended losses, and only to the extent such at-risk amount exceeds in such following years. Note, however, that the deduction of suspended losses (like current, un-suspended losses) is subject to the passive loss rules.

(3) Nonrecourse Financing. Generally, the taxpayer is not at-risk for contributions made pursuant to “non-recourse financing,” including guarantees, stop loss agreements, or similar arrangements. Non-recourse financing means financing for which the taxpayer is not personally liable, and includes other arrangements where the lender-financier only has recourse against the taxpayer’s interest in the activity or the taxpayer’s contributed property, and no other of the taxpayer’s property. Generally, if the taxpayer is protected against economic loss by an arrangement for reimbursement or repayment, any capital contributed pursuant to such arrangement or covered by such arrangement is not at-risk.

(4) Qualified Nonrecourse Financing. The taxpayer is at-risk for qualified nonrecourse financing secured by real property used in an activity of holding real property.

(a) “Qualified nonrecourse financing” means financing for which no one has personal liability and that is:

i. Borrowed by the taxpayer in connection with the activity of holding real property;

ii. Secured by real property used in the activity;

iii. Not convertible from a debt obligation to an ownership interest; and

iv. Loaned or guaranteed by any federal, state, or local government, or borrowed by the taxpayer from a qualified person.

(b) Special rules regarding non-real property encumbered post- 8/3/98:

i. Disregard property that is incidental to the activity of holding real property.

ii. Disregard other property if the total gross fair market value of that other property is less than 10% of the total gross fair market value of all the property which secures the financing.

iii. The above two rules can also be applied to financing obtained before 8/4/98 to the extent they increase the losses allowed for those years.

(c) Qualified Person. A qualified person is a person who actively and regularly engages in the business of lending money (most commonly a bank), except that none of the following are qualified persons:

i. A person related to the taxpayer in any of the ways listed above (with an exception for financing that is commercially reasonable and available on the same terms for unrelated persons).

ii. A person from whom the taxpayer acquired the property or a person related to that person.

iii. A person who receives a fee due to the taxpayer’s investment in the real property or a person related to that person.

E. Reductions of Amounts at Risk and Recapture

(1) The amount the taxpayer has at risk in any activity in a given tax year is reduced by each of the following:

(a) Any losses allowed by the at-risk rules in previous years.

(b) Distributions the taxpayer received from the activity.

(c) Debts changed from recourse to non-recourse.

(d) The initiation of a stop loss or similar agreement.

(2) The Recapture Rule.

(a) Generally, if the amount at-risk is reduced below zero, the taxpayer’s previously unallowed losses are subject to the recapture rule.

(b) When the amount at-risk in a given tax year falls below zero, the taxpayer must recapture at least part of the previously allowed losses. “Recapture” means that some portion of such losses are added to income from the activity for that year. The amount added is the lesser of:

i. The negative at-risk amount; and

ii. The total amount of losses deducted in previous tax years (beginning after 1978) minus any amounts the taxpayer previously added to income from that activity under the recapture rule.

iii. Note: Do not use the recapture income to reduce any net loss from the activity for the tax year; instead, treat the recaptured amount as a deduction for the activity in the next tax year.

(c) Pre-1979 Activity. If the at-risk amount in an activity at the end of tax year that began in 1978 was negative, the taxpayer applies the preceding rule for the recapture of losses by substituting that negative amount for zero.