Special rules apply for allocating basis from loans made or guaranteed by limited liability company (LLC) members or affiliates of members. The following discusses how loans made or guaranteed by members or member affiliates generally must be allocated 100% to the member who makes or guarantees the loan (or whose affiliate makes or guarantees the loan).
Loans between a partnership or LLC and its partners can create complexity when it comes to tax basis and loss deductions. The classification of these loans as recourse vs nonrecourse is an important determination that impacts how deductions are allocated and whether partners have enough basis to deduct losses. This article provides an overview of the key factors in categorizing partner loans and their resulting tax implications.
Recourse vs Nonrecourse Debt
The first step is understanding the difference between recourse and nonrecourse debt.
Recourse debt is debt where the partners or members bear the economic risk of loss. If the partnership defaults the creditor can pursue the personal assets of the partners or members to repay the liability.
Nonrecourse debt is debt where none of the partners or members are personally liable. The creditor’s only recourse in case of default is to seize partnership assets that were pledged as collateral. The partners/members do not bear any economic risk of loss.
Impact on Tax Basis
The classification of partner loans as recourse or nonrecourse impacts the partners’ tax basis in several ways:
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Recourse debt provides basis for partners to receive tax-free distributions and to deduct partnership losses (up to the at-risk amount).
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Nonrecourse debt provides basis for tax-free distributions but generally does not provide at-risk basis to deduct losses.
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There is an exception for qualified nonrecourse financing (nonrecourse debt used for holding real property) which can provide at-risk basis like recourse debt.
Allocation of Deductions
In addition to basis categorizing partner loans also impacts the allocation of partnership deductions
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Deductions attributable to recourse partner loans are allocated to the lending partner.
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Deductions attributable to nonrecourse partner loans follow the allocation method in the partnership agreement (typically pro-rata).
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However, it may be possible to allocate nonrecourse debt deductions back to the lending partner in certain cases under the “tax follows economics” principle.
Other Important Factors
Here are some other key considerations around partner loans:
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Loan guarantees by partners are treated the same as direct partner loans for tax purposes.
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LLCs can have exculpatory liabilities where the debt is recourse to the LLC but nonrecourse to the individual members. This impacts how deductions are allocated.
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Affiliate partner rules attribute loans from partner affiliates to the partner for determining recourse vs nonrecourse status.
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Some nonrecourse loans qualify for de minimis exception allowing deductions to follow the partnership agreement allocation.
Properly categorizing loans between a partnership/LLC and its partners is important and complex. The recourse vs nonrecourse determination impacts tax basis calculations, deduction allocations, and the at-risk amount for loss deductions. Consult a tax professional when accounting for partner loans to ensure proper treatment. With careful planning, partnerships can optimize their tax position when partners provide loans or guarantees.
Frequency of Entities:
recourse debt: 7
nonrecourse debt: 7
qualified nonrecourse financing: 2
tax basis: 4
at-risk: 4
allocation of deductions: 3
loan guarantees: 1
LLCs: 2
exculpatory liabilities: 1
affiliate partner rules: 1
de minimis exception: 1
Impact of Member Affiliate Loans
As stated previously, the character of a liability as recourse or nonrecourse (and the determination of the members shares of the liability for basis purposes) depends not only on the relative rights and obligations of the members but also on those of persons related to members, i.e., member affiliates. In determining basis, the rights and obligations of these member affiliates are attributed to the related members. This means that a loan from a member affiliate is treated as if it is owed to the member related to the lender. The related member is treated as having 100% of the economic risk of loss and is allocated all the liability for basis purposes. However, the de minimis rule already discussed may apply.
The definition of member affiliates (i.e., parties that are related to members) is critical because such relationships may cause a nonrecourse loan to be treated as recourse. This treatment results in an allocation of 100% of the basis from the loan to the member affiliated with the lender. In general, a person is affiliated with a member if such person (1) is not another member in the same LLC and (2) shares with the member one of the relationships described by the related-party rules of Sec. 267(b) or the controlled partnership rules of Sec. 707(b)(1), subject to certain modifications set forth in the regulations (Regs. Secs. 1.752-1(a)(3) and 1.752-4(b)).
These relationships, as modified, are as follows:
- Members of the same family, including spouses, ancestors, and lineal descendants.
- An individual and a corporation of which more than 80% (by value) of the outstanding stock is owned directly or indirectly by or for the individual.
- Two corporations that are members of the same controlled group.
- A grantor and a fiduciary of the same trust.
- Fiduciaries of trusts with the same grantors.
- A fiduciary of a trust and a beneficiary of another trust—if the same person is the grantor of both.
- A fiduciary of a trust and the beneficiary of that trust.
- A fiduciary of a trust and a corporation if more than 80% (by value) of the stock is owned directly or indirectly by or for the trust, or by or for a grantor of the trust.
- A person and a tax-exempt organization controlled directly or indirectly by that person or by his or her spouse, ancestor, or lineal descendant.
- A corporation and an LLC (or partnership) when the same persons own more than 80% (by value) of the corporations stock and more than 80% of the capital or profits interests in the LLC (or partnership).
- Two S corporations if the same persons own more than 80% (by value) of the stock of both corporations.
- An S corporation and a C corporation if the same persons own more than 80% (by value) of the stock of both corporations.
- An LLC (or partnership) and a person that owns, directly or indirectly, more than 80% of the capital or profits interests in the LLC (or partnership).
- Two LLCs (two partnerships, or an LLC and a partnership) in which the same persons own, directly or indirectly, more than 80% of either the capital or the profits interests in both LLCs (both partnerships, or both the LLC and the partnership).
The constructive ownership rules of Sec. 267(c) apply in determining whether these relationships are present.
If a person is related to more than one member, the person is deemed to be related only to the member with the greatest percentage of related ownership at the time of the determination. If two or more members have the same percentage of related ownership with a person and no other member has a greater percentage, the basis of the related persons loan or guaranteed loan is allocated equally among those members (Regs. Sec. 1.752-4(b)(2)).
T and P are related parties as defined in Regs. Sec. 1.752-4(b). P directly owns 45% of T s stock value and indirectly owns an additional 40% (because under the constructive ownership rules of Sec. 267(c), P is considered to own the stock owned by his family, including his son). Under the related-party rules, as modified by Regs. Sec. 1.752-4(b), an individual and a corporation are related parties when more than 80% (by value) of the corporations outstanding stock is owned directly or indirectly by or for the individual. Since P is deemed to own 85% of T s outstanding stock, P and T clearly meet the definition of related parties.
Because of this relationship, the otherwise nonrecourse loan to L will be treated as recourse. This results in an allocation of 100% of the basis from the loan to P, the member affiliated with the lender.
Note: Because the percentage threshold for affiliation between a member and an entity is set fairly high by the regulations (i.e., 80%), it was anticipated that taxpayers would attempt to take advantage of the rules by having members own slightly less than 80% of an affiliated entity. Therefore, if a member owns 20% or more of the lender or guarantor of an LLC liability, the transaction will likely be scrutinized to determine if its principal purpose is tax avoidance. If a tax avoidance purpose is found, the member will be treated as holding the entitys position as lender or guarantor to the extent of the members ownership interest in the entity (Regs. Sec. 1.752-4(b)(2)(iv)).
Allocating Debt Owed to Members and Member Affiliates
If a member or related person (i.e., a member affiliate) makes a loan to an LLC, it is generally categorized as recourse for basis purposes (Regs. Sec. 1.752-2(c)). This is true even if the loan would be characterized as nonrecourse if made by an unrelated person. This type of liability is called a member nonrecourse loan. The lender member or member affiliated with the lender is deemed to bear all economic risk of loss with respect to the loan. As a result, the lender member or member affiliated with the lender is allocated 100% of the liability for basis purposes. A similar rule applies to guarantees of nonrecourse debt by a member or member affiliate.
As discussed in the previous paragraph, nonrecourse loans from members or member affiliates are generally allocated 100% to the lender member (or member related to the lender). However, a de minimis rule applies to member (or member affiliate) nonrecourse loans if (1) such members interest in each and every item of income, gain, loss, deduction, or credit is 10% or less over the life of the LLC, and (2) the loan constitutes qualified nonrecourse financing under the at-risk rules. If both criteria are met, member nonrecourse loans are treated as true nonrecourse debt that is allocated based on the three-tier system described in Regs. Sec. 1.752-3(a).
The determination of whether a debt is qualified nonrecourse financing for purposes of this de minimis rule is made without regard to the type of activity for which the debt is used (i.e., it need not be held in connection with real estate activities). The intent of this rule is to allow the allocation of basis to nonlender members for nonrecourse loans owed to a member (or member affiliate) who is predominantly a creditor of the LLC rather than a member. For direct member nonrecourse loans, this rule applies to debt incurred, assumed, or materially modified on or after March 1, 1984. With respect to nonrecourse loans from member affiliates, the de minimis rule applies to post–January 29, 1989, debt.
Under the general rule for nonrecourse loans directly from LLC members or member affiliates, F would be deemed to bear all economic risk of loss for the loan under Regs. Sec. 1.752-2(c)(1). As a result, the entire $100,000 liability would be allocated to F for basis purposes. However, because F s interest in each item of the LLCs income or loss is 10% or less, and the loan meets the definition of qualified nonrecourse financing under Sec. 465(b) (6)(B), the de minimis rule applies. Therefore, the liability is allocated as a true nonrecourse liability under Regs. Sec. 1.752-3.
Recourse vs Nonrecourse Debts of an LLC
Are member recourse loans a partner nonrecourse debt?
Such liabilities (member recourse loans) are not partner nonrecourse debt as defined under Regs. Sec. 1.704-2 (b) (4), and since they are not nonrecourse liabilities under Regs. Sec. 1.704-2 (b) (3), the rules outlined in Regs. Sec. 1.704-2 do not literally apply to them.
What is the difference between a recourse and a non-recourse loan?
In summary, while both types of loans allow lenders to seize collateralized assets after a borrower fails to repay, **recourse loans** give lenders the option to pursue additional assets beyond the collateral
What is a member nonrecourse loan?
If a member or related person (i.e., a member affiliate) makes a loan to an LLC, it is generally categorized as recourse for basis purposes (Regs. Sec. 1.752-2 (c)). This is true even if the loan would be characterized as nonrecourse if made by an unrelated person. This type of liability is called a member nonrecourse loan.
How does a nonrecourse loan work in an LLC?
Under the LLC’s operating agreement, M and F share all LLC items, including income, losses, and credits, on a 95/5 basis. Under the general rule for nonrecourse loans directly from LLC members or member affiliates, F would be deemed to bear all economic risk of loss for the loan under Regs. Sec. 1.752-2 (c) (1).