Recourse and Nonrecourse Debt: Basis for LLC Member’s Interest in LLC   Term Paper ID:43851 Click to get this paper

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Paper Abstract: This paper discusses the advantages of nonrecourse debt available through the LLC structure to explain why the LLC is attractive to investors. Paper Introduction: Recourse and Nonrecourse Debt Basis for LLC Member\'s Interest in LLC An LLC member\'s interest in being part of a limited liabilitycorporation or LLC is predicated in part on the difference betweenrecourse and nonrecourse debt and the advantages that accrue as a result ofthe latter Recourse debt is that which allows the lender to come afterthe borrower in case of borrower default Nonrecourse debt on the otherhand does not allow the lender to pursue anything other than collateral meaning that if the Text of the Paper: The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper. Riverwoods: Nov/Dec 2 8.Vol. ||85 Note again that a partner may subject himself to a continuing ||obligation under some sort of guarantee. 752(d) states that, "[i]n the case of a sale or exchange of an||interest in a partnership, liabilities shall be treated in the same ||manner as liabilities in connection with the sale or exchange of ||property not associated with partnerships [emphasis added]." As such, ||Code Sec. In a DAT transaction, a taxindifferent party ("Contributor") directly or indirectly (through apartnership) contributes distressed assets (e.g., debt instruments) havinga high basis and a low value to a trust or series of trusts ("Main Trust").Contributor is intended to be the grantor of Main Trust. At theend of Year 3, Martha gifts her entire LLC interest to her daughter Wilma.At the end of Year 3, Martha and Sue each have capital account deficits of$9, , as shown in Table 6.[pic]Does Martha have any recognized gain on the gift of her interest to Wilma?Certainly her amount realized includes her $2 , share of the $4 , unsecured LLC debt. Note also the qualified nonrecourse ||financing exception to the passive loss rules provided for in Code Sec. Reg. The borrowing in conjunction with the distribution alsocreates minimum gain of $4 , , allocated $2 , to Paul and toSusan.95 As such, $4 , of the debt is allocated under the first tier,and the balance, $1 million is allocated under the third tier.Subsequently, Paul and Susan each gift fivepercent limited partnershipinterests to their son, David, who becomes a 1 -percent limited partner,and holds a $6 , capital account. 1 31 and stillavoid state transfer taxes.Even if a partnership or LLC owning real estate is not a disregarded entitybecause there is more than one equity owner, the dual objectives of a CodeSec. In addition, no LLC member is obligated by statelaw or the LLC agreement to restore a capital account deficit. 741 states any gain on the sale or exchange of a partnershipinterest shall be capital gain, unless Code sec. Once the donor's gainon the gift is determined, the complexity does not end, because Code sec.751 (a) must be addressed.Recourse DebtAllocation Issues-The Doomsday LiquidationAs we have noted above, the allocation of partnership debt to partners foroutside basis purposes determines their amount realized for computing anypotential gain on the gifting of that partnership interest. Because it is viewed as a continuation of Acme ||LLC, Newco is treated as holding the office building for investment to ||the same extent as Acme LLC, with no resulting threat to like-kind ||exchange treatment. taxpayer("Taxpayer") transfers cash or a note to Main Trust in exchange for abeneficial interest in Main Trust. ||25 Reg. ||25 Code Sec. 2 5-7 , IRB 2 5-47, Nov. 48, 189(M), TC Memo. 465. Consider the following example.Example 5. Cathy nowowns 4 percent, John now owns 3 percent and Ben now owns 3 percent ofAcme LLC. 7 4(c) "tax" minimum gain, if any, butthat gain is limited to the amount the partnership would recognize upondisposition of partnership property solely in exchange for relief of anynonrecourse debt securing the property3) The partner's share of "excess" nonrecourse liabilities (that notallocated under 1 and 2 above) are determined in accordance with thepartner's share of partnership profits.7 Initially we assume that only parts (1) and (3) of the three-tier processapply. It isfrom this implicit sale that the income tax consequences arise.Some Basic PrinciplesGifts GenerallyThe thrust of this article is the income tax consequences to the donor whomakes a gift of a partnership interest. 1 31. 7 4(b)] book value and ||adjusted tax basis," as the property is depreciated. 46,87 (M), TC Memo. As a ||result, she must also be allocated the tax depreciation. Specifically, the regulations state that apartnership liability is recourse to a partner, and thus she bears the"economic risk of loss" for that liability, to the extent that the partner,or a party related to the partner, would be required personally to satisfythe liability or make a capital contribution to the partnership if thepartnership were liquidated and all liabilities became due.35In determining the extent to which a partner or related person is requiredto make a payment, all the facts and circumstances are to be considered,including statutory and contractual obligations, such as debt guarantees orthe requirement to make a capital contribution to restore a deficit capitalaccount.36The actual method required by the regulations is often describedas the "Doomsday Liquidation." Under a Doomsday Liquidation, all thepartnership's assets, including cash, generally become worthless and aredisposed of for no consideration whatsoever.37 At the same time, allpartnership liabilities and obligations become immediately due.This is certainly a bad situation for the partnership, a time of gloom anddoom. §1.7 4 -1 (b)(2)(iv)(l). The operating agreement should contain a provision that requires themember who triggers the tax to pay. ||2 Reg. ||47 The amount of debt relief is often negotiable (especially in the case||of an actual sale), and this should be considered when analyzing the tax||consequences of a transfer of a partnership interest. The deficit represents allocated deductions inexcess of her actual investment in the LLC, and so there is some logichere.78As a corollary to Linda's tax consequences, Kelly takes an outside basis of$5 , , as this is greater than Linda's own basis in the LLC interest. Let's take a look at recourse loans, how theywork, and how to identify them.Recourse Loans - The RecourseRecourse loans get their name from the fact that lenders have power. 1 15(a), which generally requires a carryover outside basis||from Martha to Wilma, should not apply here, because the debt cannot be ||allocated to Wilma under the Doomsday Liquidation analysis for recourse ||liabilities. The gift taxes paid by thechildren exceeded the parents' aggregate basis in the shares transferred.The court held that the taxpayers recognized taxable gain equal to thisexcess. || ||[Footnote] ||ENDNOTES ||1 Code Sec. If the only assets of thepartnership are individual parcels of appreciated land held for investment,then the gain is capital gain. Ifa Code sec. ||4 Code Sec. ABC owns aparcel of land having a value of $5 , and a basis of $1 million. ||§1.7 4-3(a)(3)(ii). ||52 Rev. Rul. Because Kelly is a 5 -percentmember, the third-tier debt allocation remains at 5 percent for bothpartners. §1.1 11-2(b) for basis apportionment rules on bargain sales ||of property for purposes of the charitable deduction. 78, cert,||denied, 54 US 984, and 54 US 1 9 (2 3); The Classics Chicago, Inc. (2 7). §1.7 4-2(g)(1)(i), unlike 1.7 4-3(a)(7), does not use the word ||"proportionate," or any similar construction. 7 2. 731 (a)(1). Even if the purchase price does notcover losses that the business incurs, the purchaser does not have to coverthem; they are the responsibility of the lender. This has the parallel effect of setting Anne's tax-basis capital account to zero. Taking out a non-recourseloan on an already owned asset can actually reduce risk, since the borrowedfunds become yours, while the risk of loss is transferred to the lender.But recourse debt is something else entirely. ||§1.7 4-2(f)), should work to restore the partners' accounts to zero ||balances. 752and delve into its mysteries. (2 9). tax returns that they wereat risk under Code Sec. Vol. Judge Laro firstdetermined that the amendment to the operating agreement was not effectivefor the 2 taxable year, but only for the 2 1 taxable year.34 Judge Larothen concluded that the members were not at risk with respect to the LLC'srecourse debt for 2 ?. 752(d) would permit only a partial basis offset when a partner||transfers less than his entire interest in his partnership. Gifts of a partial interest in thepartnership interest are considered subsequently.Example 7. Not coincidentally, John's gain reflects a"recapture" of his $6, capital account deficit, which represents hisallocated deductions in excess of his actual cash investment in thepartnership. Economic Policy Journal, (Mar 23). ||69 Reg. §1.752-1(a)(1). Few people today are willing to risk all oftheir savings and all the capital they can raise for a business, but ifthey know that their personal funds and other assets, at least, are safe,they can launch a new business without risking personal bankruptcy. Tax Almanac. ||3 Hubert I, 125 T.C. 743(b)). ||7 Code Sec. 4.[17] Anonymous, p. 7 4(c) "tax" minimum gain is limited to the amount the partnership ||would recognize upon disposition of partnership property solely in ||exchange for relief of any nonrecourse debt securing the property (and ||this amount may well be less than the full amount subject to Code Sec. Dependingupon the donor's basis, he may recognize gain, but he will not recognizeloss on the sale portion of the transaction.Certain techniques are available to minimize the impact of debt shift.These may entail guarantees by donor partners, or the use of recourse debtin conjunction with the gift of limited partner (or LLC) interests. Based upon the DRO, the LLCmembers took the position on their 2 and 2 ? In the case of abusiness property purchase, the buyer may purchase a property for abusiness that fails to be as lucrative as expected and will then be liablefor the costs despite the business's failure. If Maria's tax basis in the property had been $8 , , no losswould be recognized, although the amount of the gift remains at $4 , .15Another instance where a donor recognizes gain is when the gift isconditioned on the donee paying any resulting gift tax obligation of thedonor. Thus, the preponderance offinancial risk in recourse debt is on the side of the borrower. They point out thatpeople may assume that when they transfer their interests for no cashconsideration, that it is "a rather straightforward affair, with no incometax consequences," but this is not the case, because there is a possibilityof the transfer reducing the transferor partner's share of the debt.[21]Moreover, the authors note that the debt reduction "could trigger gainunder Subchapter K directly or through the application of the bargain salerules."[22] Debt relief as covered under Code Sec. We Take the Risk +Get You Fast Cash.BusinessFactors.comKeyBank Auto LoansSave money & Save the Environment No Fees/Greenfinancing. 671 .The objective of these transactions is to cause ||Taxpayer to be "another person" within the meaning of Code Sec. The sequence of events for theDoomsday Liquidation is summarized below39:1 ) The partnership's liabilities become payable in full.2) The partnership's assets (generally) become worthless.3) The partnership disposes of all of these worthless assets in fullytaxable transactions for no consideration (except relief from liabilitiesforwhich the creditors' right to repayment is limited solely to one or moreassets of the partnership).4 4) All items of loss or deduction are allocated among the partners.5) The partnership liquidates.All that is leftafterthe Doomsday Liquidation are the partners' capitalaccounts, most likely showing deficit balances, and the partnership'srecourse liabilities. ||29 Whether the adjustment is made pursuant to Code Sec. When such a shift occurs, the transaction is convertedto a part sale, part gift transaction. Lewis sells corporate stock with a FMV of $2 , to hisdaughter Sue for $5 , cash. 7 4(c).88 Further assume thatthe real estate is secured by nonrecourse financing in the amount of$4 , . ||78 In a sense, the $1 , gain Linda recognizes parallels the "minimum||gain chargeback" that is mandated by the Code Sec. || ||ENDNOTES ||1 Reg. John and Ben own the interests in Acme LLC in equal percentages.Acme LLC is treated as a partnership for federal and state income taxpurposes. ||11 R.A. §1.7 4-2(d)(1). 434. 743(b). foreclosures . » Jump to indexing (document details)|Full Text || (13 68 ||words) |Copyright CCH INCORPORATED Apr 2 7IntroductionThe movement to repeal the federal estate tax, or what some call "the deathtax," has left many taxpayers perhaps thinking that its repeal will alsocause the elimination of the federal gift tax. When sucha shift occurs, the transaction is converted to a part sale, part gifttransaction. ||Code Sec. ||91 Absent a special allocation of the built-in gain. For example, ifMartha recognizes no proceeds because she was not relieved of personalliability for the recourse debt, can Wilma nevertheless include the$1 , debt in her own outside basis? Treasury Department Releases Details on PublicPrivate Partnership Investment Program. This is her "amount paid" that becomesher outside basis.28 This amount exceeds Harold's basis of $4 , .If the partnership has a Code sec. ||18 Reg. 2; pg. Journal of Passthrough Entities. ||16 V.P. 25 3(b). 7 4(b) capital accounts, and not their tax capital ||accounts; however, because in this case the two are identical (there are||no book-tax disparities), the conclusion is unaffected by the choice of ||capital account. 761 (b). Weiss, supra ||note 21. The value of the1 -percent interest, for gift tax purposes, is $4 , ($5 , +$1 , - $2 , ) × 1 % = $4 , ).When Is a Gift Also a Sale?Generally the donor will not recognize any gain from the gifting ofproperty to a donee. What is clear isthat Judge Laro believes the at-risk standard (payor of last resort orotherwise) is a different standard than economic risk of loss for basispurposes. ||48 Code Sec. Assume that at the end of Year 4, Linda's capitalaccount in the LLC shows a deficit of $3 , , due to operating lossesfrom the LLC as well as the depreciation deduction. 731(a)(1) (which ||requires a partner to recognize gain if he receives a cash distribution ||that exceeds his pre-distribution basis), and Code Sec. At the end of Year3, however, the book value of the building is $85 , , and at Year 4 it is$8 , . In a case in California, transferredappreciated stock and received cash in return, along with the right toobtain the equivalent number of stock shares in three years, "without anyreal obligation to return the cash received or any demonstrated intent torepay the purported loan."[15] Unlike an ordinary margin loan purchasedfrom a broker, in this loan, the taxpayer transferred the stock to the LLC--not to the broker--and did not have to post any further collateral if thestock's value went down.[16] In addition, the nonrecourse loan was securedsolely by the shares transferred, and the loan received by the investor was9 % of the shares' value.[17] The investor was not allowed to pay anyprincipal or interest on the loan for three years and could not replace thestock with some other stock or property during the loan term.[18] Not onlydid the LLC obtain "complete and unfettered control of the stock,"retaining "most of the benefits and burdens related to stock ownership,"the taxpayer was only entitled to obtain the same number of shares threeyears later upon repayment of the loan.[19] Moreover, the loan wastaxable, as it does not qualify as a nontaxable loan according to IRC§1 58, where "the stock lender does not reduce its risk of loss orpotential for gain."[2 ] Yuhas and Fellows (2 7) likewise discuss the issue of taxation withrespect to LLCs, identifying the tax consequences of an LLC partner's giftof a member's gift of his interest in the partnership. Thus, Johnand Buyer have avoided the real estate transfer tax. §1.7 4-1(b)(2)(iv)(l). ||49 Reg. §§1.7 4-3(a)(7) and 1.752-3(a)(2). In thepreceding example, Emily has a recognized gain of $2 , , equal to the$45, liability shift to Dennis, less $25, , which is one-half of heroutside basis. 752(a). It is crucial, though, thattaxpayers and their advisors understand that gifting a partnership interestis not exempt from the provisions of Code sec. Reg. Individual A is a 4 -percent member in the ABC LLC. 7 4(d). §1.752-3(a). ||22 A deficit could also arise from the contribution of low-basis ||property to the partnership, in which case gain initially deferred under||Code Sec. Code sec. D's basis ("outside basis") in his LLC interest is now $4 , and his holding period in his LLC interest begins on the closing date.However, D's share of ABC's basis ("inside basis") in the land remains at$8 , . Tax Almanac.[13] Internal Revenue Code:Sec. Linda's outside basisis $2 , , equal to the $3 , capital account deficit plus her$5 , share of the mortgage. John makes a $9, cash contribution and Bob makes a $1, cash contribution to form The Red Door Partnership. The most typical example being a home mortgage.If the difference between the remaining loan amount owed and the sell priceof the collateral does not satiate the amount still owed, the lender willhave to write-off the remaining debt as a loss with no further recourse.Who Can Obtain Non-Recourse LoansBoth individuals and businesses can obtain non-recourse loans. §1.1 15 -4(a). ABC owns aparcel of land having a value of $1 million. This point will be||analyzed in greater detail later in the article. These may entail guarantees by donor partners, or the use ofrecourse debt in conjunction with the gift of limited partner (or LLC)interests. 743(b) in the gifting context lends||further support to the position that the transaction is appropriately ||analyzed under Code Sec. » Jump to indexing (document details)|Full Text || (1471 words) |Copyright CCH INCORPORATED Nov/Dec 2 8|[Headnote] ||Dealing With Real Estate Transfer Taxes on Indirect Transfers || |In searching for new revenue sources, a growing number of states (and theDistrict of Columbia) have focused on closing various tax "loopholes." Wellpublicized techniques that have been attacked include the use of Delawareholding companies1 and private REITS2 to shift deductions to high taxstates and income to low tax states. §1.7 4-1 (b)(2)(ii). 75-194, 1975-1 CB ||8 , and M. The debt reduction, in turn, could trigger gainunder Subchapter K directly3 or through the application of the bargain-salerules.Note that, under Code Sec. §1.7 4-2(b)(2); see also Reg. 7 4(b).In this instance, minimum gain is the amount of gain, for book purposes,that the partnership would recognize if it sold property secured by anonrecourse debt for no consideration other than full satisfaction of thedebt.73 The amount realized upon satisfaction of a nonrecourse debt is itsfull face amount. 84-53, 1984-1 CB 159, Situation 3. This wouldenable Taxpayer to benefit from the discrepancy between the value of thedistressed assets and the historic basis of the distressed assets in thehands of Contributor.18 When the distressed assets are subsequently sold orwritten off as worthless, the Taxpayer, as grantor, takes the loss.19In Notice 2 8-34, the government concludes that the shift in built-in lossusing the DAT is improper and provides notice that the DAT is a "listedtransaction" for purposes of the tax shelter rules.2 The IRS indicatesthat, in attacking the DAT transaction, it may use one or more of thefollowing arguments:* Contributor's transfer of cash and notes to Main Trust is a sale orexchange of the distressed assets under Code Sec. Theallocation of partnership debt is more technical than merely concludingthat two equal partners share all debt equally. 647.[7] Ellentuck, p. The so-called Tufts rule ||has been codified by Congress in Code Sec. Journal of Passthrough Entities. 7 4(c). This would generate $4 , of gain ||(proceeds of $1.4 million less basis of $1 million), allocated $2 , ||each to Paul and Susan. 7 4(b) and tax bases of partnership assets. Should John, for example, gift his entire partnership interest tohis daughter, the amount he would realize from the gift would be $5 , .But of course since his outside basis is $6 , , he has no gain torecognize. §1.752-2(b)(3)(i). As Ellentuck (2 5)points out, "LLC debts are typically treated as nonrecourse, at-riskbasis," which results in a reduction in at-risk basis that can cause gainrecognition on the part of the former proprietor "if the reduction in theamount at risk causes the previously deducted losses to exceed the member'sat-risk basis."[6] In an example, the owner of a sole proprietorship operates a retailshop which he converts to an LLC, with his only debt being a $1 , loanfrom a personal bank; he has personal liability for the loan.[7] When theproprietorship is converted to an LLC, however, the bank substitutes theLLC for the borrower, thus releasing the owner from personal liability forthe debt; now the debt is secured by the assets of the LLC.[8] Prior tothe conversion, the owner had contributed $75, to the shop's operationand deducted $15 , in losses, his at-risk basis in the $1 , due tothe debt's being recourse was $25, , which is calculated by subtractingthe $15 , in losses from the $175, basis.[9] After the conversion,however, he is no longer at risk for the $1 , note-now classified as"exculpatory debt for which no member is liable"-so he now has $75, ordinary income, calculated by subtracting the current at-risk basis of hisinterest--$75, -from the losses he previously deducted--$1 , .[1 ]This example shows clearly why LLCs are attractive to business owners.Having an LLC eliminates the stress of liability from the debt, which nowdevolves upon the lender. §1.752-2(b)(7)(i) through (v). 465.[15] Anonymous. For gifted property that isin part a sale and in part a gift, however, the donee's tax basis in thegifted property is the greater of the amount paid by the donee or thedonor's own tax basis.27 In Example 4, Ann is now allocated the $7 , debt previously allocated to Harold. But in this case should Emily simply treat the$45, as an implicit money distribution under Code sec. The same situation arises if the property is ||not initially built-in gain property (because, for example, the ||partnership acquired the property for cash), but later is subject to ||"reverse section 7 4(c) allocations" because of a partnership ||revaluation; Reg. Retrieved on September 6, 2 9 from: http://proquest.umi.com/pqdweb?did=1614269861&sid=1&Fmt=3&clientId=26 6 &RQT=3 9&VName=PQDEllentuck, A.B. Nonrecourse debt, on the other hand, shifts most of the risk to thelender. In such a case, the guarantor would not bear the ultimate risk||of loss for the guaranteed debt. 752(b) or (d). InvestorWords.com.[5] Klarman.[6] Ellentuck, A.B. ||2 Md. Seay, 63 TCM 2911, Dec. 4 ,557 ||(1983), aff'd, CA-9, 85-1 ustc If 92 5, 753 F2d 149 ;;./?. Based on this scenario, the nonrecoursedebt atthe end ofYear4 is allocated between Linda and Colleen as shown inTable 7.76[pic]Based on the LLC agreement, if the LLC relinquishes the buildingfor nothingmore than debt satisfaction, itwill have a $1 , book (and tax) gain.Because Linda received the economic benefit of the depreciation,77 she mustbe allocated this entire $1 , gain. Lewis has made a gift of $15 , . The partnership purchases property for $1 , , using the $2 , cash and an $8 , recourse liability. What canthey do?Example 4. These rules may create the potential for variousreductions in tax liabilities, including some reductions that may notreflect Congressional intent.Example 1. After all, there still is a $1 , excess of the mortgage overthe book value of the property, i.e., minimum gain. ||7 4(c)). The result should be the||same if they guarantee the debt of an LLC. 1 31 structure and transfer tax avoidance could easily be achievedwith minor restructuring.Example 3. Maria also recognizes gain of$5 , , equal to the $6 , sales price less her $1 , basis in theproperty. Code Ann., Tax-Gen. Eachpartner is required to restore any capital account deficit balance uponliquidation of the partnership. ProQuest. How Deficiency Judgments WorkNon-Recourse LoansA non-recourse loan does not allow the lender to pursue anything other thancollateral. But what if an LLC member must personally guarantee a debtbecause a creditor refuses to rely merely on the general credit of the LLC?How is this considered in computing outside basis and the amount realizedon a gift of the LLC interest?The regulations under Code sec. 751 (c), flush language. Due to operating losses, each has a deficit inher capital account of $5, at the end of Year 1. In this context, see Rev. Rul. 752(b) (which ||treats a reduction in a partner's share of partnership liabilities as a ||cash distribution). In other words, could she demonstrate that, upon aDoomsday Liquidation, her son is not obligated to restore a deficit, and assuch she has not been discharged of any recourse debt? Assume Paul and his wifeSusan jointly contribute recently purchased land to a family limitedpartnership. ||14 Note that if D were to sell his interest in ABC to E for its fair ||market value of $2 , (or receive a liquidating distribution from ABC||in that amount), D would have a taxable gain of $2 , without having ||experienced an increase in the value of the ABC interest. (2 2). Retrieved on September 6, 2 9 from: http://banking.about.com/od/loans/a/recourseloan.htmWenzel, R. The donee also adds to his own basis a pro ||rata portion of any gift tax paid by the donor. Linda should now recognize $3 , of gainon the transfer of her membership interest to Kelly. The partnership is an"aggregate" of the partners1 (just like a tenancy-in-common). See generally Reg. 5. These computationsare summarized in Table 5.[pic]Based on this analysis, John is allocated $69, of the debt and Bob$21, . ||14 See Reg. The general rule for a donee is that, underCode sec. In the case of partial transfers of interests, Code Sec. 2 1 (c). In this section of thearticle, we consider the allocation of recourse liabilities, which canarise in any type of partnership or LLC arrangement.33 Nonrecourse debtallocations are covered in the latter part of the article.All that is required for a partner to be allocated a recourse liability isfor the partner or LLC member to bear the "economic risk of loss"pertaining to the liability.34 But what does this mean? §1.752-2(b)(3). (ABC is an entity separate and apart from its members.) Thus, ifABC sold the land for $1 million after D becomes a member, D would beallocated $32 , of taxable gain even though he would have had no gain ifhe had sold his LLC interest (Note if ABC liquidated, D would have anoffsetting loss on the liquidation of his LLC interest).13The disconnect between inside basis and outside basis in the partnershipcontext can be "remedied" by having the partnership make a "Section 754election." A Section 754 election would result in D's inside basis in hisshare of the LLC assets being stepped up to $4 , so that it wouldmirror D's outside basis in his LLC interest. ||94 Assume that none of the disguised-sale rules apply. ||13 Code Sec. The Main Trust agreement entitles the Taxpayer, asholder of the beneficial interest in the Sub-Trust, to various rights thatare designed to cause the Taxpayer to be the owner of the Sub-Trust assetsfor income tax purposes and the Sub-Trust to be a grantor trust. Ultimately, the amount of debt shiftis treated as proceeds from the sale of a partnership interest. Unfortunately it isnot a question easily answered, and requires us to take the partnershipthrough a "Doomsday Liquidation."The Code itself is silent as to the method of allocating recourseliabilities. Crane, SCt, 47-1 USTC ¶ 9217, 331 US 1. Theamount realized includes the partner's allocable share of partnership debt.Code sec. ||26 Reg. The adjusted tax basis of the property toMaria is $1 , at the time of the sale, and its FMV is $1 , . Assuming that there were no transfers of interests in Acme LLCwithin the preceding 12 months, the transfers to Cathy would not triggertransfer tax. §3 1.77 1 -4. In reaching this conclusion, Judge Laro made thefollowing observations:* In a worst case scenario, the recourse lender to the LLC could notrecover directly from the members nor could the creditor force aliquidation of the LLC or of the member's interest.* The DRO would only be operative if at the time of liquidation the memberhad a negative capital account. ||1 14. §1.7 4 -1(b)(2)(iii). We ignore these||other possibilities because they are beyond the scope of this article. Nonrecourse debt obtained as an LLC is a strategy that can be used toenable new startups to go into business and help play a part inresuscitating the economy. No minimum gain exists at either date. Note again that, for purposes of allocating ||nonrecourse liabilities under the second tier, a partner's share of Code||Sec. ||9 Reg. If, however, a donor realizes an economic benefit fromthe gift, she recognizes gain in an amount equal to the excess of thisbenefit over the adjusted tax basis of the property gifted. These rules are summarized in Table 9.[pic] Second-Tier DebtWith respect to nonrecourse debt allocated under the second tier, thereseems to be little maneuvering room.86The regulation clearly states that atransferee is responsible for a "proportionate" amount of the transferor'sbuilt-in gain; consequently, if a donor transfers an interest in apartnership and that partnership holds highly appreciated property securedby nonrecourse financing, there is a good possibility that the donor willbe relieved of a portion of that debt.87 In a rather typical case, parentscontribute highly appreciated, and partially leveraged, real estate to afamily limited partnership. ||15 Code Sec. In this case the contributing partner bears the ||economic risk of loss for the liability to the extent of the property's ||FMV. For an excellent analysis of the ||basis allocation, see Willis, Pennell and Postlewaite, Partnership ||Taxation (Warren, Gorham & Lamont/R1A 5th ed.), Chapter 12, at §12. ||11 Code Sec. A donor is subject to thefederal gift tax whenever gifts to any one donee exceed $12, for theyear ($24, for gifts made by married couples who elect the gift-splitting procedure).4 Due to the use of a substantial unified tax creditagainst the gift tax liability, individuals can make gifts of up to $1million without paying any actual gift tax.5 This amount is $2 billion formarried couples who elect gift-splitting. 7 4(b) even though the allocationslack "economic effect." Even though there is no deficit restorationobligation, the allocations would presumably pass muster under thealternate test for economic effect.58 In addition, the allocations shouldsatisfy the "partners' interest in the partnership" test because theallocations reflect each member's interest in the LLC, taking intoconsiderations all the facts and circumstances, and are consistent with theeconomic arrangement of the LLC.59Example 1 . The ability toobtain such a loan intimates that the business has survived intensivescrutiny and is a good credit risk, especially since lenders are lesswilling to take on loans where they incur all of the risks. The Gifting of a PartnershipInterest: The Income Tax Consequences of Partnership Debt to the Donor.Taxes, 85(4), (Apr), p. The amount of tax gainsubject to this mandatory allocation provision is initially equal to theexcess of the property's FMV over its tax basis on the date ofcontribution.72 We will come to this second-tier allocation later. 93-12, 1993-1 CB 2 2; TAM 9449 1; W.G. It is here that the "economic risk of loss"analysis is set forth. ||3 We wish to note that, if Code Sec. ||59 Regs. Linda's outside basis is $75 , , equal to the $1 , capital account deficit plus her $85 , share of the LLC's debt. ||42 In addition, the amount so determined is used to test allocations ||made to the partners pursuant to the economic effect rules; see ||generally Reg. 721 would finally be recognized when he terminates his ||interest in the contributed property. Oct. See Reg. Further, Dennis takes anoutside basis of $45, , as this is greater than one-half of Emily'soutside basis. 752(b) or(d). Lindashould now recognize $1 , of gain on the transfer of her membershipinterest to Kelly (Linda's amount realized is $85 , , while her basis is$75 , ).At this juncture, it is again useful to consider the tax consequences toKelly. However, if no Section 754 election is made, D's share of insidebasis in the land remains at $4 , . 723. These loans may have higher interestrates than recourse loans.Identifying Loan TypesYou should consult your attorney or tax adviser be certain whether you havea recourse loan or a non-recourse loan. Evaluating the Risks of PublicPrivate Partnerships for Infrastructure Projects. John'scapital account would now, hypotheticalIy, reflect a $69, deficit, andBob's capital account would show a deficit of $21, . ||4 See, e.g., LTR 2 732 12 (May 11, 2 7). BusinessFinance.com. If real estate islocated in a state that imposes high transfer taxes, this avoidance canmean substantial savings.As a practical matter, indirect transfers are sometimes a concern tosellers who are trying to structure a deal for federal and state income taxpurposes as a like-kind exchange. But what are the tax consequencesto Linda if she gifts her entire partnership interest to her daughter Kellyon the first day of Year 5?Example 11-Continued. 6111 and 6112. The revaluation can generate differences between ||the Code Sec. ||44 Reg. One must therefore ponder the regulations under Code sec. Acme LLC ownsan office building. When thesesituations have been exposed, Congress has taken action to stop theperceived abuse.Loss DuplicationsWe have, from time to time, discussed that a partnership or a limitedliability company9 is sometimes viewed as an "aggregate" for income taxpurposes and, in other situations, is viewed as an "entity" separate andapart from its equity owners. 742, 752(d) and 1 12. (2 5) Converting a Sole Proprietorship into an LLC.The Tax Adviser, (Oct), p. 678. 4[2 ] Anonymous, p. Thegovernment challenged this position.The Tax Court determined in its Hubert I decision that the taxpayer was notat risk for, and therefore could not deduct, the losses allocated to it.Judge Laro first determined that the members did not have any directobligation under the LLC's recourse debt. §1.752-2(b)(5) with ||respect to reimbursement rights. §1.7 4-1(b)(1)(i) and(b)(3). In any case,||authoritative consensus leans toward applying Code Sec. §1.7 4-3(a)(3)(i). 11, Iss. The annual exclusion was raised to $12, ||beginning in 2 6. At the time of the gift, Harold'stax basis in the interest, his outside basis, is $4 , . The loan is an interest-only loan for ten years, and is payable infull at the end of that time. 99-6, 1 999-1 CB. The cash and/or note would equal thevalue of the distressed assets. 7 4(b)basis, $6 , ).second TierOn the other hand, the land does have $5 , of gain subject to Code sec.7 4(c) (excess of 7 4(b) basis, $6 , , over its tax basis, $1 , ).Note, however, that only $3 , of this gain drives the second-tier debtal location, because we consider only the gain that would be recognizedupon a taxable disposition of the land for no consideration other thanrelief of the nonrecourse debt (debt proceeds of $4 , less tax basis of$1 , = $3 , ). Companies faresomewhat better, since they can take refuge in the LLC structure, but evenso, businesses that have a poor credit history are not likely to obtainnonrecourse loans, particularly in a recessionary economy. 7 4(c) would not apply, and no debt would be allocated under the ||second tier. If we performeda Doomsday Liquidation for a partnership, and it held only nonrecourseliabilities, no partner would be required to make up a capital accountdeficit or discharge a personal guarantee for any partnership liability.68Ultimately it is the lender who bears the true economic risk fornonrecourse debt, as the possibility always exists that the debt will notbe paid, and even if secured by partnership property, the FMV of theproperty may not be sufficient to cover the balance of the debt.How, then, are these nonrecourse loans allocated to partners for purposesof their outside basis, as well as for determining their amount realized ona gift of their partnership interest? Weiss, ||CA-11, 92-1 USTC ¶ 5 ,168, 936 F2d 242, vac'g and rem'g, 6 TCM 746, ||Dec. The losses that have generated the capital accountdeficits are allowed under Code sec. Depending on theprecise terms of the debt, a decline in the value of your holdings couldforce you either to put up more collateral--which you may not have--or tosell off some of the investments you purportedly like to meet margin calls.By borrowing, you have ceased to be the master of your own fate and allowedthe lender--or actually the market--to be.What Are Non-Recourse Loans? §25.2512-1. Reverse Code Sec. ||6 Depending upon the relationship of the transferor and transferee, a ||transfer for less than full and adequate consideration could also be ||classified as compensation (employer-employee) or a dividend ||(corporation-shareholder) under the income tax. 5[2][c]; and Kemp, 718 T.M., Dispositions ||of Partnership Interests; Termination of a Partnership, text at note ||126. A sells his LLC interest to D for$2 , , thereby triggering a loss of $2 , . The rationale for thisapproach is that the creditor does not have any recourse against any of thepartners and must look to the partnership profits to satisfy the debt.Unfortunately the regulations do not simply look at the partners' basicprofit-sharing ratios, but take us through a proverbial "three-step," aregulatory pas de trois, in assigning nonrecourse debt.Minimum Gain and the Three-Tier ProcessIn allocating nonrecourse debt to partners, the partnership must undertakea three-step allocation process.69 Partners are allocated nonrecourse debtin the following sequential order:1) The partner's share of Code sec. 648.[11] Owen, S.L. Thus, in Example 2, John couldstructure the sale of inter- ests in Acme LLC as the disposition ofrelinquished property (the office building) under Code Sec. Nothing it owns has any value, even its cash balances, and yet allliabilities are suddenly due, and the partners must use their own personalassets (which miraculously are not worthless) to pay theseliabilities.38The Doomsday Liquidation is of course merely a hypotheticalexercise, a fictitious liquidation undertaken just to determine theallocation of recourse debt to partners. 11, Iss. As stated inour example earlier, the most common form of a personal non-recourse loanis a mortgage, since the bank can only seize and resell your home once yourpayments go into default. Recall that partners (and LLCmembers) bear the "economic risk of loss" for any debt that they personallyguarantee, or a related party guarantees.61 If Martha is Wilma's mother,then they are related parties.62 Under a mechanical application of theliability allocation rules, Wilma is, apparently, allowed to include the$1 , debt in her own outside basis-even though Martha has notrecognized deemed proceeds from the transfer of this portion of the debt.63In effect, the $1 , debt generates a dual benefit in that it (1 )defers gain recognition by Martha, and (2) give Wilma $1 , of basisagainst which to claim losses. I would suggest looking intoyour own states laws before proceeding with any type of collateral basednon-resource loan.Businesses can also secure assets with the use of non-recourse loans. Subsequently, the land appreciates in value to $2 million, atwhich time the partnership borrows $1.4 million against the land on anonrecourse basis. 752(d) states that, "[i]n the case of a sale or exchange of aninterest in a partnership, liabilities shall be treated in the same manneras liabilities in connection with the sale or exchange of property notassociated with partnerships."19 The regulations under Code sec. If a lender iswilling to issue a nonrecourse loan to an LLC, that LLC no doubt stands toremain solvent, at least, if not to profit significantly. ||6 See, for example, P. Economic Policy Journal, (Mar 23).[3 ] Wenzel.[31] Wenzel.[32] Wenzel. 7 4(b),the partnership agreement must provide that, should the partnership disposeof the property, it will charge back the partnership minimum gain to thosepartners who "were allocated nonrecourse deductions or receiveddistributions of proceeds attributable to a nonrecourse borrowing."75Let us assume that the LLC agreement stipulated that both members are toshare profits and losses equally, except that the depreciation deduction onthe building is to be allocated solely to Linda. In addition, the U.S. Independent ofthe FMV of the interest, Harold's taxable gain is purely a function of the$7 , liability shift to Ann, in conjunction with his $4 , outsidebasis.Requiring Harold to recognize $3 , gain makes logical sense, as he is inessence "recapturing" his $3 , deficit capital account, which, in theexample above, represents allocated losses in excess of his actualinvestment in the partnership.22 If Harold is relieved of his share ofpartnership debt, there is no doubt that Harold has recognized gain. For example, if realestate is subject to a mortgage that exceeds the property's tax basis, agift of the real estate subject to the mortgage causes the donor torecognize gain equal to the excess. State Tax Review, 69(28), 4. §1.1 15-4(a). §1.1 1-1(e)(1). Thus, the seller could structure the disposition of interests ina disregarded entity to qualify as an exchange under Section 1 31. §1.752-2(b)(6). But if those parcels of land are consideredinventory (because the partnership is a development company), then Harold's$3 , gain is reclassified as ordinary income under Code sec. See Code Sec. 751 (a). Other partners ||should not participate in a windfall because of a gift made to another. 1 15(a), she takes a tax basis in gifted property that is thesame tax basis the donor had in the property. §1.7 4 -2(h). 7 4(e) is generally ||inapplicable-but note that Code Sec. ||81 Reg. And what are the tax consequences to Ann and thepartnership?The Specter of Code sec. 743(d). 7 4(b)-basis financial ||statements would only reflect the transfer of capital (Reg. Cir. §1.7523(a)(2). 22.[23] Yuhas & Fellows, p. 7 2 or Code Sec. But no loss is recognized if theallocated debt is less than outside basis, i.e., there is a positive tax-basis capital account. ||27 Reg. Included inHarold's outside basis is a $7 , recourse debt of the partnership.Harold's tax-basis capital account reflects a deficit of $(3 , ), due toprior loss allocations. §1.7 42(f). ||61 Reg. See Reg. A partnership is not taxed on its income;rather, partnership income is taxed to the partners. John and Ben then contribute their interests in Acme LLCto Newco in exchange for equal interests in Newco. See P. Moreover, the same flexibility shouldbe available if the minimum gain is created by depreciation deductions,rather than debt-financed distributions.Under this theory, there is no debt shift to David, so Paul and Susan arenot required to recognize gain upon making a gift of their partnershipinterests. 722. In this section of the article, we look more closelyat gifting a partnership interest when the partner has only recourse debtincluded in his outside basis. (2 9). The LLC generatedsubstantial tax losses.On March 28, 2 1, the LLC members amended and restated the operatingagreement to add a "deficit restoration obligation" ("DRO") clause. 25, 4 pgshttp://proquest.umi.com/pqdweb?did=1483143211&sid=1&Fmt=4&clientId=26 6&RQT=3 9&VName=PQDAbstract (Summary)The tax laws offer taxpayers the opportunity to deduct losses even when thetaxpayer does not realize an economic loss. ||6 Code Sec. Rather, the guaranteed debt isrecourse debt, allocated to the guarantor partner, in accordance with hisrelative risk of loss,55 using the Doomsday Liquidation analysis.In the following examples, we assume that the guarantor has no rights ofreimbursement against the LLC or any other member if the guarantor mustmake payment on the debt. Despite the fact that the estate tax may be in its deaththroes (pun intended), there is no movement afoot to repeal the federalgift tax. Indeed, why accelerate gain recognition simply because they madea gift of their interests to their son? Another perceived loophole is found inthe area of real estate transfer taxes. 1 31 and also avoids thestate transfer tax.Beyond the issue of Code Sec. Perhaps the taxpayer will appeal again to the Sixth Circuit.|[Sidebar] ||This Tax Court decision is disappointing because it fails to provide a ||clear articulation of what, in Judge Laro's opinion, is the law. ||54 Reg. ||63 authorities which hold that a transferor partner does not realize ||proceeds when he retains responsibility for the debt do not squarely ||address the debt consequences to the transferee. In many states, this means that there is no transfer tax triggeredeven though some would argue that this is a mere difference in form ratherthan substance. Inthis case the asset is used as the collateral on the loan, if theinvestment goes bad the lender can reclaim and resell the asset. (2 5). Deducting Losses: Government Says Don't Do DATs (Among Other Things). On the other hand, debt shifts ||under the third tier may be eliminated by (1) specifying the profits ||interest to be used for this purpose (zero percent to the donee), and ||(2) ensuring that the profits interest is "reasonably consistent" with ||an allocation of a "significant item of partnership income or gain." ||This means that a partnership could adopt a special allocation (zero ||percent to the donee) with respect to some portion of its income or gain||(rather than the entirety of its Code Sec. Keep reading to learn more about non-recourse loans.[pic][pic]Non-Recourse Loan DefinitionA Non-Recourse loan is a collateral secured loan in which the originalcollateral (pledged assets) serve as the only method of repayment shouldthe loan end up in default. 4.[18] Anonymous, p. Code Ann., ||Tax-Prop. 7 4(c) gain), and use this to||support the third-tier debt allocation. Having said this, the purpose of a family limitedpartnership is to facilitate the transfer of wealth at a discount. All Section references are to the Internal Revenue Code||of 1986 as amended from time to time, unless otherwise indicated. Journal of Passthrough Entities, 11(6), (Nov/Dec), p.25. Journal of Passthrough Entities, 11(6), (Nov/Dec), 41- 43. 671 and ||a "person other than the grantor" within the meaning of Code Sec. FMV is defined as "the price at whichthe property would change hands between a willing buyer and a willingseller, neither being under any compulsion to buy or sell and both having areasonable knowledge of all the facts."8 If the property gifted isencumbered by a liability, the amount of the gift is the FMV of theproperty less the liability.Example 1. For the sake of simplicity, assume that Lindaremains a 5 -percent member.83First TierUnder these facts, there is no "minimum gain" with respect to the land(because the debt, $4 , does not exceed the asset's Code sec. John is, therefore, allocated $5 , of the debt and John$3 , .43 Their outside bases at the end of the year are $6 , for Johnand $4 , for Bob, equal to their cash contributions plus their allocatedshares of debt ($1 , + $5 , = $6 , ; and $1 , + $3 , =$4 , ). (2 8). If a Code sec. In ourfirst example, we assume that all partnership property is purchased by thepartnership from third parties, that none is contributed by any of thepartners, and that the partnership's balance sheet has not been revalued.As a result, book depreciation deductions and tax depreciation deductionson property acquired by the partnership are identical.The first step in assigning nonrecourse debt is to allocate to a partnerher share of partnership minimum gain, as defined by the Code sec. He has a recognized gain of $3 , . By granting Taxpayer such rights and powers with ||respect to the Sub-Trust, the Sub-Trust's items of income and loss ||become attributable to Taxpayer. Consequently, they could guaranteethe debt, to convert it to recourse debt, thus preventing a debt shift.92First-Tier DebtUnlike the second-tier allocation, there may be a theoretical basis tominimize debt shifts under the first tier. ||For purposes of this analysis, it is sufficient merely to assume that ||the debt is allocated equally. (2 9). Treasury Department Releases Details on Public Private Partnership Investment Program. ||16 Notice 2 8-34, IRB 2 8-12, February 27, 2 8. The ledger has been squared, because Paul and ||Susan contributed, in the aggregate, $1 million of tax basis to the ||partnership, were required to report $4 , of gain, took ||distributions of $1.34 million, and made a gift of $6 , to their son,||David (which was, hopefully, eligible for discount). 84-53, 1984-1 CB 159, Situation 3. 7 4(b) and taxbasis capital accounts to$3 , each. John and Buyer do not want to pay transfer taxes. §§3 1.77 1 -2(a), 3 1.77 1 -3(a), and Code Sec. ||38 Generally, partners (and related persons) are assumed actually to ||satisfy any payment obligations. 49,455(M), TC Memo. 7 4(b) "book" minimum gain, if any2) The partner's share of Code sec. Ann's pro rata share of theinside tax basis of partnership property is $4 , , as she has succeededto Harold's 2 -percent share. 742(d)), the basis adjustment would be triggered by ||Code Sec. 752(d). At the same time, no transfer tax is triggered becausethe office building is not being transferred by deed to Buyer. DoesMartha therefore have $9, of recognized gain from her gift?Even after the transfer of her interest to Wilma, the bank is still lookingto Martha for payment of the debt. We alsoassume that any nonrecourse debt not personally guaranteed is allocated prorata to members.56Example 9. John and Bob each contribute $1 , cash to thepartnership. Also,||this analysis should technically be undertaken by examining the ||partners' Code Sec. Thus, that the liquidation had not, inreality, occurred is irrelevant in applying this fictional test.On February 28, 2 8, the Tax Court (Judge Laro) reached its conclusion.33The taxpayer was not at risk by virtue of the DRO. 1993-58 . at 85. 1984-52 (1984); in both cases, a selling ||partner remained liable on his pre-sale share of partnership debt, such ||that his share of debt was not treated as realized upon the sale of his ||interest. ||72 This is complicated by the fact that the amount of the tax gain ||subject to the required allocation must be "reduced by decreases in the ||difference between the property's [Code Sec. We also consider pitfalls that may require gain to be recognized upona donative transfer, and opportunities for minimizing the debt shift thatwould otherwise occur.Again, nonrecourse debt is analyzed by breaking it down into three tiers.As we have seen, the regulations prescribe rules for determining atransferee's share of liabilities. 1211. 465. As a donee, Kelly steps into Linda's shoes both with respect to thebook minimum gain, and the Code sec. (2 8). 4.[19] Anonymous, p. 755. There seems to be nocompelling conceptual basis or policy reason96 to trigger gain prematurelywhen the tainted parties (i.e., the distributees in this case97) continueto be partners, and the provisions of Subchapter K serve to keep them onthe hook.Third-Tier DebtExcess nonrecourse liabilities are allocated in accordance with thepartners' interest in profits.98 While the partners have some latitude indefining the profits interest used for this purpose, the specified profitsinterest must be reasonably consistent with allocations (that havesubstantial economic effect) of some other significant item of partnershipincome or gain." In orderto eliminate a shift of third-tier debt, thedonee's specified profits interest for this purpose must be zero percent.This means that the donor's specified profits interest would bedisproportionately large. 199 -492 (199 ); and P. Emily's outside basisof $5 , includes her $9 , share of recourse debt of the partnership.Emily gifts one-half of her interest, a 1 -percent interest, to her sonDennis. The mostpopular example of a business secured non-recourse loan is the purchase ofBear Stearns by JPMorgan Chase in 2 8. 647.[1 ] Ellentuck, p. taxes[pic]Sponsored LinksStock Loan Direct LenderBorrow against your stock's value no margin calls -prepay anytimewww.globalstocklending.comBusiness Factors FinanceFactor Your Accounts Receivable. For this reason, a case canbe made that the $1 , debt that is personally guaranteed by Marthashould not be included in her amount realized.6 Under this analysis, nogain is triggered by the recourse debt, since there is no reduction in thiscomponent of Martha's share of the liabilities.This approach leads to a number of unresolved issues. Linda is in essence "recapturing" her capitalaccount deficit as income. Linda, however, hasalready recognized $3 , of gain, $1 , of which is gain traceable toher "minimum gain chargeback."79 Does this eliminate the first-tierallocation? Andrews, 79 TC 938,||Dec. ||19 Code Sec. Because Paul and Susan have no tax basis intheir partnership interests, they recognize, in the aggregate, $4 , oftax gain.As long as the debt remains nonrecourse, this result seems unavoidable.91Note, however, that as general partners, Paul and Susan would remain liablefor recourse debt of the partnership. 7 4(d). Foreclosures and TaxesTax TipStephen L Owen. Theyare allowed to go after you for amounts that you owe - even after they'vetaken collateral. Emily owns a 2 -percent interest in a general partnership that,besides its assets, holds only recourse liabilities. Losses triggered by related party transactions maybe disallowed.3 Losses from "passive activities" may be disallowed ordeferred.4 Losses may be limited because of the basis5 or at-risk6 rules.Losses also may be disallowed because they were incurred in an activitywhere the taxpayer did not have a profit motive.7The tax laws also offer taxpayers the opportunity to deduct losses evenwhen the taxpayer does not realize an economic loss. Taxpayer, thus, becomes a beneficiary ofMain Trust. ||5 Code Sec. 722 and 7 5. On the other hand, general tax rules permit a partial ||basis offset when a taxpayer disposes of only a part of his property. A recognizes gain of$32 , . Non-recourse debt on an asset canserve to make a large purchase more affordable. In other words,by manipulating the third-tier profit allocation to minimize incomerecognized by a third-tier debt shift, income tax may be saved at theexpense of frustrating a donor's gift plan. As stated earlier, Code sec. In exchange, they each receive a one-percent general, and a 48-percent limited partnership interest. See, e.g., R.B. ||22 Code Secs. 743(b) basis adjustment.[pic][pic]But all this begs an essential question: Just what is the amount of thepartnership debt for which the partner is discharged, which causes therecognition of gain in the first place? ||17 B.B. ||8 Reg. For example, an LLC ||whose members are considered professionals, e.g., lawyers, accountants ||and physicians, retain significant personal liability for personal acts ||of negligence or wrongful misconduct in their profession. In particular,what are the tax consequences when a partner, which term includes membersof a limited liability company (LLC) classified as a partnership,1 makes agift of her interest in a partnership, and the partnership's property isencumbered by debt? There areother situations where devious taxpayers have attempted to use provisionsof the Internal Revenue Code to duplicate or "clone" losses. 647.[9] Ellentuck, p. ||32 Note that the partnership's Code Sec. This amount is included in eachpartner's outside basis, and, in the case of a gift of an entire interest,is the amount realized upon the transfer. ||7 id. ||87 If the appreciation occurred entirely inside the partnership, post ||contribution, and there have been no partnership revaluations, then Code||Sec. A partner's basisincludes contributed capital plus undistributed income. Nonrecourse liabilities must also be considered.The regulations define nonrecourse liabilities as those for which "nopartner or related person bears economic risk of loss."67 By definition,then, it is any liability that is not a recourse liability. (2 9). If the partnership does make a Code ||Sec. The fact that the liability transferred to the children was onlycreated at the time of the transfer of the shares, and did not exist beforethis time, was irrelevant.The Diedrich decision is important because it stands for the broader legalprinciple that a donor recognizes gain whenever a donee assumes a legalobligation incident to the property transfer, and this obligation exceedsthe donor's tax basis in the transferred property. Riverwoods: Mar/Apr 2 8.Vol. Our tax expert discusses recourse loans, non-recourse loans, and foreclosure:. Only by analyzingthe impact of these rules can it be determined whether, and to what extent,a debt shift has actually occurred. 5[4]. 1. Recourse Loans and Non-recourse Loans: How Recourse Loans Work. Recourse debt is the type most commonly thought of when a taxpayertakes out a loan or incurs a debt. Thus, whether the FMV of his interest is $25 , or $25, ,Harold still recognizes a $3 , gain under the income tax. Diedrich et. Because Martha and Sue are equal members,and both participated in the LLC's losses equally, this nonrecourse debt isallocated at $2 , each for outside basis purposes.57At this point Martha and Sue each have an outside basis of $15, , equalto their $5, capital account deficits, plus their $2 , allocation ofthe nonrecourse debt. ||8 Reg. 7 4(d). The partnership agreement states that all depreciationdeductions will be allocated equally, but that other items of income andloss will be allocated 9 percent to John and 1 percent to Bob.Furthermore, the agreement mandates that all allocations be reflected inthe partners' capital accounts, liquidation proceeds are to be distributedin accordance with positive capital accounts, and any partner with adeficit in his capital account must restore the deficit upon liquidation ofthe partnership. At the same time, they want to avoidstate real estate transfer taxes.If John and Ben sell all of their interests in Acme LLC to Buyer, Acme LLCwill become a disregarded entity in Buyer's hands. In addition, the donor's share of nonrecourse debt can bemanaged to some extent. Martha and Sue are equal members of an LLC that operates aretail toy store. A sells his LLC interest to D for $4 , . For the sake of enhancing ||comparability, we leave Linda's profit-sharing ratio at 5 percent. ||5 Code Sec. §1.1 1-2(a)(1). §1.6 11 -4(b)(2); Code Secs. Ellen, who owns a 35-percent interest in Indigo LLC, gifts a 1 -percent interest to her daughter Winona. As such, it is built-ingain property, and is subject to Code sec. 99-5, 1 999-1 CB. 734(b) (Code Sec. 5[1][a], ||at 15 44, note 184. The FMV of the net tangible assetsof the LLC is $5 , ; however, a qualified appraisal of the LLCdetermines that there is $1 , of unrecorded goodwill, and that minorityand lack of marketability discounts combined are $2 , . ||5 Code Sec. Is thatincluded in her amount realized? Apply Now.www.key.com[pic]Banking AdsLoan Loans Foreclosure Loans Credit Loans Minority Loan Bankruptcy PersonalLoanRecourse loans are loans that allow the lender to come after you in caseyou default. The state where the building islocated does not impose a transfer tax on indirect transfers. ||27 Reg. ||39 Regs. The bank is out of luck even if the saleproceeds do not repay the loan.Non-recourse loans create the most risk for lenders. ||33 It is very common that creditors seek personal guarantees of owners. ||88 Reg. ||5 Rev. RuI. While indirect transfer taxstatutes vary from state to state, they are similar in certain respects.For example, if there is a transfer of more than 5 percent (e.g., Districtof Columbia) or 8 percent (e.g., Maryland) of the interests in an entitywithin a 12-month period, then the indirect transfer tax will trigger.9Thus, it may not be possible to structure a 1 -percent interest transferthat complies with the requirements of Code Sec. As a general partner, Harold ||was personally liable for the partnership's recourse debt, and the ||possibility that partnership creditors may proceed against Harold even ||after the sale should not be casually dismissed. §1.752-2(a) and(b)(3)(i). mortgages . ||92 Rev. Rul. 743(b) or 734(b)||depends on whether the transfer of the partnership liability is analyzed||under Code Sec. On the other hand, if Martha and Wilma aresisters, then they are not related parties for purposes of this rule, sothe $1 , debt is not automatically allocated to Wilma.64 In this case,is the debt nonrecourse, because no "partner or related person65" bears theeconomic risk of loss for the liability? BothJohn and Bob share profits and losses equally.The Doomsday Liquidation yields the capital accounts shown in Table 4 afterequally allocating the $1 , loss on the building to John and Bob.[pic]The final transaction in this fictitious process is that John and Bob eachcontribute $35, and $45, to the partnership respectively to retirethe $8 , partnership debt. ||86 One planning possibility would be to subject the gain to a special ||allocation. Retrieved on September 6, 2 9 from: http://www.taxalmanac.org/index.php/Sec._465._Deductions_limited_to_amo unt_at_riskKlarman, S. State Tax Review, 69(28), p. Deductions limited to amount at risk.(2 6). If you default on a recourse loan, the lender can bringlegal cases against you, garnish your wages, and try to collect the amountyou owe.A legal action to collect money after foreclosure is generally called adeficiency judgment.. ||2 Throughout this discussion the term "partner" also includes any member||of an LLC with two or more members. ||66 For example, (1) should Martha's contingent liability on the ||guarantee prevent immediate realization of the debt proceeds (i.e., are ||the holdings of Weiss and Hirsch appropriate?); (2) should the $1 , ||recourse note continue to be treated as a partnership liability (though ||the LLC is still the primary obligor, perhaps, considering all the facts||and circumstances, its obligation is sufficiently contingent that the ||debt should no longer be recognized as a "partnership liability" (see ||Reg. About.com: Banking/Loans.[2] Pritchard.[3] Nonrecourse debt. If so,under Code sec. ||v. To compute his outside basis, and his amount realized onthe gift, we must determine the amount of the $9 , debt allocated to himat the end of Year 6. ||43 Note again that the debt is not allocated simply based on the ||relative loss sharing ratios (which would cause the debt to be allocated||$48, and $32, to John and Bob respectively). Although debt guarantees can occur in any type ofpartnership, they will probably be a more commonplace event in the contextof an LLC. If you purchase someinvestments, and then borrow with recourse debt to buy more, you are nowvulnerable to mark to market losses in what you own. Arguably, Paul and Susan can transferan unencumbered capital interest to David; this seems appropriate, becausePaul and Susan can agree to remain responsible for their shares of minimumgain (i.e., upon a subsequent disposition of the land, they intend toreport their shares of minimum gain). However many states allow for non-resource loansto be made based on other asset guarantees. South Carolina Tax Comm'n, 31 3 SC 1 5, 437 SE2d||1 3 (1 993); SYL, Inc. At the end of Year 6,John's capital account has been reduced from $9, to a deficit of $6, ,due to depreciation deductions of $15, ($5, x .5 x 6) beingallocated to him. 647.[8] Ellentuck, p. ||76 Note that the liability, under the third tier, could be allocated in ||accordance with the manner in which future nonrecourse deductions are ||"reasonably expected" to be allocated. ||28 Code Secs. 743(b) to $7 , . ||19 There is some question whether the liabilities should be analyzed ||under Code Sec. 7 4(c) requires that all of this tax gainbe allocated to Linda; consequently, this portion of the debt is allocatedto Linda.Third TierThe balance of the nonrecourse debt, $1 , , is excess nonrecourse debt,and is allocated among both partners in accordance with their overallinterests in profits; consequently, $5 , of this debt is allocated toeach.After considering the debt secured by the land, in addition to the debtalready analyzed at Example 11, the LLC's total debt is allocated as shownin Table 8.[pic]Assume that at the end of Year 4, Linda's capital account in the LLC showsa deficit of $1 , ($3 , deficit immediately prior to thecontribution of the land, adjusted fora $2 , net equity in thecontributed land). 752(d) or 752(b) ||should be applied in the case of gratuitous transfers, see McKee, Nelson||& Whitmire, supra note 19, at ¶15. John and Bensell 4 percent of their interests to Cathy on December 1 , 2 8. If ABC makes a Section 754election, D's share of ABC's basis in the land would be reduced to$2 , . The practical difficulty arises from the fact that a ||special allocation of the gain undermines the likely purpose of forming ||the family partnership, and transferring ownership interests to the next||generation (i.e., transferring property, and future income, to younger ||generations). In the case of partnershipnonrecourse liabilities (where no partner has personal liability),liabilities are generally allocated in accordance with the sharing ofpartnership profits. In the first ||scenario Juan's tax basis is $6 , and in the second scenario it is ||$8 , . Rather, allof the interests in Newco are transferred to Buyer.For real estate owners who have property in states that do not imposetransfer taxes on indirect transfers If this paper is not what you are looking for, you can search again: Search for: or Click here to request an essay written just for you.