Partners and S corporation shareholders have three hurdles to overcome before they’re permitted to deduct the losses allocated to them on Schedule K-1. First, they’ve got to have adequate basis, under either I.R.C. § 704 or I.R.C. § 1366. On the back end, they’ve got the passive activity rules of I.R.C. § 469 to deal with. Stuck in the middle of the two limitations lay the oft-misunderstood at-risk rules of I.R.C. § 465.
When an individual is engaged in certain activities, I.R.C. § 465(a) limits the losses that an individual may claim as deductions to the amount for which the individual is “at risk” in the activity. Section 465(b)(1) provides that a taxpayer is considered at risk for an activity with respect to the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity and for certain amounts borrowed with respect to the activity. Section 465(b)(2) provides that a taxpayer shall be considered at risk with respect to amounts borrowed for use in an activity to the extent that he is personally liable for the repayment of such amounts.
While the statutory language under I.R.C. § 465 serves mainly to cause confusion, the concepts therein can be clearly explained through real life examples, as evidenced by the Tax Court’s decision today in Zeluck v. Commissioner, T.C. Memo 2012-98 (April 3, 2012).
Roy Zeluck (Zeluck) invested $310,000 in an oil and gas partnership in 2001; $110,000 was contributed in cash, and $200,000 was contributed in the form of a note maturing Dec. 31, 2009. The partnership in turn used Zeluck’s and other investors’ notes as security on a note it wrote to a drilling company. Zeluck signed an assumption agreement which made him personally liable on the partnership note up to the amount of his $200,000 liability to the partnership. This guarantee made Zeluck “at-risk” to the extent of the $200,000 loan, which when added to his $110,000 cash contribution, gave Zeluck total at-risk basis of $310,000.
In 2001 and 2002, Zeluck was allocated losses from the partnership which reduced his at-risk basis from $310,000 to $32,407. In 2003 the partnership terminated and distributed $32,407 to Zeluck, zeroing out his at-risk basist. Zeluck had not made payments of principal on the $200,000 note and failed to make certain required interest payments as well.
The IRS issued a notice of deficiency stating that Zeluck ceased to be at-risk for the $200,000 note in 2003 when the partnership liquidated. The IRS argued that Zeluck’s guarantee of the partnership’s debt to the drilling company became meaningless in 2003 after the liquidation of the partnership. As a result, Zeluck’s at-risk basis in the partnership had to be reduced from zero to a negative $200,000, requiring Zeluck to recapture $200,000 of income in 2003 under I.R.C. § 465(e):
Section 465(e) provides that if zero exceeds the amount for which the taxpayer is at risk in any activity at the close of any taxable year the taxpayer shall include in his gross income for such taxable year an amount equal to the excess.
Countering the IRS, Zeluck argued that the $200,000 debt to the partnership was genuine in 2001, 2002, and 2003, because even after the partnership liquidated, Zeluck continued to owe the drilling company for the $200,000 of debt he had previously guaranteed.
To determine whether Zeluck had a valid debt to the drilling company for his guaranteed liability, the Tax Court examined the following factors:
(1) whether the promise to repay is evidenced by a note or other instrument;
(2) whether interest was charged;
(3) whether a fixed schedule for repayments was established;
(4) whether collateral was given to secure payment;
(5) whether repayments were made;
(6) whether the borrower had a reasonable prospect of repaying the debt; and
(7) whether the parties conducted themselves as if the debt was genuine.
After an examination of the factors, the Tax Court held that Zeluck’s note payable to the partnership was valid in 2002, but ceased to be valid in 2003:
We find that the…liabilities were genuine debts in 2002 but were not genuine debts in 2003. Our conclusion turns primarily on the lack of payments made and enforcement sought after the termination and liquidation of the partnership at the beginning of 2003. No demand for payment was made by any party upon the notes maturity date of December 31, 2009, and petitioner had made no arrangements to pay the balance due as of the time of trial, even though the amount due was allegedly accruing interest at 15%. It also appears that petitioner would not be able to pay the balance due under the note as of the time of trial, testifying that it “would be a ridiculously large check” for him to write.
Having concluded that no valid debt existed in 2003 between Zeluck and the partnership or Zeluck and the drilling company, the Tax Court applied Section 465(e) and required Zeluck to recapture $200,000 of previous losses as income.
Illustrating the principles of I.R.C. § 465 throughout Zeluck’s tenure in the partnership, he began with an at-risk amount of $310,000: $110,000 in cash invested and $200,000 in guaranteed partnership debt to the drilling company. In 2001 and 2002, Zeluck was allocated losses totaling approximately $270,000, which reduced his at-risk basis to $32,000. In 2003, the partnership terminated, and Zeluck’s at-risk basis was further reduced by the $32,000 liquidating distribution to zero.
Also upon the liquidation, Zeluck’s guarantee of the partnership debt ceased to bear consequence, as the court concluded the debt was no longer valid after the partnership’s liquidation. This drove Zeluck’s at-risk basis from $0 to negative $200,000, triggering Section 465(e) and the recapture of $200,000 of previously deducted losses.