By Vicki R. Carney and Tracy D. Lee at The Tax Adviser on April 1, 2019
The at-risk rules of Sec. 465 originated with the enactment of the Tax Reform Act of 1976, P.L. 94-455. It was a time of 70% tax rates, when tax shelters were aggressively marketed to manipulate taxable income. Originally, the rules applied only to certain narrowly defined types of activities, but subsequent amendments expanded their scope to cover all trades or businesses and other income-producing activities (Sec. 465(c)(3)). The at-risk rules apply to individuals and closely held C corporations (Sec. 465(a)(1)). Notably, Treasury has never finalized the bulk of the regulations implementing Sec. 465; as a result, reliance on proposed regulations issued in 1979 is the norm and is assumed in this discussion.
What was the problem?
Prior to the enactment of Sec. 465, the only limitation on a partner's ability to deduct properly allocated losses was its outside tax basis in the partnership. The outside tax basis in a partnership includes a partner's share of both liabilities that the partner could be required to pay (recourse liabilities), as well as liabilities for which the partner bears no economic risk of loss (nonrecourse liabilities) (Sec. 752). The inclusion of nonrecourse debt in a partner's outside tax basis provided an opportunity for taxpayers to claim deductions far in excess of their economic losses. The at-risk rules reflect an attempt to curb this perceived abuse.
Calculating a partner's at-risk basis in a partnership
A taxpayer's initial amount at risk in an activity (sometimes referred to as an "at-risk basis") is calculated by combining the taxpayer's cash investment with any amount that the taxpayer has borrowed and is personally liable for (Sec. 465(b)). A taxpayer's amount at risk is measured annually at the end of the tax year (Sec. 465(a)(1)). At-risk basis is increased annually by any amount of income in excess of deductions, plus additional contributions, and is decreased annually by the amount by which deductions exceed income and distributions (Prop. Regs. Sec. 1.465-22(c)). For purposes of adjusting at-risk basis, income includes tax-exempt income, and deductions include nondeductible expenses. In a real estate context, an increase of qualified nonrecourse financing increases the taxpayer's basis.
Avoidance of at-risk rules
These annual adjustments to at-risk basis have led to the following question: Because at-risk basis is determined at the end of the tax year, could a partnership increase debt at the end of the year to increase the amount of deductions that partners could use? Prop. Regs. Sec. 1.465-4 states that this type of debt manipulation may not occur; however, if there is a valid business purpose for the debt, then certain facts and circumstances will be examined to determine whether an increase followed by a decrease in debt is allowed. These factors include the time between the increase and decrease of debt, what normal business practices dictate, and contractual agreements between the parties (Prop. Regs. Sec. 1.465-4(b)).