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May 1991

Personal liability and at risk amount. (Federal Taxation)

by Landau, Zev

    Abstract- The Tax Reform Act of 1976 added Section 465 to the Internal Revenue Code (IRC) and introduced the concept of at-risk basis. The effect of the change to the IRC was that certain classes of taxpayers were not allowed to deduct their losses over their at-risk basis. Investors' at-risk basis includes cash contributions, the adjusted basis of contributed property, and loans for activities for which they assume personal liability upon default. Economic losses do not necessarily accrue from assumptions of liabilities to pay obligations out of personal assets. The key question in contractual agreements is whether the investors are protected in any way from incurring losses.

Without the exceptions set forth in Sec. 465(b)(4) investors could become abusive in structuring tax shelters and loan arrangements. They could deduct tax losses in excess of their at risk basis through guarantees, stop loss agreements, guaranteed repurchase agreements, and similar other devices. Several recent cases again made it clear that an assumption of personal liability to pay an obligation out of personal assets in the event of default did not necessarily represent a realistic possibility for an economic loss, and did not always imply additional at risk basis.

Recent cases presented an opportunity to study what must be considered when tax practitioners review agreements and arrangements involving recourse financing. Binding contractual agreements are not the only devices to reduce risks of losses. There are some other similar loss limitation arrangements employed to achieve elimination of risk. Following are the factors that must be observed and considered.

Carefully Analyze the

Arrangements to Identify Parties

and Evaluate Risks

In computer equipment leasing arrangements, for example, the courts identified certain factors and elements including the computer owner, the leasing company, the end user, the financing institution, the middleman, the terms of recourse and nonrecourse notes, security interests versus outright interests in the equipment, and the guaranty arrangements.

To illustrate, in the case of American Principals Leasing Corporation v. U.S. (CA-9 66 AFTR 2d 90-5012, revg & remg Richard Baldwin 62 AFTR 2d 88-5137), a limited partnership (LP) paid with cash and recourse notes for computer equipment purchased from "Corporation A," which had purchased the same computer from "Corporation B." LP leased the computer back to B. The obligations in the sale and leaseback transactions were circular in nature because the two sales had substantially the same price. In addition, note payments by LP to A and by A to B were identical to the lease payments due to LP by B. No cash ever changed hands because all the participants lacked the independent means to pay their obligations.

All payments were made by offsetting booking entries. The partners of LP assumed $120,000 of LP's notes to A and believed that their at risk tax basis should be increased accordingly.

Assumption of Personal Liability

Does Not Imply Existing Risk of

Economic Loss

The ultimate question is whether the investor is, in any way, protected against loss. "If the investor is liable for the loan only upon occurrence of a specific event, the taxpayer is effectively protected against the loss if the likelihood of the event is slim" Prop. Reg. Sec. 1.465-6(c).

Agreements and arrangements must be reviewed to detect events that trigger or relieve taxpayers of personal liability. The question is always whether the taxpayer who assumes personal liability is ever required to satisfy the liability, or whether he or she is protected in any way from being required to do so out of his or her own funds.

Identification of Circular


An identification of a circular transaction must be followed by a determination as to whether the taxpayer is protected against loss. To illustrate, in American Principals Leasing Corporation, the arrangement, as described above, called for identical terms between buyers, sellers, lessors and lessees. Under no circumstance were any of the parties expected to demand that the obligee satisfy his or her obligation. The relationships between the parties prevented a default by any one of them. "Given that no party had the means to meet its obligations without its obligee's payments, if one party failed to pay he could only expect a chain reaction resulting in obligor ceasing payments as well," the court stated. If the likelihood of default was slim, so was the likelihood that the taxpayer could ever be expected to pay his or her personal liability, and he or she was barred from being considered at risk.

The court, however, ignored one possibility of realizing an economic loss. The dissenting judge mentioned a possibility that one party in the circular arrangement might have needed cash. It could legally discount the note to a third party and the new note holder could have looked to the repayment of the note from the obligor and to the personal liability of the guarantors for the portion of the indebtedness they assumed.

Ambiguous Terms May Raise

Questions About Risks

A multi-layered complex contractual relationship between the parties engaged in purchase and lease of computer equipment was described in Barton v. Commissioner (65 AFTR 2d 90-591). An amendment of a non- recourse loan agreement described in this case provided that during certain years the non-recourse language of the installment note, issued by the taxpayer, would only apply to amounts in excess of specific amounts. The taxpayer, however, could rescind the agreement if the rating of the bonds issued by the lessee went below a certain standard. The word "rescind" was ambiguous. If it was intended to mean prospective recision only, then the amendment would not operate as a stop loss agreement because the taxpayer could still be at risk for the specified amounts prior to the date of the recision. If, however, recision meant a relief of all past, present, and future personal liabilities, then the amendment would have operated as a stop loss agreement. The taxpayer identified two possible situations in which he could be at risk despite the recision clause, each related to a default by a different party. The Court of Appeals did not decide the case because the Tax Court failed to consider evidence on a relevant issue. The case was remanded for the Tax Court "to start with a clean slate."

Review Reimbursement

Arrangements to Ascertain

Substance of Risk

It may be necessary to detect covenants that indemnify taxpayers for debts secured by liens against the property. In Casebeer v. Commissioner (CA 9,66 AFFR 2d 90-5361) a leasing company purchased computer equipment which was then leased to the end user. The leasing company sold the computer to the taxpayer. The taxpayer's at risk basis included not only its own note, but also the portion of the non-recourse note issued by the leasing company to its bank, a portion of which the taxpayer assumed. The taxpayer leased the equipment back to the leasing company and both parties agreed that if a previous owner breached covenants, warranties, representations or obligations secured by the property, the taxpayer will be indemnified by the leasing company for any loss, cost, damage, injury, expense, or payment of debt that the taxpayer incurred. The indemnification clause constituted a stop loss agreement or similar arrangement under Sec. 465(b)(4). The taxpayer's at risk basis was, therefore, overstated.

Receiving a guaranty may imply lack of economic risk despite personal liability. Guarantors are not assured an increase in at risk basis, either. There must be a certainty that the guarantors have no remaining legal rights against the primary obligor Prop. Reg. Sec. 1.465-6(d). The critical inquiry is always who is the obligor of the last resort, and the scenario that controls is the worst case scenario, rather than the best case. The Senate Finance Committee Report indicated that a possibility for a failure by a guarantor to carry out the agreement always exists because of various financial factors. This possibility, however, is theoretical and immaterial "unless and until the time when the taxpayer becomes unconditionally entitled to payment and at that time he demonstrates that he cannot recover under the agreement" (S Rep No. 938, 94th Cong 2nd Session SO).

Watch Out for State Laws

State laws granting rights to contributions from other partners may be considered as a loss limiting arrangement. In Melvin v. Commissioner (CA 9,65 AFTR 2d 90-508 affg 88 TC 63) the taxpayer owned interest in a general partnership which made a cash down payment of $35,000 and gave a $70,000 promissory recourse note in exchange for an ownership interest in a California limited partnership. The limited partnership obtained a bank loan in the amount of $3.5 million and the $70,000 recourse note was pledged as collateral to the bank. Although it was agreed that the at risk tax basis of Melvin included his promissory note because of his personal liability, measurement of at risk amount was disputed. Under a State of California law, a protection was provided to partners to the extent they had to pay personal liability in excess of their pro rata share in the partnership debts. The partner's statutory right to future reimbursement in the form of contributions by other partners indicated that Melvin was not the one who was ultimately liable for any amount in excess of his distributive share. No distinction could be made between an active arrangement initiated by the participants and rights conferred by state laws. Both could be perceived as loss limit arrangements.

Not Always What it Appears

In the area of at risk basis, as in other tax areas, transactions are not necessarily what they appear to be. All facts and circumstances must be taken into account to determine which investors are ultimately responsible for the payment of the obligations. Binding contractual agreements to protect investors must be considered together with other voluntary or involuntary arrangements.

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