Under Regs. Sec. 1.752-2(a), limited liability company (LLC) members share recourse liabilities in the same proportions in which they bear the economic risk of loss with respect to the liability. In other words, members are allocated basis from recourse debt to reflect the way they would be legally obligated to bear the burden of discharging the liability if the LLC were unable to do so. Because of the limited liability characteristic of LLCs, members generally do not bear any economic risk of loss with respect to LLC liabilities.
However, loans made to the LLC or guaranteed by a member (or a member affiliate) generally are treated as recourse for the debt allocation rules. Also, an LLC may have recourse debt if its members elect to assume the LLC's debt under state law, the LLC is a converted general partnership (the former general partners remain liable for debts incurred before the conversion), or the LLC members have a financial obligation (under state law) to make contributions that are available to LLC creditors.
To properly determine the members' economic risk of loss with respect to an obligation to contribute capital or return a prohibited distribution, the practitioner should review the LLC's articles of organization, the operating agreement, and the appropriate state LLC statute. Members with a deficit restoration obligation may, in certain situations, be allocated a share of LLC recourse debt.
Determining a member's economic risk of loss
Under Regs. Sec. 1.752-2(b)(1), a member bears the economic risk of loss with respect to an LLC recourse liability to the extent that, after a no-value liquidation (see below), the member (or member affiliate) would be obligated to make a payment to another person or the LLC. This obligation is referred to as the member's payment obligation. The member's ability to actually satisfy the obligation (i.e., the member's net worth) is generally irrelevant unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (Regs. Sec. 1.752-2(b)(6)) or if the member is a disregarded entity. In addition, the member (or member affiliate) is deemed to bear the economic risk of loss only to the extent he or she is not entitled to reimbursement from another member (or member affiliate).
IPO II, 122 T.C. 295 (2004), addressed the effects of guarantees by related owners and the impact of the "related partner exception" on the allocation of recourse debt. (The related-partner exception of Regs. Sec. 1.752-4(b)(2)(iii) provides that, notwithstanding the general definition of related persons, persons owning interests directly or indirectly in the same partnership are not treated as related for purposes of determining the economic risk of loss borne by each of them for the liabilities of the partnership.) In this case, an LLC classified as a partnership borrowed money on a recourse basis to purchase an airplane. The LLC was owned by an individual and an S corporation solely owned by the same individual. That individual...