At-risk limitation on deducting an L.L.C. member's losses.

• Author: Ellentuck, Albert B.

BEFORE THE ADVENT OF LLCs, THE AT-RISK rules were for the most part a poor stepchild when it came to loss limitations. If a partner could avoid application of the passive loss rules and the basis limitation rules, the at-risk rules seldom created a problem. Accordingly, the IRS and Treasury have made little effort to provide guidance in the at-risk area. The at-risk regulations are predominantly proposed and temporary regulations that have been on the books for many years without being finalized.

However, the at-risk rules may frequently limit the ability of LLC members to deduct losses. This is largely the result of the at-risk provision that denies members in LLCs taxed as partnerships at-risk basis for their share of LLC nonrecourse debts. Since all LLC debt is generally nonrecourse (either true nonrecourse or exculpatory), most LLC members can deduct only cash out-of-pocket LLC losses under the at-risk provisions. Treasury has indicated that it expects to review the at-risk rules and regulations in the near future.

The at-risk rules apply to individual taxpayers and closely held corporations under Sec. 465(a)(1). Consequently, an LLC itself is not subject to the at-risk rules. However, those rules are applied at the individual member level to losses passed through from the LLC.

The at-risk rules were designed to prevent the deduction of losses when the taxpayer is protected from suffering an actual out-of-pocket loss. When the at-risk rules were first enacted by Congress, the rules applied only to the following activities (Sec. 465(c)(1)):

* Farming;

* Exploring for or exploiting oil and gas resources;

* Holding, producing, or distributing motion picture films or videotapes;

* Leasing equipment; and

* Exploring for or exploiting geothermal deposits.

These five areas were considered at the time to be the most fertile ground for tax-shelter abuses. Then in 1978, Congress extended the at-risk rules to all other activities except real estate. Finally, as part of the Tax Reform Act of 1986, P.L. 99-514, the rules were extended to cover real estate activities in certain circumstances. The at-risk rules now apply to all activities engaged in as part of a trade or business or for the production of income (Sec. 465(c)(3)).

Note: The at-risk rules generally apply to losses incurred after December 31, 1986, with respect to the activity of holding real property that the taxpayer placed in service after that date. Under this general rule, as long as...