LLC member debt: recourse or nonrecourse?

• Author: Smith, Annette B.
• Position: Limited liability company

Regs. Sec. 1.704-2(b) (4) defines the term "partner nonrecourse debt" as "any partnership liability to the extent the liability is nonrecourse for purposes of [section] 1.1001-2, and a partner or related person (within the meaning of [section] 1.752-4(b)) bears the economic risk of loss under [section] 1.752-2 because, for example, the partner or related person is the creditor or a guarantor." A key issue is how deductions should be allocated that are funded by a general obligation of a limited liability company (LLC) if the obligation is guaranteed by or borrowed from a member and is recourse debt under Sec. 1001.

Treatment should be consistent with the general "tax follows economics" analysis on which Sec. 704(b) is based. In most cases, analyzing a general obligation of an LLC that is guaranteed by or borrowed from a member as if it were a partner nonrecourse debt may yield the most appropriate result, even though such a loan does not fall squarely within the definition of partner nonrecourse debt.

Categorizing Debt

To understand Treasury's intention behind Regs. Sec. 1.704-2(b) (4), it is helpful to look first to the legislative history of the statute. The preamble to the Sec. 704(b) and Sec. 752 temporary regulations, which the IRS released together in the same package, indicates that

[t]he coordination of these two sections reflects the fact that one of the principal purposes for including partnership liabilities in the bases of the partners' interests in the partnership is to support the deductions that will be claimed by the partners for the items attributable to those liabilities. [T.D. 8237] The preamble also indicates that the allocation of partnership liabilities equalizes the partnership's inside basis with the partners' outside basis, thereby allowing the partners that are allocated the deductions attributable to a partnership liability to be allocated the basis for that liability and enabling them to have enough tax basis to recognize the deductions on their tax returns. These statements make it clear that Treasury's intention was for the deductions that are attributable to a specific liability to be allocated among the partners in the same manner as the liability itself.

This concept appears very straightforward, until the complexities of categorizing debt as recourse or nonrecourse under Secs. 752 and 1001 are layered on top of the liability classification as nonrecourse or partner nonrecourse and the deduction allocation...