Tax court says taxpayer not at risk for DRA.

• Author: Tapia, Jennifer
• Position: Deficit restoration agreement

Deficit restoration agreements (DRAs) are widely used to increase basis to use partnership losses or maintain basis when capital accounts have been taken below zero. There has been substantial legal precedent in this area; this has laid the groundwork for DRAs to be a viable option for holding partners liable for a portion of the partnership's liabilities, giving them basis and allowing them to take current-year losses. Many taxpayers have relied on that precedent while drafting DRAs and using the at-risk basis created thereby. The Tax Court recently decided a case involving a limited liability company (LLC), in which it ignored prior cases in the area. This decision has created confusion as to whether the use of DRAs will continue to provide at-risk basis.

Hubert Enterprises

In Hubert Enterprises, Inc., 125 TC 72 (2005), aff'd in part, vact'd and rem'd in part, 6th Cir. (4/27/07), the Tax Court ruled in favor of the IRS on three separate issues; whether the:

1. Parent corporation could claim a business bad debt deduction on its transfer of funds to an LLC controlled by the same group of individuals that controlled the corporation;

2. Taxpayer could aggregate leasing activities into a single activity when the leases had commenced in different years; and

3. Taxpayer could use a DRA that made the LLC members liable for the entity's otherwise recourse obligations to deduct current-year equipment-leasing activity losses.

The first and second issues are not discussed in detail in this item. As to the first issue, the court concluded that the funds transferred from the parent to the LLC should be characterized as a capital contribution instead of a loan, because the loan was unsecured, at a low interest rate and for an unstated period. The court applied the 11 factors from Roth Steel Tube Co., 800 F2d 625 (6th Cir. 1986), which determine whether a funds transfer between entities should be characterized as debt or equity. The court decided that there were insufficient debt factors present and that an unrelated third party would not have made the same loan to the LLC. Thus, the court sided with the Service.

On the second issue, the court again held for the IRS, ruling that the leasing activities could not be aggregated into a single activity. The taxpayer had argued that under Sec. 465(c)(2)(B)(i),the activities could be aggregated. Generally under Sec. 465(c)(2), leasing activities involving Sec. 1245 property cannot be aggregated for purposes of...