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Form 6198 At-Risk Limitations: IRC 465

Calculations, Grouping, Elections and Schedules Identifying Loss Deferrals, Recapture Requirements; Tracking Carry-Forward Amounts

TUESDAY, SEPTEMBER 26, 2017, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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Sept. 26, 2017

Form 6198 At-Risk Limitations

Robert S. Barnett, Partner

Capell Barnett Matalon & Schoenfeld, Jericho, N.Y.

rbarnett@cbmslaw.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

At Risk Rules and S Corporation Basis and

Losses

By Robert S. Barnett CPA, JD, MS (TAXATION)

CAPELL BARNETT MATALON & SCHOENFELD, LLP.

ATTORNEYS AT LAW (516) 931-8100

rbarnett@cbmslaw.com

5

LOSS ORDERING

•Apply other disallowance provisions;

§162, §163(d), etc.

•Determine if there is Basis

•Apply §465 At-Risk Rules

•Apply §469 PAL

•Therefore, Basis, At-Risk Tests & PAL

6

LOSS

•Excess of Deductions

•Over income received or accrued

•During the taxable year

•From the activity

7

Why At-Risk Rules?

•Key aspects of Tax Shelters:

Little cash upfront (low risk)

Funded by non-recourse loans

Consolidate income and deductions

•Result: deductions exceed outlay

8

Why At-Risk Rules? “This leveraging aspect of virtually all classical tax shelters was based on the long-established right to deduct interest, business expenses, and other out-of-pocket items when paid or incurred, even if they are defrayed with borrowed funds, and on the fact that depreciation and amortization are computed on the full adjusted basis of property, even if it is purchased with funds borrowed on a nonrecourse basis. In effect, the tax law gives taxpayers ‘advance credit’ for the debt.” Bittker & Lokken: Federal Taxation of Income, Estates, and Gifts (WG&L), ¶28.1. Introductory.

9

Crane v. Comm’r, 331 U.S. 1 (1947)

•TP include nonrecourse liability in Basis

•Depreciable Basis includes liability

•Losses w/o economic risk

10

Goal of At-Risk Rules

•Deduct loss if at risk

•Limit non-economic losses

•Attack two aspects of tax shelters:

Aggregation of income/deductions

Abuse of non-recourse loans

•BUT not limited to Tax Shelters

11

Who Is Affected?

•Individuals

•S corp Shareholders

•Partners

•Personal holding companies

•Estates

•Trusts

•Closely held C corporations 12

Closely Held Corps

•5 or fewer SH own > 50% stock

Attribution applies

13

Flow Through Entities

•Not applicable to S corps

IS applicable to S corp shareholders

•Not applicable to partnerships

IS applicable to partners

•Not applicable to LLCs

IS applicable to LLC members

14

Reporting

•Form 6198

Separate form for each activity

Partnerships and S corps - separate statements for each activity

•Two methods

Simplified: If Adjusted Basis known

Detailed: May allow more At-Risk 15

Activity

1. Motion pictures and video tapes

2. Farming

3. Leasing 1245 property

4. Oil and gas

5. Geothermal deposits

•Other T/B or production of income

16

§465 At-Risk Rules

•Loss limited

•To amount at risk in activity

•Initial Amount = AB in activity

•Amount at risk = money + AB property + amounts borrowed

•If personally liable 17

Not At-Risk

•To extent protected from loss

Nonrecourse financing

Guarantee – 3rd party

Stop Loss Agreement

Etc.

18

Rev. Rul. 78-413

•2 TPs

•Each buys half of a TV series

•Each uses an identical note

•Each personally liable on respective note

•Cross indemnification

Each entitled to reimbursed from other

•Not At-Risk

19

Moreno, 113 AFTR 2d 2014-2149 (DC LA 2014)

•Loan to Aircraft Leasing LLC

•TP personally guaranteed loan

•Right to 50% contribution

•TP At-Risk for 50%

20

Unused Losses

•Carry Forward

•Unlimited years

21

Example

•Joe starts a farm, contributes:

$110K from personal savings

$360K equipment, AB = $240K

$280K from loans

•Joe’s total At-Risk = $110K + $240K + $280K = $630K. OR IS IT?

22

At-Risk Adjustments

•Adjust each year

•Increase/decrease At-Risk before determining loss allowed

Allowed Losses reduce At-Risk

•Increase/Decrease adjustments

23

•INCREASE:

Additional contributions

Activity income > deductions

Activity’s tax-exempt income

At-Risk Adjustments

24

•DECREASE:

Allowable loss

Money and property distributions

Repayments of debt by others

Non-deductible expenses relating to tax-exempt income

At-Risk Adjustments

25

Definition of Loss

•Excess of deductions over income

•Losses cannot reduce At-Risk below 0

•Recapture

26

Loss Disallowed

•Joe At-Risk at start of year = $1,000

•$3000 income during the year

•$7500 deductions during year

•$3500 disallowed

•Disallowed deductions carry forward

27

Loss Recapture

•Loss cannot reduce At-Risk below 0

•At-Risk may be less than 0

RECAPTURE

Initial At-Risk = $100

$120 distributed from activity

At-Risk = -$20

28

Loss Recapture (Continued)

•At-Risk falls to -$20

Recognize $20 gross income AND

receive $20 deferred deduction

At-Risk rises to $0

$20 deduction carries forward

•Effect: recapture previous loss deductions

29

LOSS RECAPTURE (Continued)

•Debt/Equity Classification

•Shift in debt

•Recourse Non Recourse

•Distributions

•Guaranty or Contract Modification

•Not Losses

30

ZELUCK, TCM 2012-98

•At Risk Recapture

•Drilling Partnerships

•Loss years closed

•Debt not paid/demanded

•Debt becomes NONGENUINE

•Accuracy Penalties Applied

31

FRAUD OMEGA FOREX GROUP 119 AFTR 2d ¶ 2017-519 (DC UT 3/8/17)

•Currency Speculation

•T/P college grad./dentist

•Didn’t tell CPA about offshore account

•He had access to investment

•“Creative Bookkeeping”

•No Loss Potential 32

WATCH OUT !

•T/P Claimed

•RELIANCE ON CPA

33

Activity Grouping •Allocate loss based on activity

1. Motion pictures and video tapes

2. Farming

3. Leasing 1245 property

4. Oil and gas

5. Geothermal deposits

•Other T/B or production of income

35

Individuals

•Separate activities; No Aggregation:

Interest in each different film

Interest in each different farm

Interest in each different §1245 property

Interest in each different oil/gas activity

36

Partnerships or S Corp

•Partner or S corp SH MAY aggregate:

Interests in different films

Interests in different farms

Interests in different oil/gas activities

Interests in different geothermal activities

•Partner or S corp SH MUST aggregate:

§1245 leasing activities placed in service in taxable year

37

Reporting Partnerships or S Corp At-Risk

•Partnership, S Corporation:

Give separate statement of income, expenses, and deductions for each at-risk and not-at-risk activity

•Partner, S Corp SH:

Use info on K-1 or similar

Report At-Risk on Form 6198

38

NOTICE 89-39

•IRS Recognized Admin. Nightmare

•TP may use old rules

•Not for Leasing

•Activities in same category

39

Other T/B

•Other T/B aggregated if

Activities constitute a single T/B AND

TP Actively Participates, or

S corp, partnership – 65% of losses allocated to active members

40

What is an Activity? •1976 – Originally enumerated 5

•1978 – dragnet “Other T/B” added

•Treasury authorized to regulate

Tax shelter characteristics; inter alia:

1. Accelerated deductions

2. Mismatching income and deductions

3. Substantial nonrecourse financing*

•BUT Regulations never issued *HR Rep. No. 1445, 95th Cong. 2d Sess. 70 (1978).

41

§469 Activity Compared

•§469 Appropriate Economic Unit

•Important Factors:

Similarities & differences in T/B

Extent of common control

Extent of common ownership

Geographical location

Interdependencies 42

§469 Interdependencies

•Activities:

Buy/sell goods

Related products/services

Same customers

Same employees

Same books and records

•§465? 43

What Is Active Participation?

•FACTORS FAVORING:

Day-to-day decisions

Performing services

Hires/fires employees

H.R. Rep. No. 1445, 95th Cong. 2d Sess. 69-70 (1978).

44

Contrast: PAL Material Participation

•TP materially participates

Regular

Continuous

Substantial

•Seven different tests, including:

Quantitative - > 500 hours in year

Facts and Circumstances 45

§469 Active Participation

•Material Participation Not Required

•Significant & bona fide participation – making management decisions – approving new tenants, deciding rental terms, approving capital expenses; or

•Arranging of others to provide services

46

No Aggregation

47

Restaurant Oil & Gas

Partnership 1

• Active participation BUT

• No aggregation

Separate T/B

Determine At-Risk separately

PLR 9035005

Partnership 2

NO AGGREGATION

•Distribution Activity

•Sublicense Activity

•John v. Commissioner 86 TC 492 (1986)

48

Cash Contributions

•Source?

From taxpayer?

Borrowed? Apply Rules

• Implicit tracing (no specific rules)

§163-8T a guide?

•How is cash used?

•Loss limitation? 49

Property Contributions •At-risk = AB, unless encumbered

• If encumbered, personal liability?

•B contributes property P

•FMV = $100K

•AB = $50K

•$25K nonrecourse debt secured by P

•B At-Risk = $25K

50

Contributions of Borrowed $

•Two Views:

1. Economic Reality Approach

•Generally followed (circuit split)

•No realistic possibility of economic loss

2. Payor of last resort

•Economic loss in worst-case scenario

•Related party rules apply 51

Economic Reality

•Sale-Leaseback → Not At-Risk

•No realistic possibility of loss

Offsetting payments & bookkeeping entries

Circularity

Broad indemnity

Kimmich v. Comm’r, T.C. Memo 1999-349 (1999) 52

GCC TP Elmco

Sale Sale

Lease

Worst Case (6th Cir.)

•Sale Leaseback → At-Risk

•TP payer of last resort; in worst case:

CIS bankrupt

TP required to pay PLS

No collateral agreement/indemnity Emershaw v. Comm’r, 949 F2d 841 (1991) 53

TP

7.57% CIS PLS

Sale Sale

Lease

LEA

Recourse Liabilities

•At-Risk If:

1. Incurred for use in activity AND

2. TP personally liable

3. Lender Only a Creditor

No interest in activity

Not related to person with interest

•Repayment of recourse loan

•Does not affect TP’s At-Risk 54

Nonrecourse Liabilities

•Generally not At-Risk

•Subsequent repayment by TP

Increases At-Risk

55

Nonrecourse Liabilities

Pledged Property:

•Readily Ascertainable FMV §1.465-8

At-Risk to extent of FMV

NOT property used in activity

•IF NO FMV

Lender may not receive financial gain

Ex. Commissions from activity 56

Nonrecourse Liabilities 1. Joe spends $100K to make a film

$10K from savings

$90K borrowed nonrecourse

Film loses $50K

At-Risk $10K

$40K loss carries over

2. If Joe repays $30K of loan

At-Risk for additional $30K 57

At-Risk & Related Party

•Not At-Risk – borrowed from:

Person with interest in activity OR

Related party (other than the borrower) with interest in activity

•Related Party (inter alia):

Siblings, spouse, ancestors, etc.

Corp >10% ownership

S corps with common (>10%) owner 58

Interest in Activity

•Other than as creditor only if :

Capital Interest or

Net Profits Interest

Capital Interest – interest in activity assets if liquidated (partners & SH)

Net Profits Interest – activity net profits determine compensation

59

Related – Not At-Risk

60

SH1 SH2

S corp

Loan

• SH1 & SH2

Related

• SH1 interested in

activity

• SH2 not At-Risk

Van Wyk v. Comm’r, 113 TC 440 (1999)

Not Related – Not At-Risk

61

SH1 SH2

S corp

Loan

• SH1 & SH2 Not

Related

• SH1 has Capital

Interest

• SH2 not At-Risk

Not Related – Not At-Risk

62

SH1 SH2

S corp

Loan

• SH1 & SH2 Not

Related

• SH1 has Profits

Interest

• SH2 not At-Risk Pritchett, TC Memo 1989-21.

Not Related – At-Risk

63

SH1 SH2

S corp

Loan

• SH1 & SH2 Not Related

• SH1 - no Capital Interest

• SH1 - no Profits Interest

• SH2 At-Risk

Anti-Abuse

•IRS may make adjustments if:

Not normal commercial practice

No valid business purpose

Device to avoid §465

•Facts and circumstances

65

Qualified Non-Recourse Debt

•5 Requirements:

1. Relates to holding real property

2. Secured by Real property

3. Lender is a “Qualified Person”

4. No one is personally liable; AND

5. Instrument cannot be convertible

66

Qualified Person (QP)

1. Actively & regularly in $ lending business

2. QP NOT Related to TP*;

3. TP did NOT acquire the property from QP;

4. QP does NOT receive fee from TP’s investment

*Exception: Commercially reasonable and terms substantially same as unrelated

67

Partner Basis

•§704(d) loss limited to AB

•§722 Basis – Contribution $ or Property

•§752 – Partner’s share of liabilities

Considered contribution of $

68

Partnership At-Risk

•Applied to partner, not partnership

•Each partner computed separately

•Prop. Reg. §1.465-7 applies §1.752-1(e) Basis rules

69

Partnership Example

•Joe contributes $100K to partnership

•Joe has a 20% interest in the partnership

•Partnership invests in $1,000K oil well

•P’ship borrows $500K, nonrecourse

•Joe’s initial Basis is $200K

•Loan Basis - §752

•Joe’s initial At-Risk is $100K 70

Limited Partner At-Risk •EXCLUDE: Most partnership liabilities

• INCLUDE:

Share of Qualified Nonrecourse Debt

Contractually obligated contributions Gefen v. Comm’r, 87 TC 1471 (1986)

Guarantee, no reimbursement

Creditor could proceed against LP Melvin v. Comm’r, 88 TC 63 (1987).

Arms-length contribution obligations 71

At-Risk & S Corp

•Prop. Reg. §1.465-10 (6/5/1979):

Corp must be At-Risk

SH must be At-Risk

•PL 97-354 (1982):

Removed S corp

Retained individual 72

S Corp SH Basis

•Similar to Partner

•BUT no Basis for corporate debt

•LOSS LIMITED

AB Stock

AB Corp. Debt to SH

73

At-Risk & S Corp

•SH At-Risk – AB in activity includes Corp Debt to SH, §1366(d)

Joe contributes $50K to S Corp

Joe borrows $40K, personally liable

Joe contributes borrowed $40K

Borrowed $40K used in activity

At-Risk for $90K? Or $50K?

74

S CORP. FINAL YEAR

•Suspended Losses – Carried Forward

•May be used in PTTP

Generally 1 year after S termination

•1996 Tax Act

75

Broz, 137 TC 46; 727 F.3d 621 (6th Cir., 2013)

•RFB – Cellular telephone

•Alpine – New licenses; loss

•Alpine – Not in T/B

D/N meet FCC Rules

76

RFB

TP

Alpine Bank Loan

100%

Pledge RFB stock

as security

99% Loan

•TP Pledge RFB stock

•RFB stock used in activity?

•Does RFB have interest in activity?

Related Corp Stock “Used” in Business?

77

•Bookkeeping entries

•No Economic Outlay

•Recharacterized loans

•Financial statements – w/n enforce

•§1366(d) – NO BASIS

78

Back-to-Back Loan

•Never guaranteed loan

•No realistic possibility of loss

•Pledge RFB Stock

•TC → Stock in related S Corp is property used in the business

•6th Cir D/N address At-Risk No Basis and not T/B

79

Not At-Risk

•Not determinable FMV

•But does RFB have economic interest in activity?

•Treas. Reg. §1.465-8

80

TC Correct?

Circular Loan

81

Dart HL HS

SH Loan

Loan Loan

Loan

Loan

Oren, TC Memo 2002-172

•§465: not At-Risk

Circularity – Default unlikely

No economic change

Unlimited control

No realistic possibility payment

Insurance

Worst-case scenario inappropriate

82

Oren, TC Memo 2002-172

BACK TO BACK LOANS

•Treas. Reg. §1.1366-2 (7/23/14)

• “Bona fide indebtedness”

•All facts & circumstances considered

•MAGUIRE, TCM 2012-160

Auto dealer and finance company

A/R distributed then contributed

•Substitutions – state law formalities 83

Example Based on Maguire

FB AB

Owners Distribute

$600 AR

Contribute

$600 AR

$6,000 profit $400 basis $1000 loss 84

Maguire Example (Cont.)

•IRS: No economic outlay, no cost

•Court: Economic outlay

•Legitimate loans

SH resolutions

Formalities – documentation

Consistency and timing

Distribution reduced Basis in FB

Exposure to AB’s creditors

85

Maguire Example (Cont.)

•Owner at risk?

Related party but to borrower

Interest only as a creditor?

Interested in activity?

Capital interest?

Interest in net profits?

86

Maguire Example, Modified

•DIRECT LOAN

FB AB $6,000 profit $400 basis

$1,000 loss

Loan $600

87

Maguire Example, Modified

•Owner At-Risk?

No – Remember Broz

Not personally liable &

No contribution to AB

• Also, §1366(d) → No Basis 88

QSub & At-Risk Rules

•PL 97-354 (1982)

Removed S corp

Retained individual

•Committee Report H.R. 104-586 (1996)

•SH ability to deduct losses Limited:

To extent At-Risk w/r/t Qsub

89

QSub At-Risk Example

FB QSub AB QSub

Shareholder

$6,000 profit $400 basis

$1,000 loss

S corp

Loan $600

90

QSub & At-Risk Example

•SH At-Risk?

Perhaps – Facts and circumstances

Active participation in both operations

Aggregation? Perhaps

•§1366(d) Basis → QSub attributes to S

91

QSub At-Risk Example

FB QSub AB QSub

Shareholder

$6,000 profit $400 basis

$1,000 loss

S corp

Loan $600

Guaran tee Loan

92

QSub & At-Risk Example

•SH At-Risk? Yes, if: Bona fide and enforceable

No contribution/reimbursement

Not otherwise protected

Goatcher – state law

• Also, consider aggregation 93

What if:

Shareholder

Ford QSub VW QSub

$6,000 profit $400 basis

$1,000 loss

S corp

BMW

QSub $400 basis

$3,000 loss

•Aggregation?

•Single T/B 94

Thank You

Robert S. Barnett CPA, JD, MS (TAXATION)

CAPELL BARNETT MATALON & SCHOENFELD, LLP.

ATTORNEYS AT LAW (516) 931-8100

rbarnett@cbmslaw.com

95