Risky Business: Deducting Loan-Related Losses On Your Taxes

When my daughter was small, she used to launch herself off window ledges a few feet high. We grew used to it and had faith that she would be just fine. But friends and passersby would gasp at her daring and worry for us: What if she got hurt?

The perception of risk, we learned, depended on who was asking. That question is precisely the issue faced by taxpayers in a U.S. Tax Court case: What constitutes a real risk?

The case Bordelon v. Commissioner involves married taxpayers, Rock and Torie Bordelon. The Internal Revenue Service determined tax deficiencies and penalty for tax years 2008 and 2009 for the two, as well as tax deficiencies and penalties for Rock Bordelon for 2010 and 2011 (he filed separate Forms 1040 for those years).

Bordelon owned 100% of Allegiance Health Management Inc. (AHM) during the years in question. AHM was a C corporation during 2008 and 2009 and an S corporation beginning in 2010.

Bordelon was also the sole owner of Many LLC, which he formed to buy a hospital. Many LLC was a single-member limited liability company treated as a disregarded entity for federal tax purposes.

In July 2008, Many LLC and AHM purchased the hospital for $9.9 million. To pay for it, Bordelon took out a loan, listing Many LLC and AHM as co-borrowers. The loan required him to execute a personal guarantee for the entire $9.9 million for as long as the loan was outstanding, which he did.

Bordelon also owned a majority interest in Kilgore LLC, which owned and operated a different hospital. Kilgore LLC was treated as a partnership for federal tax purposes.

Kilgore LLC had a rough start, incurring losses in 2008 and earning very little or no income in 2009, 2010, and 2011. In 2011, to prop up the business, Kilgore LLC borrowed $550,000. The Bordelons put up their residence as collateral. As before, Bordelon again personally guaranteed the loan: No other member of Kilgore LLC was personally liable for the debt.

In 2008, the IRS disallowed deductions related to Many LLC, claiming that Bordelon had not proved that he was “at-risk” to the extent of the loss. The IRS also disallowed the deductions related to Kilgore LLC because Bordelon did not have a sufficient adjusted basis for claiming the deductions.

The “at-risk rules” are critical here. For some taxpayers, including individuals and closely held corporations, Section 465 generally limits loss deductions to the amount for which the taxpayer is considered “at-risk” when carrying on a trade or business or producing income. The amount at risk generally includes money and property contributed to the activity, and the amounts borrowed. Borrowed amounts are considered at-risk only to the extent that the taxpayer is personally liable for the repayment, or if the taxpayer has pledged property not used in the activity as security.

Not at Risk, IRS Argued

The IRS argued that the deductions attributed to the Many LLC loan should be disallowed because Bordelon wasn’t actually at risk for those amounts. To qualify under Section 465, he must be “personally liable” for the loan, and he must not be “protected against loss.”

It might be tempting to jump to the guarantee as proof of risk, but merely signing a personal guarantee isn’t enough to establish personal liability for purposes of the at-risk rules. That’s because, in a typical scenario, there may be an option under contract or state law for the taxpayer to be repaid. If the taxpayer could simply be reimbursed, that’s not much of a risk.

But not all guarantees are created equal. In Abramson v. Commissioner in 1986, the court found that when a taxpayer is directly liable for the loan—with no meaningful right to reimbursement—the taxpayer is ultimately responsible for the debt.

That was the case here. If the Many LLC loan went into default, the bank could pursue Bordelon directly. Alternatively, the bank could seek loss payments from the government lending program, which created the loan, resulting in federal debt. Either way, Bordelon would have been ultimately liable to pay.

The IRS argued that under the terms of the loan, Many LLC or AHM could have also been responsible for the debt. The court thought that was a stretch but found that even if it were true, Bordelon was the sole owner of Many LLC and AHM, making him still responsible.

The IRS also argued that the Many LLC loan was substantially collateralized, which meant that it was unlikely that Bordelon would have to pay. The court found that immaterial, noting that in a worst-case scenario, the ultimate responsibility still fell to Bordelon to pay the loan. That made him personally liable for the loan, and because he had no right to right to reimbursement from any other party, he wasn’t protected against loss for purposes of Section 465(b)(4).

Lack of Basis, IRS Said

But what about the second loan? Kilgore LLC reported losses for 2008, and Bordelon claimed a deduction for those losses on his return. The IRS disallowed the deduction for lack of basis. Eventually, the taxpayer agreed that the deductions should be rejected in 2008 because his basis in Kilgore LLC was zero. Under Section 704(d), a partner’s loss deduction is generally limited to the partner’s adjusted basis at the end of the partnership year in which the loss occurred.

While conceding the zero basis for 2008, the taxpayer argued that his basis in Kilgore LLC increased for 2011 by $550,000 because of the second loan. Under Section 752, a partner’s basis is increased by an increase in the partner’s share of partnership liabilities. The second loan, argued Bordelon, resulted in an increased basis, which means that he could deduct the previously disallowed losses in 2011. Remember: Any excess not deducted in a tax year can typically be carried forward until the loss can be deducted.

The IRS argued that the basis didn’t increase in 2011 or, in the alternative, that Bordelon wasn’t at risk for the Kilgore loan. The court, however, found that there could be no scenario in which Bordelon was not economically at risk for the 2011 loan to the extent of his personal guarantee. The loan wasn’t secured by partnership assets, and no other partner was liable for any portion of the debt. If the note weren’t repaid, the bank would certainly have chased Bordelon for the balance.

Further, if a default occurred, there was no right for a contribution or reimbursement from any other member of Kilgore LLC. It was all on the taxpayer. Ultimately, he was at risk. That means he was able to increase his basis in Kilgore LLC by $550,000, which then allowed him to deduct the same amount in losses carried forward from 2008.

It can be tempting to substitute our judgment for what constitutes a risk. That’s dangerous because risk can be subjective—whether jumping from a window ledge or borrowing funds for a business. Fortunately, the tax code offers a road map for evaluating the latter.

This is a weekly column from Kelly Phillips Erb, the TaxGirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.