In a previous article by The McGuire Law Firm, a Denver small business attorney discussed the equity generated rules relating to deficit restoration obligations. In addition to these equity rules, there are more complex issues and considerations to make regarding a deficit restoration obligation’s impact in respect to a limited liability company debt that is considered recourse debt for state law purposes. In general, a partner will be allocated both the debt under Internal Revenue Code Section 752 and the related deductions under Internal Revenue Code 704(b) to the extent that partner bears the economic risk of loss. The key issue is whether the allocation of full recourse limited liability debt would be shifted to a partner solely because the partner agrees to a deficit restoration obligation. Does a partner’s agreement to a deficit restoration obligation allow the partner to be allocated full recourse LLC debt? The article below drafted by a Denver small business attorney discusses this issue. However, it appears there may no clear answer to the above question and issue. Of course, prior to entering into any agreement relating to your partnership we recommend you consult your business attorney, and a tax attorney.
The allocation of recourse debt and related allocations of a partnership are controlled under the 752 and 704(b) Treasury Regulations. The regulations consider who bears the economic risk of loss if the partnership were liquidated. Thus, the regulations view the situation under a “constructive liquidation.” The partners who would be obligated to make payments to creditors or make contributions of cash or property to the partnership to satisfy any debts, and have no right to reimbursement, are considered to bear the economic risk of loss for the debts of the partnership. Therefore, these partners bearing the risk of loss are allocated the debt and loss attributable to the debt. Below is an example that may help illustrate a related situation.
Supposed the general partnership of ABC incurs a $1,000 recourse debt obligation and purchases an asset for $1,000. Partner A has a full deficit restoration obligation, partner’s B and C only have a deficit restoration obligation limited to $200 each. Under a constructive liquidation, A would be allocated $600 of the loss and B and C would each be allocated $200 of the loss. The debt would be allocated $600, $200 and $200 to A, B and C respectively and would the losses. See Treasury Regulations Section 1.752-2(f).
The Section 752 and 704 regulations are pretty straight forward when applied to the lack or avoidance of a deficit restoration obligation in the context of a limited partnership or general partnership, but issues appear through the application to a partnership in the form of a limited liability company.
To consider the implications of the applicable regulations, you must start under the context of a constructive liquidation whereby partnership debts are payable in full, all partnership assets are considered worthless, the partnership disposes of all partnership assets in a fully taxable transaction for no consideration and the only relief would come in the form of a non recourse debt whereby the creditor’s right to repayment is limited to the asset or assets.
For example, assume A, B and C contribute $1,000 each to ABC, LLC, which is a newly formed limited liability company. ABC, LLC borrow $5,000 on a full recourse basis from an unrelated third party and the loan is not subject to anti-abuse, property pledge or the interest guarantee. ABC, LLC uses the cash to buy an asset for $10,000.
Based off of the example above, in the absence of a deficit restoration obligation, the LLC’s debt is nonrecourse for the purpose of Section 752 and 704(b) because no member is obligated to make a contribution to the LLC or make payment to the creditor upon a constructive liquidation. Thus, upon a constructive liquidation the LLC’s assets would be considered sold for the $5,000 debt.
Assuming an individual member (or an individual related to a member) guaranteed ABC, LLC’s debt, but there was no deficit restoration obligation, the debt would become recourse for the purposes of Section 752 and partner nonrecourse under 704(b) because a member bears the economic risk of loss for a liability of the LLC that is really a non recourse liability to the LLC. Therefore, the debt and deductions would be allocated to the member who personally guaranteed the debt or was related to the individual who guaranteed the debt.
Assuming there is a deficit restoration obligation, the treatment of the debt and deductions is somewhat unclear and are likely to depend upon whether the deficit restoration obligation expanded the creditor’s right’s beyond the assets of the LLC. If it is determined that the deficit restoration obligation has expanded the rights of the creditor beyond the assets of the partnership, the deficit restoration obligation can convert a nonrecourse debt into a recourse debt obligation for purposes of Section 752 and 704(b).
The implementation of deficit restoration obligations into a partnership agreement or operating agreement, and partner’s guaranteeing partnership debt can significantly impact a partner’s allocation of losses and deductions. These issues impact the business and taxation of the individual partners. Any partnership or individual considering these issues may wish to consult a business attorney and a tax attorney.