In episode 14 of How Tax Works, Matt Foreman discusses another signature change from the Tax Reform Act of 1986, section 465, which often prevents deductions from activities where the owner does not have capital subject to a risk of loss.  This episode is for anyone who is using leverage or investing in a business that will produce initial losses without requiring an initial capital contribution.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 14th episode of How Tax Works. I’m Matt Forman. In this episode, I’ll discuss the at risk loss limitations under Section 465 of the Internal Revenue Code. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please, please, please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices that we all make.

Matthew Foreman [00:00:42]:
Before we get started, a few administrative things. First episodes in two weeks. Two weeks. Every two weeks. The next episode is going to talk about various tax issues with divorce. I know, I know, how fun. Let’s talk about divorce. All the kids are lining up to talk about it.

Matthew Foreman [00:00:57]:
So, you know, it should be a good one. There’s a lot of, I don’t call them hidden issues, but they’re issues that tend to rear their head a lot and come up with it because people think, you know, hey, you know, divorces, it’s tax free 1041. And they can say, that’s true, but so it’s really issues that are common in divorces rather than tax issues with divorce. I know I said that wrong, but that’s on purpose, right? It’s okay to misphrase things if you then have another 20 minutes to explain it. If you have any questions, comments or constructive criticism, email me my FRB email address. You can find it near your favorite search engine. And now it’s time to talk about the at risk loss limitations. So what does at risk mean? First, let’s back up, right.

Matthew Foreman [00:01:38]:
Similar to last week and a number of other ones, right. The at risk limitations Tax reform act of 86 people were just, you know, non recourse debt. And they’re like, I’m taking the losses, I’m taking them all. And Congress went, look, if you’re not really at risk for the money, you know, for the money in, why can you deduct a loss? Right? And there’s exceptions to that. We’re going to talk about real estate a whole bunch again, as is tradition. But you know, it’s in first and foremost important to talk about what, you know, the definition, right? What does at risk mean? And it says, you know, the 465 says there’s no deduction to the extent the losses exceed the amount at risk. Okay? So the amount at risk is the amount of actual economic risk, specifically how much the taxpayer could actually lose. Again, we’re Talking about non recourse debt, that’s the problematic debt.

Matthew Foreman [00:02:30]:
Cause if it’s non recourse, the taxpayer can’t lose a penny because there’s no recourse against them. Literally using the words, right? But last time I said, look, basis is considered first. So how can you have basis but not an amount at risk? And I think that’s really important. So think about this, right? How can you conceivably have basis, right, in the partnership or an asset, but not amount at risk? So we’re going to kind of break that down, right? Recourse debt, even if no basis, is clearly at risk. So you put in recourse debt. Let’s think about a partnership. We’re not going to talk about S Corps for a moment. I’ll talk about that in a moment.

Matthew Foreman [00:03:07]:
But let’s talk about partnerships, right? So you take out debt, have a partnership, multi member llc, whatever, it doesn’t matter. You take out debt, it’s non recourse debt. So all they can do is take back again, costly, going to use real estate. But let’s say you buy a tractor, right? Tractors are hundreds of thousands of dollars and if no one’s at risk, right, you still get outside basis from it. 752 debt basis. So you get basis, you’re past the first and the ordering rules and you’ve hit at risk. And they’re going to say no, no, no, you don’t have anything at risk, right? So if it’s recourse debt, which means to the owners, to the taxpayer at hand, because it’s going to flow through 10, 65, 11, 20s, whatever return recourse debt, even if no basis is clearly at risk, if the debt is recourse debt, you’re at risk. That’s it.

Matthew Foreman [00:03:52]:
That’s the thing. If it’s a recourse to that taxpayer who’s claiming the, the deduction for loss, right? Because this business has to kick off losses. If you have a passive activity or you have no money at risk, that’s kicking off income. Congress doesn’t really care. They don’t want to limit that. I think for obvious reasons, they just want to tax you, right? That’s the idea. So again, recourse debt, no basis, doesn’t matter. You know, the key is that the recourse debt, you’re at risk.

Matthew Foreman [00:04:15]:
You can take the deduction for non recourse debt is generally the default presumption, is that you are not at risk. The key is that it’s non recourse to that taxpayer and I didn’t use the, I used that, that specific taxpayer. So not that it’s you know, recourse or non recourse or however society to the partnership, that’s irrelevant. Okay? It’s that it’s recourse or non recourse to the taxpayer. So you can have non recourse debt to the partnership, but one of the partners may have given their own pledge, their own backup right to it. And because of that, even though it’s non recourse to the partnership, it’s recourse to the partner and that’s what matters. Okay. And that’s what’s important.

Matthew Foreman [00:04:58]:
So let’s say you have recourse debt, right? And you think oh, a 50, 50 partnership. But if one of the two partners then indemnifies the partnership itself, it becomes non recourse to the partnership and recourse to the guaranteeing partner. So there’s different ways to accomplish that. Either to make non recourse debt into recourse or make recourse debt into partial non recourse, partial recourse. This is only partnership type stuff. S corporations are likely to be limited by basis because they don’t have basis. Like what partnerships call outside basis. It’s stock basis.

Matthew Foreman [00:05:28]:
And S Corp’s even through LLCs it’s still stock basis. So they tend not to have as much available basis. Now if they put cash in then they are going to have basis and they, if you put cash in, you likely have money at risk so you can get it, it’s just more limited. The common fact pattern that I see, and I suspect I’m not the only one in this bucket, the common fact pattern is really a situation with partnership non recourse debt within it ease it to buy equipment, you know, tangible personal property, buy real estate, real property, whatever you can use by intangibles doesn’t really matter. And the question is, can I take the deduction, I didn’t put any money in or we’ve already deducted for all the money I’ve taken. Right. And again, you know, similar to 469 passive activity losses, this is not saying you can never take the deductions, okay. This is actually saying that they’re suspended, they’re sitting in suspension for you to use when you’ve exited the transaction or there’s otherwise income from the activity.

Matthew Foreman [00:06:26]:
Right. It’s going to offset it. So I think that’s really important. So before we go into the exceptions to non recourse, again, non recourse is generally not at risk. I want to talk about a couple other things that I think are really, really, really important. First is what kind of activities apply to this. So it’s not every activity, right? There’s a list in section 465C, but the catch all is way more important. There’s a bunch that are specifically limited because those are the ones that Congress felt were particularly problematic.

Matthew Foreman [00:06:53]:
Not going to list them here, don’t think it’s helpful. You can go look yourself. But the catch all is more important. It says any activity where the taxpayer carries on a trade or business for the production of income, right? That’s enough. That’s where 465 at risk rules apply. And there are a lot of activities, you know, that are problematic. You look at them, you’re like, okay, that one is it. And you sort of say, well, if they’re not carried on for the production of income, should we even get the deduction? There’s other issues there.

Matthew Foreman [00:07:20]:
Investment, right? If it’s not a trade or business, but an investment, do you get to take it? When do you get to take it? And that’s the key. Basically what I think they are and how I view it is a lot of them are investment opportunities. And then it says, oh, and also any trader business. And that’s, that’s what I think 465C does. Secondly is how much is the amount at risk? Okay, it is any cash you’ve actually contributed the basis, not the fair market value, the basis of the property contributed, right? So less depreciation. So you’re amount at risk. As you take losses, your depreciation slowly decreases and then a recourse debt again, debt that is recourse to you, the individual taxpayer, not the partnership itself. And that’s the important thing.

Matthew Foreman [00:08:01]:
That’s the amount of risk. That’s how you compute it. Again, cash, basis of property contributed, amount of recourse, debt. Those are your three factors. That’s what you’re looking for. That’s what’s going to end up being the amount of money that you have at risk to start. You know, people say, oh, there’s ways to increase it. There are.

Matthew Foreman [00:08:18]:
We’re going to talk about that in a second. Go on a quick break. Be back in just a moment. Okay, we’re back. First off, you know, thank you for listening. Obviously you can get this a number of places on the FRB website, Spotify, Amazon, Apple, if you want to tell people about it. Rate, you know, people say, oh, you should tell them to rate and review, but only rate and review. If you’re gonna give a really good rating and an even better review.

Matthew Foreman [00:08:43]:
Okay, so, so no, no bad reviews or maybe bad reviews, I don’t know. Whatever you think, if you’re still listening at this point and you, you think like I should give them Matt, a bad review, like that’s, that’s cool, that’s fine. Got it. So now, now we’re going back to 465 at risk limitations. So the question becomes, and this is always the most important question, right? When does non recourse debt create or increase the amount at risk? Right? And the answer is very simple. Under 465B6 Cap A, it creates or increases the amount at risk when it is qualified non recourse financing. Right? So what is qualified non recourse financing? The requirements for 465 B6 cap B. Very nice.

Matthew Foreman [00:09:26]:
When they say, well it’s, it’s if it, you know, increases when it’s qualified non recourse financing. Oh, and here are the rules, right? First one is very simple. Borrowed by a taxpayer or the partnership, right? It flows up because partnerships, this is an area where you pretend the partner is doing it themselves and the partnership just kind of splits up the income or in this case loss it borrowed by the taxpayer for, for activity of holding real property, right? So you can’t use this if you’re using it to buy a tractor. Congress has decided that it can only be qualified non recourse financing if it’s for the taxpayer to hold real property. I’ve never totally understood this one, to be honest. I don’t have a fundamental problem for a car or a tractor. Someone told me that if you could do this for holding, you know, in order to hold a car, that the sheer number of. They said Maseratis.

Matthew Foreman [00:10:25]:
I think the answer now is G Wagons. That’s the cool one to have. Would skyrocket, right? Because if they could just take out the business could do it. They’re just going to do it and you’re going to say Matt, that’s not a deductible expense. And I’m going to say yeah, that hasn’t stopped anyone yet. So it limits it another way. So there’s another reason for it to get caught, another thing to look at. Not sure, totally helps, but whatever.

Matthew Foreman [00:10:48]:
But you know, a car for the business, etc. Etc. The second one is the lender cannot be the seller or a person related to the seller. The word person is not as we use the person in common English, it’s the tax person. 7701. So the person related to the seller can be an individual. Right. It could be a company, could be a corporation, could be an LLC partnership, it could be a trust, it could be whatever you want it to be.

Matthew Foreman [00:11:11]:
Right. A lot of things. So, you know, again, one, hold real property. Two, lender cannot be the seller or related to the seller. Three, the money must be borrowed from a qualified person, which is basically a commercial lender. You have to qualify essentially as one. So if, you know, if it’s someone, their neighbor, almost certainly not unless your neighbor is a bank, I guess, or the other one is the government is the lender or the money is guaranteed by the government. This is a really interesting one.

Matthew Foreman [00:11:41]:
Right. So an SBA loan could be. Right, it could be if the loan is otherwise guaranteed by the government. Really, really kind of quirky that they had that. But I suspect that’s where the government wants to be the lender, but doesn’t actually want to lend. So they just guarantee it, the bank does it, or a private third unrelated party does it. And four, there is no person personally liable for repayment. So it cannot, one word, cannot be recourse to anyone.

Matthew Foreman [00:12:09]:
So if anyone has to pay under any circumstances out of their own pocket, it is not qualified non recourse finance. And of course to that person, it is recourse to a single person, then it’s recourse debt to that person, that taxpayer, so they may get it. So it’s important to note that, you know, and you’ll see this from time to time where there’s qualified non recourse financing. And what happens is one of the partners, they go to a bank, they get it, it’s non recourse, it’s on real estate, no problems. But what happens is one of the partners agrees to backstop it, things go sideways. And they only do that with the partnership. They don’t even do that otherwise. Or there’s other ways to do it.

Matthew Foreman [00:12:46]:
We’re going to, we’ll get into that momentarily. And I think it’s really important to note that it can’t be recourse to anyone because it’s no longer qualified non recourse and it’s just recourse debt. Recourse debt does increase the amount at risk, but only to that partner, not to everyone. The idea of qualified non recourse is it increases it to everyone. Right. And someone asked me, well, why does qualified non recourse financing exist? And the answer is lobbying anyone who says, oh, it’s done for this reason. No, that’s that’s nice. There’s a thousand industries.

Matthew Foreman [00:13:14]:
I would like to have it. I’m sure Caterpillar would love to have this. I’m sure that, you know, some trucking company, Mack Trucks, whatever, would love to have this on their 18 wheelers or something large like this, right? They would. And there’s a viable reason why, you know, those huge trucks, maybe they should be qualified non recourse financing, you know, they should be eligible for it. The answer is it’s locked in. One, real estate’s getting a tax benefit and that’s that, that’s just, that’s the way the cookie crumbles, so to speak. So I think that’s a really important one to think about. Why does it exist whenever there’s a tax code section drop, trying to understand it or regulations or whatever, especially code sections, more so than regulations, I try to understand why it exists in the context of when it was again, 1986.

Matthew Foreman [00:13:57]:
Huge problems at risk, passive activity loss limitations. I’m a bit of an aside here. If you Remember back in 2015, right, Jeb Bush released his tax return, so people noticed that his tax returns, and again, why you release a 30 plus year old tax return is beyond my comprehension. But here we are and they noticed that he was involved in a number of tax shelters that kicked off passive losses which he used to offset his income. And people are like, oh, that’s terrible, that’s terrible. He said, look, everyone was doing it then and okay, no, everyone was not doing it then, but a lot of wealthy people were absolutely doing this then. And so 469, 465 were put in as sledgehammers to stop that. People structure around it, they do a lot of things, but as I always say, 469, 465, right? Passive activity loss rules at risk limitations.

Matthew Foreman [00:14:41]:
You got to want it. You have to be willing to take audit risk. If you’re on the line or you have to put in time, you have to put in money, it’s some, there’s some sort of real risk and that’s the important thing. Put in effort, put in risk, and that’s really important anyway, then inside, sorry, but not really. So what are other ways to create risk, right? Other than to do it? Other than, you know, qualified non recourse financing, other than having recourse debt, etc. First off, you can be the general partner. If you are personally liable for any debts of a general partnership, then congratulations, you have liability, right? Because they’re gonna say, oh, you can only go after the asset, the partnership and they’re well, you’re responsible for it, may create it. Right.

Matthew Foreman [00:15:24]:
Second one is a deficit restoration obligation or a deficit makeup obligation. Same thing, different term. DRO DMO there’s a case, Hubert TC Mao 2008-46 which is affirming 125 TC 12 there’s also, I believe it was a 6th Circuit case, but Tax Court, 6th Circuit remanded back to the tax court. And basically what it says is if you have a deficit restoration obligation, then you have it’s. I’ll get into why it didn’t say it, but does it. What it implies is that if you have a deficit restoration obligation, then you are personally responsible and that creates an at risk amount. What it actually says is they never actually elected the deficit restoration or they never made some election or said oh, this is, you know, I have, this is recourse. So they said, oh, because you didn’t do that, it doesn’t qualify.

Matthew Foreman [00:16:15]:
But the question would be moot if the other weren’t true. I haven’t read T root probably in a couple years, but that’s the premise behind it. If I’m wrong, email me Constructive criticism always, always enjoyed. So what about a qualified income offset? And the answer is probably not qualified income offset. So deficit restoration obligation is if your capital account’s negative and the partnership ends, you have to put money in to bring it to zero. A qualified income offset is you just have to recognize income to bring it back up to zero. Probably not. Maybe to the extent of the tax, you’re at risk.

Matthew Foreman [00:16:48]:
Maybe, possibly, probably not. I’d be very hesitant to say that I’m at risk because I have to pay tax. I just think that’s a bit of a fatuous argument. But I think that, you know, when you think about how to do it, this is one downside to a qualified income offset, that it does not create them out at risk. But again, the majority of times that you deal with partnerships that need qualified income offsets, where people are going to take out debt, depreciate or amortize. This is real estate, right? People very rarely take out debt to buy ip and if they do and they’re buying the ip, they’re likely exploiting it rather quickly or they need cash to do it. Businesses rarely extend debt to have someone develop an exploit ip. They do, they absolutely do.

Matthew Foreman [00:17:33]:
But a lot of times it’s more in the form of equity or the founders putting in money rather than, you know, venture debt or things like that. If you’re at that point or if you’re developing the ip, that’s a different situation altogether, right? Different thing you’re trying to do. So that’s the idea. You know, you can create at risk, we can talk about it. But the best, the best, the best is always qualified non recourse financing. It is not a terribly high bar to me. Pretty easy to prove. But it’s something you absolutely need to focus on.

Matthew Foreman [00:17:59]:
A lot of times, I guess I’ve noticed talking to people, et cetera, the IRS tends to actually audit even though the order is, you know, again, we’re talking about ordering in a second, you know, oh, we’ll talk about it now. Right, Ordering. So one basis, right? How much basis do you actually have? So once basis is zero, you’re done. Two, whether you have an amount at risk. Three passive activity loss and limitations and four is the excess business loss. 461 L. So a lot of times the IRS actually audits on passive activity first. I actually think that they should audit on the at risk rules first.

Matthew Foreman [00:18:31]:
I think they’re much more mechanical, much less facts and circumstances and it just should be the question that they ask first. They don’t. I suspect it’s because they look at it, they pull through the return before you actually get the letter, you know, with the IDR in it or something saying we’re starting an audit. And I think it’s because they’ve already kind of crossed this off. But I found they actually audit for the passive activity loss rules first, possibly because they’re more interesting or they’re more likely to be one that to trip up. So I think that’s really important to know that even though you know this rule is applied before it, they don’t always audit in order, so to speak. And I think that that’s something always important to consider. But you know, similar to the past act, we lost rules.

Matthew Foreman [00:19:12]:
It’s about documentation being able to prove it. Keep papers. You know, people say, oh, I don’t, I don’t have my work papers on my on basis. And that’s problematic. If you don’t, you know, you need to keep work papers, you need to keep your documents. And I think that’s really important. You know, whenever you get an IDR on a whole host of issues, the IRS always asks for your work papers. And if you don’t have them, they’re just going to disallow.

Matthew Foreman [00:19:32]:
So, so keep the math. Do separate work papers. Keep this if you’re going to do it. And you know, when you negotiate this debt. Right. If it’s going to be considered a qualified non recourse financing. You know, look at the requirements for qualified non recourse financing. They are not a high bar.

Matthew Foreman [00:19:48]:
They’re met pretty easily, especially by a commercial bank or any, you know, most private lenders are very happy to, to meet those requirements. I, I would just, you know, just make sure check the box. Right. It’s pretty easy. Okay. So thank you for listening. That was the 14th episode of How Tax Works. I hope you learned something.

Matthew Foreman [00:20:04]:
Hope you enjoyed it. I’ll be back with the 15th episode. Kind of wild to think about that one. And I’m going to talk about tax issues with divorces. Perfect for this time of year. Everyone’s hanging out with their family, a lot of stress. So we’re going to talk about a lot of issues that are common. It’ll be about individual divorces, but I guess conceptually business divorces could have similar issues.

Matthew Foreman [00:20:22]:
So we’ll talk about it. But now, you know, for everyone’s favorite song. Thanks for listening. Have a good one. Sam.