Passthrough Losses Disallowed Due to Taxpayers' Lack of Outside Basis in Partnerships

(Parker Tax Publishing July 2023)

The Tax Court held that the IRS properly disallowed losses claimed by a taxpayer as passthrough losses from an upper-tier and a lower-tier partnership as a result of promissory notes he gave to the partnerships because the notes did not increase the taxpayer's basis under Code Sec. 752. The court rejected the taxpayer's argument that he bore the economic risk of loss with respect to the lower tier partnership's liability because the notes secured a loan to the partnership after finding that the notes were not pledged as collateral and further, the taxpayer was not at risk with respect to the lower tier partnership's movie making activity. Bryan v. Comm'r, T.C. Memo. 2023-74.

Background

For years 2007-2012, Anthony Bryan owned 99 percent of the Watley Group, LLC (Watley), a California limited liability company. Under Watley's operating agreement, members were not liable for Watley's debts. The operating agreement also did not require members to contribute additional capital to Watley in excess of the "Maximum Capital Contribution" listed in the operating agreement. Watley owned a 20 percent interest in Pool Boy the Movie, LLC (Pool Boy), a Louisiana limited liability company formed to produce the movie "American Summer."

In September 2007, Bryan gave Watley a purported promissory note stating that he would pay $2.7 million to Watley on or before December 31, 2030, with interest accruing at an annual rate of 4.75 percent. The note is neither secured nor collateralized and does not include a repayment schedule. Watley gave Pool Boy a promissory note of $2.7 million payable with interest at 4.75 percent in return for its 20 percent interest in Pool Boy. The Watley note to Pool Boy had the same terms as Bryan's note to Watley. Neither Watley nor Bryan made any payment on the Watley note. Pool Boy's operating agreement stated that its members were not personally liable for the company's debts. Watley was not required to make any capital contribution to Pool Boy in addition to the note.

In May 2007, Palm Finance Corp. (Palm Finance) agreed to lend up to $5,500,000 to Pool Boy. Neither Watley nor Bryan was personally liable for the Palm Finance loan. Neither Pool Boy, Watley, nor Bryan made any payment on the Palm Finance loan. In the event of a default, Palm Finance was not entitled to directly collect on the loan against Watley's or Bryan's assets. Neither Watley nor Bryan pledged any of their assets as collateral or security for the Palm Finance loan, and neither Watley nor Bryan was a guarantor of the Palm Finance loan.

Watley issued Bryan a 2007 Schedule K-1 reporting a $2.6 million loss. Watley included a nonpassive ordinary loss of $3 million attributable to Pool Boy in computing net profit/loss for 2007. Bryan reported the loss on his 2007 Schedule E, Supplemental Income and Loss, and to the extent it exceeded his income for that year, carried the loss forward as a net operating loss (NOL) to future years. In a notice of deficiency, the IRS disallowed Bryan's NOL deductions for 2010-2012 after determining that he did not have sufficient basis and was not at risk with respect to Pool Boy's activities. Bryan challenged the notice in the Tax Court.

Under Code Sec. 704(d), a partner's distributive share of a partnership loss is allowed only to the extent of the partner's basis in the partnership (i.e., outside basis). Under Code Sec. 752(a), an increase in a partner's share of partnership liabilities is treated as a contribution of money by the partner to the partnership, resulting in an increase of the partner's outside basis.

The amount of a partnership liability that is included in a partner's outside basis depends on whether the liability is recourse or nonrecourse. Reg. Sec. 1.752-1(a) defines recourse liability as a partnership liability to the extent that a partner or related person bears the economic risk of loss as to the liability. Under Reg. Sec. 1.752-2(b)(3), a partners bears the economic risk of loss to the extent that, in a constructive liquidation of the partnership, the partner or a related person would be obligated to make a payment on the liability. Reg. Sec. 1.752-2(h)(1) and (2) provide that a partner bears the economic risk of loss for a partnership liability to the extent of property the partner pledges as security for the liability (i.e., direct pledge) or property he contributes to the partnership solely for the purpose of securing a partnership liability (i.e., indirect pledge). However, Reg. Sec. 1.752-2(h)(4) specifies that a promissory note contributed to a partnership for the purpose of securing a partnership liability is not taken into consideration in determining the partner's economic risk of loss unless the note is readily tradeable on an established securities market.

In cases of tiered partnerships with recourse liabilities, Reg. Sec. 1.752-2(i) provides that the liabilities of a lower-tier partnership allocated to the upper-tier partnership equal the amount of economic risk of loss the upper-tier partnership bears with respect to the liabilities, plus any other liabilities for which the partners of the upper-tier partnership bear the economic risk of loss.

Under Code Sec. 465(a)(1), an individual taxpayer's loss deduction from certain activities is limited to the aggregate amount for which he or she is at risk for that activity. Code Sec. 465(b) provides that a taxpayer is at risk with respect to a particular activity to the extent of (1) money and adjusted basis of property he or she contributed to the activity and (2) amounts borrowed with respect to the activity for which the taxpayer is personally liable for repayment or has pledged property (other than property used in the activity) as security for the loan. In Pritchett v. Comm'r, 827 F.2d 644 (9th Cir. 1987), the Ninth Circuit held that a taxpayer is personally liable for repayment of borrowed money under Code Sec. 465(b)(2) if the taxpayer would be the "obligor of last resort."

Bryan argued that the Watley loss passed through to him because the notes from him to Watley and from Watley to Pool Boy were assets of the respective entities, and therefore collateral for the Palm Finance loan. Bryan also argued that he was at risk under Code Sec. 465 with respect to Pool Boy's movie making activity by relying on Melvin v. Comm'r, 88 T.C. 63 (1987), aff'd 894 F.2d 1072 (9th Cir. 1990). In Melvin, a partnership pledged assets, including a note from the taxpayer, as collateral for a loan. The lender required that the taxpayer's note be physically transferred to the bank in order to protect the bank's security interest. The Tax Court concluded that a taxpayer was at risk for the amounts borrowed by the partnership because he was personally liable for the borrowed money.

Analysis

The Tax Court sustained the IRS's determinations after finding that (1) Watley did not have sufficient basis in Pool Boy to deduct the $3 million loss from Pool Boy for 2007, (2) Bryan lacked sufficient basis in Watley to deduct the losses that Watley apportioned to him, and (3) Bryan was not at risk with respect to Pool Boy's movie making activity.

In the court's view, the Palm Finance loan did not result in an increase to Watley's basis in Pool Boy because none of Pool Boy's members were liable for the company's debts and would have no obligation to pay off the loan if Pool Boy lacked sufficient assets to satisfy the liability. Likewise, the court found that Bryan had no outside basis in Watley because under Reg. Sec. 1.752-2(i), Watley bore no economic risk of loss as to a Pool Boy liability, nor did Bryan bear any economic risk of loss as to a Pool Boy liability.

The court rejected Bryan's argument that his note and the Watley note were collateral for the Palm Finance loan. The court noted that Bryan and Watley did not personally provide any property as security for the loan, and the notes were contributed to the entities, not given to the lender nor specifically designated as collateral in the loan agreement. The court said that Palm Finance was possibly not aware of these notes at the time of the loan agreement. The notes therefore were not, in the court's view, a direct pledge under Reg. Sec. 1.752-2(h). The court also concluded that the notes were not an indirect pledge under Reg. Sec. 1.752-2(h)(4) because they were not readily tradeable on an established securities market.

On the issue of whether Bryan was at risk with respect to Pool Boy's movie making activity, the court found that it did not need to decide whether the Melvin case applied because Bryan's $2.7 million note was not a bona fide debt. The court observed that the note was unsecured, uncollateralized, and provided no payment schedule other than that it had to be fully repaid almost a quarter of a century after the date that the noted stated that it was made. The court also found no evidence that any amount was ever paid on the note or that Bryan had the ability to pay any significant portion of the note. In addition, the court found that Bryan did not establish that the $2.7 million note was executed in September 2007 or that either party to the note considered it to represent debt. In the court's view, Bryan had no business reason for executing the note and instead created it solely to support his position that he was at risk with respect to Pool Boy's activities.

For a discussion of the effect of liabilities on a partner's outside basis, see Parker Tax ¶24,620. For a discussion of the rules for determining the amount for which a taxpayer is considered to be at risk, see Parker Tax ¶247,520.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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