10.19 Amounts Not At Risk

The following may not be treated as part of basis for at-risk purposes in determining your tax position in a business or investment:

Liabilities for which you have no personal liability, except in the case of certain real estate financing (10.18).
Liabilities for which you have personal liability, but the lender also has a capital or profit-sharing interest in the venture; but see the exception in 10.18.
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Lender Has Interest
Even if you are personally liable for a debt, you may not be considered at risk if the lender has an interest in the activity other than as a creditor (10.18).
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Recourse liabilities convertible to a nonrecourse basis.
Money borrowed from a relative listed in 5.6 who has an interest in the venture, other than as a creditor, or from a partnership in which you own more than a 10% interest.
Funds borrowed from a person whose recourse is solely your interest in the activity or property used in the activity.
Amounts for which your economic loss is limited by a nonrecourse financing guarantee, stop-loss agreement, or other similar arrangement.
Investments protected by insurance or loss reimbursement agreement between you and another person. If you are personally liable on a mortgage but you separately obtain insurance to compensate you for any mortgage payments, you are at risk only to the extent of the uninsured portion of the personal liability. You may, however, include as at risk any amount of premium paid from your personal assets. Taking out casualty insurance or insurance protecting you against tort liability is not considered within the at-risk provisions, and such insurance does not affect your investment basis.
EXAMPLES
1. Some commercial feedlots in livestock feeding operations may reimburse investors against any loss sustained on sales of the livestock above a stated dollar amount per head. Under such “stop-loss” orders, an investor is at risk only to the extent of the portion of his or her capital against which he or she is not entitled to reimbursement. Where a limited partnership makes an agreement with a limited partner that, at the partner’s election, his or her partnership interest will be bought at a stated minimum dollar amount (usually less than the investor’s original capital contribution), the partner is considered at risk only to the extent of his or her investment exceeding the guaranteed repurchase price.
2. A TV film promoter sold half-hour TV series programs to individual investors. Each investor gave a cash down payment and a note for which he or she was personally liable for the balance. Each investor’s note, which was identical in face amount, terms, and maturity date, was payable out of the distribution proceeds from the film. Each investor also bought from the promoter the right to the unpaid balance on another investor’s note. The promoter arranged the distribution of the films as a unit and was to apportion the sales proceeds equally among the investors.
The IRS held that each investor is not at risk on the investment evidenced by the note. Upon maturity, each may receive a payment from another investor equal to the one that he or she owes.
3. A gold mine investment offered tax write-offs of four times the cash invested. For $10,000 cash, an investor bought from a foreign mining company a seven-year mineral claim lease to a gold reserve. Under the lease, he could develop and extract all of the gold in the reserve. At the same time, he agreed to spend $40,000 to develop the lease before the end of the year. To fund this commitment, the investor authorized the promoter to sell an option for $30,000 to a third party who was to buy all the gold to be extracted. The $30,000 along with the $10,000 down payment was to be used to develop the reserve. The promoter advised the investor that he could claim a $40,000 deduction for certain development costs.
The IRS ruled that $30,000 was not deductible because the amount was not “risk capital.” The investor got $30,000 by selling an option that could be exercised only if gold were found. If no gold were found, he would be under no obligation to the option holder. The investor’s risk position for the $30,000 was substantially the same as if he had borrowed from the option holder on a nonrecourse basis repayable only from his interest in the activity.
The Tax Court struck down a similar plan on different grounds. Without deciding the question of what was at risk, the court held that the option was only a right of first refusal. Thus, $30,000 was taxable income to the investor in the year of the arranged sale.
4. David Krepp, an investor, purchases cattle from a rancher for $10,000 cash and a $30,000 note payable to the rancher. Krepp is personally liable on the note. In a separate agreement, the rancher agrees to care for the cattle for 6% of Krepp’s net profits from the cattle activity. Krepp is considered at risk for $10,000; he may not increase the amount at risk by the $30,000 borrowed from the rancher.

Limited partner’s potential cash call.

Under the terms of a partnership agreement, limited partners may be required to make additional capital contributions under specified circumstances. Whether such a potential cash call increases the limited partner’s at-risk amount has been a matter of dispute.

In one case, the IRS and Tax Court held that a limited partner was not at risk with respect to a partnership note where, under the terms of the partnership agreement, he could be required to make additional capital contributions if the general partners did not pay off the note at maturity. The possibility of such a potential cash call was too uncertain; the partnership might earn profits to pay off the note and even if there were losses, the general partners might not demand additional contributions from the limited partners.

However, a federal appeals court reversed, holding that the limited partner was at risk because his obligation was mandatory and “economic reality” insured that the general partners would insure their rights by requiring the additional capital contribution.

In another case, limited partners relied upon the earlier favorable federal appeals court decision to argue that they were at risk where they could be required by the general partners to make additional cash contributions, but only in order to cover liabilities or expenses that could not be paid out of partnership assets. So long as the partnership was solvent, the limited partners could “elect out” of the call provision. Because of this election, the Tax Court held that the limited partners’ obligation was contingent, rather than unavoidable as in the earlier federal appeals court case. Thus, the cash call provision did not increase their at-risk amount.

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