Valley Forge, PA

In Hubert Enterprises Inc. v. Comr.,¹ the Tax Court ruled that a deficit restoration obligation (DRO) did not cause LLC members to be at risk with respect to recourse indebtedness of the LLC, making it even more difficult for limited partners and LLC members to satisfy the at-risk rules. Essentially, a limited partner or LLC member will not be considered at-risk with respect to an entity level recourse debt unless that partner/member is the “payor of last resort” with respect to the indebtedness.² The issue in Hubert Enterprises was whether a DRO caused the LLC members to become the payors of last resort with respect to LLC recourse debt.

In this case, the DRO provided that if any LLC member had a deficit in his or her capital account upon liquidation of his or her interest, the partner was required to restore the amount of the deficit balance to the partnership. In its original opinion, the Tax Court held that the DRO did not increase the LLC members' amount at-risk because it was contingent upon liquidation of a member's interest. The Tax Court did not give a detailed “payor of last resort” analysis. The Court of Appeals remanded the case on this issue in order for the Tax Court to determine whether the LLC members were the “payors of last resort” with respect to the LLC debt.³ The Tax Court applied the “payor of last resort” analysis and affirmed its decision that the LLC members were not at-risk as a result of the DRO.⁴

There were several facts weighing against the taxpayers in Hubert Enterprises. The LLC members had not personally guaranteed the LLC debt. In addition, the LLC agreement included a provision that specifically stated that no part of the agreement (including the DRO) could be construed as giving any third-party any rights or remedies. The Tax Court pointed out both of these facts in holding that the DRO was not, in and of itself, sufficient to make the LLC members payors of last resort. The court also focused on the fact that the DRO was contingent on both a liquidation of the LLC member's interest and a deficit in the member's capital account. In addition, the DRO did not obligate an LLC member to contribute a fixed amount equal to its share of the unpaid debt and did not require the contribution to be paid to creditors (the contribution could be distributed to partners with positive capital account balances).

The Tax Court's analysis in this case is concerning in some respects. First, it is arguably unreasonable to require that a limited partner or LLC member guarantee entity level debt in order to be considered at-risk. Personally guaranteeing the debt defeats the purpose of being a limited partner or LLC member, which is generally to avoid personal liability for entity level debts. Second, there is a solid argument that in a worst case scenario, the partnership/LLC liquidates, there are no funds to pay the debt, and the DRO obligates the partners to contribute the full amount of the debt. In the context of §752, relevant to determining whether a partner/LLC member has the economic risk of loss with respect to entity level recourse debt, the test used assumes a constructive liquidation in which all of the entity's debt become payable in full and the entity's assets are worthless. If a similar test were used in Hubert Enterprises to analyze who was the payor of last resort, the DRO would, in fact, obligate the LLC members to contribute the full amount of the LLC debt.

On the other hand, the Tax Court's conclusion in Hubert Enterprises is not necessarily inconsistent with prior cases. In almost every case that has analyzed the payor of last resort test in the context of a limited partner or LLC member, the limited partner or LLC member personally guaranteed or assumed the partnership/LLC debt.⁵

It remains to be seen whether this decision is appealed and, if so, what the Sixth Circuit does with it. For now, it has become increasingly more difficult for limited partners and/or LLC members to increase their amount at-risk without personally guaranteeing or assuming entity level debt.

For more information, in the Tax Management Portfolios, see Starczewski, 550 T.M., At-Risk Rules, and in Tax Practice Series, see ¶2970, The At-Risk Rules.