If you are an owner of a partnership or Limited Liability Company interest, you may wonder why your K1 shows allocations of debt. Understanding how debt is allocated can also help you understand how this allocation affects your ability to take losses on your tax return.
To determine your tax basis, start with the initial contribution you made to the investment. Then you add additional contributions and profits since inception. And finally, you subtract distributions and losses since inception. The ending number is your tax basis. If you receive a loss allocation and do not have sufficient basis, the loss can be suspended until you have sufficient basis to take the loss.
A potential relief to suspended losses is if the taxpayer has debt basis, commonly called “at risk” basis. At risk basis means that as an owner you are “at risk” of having to help the company pay this debt upon liquidation. This is where the allocations on your K1 come into play.
It is important to understand the Internal Revenue Service (IRS) rules for allocation of liabilities and how they affect your ability to take losses. IRS Code 752 covers treatment of liabilities on partnerships or Limited Liability Companies treated as partnerships. There are several categories of debt: bifurcated, exculpatory, nonrecourse, nonrecourse member loan, qualified nonrecourse, recourse, and wrapped. Each category is subject to various rules on the allocation to owners of a business. Here is a brief summary:
- Bifurcated debt can be either recourse or nonrecourse in nature. If there is a portion of the debt that the owners do not bear economic risk of loss, that portion is not allocated to the owners. The portion that the owners are at risk for will be treated as recourse debt to the owners who bear economic risk of loss and will be allocated to them.
- Exculpatory debt is not secured by specific partnership or LLC property and no owner has personal liability for them. Normally this type of debt is allocated in accordance with the profit sharing ratios.
- Nonrecourse debt is a liability of the partnership where no owner bears the risk of loss. The creditor is the only one at risk of loss. Normally this type of debt is allocated in accordance with the profit sharing ratios.
- Nonrecourse member loans are a loan that if made by an unrelated person would be considered nonrecourse debt because no owner is personally liable. This debt will be categorized as recourse debt for basis purposes and allocated to the member who loaned the money.
- Qualified Nonrecourse debt is debt borrowed in the connection of an activity that is holding real property.
- The loan must come from either a business that is generally in the business of making loans (i.e. a bank) or guaranteed by a federal, state or local government.
- It cannot be made by the seller of the property or from a related person.
- No person can per personally liable for repayment and it cannot be convertible debt.
- Recourse debt is where an owner is obligated to make the payment to the creditor upon liquidation. This debt is allocated directly to the owner who is at risk of loss.
- Wrapped debt is debt that is wrapped around an original debt. For example, there is a first mortgage on a piece of property that is contributed. The owner that contributes the property still maintains the debt, but the company takes a loan out on the same property. This results in “wrapped” debt. On this debt the loans are looked at independently to determine the allocation of the full debt.
Debt allocations can get complicated and not all debt will add to your debt basis. If you would like more information, reach out using the form below.