[Federal Register Volume 69, Number 85 (Monday, May 3, 2004)]
[Rules and Regulations]
[Pages 24078-24080]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-10010]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9124]
RIN 1545-BA69


At-Risk Limitations; Interest Other Than That of a Creditor

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: These regulations finalize the rules relating to the 
treatment, for purposes of the at-risk limitations, of amounts borrowed 
from a person who has an interest in an activity other than that of a 
creditor or from a person related to a person (other than the borrower) 
with such an interest. These regulations affect taxpayers subject to 
the at-risk limitations and provide them with guidance necessary to 
comply with the law.

DATES: Effective Date: These regulations are effective May 3, 2004.
    Applicability Date: For dates of applicability, see Sec. Sec.  
1.465-8(e) and 1.465-20(d).

FOR FURTHER INFORMATION CONTACT: Tara P. Volungis or Christopher L. 
Trump, 202-622-3070 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 1 to provide rules 
relating to the treatment, for purposes of the at-risk limitations 
under section 465 of the Internal Revenue Code (Code), of amounts 
borrowed from a person who has an interest in an activity other than 
that of a creditor. On June 5, 1979, the IRS published in the Federal 
Register (44 FR 32235) proposed regulations (LR-166-76) relating to the 
treatment of investments in certain activities under section 465 of the 
Code. On July 8, 2003, a notice of proposed rulemaking (REG-209377-89) 
amending Sec. Sec.  1.465-8 and 1.465-20 of the proposed regulations 
was published in the Federal Register (68 FR 40583). No comments were 
received from the public in response to the notice of proposed 
rulemaking. No public hearing was requested or held. The proposed 
regulations under Sec. Sec.  1.465-8 and 1.465-20 are adopted by this 
Treasury decision.

Explanation of Provisions

    Section 465 limits the deductibility of losses to a taxpayer's 
economic investment (the amount at risk) in the activity at the close 
of a taxable year. A

[[Page 24079]]

taxpayer is generally considered at risk in an activity to the extent 
of cash and the adjusted basis of property contributed by the taxpayer 
to the activity. In general, a taxpayer's amount at risk also includes 
any amounts borrowed for use in the activity if the taxpayer is 
personally liable for repayment or if property other than property used 
in the activity is pledged as security.
    Under section 465(b)(3), amounts borrowed for use in an activity 
will not increase the borrower's amount at risk in the activity if the 
lender has an interest other than that of a creditor in the activity (a 
disqualifying interest) or if the lender is related to a person (other 
than the borrower) who has a disqualifying interest in the activity. 
This rule applies even if the borrower is personally liable for the 
repayment of the loan or the loan is secured by property not used in 
the activity. Section 465(c)(3)(D) provides that this rule applies to 
new activities (activities that were not subject to section 465 before 
1978) only to the extent provided in regulations.
    These regulations apply the rule of section 465(b)(3) to new 
activities and provide rules for determining when a person has an 
interest in an activity other than that of a creditor. Additional rules 
are provided with respect to related persons, interests as a 
shareholder, and qualified nonrecourse financing.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations and, because 
these regulations do not impose on small entities a collection of 
information requirement, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis 
is not required. Pursuant to section 7805(f) of the Code, the notice of 
proposed rulemaking preceding these regulations was submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

Drafting Information

    The principal authors of these regulations are Tara P. Volungis and 
Christopher L. Trump of the Office of Associate Chief Counsel 
(Passthroughs and Special Industries). However, other personnel from 
the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
1. The authority citation for part 1 is amended by adding entries in 
numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805. * * *
    Section 1.465-8 also issued under 26 U.S.C. 465.
    Section 1.465-20 also issued under 26 U.S.C. 465. * * *
0
2. Sections 1.465-8 and 1.465-20 are added to read as follows:


Sec.  1.465-8  General rules; interest other than that of a creditor.

    (a) In general--(1) Amounts borrowed. This section applies to 
amounts borrowed for use in an activity described in section 465(c)(1) 
or (c)(3)(A). Amounts borrowed with respect to an activity will not 
increase the borrower's amount at risk in the activity if the lender 
has an interest in the activity other than that of a creditor or is 
related to a person (other than the borrower) who has an interest in 
the activity other than that of a creditor. This rule applies even if 
the borrower is personally liable for the repayment of the loan or the 
loan is secured by property not used in the activity. For additional 
rules relating to the treatment of amounts borrowed from these persons, 
see Sec.  1.465-20.
    (2) Certain borrowed amounts excepted. (i) For purposes of 
determining a corporation's amount at risk, an interest in the 
corporation as a shareholder is not an interest in any activity of the 
corporation. Thus, amounts borrowed by a corporation from a shareholder 
may increase the corporation's amount at risk.
    (ii) For purposes of determining a taxpayer's amount at risk in an 
activity of holding real property, paragraph (a)(1) of this section 
does not apply to financing that is secured by real property used in 
the activity and is either--
    (A) Qualified nonrecourse financing described in section 
465(b)(6)(B); or
    (B) Financing that, if it were nonrecourse, would be financing 
described in section 465(b)(6)(B).
    (b) Loans for which the borrower is personally liable for 
repayment--(1) General rule. If a borrower is personally liable for the 
repayment of a loan for use in an activity, a person shall be 
considered a person with an interest in the activity other than that of 
a creditor only if the person has either a capital interest in the 
activity or an interest in the net profits of the activity.
    (2) Capital interest. For the purposes of this section a capital 
interest in an activity means an interest in the assets of the activity 
which is distributable to the owner of the capital interest upon the 
liquidation of the activity. The partners of a partnership and the 
shareholders of an S corporation are considered to have capital 
interests in the activities conducted by the partnership or S 
corporation.
    (3) Interest in net profits. For the purposes of this section it is 
not necessary for a person to have any incidents of ownership in the 
activity in order to have an interest in the net profits of the 
activity. For example, an employee or independent contractor any part 
of whose compensation is determined with reference to the net profits 
of the activity will be considered to have an interest in the net 
profits of the activity.
    (4) Examples. The provisions of this paragraph may be illustrated 
by the following examples:

    Example 1. A, the owner of a herd of cattle sells the herd to 
partnership BCD. BCD pays A $10,000 in cash and executes a note for 
$30,000 payable to A. The three partners, B, C, and D, each assumes 
personal liability for repayment of the amount owed A. In addition, 
BCD enters into an agreement with A under which A is to take care of 
the cattle for BCD in return for compensation equal to 6 percent of 
BCD's net profits from the activity. Because A has an interest in 
the net profits of BCD's farming activity, A is considered to have 
an interest in the activity other than that of a creditor. 
Accordingly, amounts payable to A for use in that activity do not 
increase the partners' amount at risk even though the partners 
assume personal liability for repayment.
    Example 2. Assume the same facts as in Example 1 except that 
instead of receiving compensation equal to 6 percent of BCD's net 
profits from the activity, A instead receives compensation equal to 
1 percent of the gross receipts from the activity. A does not have a 
capital interest in BCD. A's interest in the gross receipts is not 
considered an interest in the net profits. Because B, C, and D 
assumed personal liability for the amounts payable to A, and A has 
neither a capital interest nor an interest in the net profits of the 
activity, A is not considered to have an interest in the activity 
other than that of a creditor with respect to the $30,000 loan. 
Accordingly, B, C, and D are at risk for their share of the loan if 
the other provisions of section 465 are met.
    Example 3.  Assume the same facts as in Example 1 except that 
instead of receiving compensation equal to 6 percent of BCD's net 
profits from the activity, A instead receives

[[Page 24080]]

compensation equal to 6 percent of the net profits from the activity 
or $15,000, whichever is greater. A is considered to have an 
interest in the net profits from the activity and accordingly will 
be treated as a person with an interest in the activity other than 
that of a creditor.

    (c) Nonrecourse loans secured by assets with a readily 
ascertainable fair market value--(1) General rule. This paragraph shall 
apply in the case of a nonrecourse loan for use in an activity where 
the loan is secured by property which has a readily ascertainable fair 
market value. In the case of such a loan a person shall be considered a 
person with an interest in the activity other than that of a creditor 
only if the person has either a capital interest in the activity or an 
interest in the net profits of the activity.
    (2) Example. The provisions of this paragraph (c) may be 
illustrated by the following example:

    Example. X is an investor in an activity described in section 
465(c)(1). In order to raise money for the investment, X borrows 
money from A, the promoter (the person who brought X together with 
other taxpayers for the purpose of investing in the activity). The 
loan is secured by stock unrelated to the activity which is listed 
on a national securities exchange. X's stock has a readily 
ascertainable fair market value. A does not have a capital interest 
in the activity or an interest in its net profits. Accordingly, with 
respect to the loan secured by X's stock, A does not have an 
interest in the activity other than that of a creditor.

    (d) Nonrecourse loans secured by assets without a readily 
ascertainable fair market value--(1) General rule. This paragraph shall 
apply in the case of a nonrecourse loan for use in an activity where 
the loan is secured by property which does not have a readily 
ascertainable fair market value. In the case of such a loan a person 
shall be considered a person with an interest in the activity other 
than that of a creditor if the person stands to receive financial gain 
(other than interest) from the activity or from the sale of interests 
in the activity. For the purposes of this section persons who stand to 
receive financial gain from the activity include persons who receive 
compensation for services rendered in connection with the organization 
or operation of the activity or for the sale of interests in the 
activity. Such a person will generally include the promoter of the 
activity who organizes the activity or solicits potential investors in 
the activity.
    (2) Example. The provisions of this paragraph (d) may be 
illustrated by the following example:

    Example. A is the promoter of an activity described in section 
465(c)(1). As the promoter, A organizes the activity and solicits 
potential investors. For these services A is paid a flat fee of 
$130x. This fee is paid out of the amounts contributed by the 
investors to the activity. X, one of the investors in the activity, 
borrows money from A for use in the activity. X is not personally 
liable for repayment to A of the amount borrowed. As security for 
the loan, X pledges an asset which does not have a readily 
ascertainable fair market value. A is considered a person with an 
interest in the activity other than that of a creditor with respect 
to this loan because the asset pledged as security does not have a 
readily ascertainable fair market value, X is not personally liable 
for repayment of the loan, and A received financial gain from the 
activity. Accordingly, X's amount at risk in the activity is not 
increased despite the fact that property was pledged as security.
    (e) Effective date. This section applies to amounts borrowed after 
May 3, 2004.


Sec.  1.465-20  Treatment of amounts borrowed from certain persons and 
amounts protected against loss.

    (a) General rule. The following amounts are treated in the same 
manner as borrowed amounts for which the taxpayer has no personal 
liability and for which no security is pledged--
    (1) Amounts that do not increase the taxpayer's amount at risk 
because they are borrowed from a person who has an interest in the 
activity other than that of a creditor or from a person who is related 
to a person (other than the taxpayer) who has an interest in the 
activity other than that of a creditor; and
    (2) Amounts (whether or not borrowed) that are protected against 
loss.
    (b) Interest other than that of a creditor; cross reference. See 
Sec.  1.465-8 for additional rules relating to amounts borrowed from a 
person who has an interest in the activity other than that of a 
creditor or is related to a person (other than the taxpayer) who has an 
interest in the activity other than that of a creditor.
    (c) Amounts protected against loss; cross reference. See Sec.  
1.465-6 for rules relating to amounts protected against loss.
    (d) Effective date. This section applies to amounts borrowed after 
May 3, 2004.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
Gregory F. Jenner,
Acting Assistant Secretary of the Treasury.
[FR Doc. 04-10010 Filed 4-30-04; 8:45 am]
BILLING CODE 4830-01-P