By Jonathan Levy
First published in Flight Levels Online, Winter 2014 issue
When a financed aircraft is owned in a special-purpose company, which lacks assets other than the aircraft, it is typical and understandable for the financing bank to insist that that loan be guaranteed by another, more solvent person or company. In fact, banks will often seek multiple, overlapping guarantees — for example, from both spouses of a couple or from an individual and another company owned by that individual. These overlapping guarantees will provide the bank the right, in the case of default, to collect from any of the guarantors in order to make the bank whole. However, a recent court case, Moreno v. U.S. (Federal District Court Louisiana, May 19, 2014) placed such guarantees in a different light. In Moreno, the IRS attempted a wide array of arguments to assess additional tax. The sole argument the court accepted creates surprising and negative tax consequences for overlapping loan guarantees.
The Moreno Case
The facts of Moreno (altered here for simplification) involved an individual taxpayer who was the sole owner of an LLC, which owned an aircraft. The LLC received tax flow-through treatment, meaning that items of income and expense of the LLC flowed through to the individual’s 1040 tax return. The LLC had borrowed money from a bank to finance the aircraft acquisition, and the loan was guaranteed both by the taxpayer individually, and by another, larger company (“Company X”) that the taxpayer also owned. Thus, in an economic sense, all the parties involved could be thought of as “being” the individual taxpayer (i.e., he and the two companies he owned). But, in a legal sense, the three were distinct.
The LLC had purchased the aircraft for $1 million with no down payment (100 percent financed) and was entitled to $600,000 tax depreciation of the aircraft (and, because we are already simplifying the facts, we will assume this depreciation to be the only income/expense item the LLC had for the year). Because of the flow-through nature of the LLC, the individual sought to claim this depreciation on his individual tax return as an expense, allowing him to offset other income received and pay less tax.
At Risk Rules Pose an Obstacle
The “at risk” rule of Section 465 of the Internal Revenue Code provides that an individual taxpayer may only deduct loss from an activity (in this case the LLC) “to the extent of the aggregate amount with respect to which the taxpayer is at risk.” An individual’s amount “at risk” can include “amounts borrowed” in the activity (in this case, the LLC’s loan to purchase the aircraft), to the extent the individual is “personally liable for the repayment of such amounts.” Because, in Moreno, the individual had guaranteed the LLC loan, he was personally liable for repayment of it and, therefore, at risk (at least, so far through the analysis). However, an individual’s amount “at risk” is reduced “with respect to amounts protected against loss….” So the Moreno court considered whether the individual “was protected against loss” if the LLC were to default and the bank were to sue the individual under his guarantee for recovery of the loan.
The court found a partial protection against loss to be present under the legal doctrine of contribution. Under this doctrine, if the bank sues one of the two guarantors for the full amount of the loan, that guarantor can, in turn, sue the other guarantor for “contribution,” requiring the other guarantor to pay its half of the liability. The theory is that the overlapping guarantee arrangement was not intended give the lender the right to stick one guarantor or the other with the full amount of the liability. But, rather, the goal was to have the guarantors split the responsibility, but maximize the lender’s likelihood of full recovery by giving it the power to recover the full amount from either, in case one became insolvent.
Under our simplified facts, this means that the Moreno individual had an “at risk” amount of $500,000 — half of the $1million loan amount. (The other half is not at risk because of his right of contribution against Company X.) This means that the individual is not able to take advantage of the full $600,000 depreciation deduction but, instead, only $500,000. The remaining $100,000 deduction is not lost, but is suspended for later use when/if the individual’s at-risk is increased.
This legal conclusion elevates fiction over substance by imagining that the individual’s option to sue his own company (Company X, the other guarantor) under the doctrine of contribution provides the individual with meaningful relief. A more rational approach would be to recognize that, because the individual owns Company X, a loss by Company X is equivalent to a loss by the individual and find him, therefore, at risk for the whole amount. Unfortunately, the Moreno court rejected this point of view.
Planning Remedy
The problem in Moreno was that some of the “at risk” associated with the aircraft financing was allocated to Company X, which was not the flow-through owner of the aircraft and, therefore, not the recipient of the aircraft depreciation deductions. The reasons the “at risk” was thus allocated were (1) that Company X had guaranteed the loan, and (2) in the event the bank recovered against the individual (who was the aircraft’s flow-through owner), Company X would be required, under the doctrine of contribution, to partially reimburse the individual.
The planning approaches are promising. Most obviously, taxpayers could ask their lending institutions to be satisfied with guarantees solely from the flow-through aircraft owners. If, in Moreno, the individual had been the sole guarantor of the loan, the at-risk division in the case would not have arisen.
Unfortunately, this approach is likely not practical, as lenders will want to maximize their recovery rights, regardless of the tax consequences this might have for their borrowers. A more practical approach may be to draft contracts between the guarantors (“Contribution Agreements”), specifically setting out what contribution rights each has in case the lender exercises a guarantee. The nature of these agreements would be to shift the burden solely to the flow-through owner of the aircraft; the flow-through owner would waive his/her right to contribution from the other/s; the other/s would receive a 100 percent contribution right from the flow-through owner.
It is unclear how courts would view such agreements in shaping the analysis of “at risk,” but the logic of Moreno suggests that such shifting could be effective by overriding the default legal rules of contribution with specific terms chosen by the parties to govern their particular arrangement.
This memorandum is not a definitive treatment of the subject and has omitted discussion of various rules. Be sure to consult the regulations themselves and a tax professional before making any decisions.
Jonathan Levy, Esq. is Legal Advisor of Advocate Consulting Legal Group, PLLC, a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, Federal Aviation Regulations, and other related organizational and operational issues.
IRS Circular 230 Disclosure: New IRS rules impose requirements concerning any written federal tax advice from attorneys. To ensure compliance with those rules, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under federal tax laws, specifically including the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
