Which Type of Debt Should Your Partnership Have?

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April 8, 2013
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May 15, 2013

Which Type of Debt Should Your Partnership Have?

By DJ Berry

Liabilities are an often overlooked topic of importance for partnerships. In theory, partners are going to be personally liable for partnership debts. Because of this, any liabilities that exist have the potential to do two things: first, increase the loss a partner will experience if the partnership ever dissolves; second, increase the amount of losses that can be deducted by the partner during the operation of the partnership. Both of these effects are generally desired because they can benefit the taxpayer, so why are these liabilities so misunderstood?

Recourse Debt

The first problem is that the type of liability is often difficult to determine. There are two types of liabilities: recourse and nonrecourse. While the IRS code provides confusing definitions of recourse debt, it can essentially be stated as this – if the company was to fold today, who would be liable for any remaining debt? In a general partnership, this would usually be all of the partners, and would include all debt, even accounts payable. In an LLC, this might not be any partners, or any of the debt. The terms of the partnership agreement could alter who bears the risk of economic loss – no two partnerships are exactly alike.

Nonrecourse Debt

Conversely, nonrecourse debt refers to a liability for which no partner bears the economic risk of loss. In its purest sense, only the creditor would bear the economic risk of loss for a nonrecourse liability. Normally, nonrecourse loans are found in the field of real estate, since a creditor would be able to foreclose on the property, rather than trying to force a partner to be personally responsible for the debt.

A Partner’s Personal Tax Return

It is important to determine the type of liability because nonrecourse debt will typically NOT increase basis, but recourse debt will. Increasing basis increases the potential for possible loss deductions on the partner’s tax return, since an increased basis means an increased at-risk amount. Put another way, the more the taxpayer’s at-risk amount increases, the more loss they can report on their personal return from the partnership/LLC.

As you can see, the type of debt a partnership utilizes can be extremely important for tax purposes, especially concerning losses. Please feel free to contact members of the tax department at Blackburn, Childers & Steagall if you would like aid in determining the type of debt that might be most beneficial to your situation.

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