Rev. Rul. 78-175

Advice has been requested concerning the extent to which an individual taxpayer, in computing taxable income under the circumstances described below, may take into account losses attributable to an activity described in section 465 of the Internal Revenue Code of 1954.

In 1976, an individual taxpayer created a trust with a cash transfer of 100x dollars. The trust was structured in such a manner that the taxpayer was treated as the "owner" of the entire trust as that term is defined in subpart E of subchapter J of chapter 1 (sections 671-679) of the Code. Shortly after the trust was created, the trust purchased an interest in an oil and gas activity described in section 465(c) for 500x dollars. The trustee paid 100x dollars in cash and gave the seller a note in the face amount of 400x dollars on behalf of the trust. The note provided for full recourse against the trust with the interest in the activity as security. No other property was pledged as security for the amount borrowed. Under state law the taxpayer is not personally liable for the debts of the trust. For 1976, the loss from the activity attributable to the interest purchased by the trust was 125x dollars.

Section 465(a) of the Code provides, in part, that in the case of a taxpayer (other than a corporation that is neither an electing small business corporation as defined in section 1371(b) nor a personal holding company as defined in section 542) engaged in an activity to which section 465 applies, any loss from such activity for the taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk within the meaning of section 465(b) for such activity at the close of the taxable year.

Section 465(b)(1) of the Code provides, in part, that for purposes of section 465 a taxpayer shall be considered at risk for an activity with respect to amounts including (A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and (B) amounts borrowed with respect to such activity.

Section 465(b)(2) of the Code provides that the purposes of section 465 a taxpayer shall be considered at risk with respect to amounts borrowed for use in an activity to the extent the taxpayer is personally liable for repayment of such amounts or has pledged property, other than property used in the activity, as security for such borrowed amounts.

Section 465(b)(4) of the Code provides that notwithstanding any other provision of section 465, a taxpayer shall not be considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.

Section 671 of the Code provides that, where it is specified in sections 673 through 679 that a grantor or another person shall be treated as the owner of any portion of a trust, there shall be included in computing the taxable income and credits of the grantor or other person, the items of income, deductions, and credits of the trust attributable to the portion of the trust considered owned by such grantor or other person to the extent such items would be taken into account in computing the taxable income or credits of an individual.

Under section 1.671-3(a)(1) of the Income Tax Regulations, when a grantor or another person is treated under subpart E of subchapter J of chapter 1 of the Code, as the owner of an entire trust, such person must take into account in computing such person's income tax liability all items of income, deduction and credit to which that person would have been entitled had the trust not been in existence during the period that person is treated as owner. In the instant case, since under subpart E of subchapter J of chapter 1 of the Code the taxpayer is treated as the owner of the entire trust, in accordance with section 1.671-3(a)(1) of the regulations the taxpayer must take into account the items of income and deduction to which the taxpayer would have been entitled had the trust not been in existence. The taxpayer will thus be treated as being engaged in the section 465 activity of the trust for purposes of determining allowable losses. Furthermore, since the taxpayer is not personally liable for repayment of the 400x dollar loan to the trust and no property other than property used in the activity has been pledged by the taxpayer or the trust as security, under section 465(b) of the Code the taxpayer is not at risk with respect to that loan. The taxpayer is at risk only for the 100x dollars contributed to the provided under Title VII of the Civil Rights Act of 1964, even where the activity.

Accordingly, since the taxpayer is treated as being engaged in an activity to which section 465 of the Code applies, the taxpayer is allowed to deduct only 100x dollars of the 125x dollar loss from the activity.