Abandoning a partnership interest: is the loss ordinary or capital? (includes related article) (Cover Story)by Sellers, Brian
Losses in a partnership interest may be claimed when it is either abandoned or becomes worthless. At what point is this determination made? Two recent cases address this issue, and one of them deals with the question of whether the loss is capital or ordinary. A recent revenue ruling on the matter is presented as a sidebar.
While partnerships are traditionally associated with the practice of law, medicine, public accounting, and other professions, they are also frequently used with venture business enterprises. Small groups of investors who wish to pool their resources for a limited period to pursue a business venture find partnerships an attractive alternative to incorporation. Partnerships are easy to form, pay no income tax, and are easy to terminate once the venture is complete. Of course, venture partnerships do not always succeed and the interes acquired in a partnership may become worthless to the investor. Depending on th investor's financial position, it may be more advantageous simply to abandon hi or her interest than contribute additional cash to a failing enterprise.
Plummeting real estate values and a less than robust economy have focused attention on the tax treatment of losses almost as frequently as on the treatment of gains. Previously sound tax shelters are springing leaks, and investors are getting soaked. To mitigate their losses, investors are abandonin partnership interests and claiming a loss under IRC Sec. 165(a), which entitles a taxpayer to a deduction for losses sustained upon the abandonment, or from th worthlessness of property. Due to changes in tax law and recent court decisions however, taxpayers must avoid falling into tax traps when retreating from faile business ventures. To succeed in claiming a loss deduction, several tax issues must be addressed. The issues include the point at which the property became worthless or abandoned, and whether the loss should be classified as ordinary o capital. An analysis of recent case law may provide some guidance in making these determinations.
Generally, a taxpayer is entitled to a deduction for losses sustained upon the abandonment, or from the worthlessness of property, provided he or she is not reimbursed by insurance or given some other compensation for the loss. The loss is allowed for a deduction only for the taxable year in which it is sustained, and it must be evidenced by closed and completed transactions and fixed by identifiable events. The taxpayer is entitled to a loss equal to the adjusted basis of the property. For individuals, such losses are deductible only if incurred in a trade or business, in a transaction entered into for profit, or from casualty or theft.
Generally, a loss allowed under IRC Sec. 165(a) is an ordinary loss because a capital loss results from the sale or exchange of a capital asset. Therefore, even in the case of capital assets, the loss may still be characterized as ordinary because abandonment or worthlessness is not a sale or exchange. However, if the taxpayer receives some form of consideration for abandoning the asset, regardless how nominal the consideration, the transaction becomes a sale or exchange, and the loss is a capital loss. Additionally, if the abandoned asset is encumbered by a liability and relinquishment of the asset relieves the taxpayer of the liability, the transaction is considered a sale or exchange, an any loss is a capital loss subject to IRC Secs. 1211 and 1212. Pursuant to IRC Sec. 1211, a taxpayer may deduct capital losses only to the extent of capital gains incurred during the year plus up to an additional $3,000. Given this limitation on capital loss deductions, it is usually more beneficial to characterize the loss as ordinary rather than capital.
While a partnership may not be prepared to abandon its assets, courts have permitted a partner to abandon his or her partnership interest or claim a loss from its worthlessness. Unfortunately, there is very little statutory authority regarding the conditions or method under which a partner is allowed to claim a deduction for the abandonment or worthlessness of a partnership interest. However, two recent cases make it clear that a partner (limited or general) may abandon a partnership interest and claim a loss not to exceed the unrecovered basis of the partnership interest. In Echols v. Commissioner, (935 F 2d 703, 1991) the Fifth Circuit Court of Appeals reversed the judgment of the Tax Court and allowed Echols, a general partner in a real estate partnership, to deduct a loss from the abandonment of his partnership interest. In Citron v. Commissioner, (97 TC 200, 1991) the Tax Court permitted Citron, a limited partner, to deduct his unrecovered investment in a partnership as an abandonmen loss and addressed the issue of how such a loss is characterized.
The Echols Case
Prior to 1974, John C. Echols owned a 37.5% interest in a partnership known as Freeway. An identical interest was owned by Scott Mann with the remaining 25% partnership interest owned by Joe Smith. Freeway's only asset was an unimproved tract of land in Houston, Texas. Mann obtained a loan (guaranteed by Echols) fo the down payment on the property. The remainder of the purchase price was financed by the seller of the land on a nonrecourse basis. Freeway planned to resell the land at a profit, based on a new highway proposed to be built adjacent to the land, which Freeway's partners expected would attract development to their property.
In 1974, local opposition stalled plans for construction, and the real estate market in the Houston area went into a slump. Freeway was unable to sell the land, and Mann was unable to service the debt incurred for the down payment on the land. Consequently, Mann and Echols entered into an agreement by which Mann transferred his interest to Echols in exchange for Echols' assumption of the recourse debt that encumbered the land.
In May of 1976, Echols called a meeting of the partners, at which time he informed them he would not continue to make his share of the mortgage payments, or the ad valorem tax payments on the land. Echols offered to convey his interest in Freeway to anyone who would "step forward and assume his portion of the nonrecourse payment obligation," but no one showed any interest. By this time, the fair market value of the land was less than the principal balance of the outstanding mortgage. Subsequent efforts to restructure the debt failed, an efforts to sell the land ceased. The land was foreclosed on by its mortgagees i February 1977.
Echols claimed a capital-loss deduction from the abandonment of his partnership interest. The Tax Court denied the deduction, focusing on the lack of identifiable steps taken by the partnership to manifest its abandonment of the land. However, the Fifth Circuit reversed the decision, noting that the Tax Court failed to make two very important distinctions in analyzing the case. First, this case involves the income tax returns of Mr. and Mrs. Echols as individual taxpayers, not those of the Freeway partnership. The second distinction was between "abandonment" and "worthlessness." Either concept can justify a deduction pursuant to IRC Sec. 165(a) under the proper circumstances. Each is separate in theory. The elements of one are separate and distinct from the other and must be addressed separately. The Tax Court and the IRS failed to recognize these distinctions that resulted in a reversible error. In reversing the Tax Court decision, the Court did not address, or even acknowledge, that Echols had claimed a capital loss rather than an ordinary loss.
Abandonment. There is no requirement that a taxpayer relinquish title to an asset to establish a loss if such loss is reasonably certain in fact and ascertainable in amount. However, the Tax Court focused on Freeway's abandonmen of the real estate and not, as was required, on Echols' abandonment of his interest in the Freeway partnership. The Court concluded the Tax Court was clearly in error by taking this approach. Therefore, the Court considered the facts surrounding Echols' abandonment of his interest in the partnership.
Focusing on the actions of Echols, the Court concluded he had sufficiently manifested his intent to abandon and did in fact abandon his partnership interest in 1976. He was entitled to a loss deduction under IRC Sec. 165(a). Th Court ruled that to establish an abandonment loss, the taxpayer must manifest a intent to abandon by some overt act or statement reasonably calculated to notif a third party of the abandonment. As noted by the Tax Court, conveyance or even tender of title is not necessary to consummate an abandonment. The announcement by Echols at the partnership meeting, combined with the overt act of refusing t make further mortgage and tax payments, comprised a clear indication to others he was relinquishing his partnership interest and were sufficient to establish the abandonment.
Worthlessness. The Tax Court entirely failed to address the issue of worthlessness, which is an alternate ground for a loss deduction under IRC Sec. 165(a). As an alternative holding, the Court concluded the facts found by the Tax Court evidenced the worthlessness of the partnership interest to Echols, thereby qualifying him for a loss deduction on the grounds his interest was worthless. While the abandonment test is objective, the test for worthlessness is based on a combination of objective and subjective criteria. To illustrate the subjective nature of worthlessness as a tax term, the Court quoted James Russell Lowell, "one man's trash is another man's treasure."
The Court used a two-prong test to determine if Echols was entitled to a loss deduction for worthless property. First, Echols must have determined subjectively during 1976 that his partnership interest had become worthless during that year, and, second, it must be objectively true the interest was essentially valueless to Echols at that time. The fact the interest might be of value to some other investor, or determined to be worthless in an earlier year is irrelevant. Unlike abandonment, the timing of worthlessness is largely a judgment call by the taxpayer based on his own particular circumstances, including the tax effects of any decision.
The Court concluded that when Echols took a loss deduction on his amended tax return for 1976, he manifested his subjective determination that his interest i the partnership had become worthless in that year. He also manifested his subjective determination of worthlessness at the partnership meeting when he acknowledged the fair market value of the partnership's only asset was less tha the mortgage owed on it, declared he would no longer contribute funds to the partnership, and tendered his interest to anyone free of charge. To determine i Echols had met the second prong of the test, the Court looked to the fair marke value of the land that was less than the outstanding mortgage on it. This satisfied the court that the property was essentially valueless.
Just as a taxpayer is entitled to exercise his or her own judgment in the timin of an overt act of abandonment, he or she is also entitled to exercise the same judgement in determining when an asset is worthless to him or her, provided it can reasonably be shown the asset was in fact valueless at the time selected to claim a loss deduction. Valueless does not require an asset's value to decline to or below zero in the year a taxpayer elects to make a loss deduction under IRC Sec. 165(a). It should be noted only a bona fide loss is allowable, substance and not mere form shall govern in determining a deductible loss.
The Citron Case
Citron borrowed $60,000 and, along with three other limited partners, invested in a partnership formed to produce a motion picture. The partnership did not borrow any money. A completed film was produced, but a controversy developed with the executive producer about who had rights to the negative. The partnership was unable to obtain the negative, and although it possessed a copy of the film, only poor quality reproductions could be made. The general partner a corporation, decided to make an X-rated film from the copy. At the partnershi meeting in 1981, Citron and the other limited partners advised the general partner they would have nothing to do with an X-rated film, and voted to dissolve the partnership. At that time, the partnership had no liabilities, and Citron made it clear he wanted nothing further to do with the partnership. He then reported an ordinary loss for his investment in the venture for that year on the grounds of theft or embezzlement (due to the withholding of the negative), or in the alternative, abandonment.
The IRS argued the loss occurred from a sale or exchange and should be characterized as capital loss and limited to $3,000 for 1981. However, the Tax Court (the Court) held the loss was by virtue of abandonment and not theft or embezzlement. It also held it was an ordinary loss and not a capital loss.
The court contrasted the result with other cases where partners were deemed to have incurred capital losses when they were relieved of partnership liabilities in connection with abandonment of their interest. Consequently, the Court found Citron did manifest his intent to abandon his interest by voting to dissolve th partnership and expressing to the partners his intent not to contribute additional funds or be associated with an X-rated movie production. Therefore, the Court allowed Citron to claim a loss deduction as an abandonment loss.
To reach this determination, the Court focused essentially on the same elements as did the Fifth Circuit Court in its review of Echols. Accordingly, the Court had to determine the character of the loss. If no consideration is paid to the taxpayer, the loss is generally all ordinary loss because there is no sale or exchange of the partnership interest. If the taxpayer is relieved of liabilities, the debt relief constitutes consideration in exchange for the partnership interest, and the loss is a capital loss. The Court, in the context of the IRC of 1954 and precedent in other courts, decided abandonment of a partnership interest was not a sale or exchange and could be accorded ordinary rather than capital loss treatment. The Court, however, stated abandonment coul be deemed as a sale if the partner's share of partnership liabilities was decreased. In this case, the partnership had no outstanding liabilities.
Citron's victory must be viewed with caution -- i.e., the victory is not exactl cause for celebration. The Tax Court specifically limited its ordinary-loss holding to situations where there are no partnership liabilities. In that event the taxpayer does not receive anything of value, so the abandonment is not a sale or exchange.
The Treatment of Partnership Liabilities
When a partner abandons an interest in a partnership, IRC Sec. 752(b) may apply In accordance with this section, a decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities due to the assumption of such liabilities by the partnership, is treated as a distribution of money to the partner by the partnership. The partner's share of liabilities in the partnership is reflected in the adjusted basis of the partner's interest in the partnership.
Nonrecourse Debt. If a partner shares a portion of the partnership's nonrecours debt, an abandonment of the partnership automatically reduces his or her share of the liabilities to zero, resulting in a distribution under IRC Sec. 752(b). Additionally, if the partner has claimed deductions in excess of capital contributions, the distribution resulting from the reduction of the share of liabilities will generate a capital gain because the distribution will exceed his or her basis in the partnership interest. Therefore, a taxpayer must carefully weigh the benefits of any distribution upon abandonment against the tax effect of such distributions. Depending on a taxpayer's circumstances, it may be more advantageous to avoid any type of distribution from a partnership upon abandonment to claim an ordinary loss deduction under IRC Sec. 165(a).
Recourse Debt. The encumbrance of partnership liabilities by recourse debt indicates withdrawal of a general partner from a partnership will not automatically relieve the partner of his or her share of partnership liabilities. Therefore, barring some expressed arrangement that relieves the abandoning partner of his or her share of partnership liabilities, the withdrawal does not trigger a deemed distribution under IRC Sec. 752(b). Accordingly, the partner is entitled to an ordinary loss deduction for abandonment under IRC Sec. 165(a).
If a partnership is declared bankrupt, whether IRC Sec. 752(b) applies to the withdrawal of a partner depends on the disposition of partnership liabilities. If there is no relief of liabilities, the withdrawal of the partner should not subject him or her to IRC Sec. 752(b), and no distribution will have been deeme to occur. So long as there is no other consideration paid to the withdrawing partner, the loss should be characterized as ordinary. However, if partnership liabilities are paid or assumed in connection with liquidation of the partnership, IRC Sec. 752(b) applies, resulting in deemed distributions, and an loss incurred is considered capital.
Limited Partners. Generally, limited partners have no obligation to contribute additional capital to the partnership and therefore do not bear the economic risk of loss for any partnership liability. Accordingly, withdrawal from a partnership cannot relieve the limited partner of liabilities since he or she had no obligation to service any partnership liabilities. However, if a partner whether limited or general, could be required to make a contribution to the partnership or a payment to a creditor to discharge a partnership liability, th partner may be considered to bear the economic risk of loss. In this case, the limited partner must be careful to avoid any debt relief or other compensation for withdrawal from the partnership if he or she wants to claim an ordinary-los deduction. Additionally, a limited partner must weigh the tax advantages of including a share of the partnership liabilities in basis, against the tax effects such a decision has, should he or she want to withdraw from the partnership.
It is uncommon for a partnership not to have liabilities. If that is the case, or the partner's basis does not include any partnership liabilities, IRC Sec. 752(b) does not apply. Under these circumstances, providing there is no consideration paid to the abandoning partner, Citron indicates the partner is entitled to an ordinary loss.
When entering into a partnership agreement, a taxpayer must carefully weigh the economic, legal, and tax ramifications of deciding if he or she will be a limited or general partner and whether to include a share of the partnership liabilities in basis. While the abandonment issue may not be a taxpayer's overriding concern in addressing these issues, the fact is not all business ventures succeed. A prudent investor will leave a safe avenue of retreat to mitigate losses.
If a taxpayer is a partner in a failed venture and has not claimed tax deductions in excess of investment, he or she should consider producing a tax loss by abandoning or claiming the worthlessness of the partnership interest. I selecting to do so, he or she should make it abundantly clear to partners and interested third parties that he or she is abandoning his or her partnership interest. Since such tax losses can be substantial, the IRS will likely scrutinize the transaction. Therefore, a taxpayer should use written statements in conveying his or her intentions to all parties involved. Additionally, since worthlessness is a separate cause for deducting a loss under IRC Sec. 165(a) an in a dispute the courts look to the subjective judgment of the taxpayer to resolve such a conflict, the taxpayer should include in correspondence an opinion as to the worthlessness of his or her interest in the partnership.
IRS ISSUES RULING ON LOSS ON ABANDONMENT OF PARTNERSHIP INTEREST
On November 10, 1993, the IRS issued Rev. Rul. 93-80, which discusses the issue of classification of loss on the abandonment or worthlessness of a partnership interest. The ruling gives a fact pattern in two situations to illustrate when such a loss might be ordinary or capital. In Situation 1, the partnership had nonrecourse debt at the time of abandonment by one of three general partners of an interest in the partnership. In Situation 2, a limited partner with no responsibility for any of the partnership's liabilities similarly abandoned an interest.
The ruling concluded that where a partner abandons an interest in a partnership that has liabilities in which the partner shares -- as in Situation 1 -- upon abandonment a deemed distribution of that partner's share of the liabilities is made. IRC Sec. 731(a) applies, and the loss is capital in nature. In Situation 2, where the partner did not benefit from a reduction in liability, there is no distribution and the loss is ordinary.
Rev. Rul. 93-80 also states that the IRS will no longer follow Rev. Rul. 76-189 which denied ordinary loss treatment to the abandonment of a partnership interest even though no distribution was made or deemed to have been made. Rev. Rul. 93-80 also serves to clarify and supersede Rev. Rul. 70-355, which concluded ordinary loss treatment was appropriate with regard to a partnership interest without discussing the relevance of partnership liabilities.
Ray A. Knight, JD, CPA, and Lee G. Knight, PhD, are professors of accounting at Middle Tennessee State University, Murfreesboro, Tennessee. Brian Sellers is a graduate student in accounting at Middle Tennessee State University.
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