Abandonment of partnership interests.
In order to claim a loss for a particular year, the partner must show, among other things, that the property was actually abandoned in that year.
Example: A, B and C are partners in partnership ABC, which owns and operates a shopping center. The center is currently in financial difficulty and is expected to remain that way for some time. A wants out and decides to "walk away" from his partnership interest at a time when ABC's tax basis balance sheet is as follows:
Shopping center (FMV $500) $ 900 Debt 1,200 Capital A (100) B (100) C (100) $ 900
A is personally liable on one-third of the debt, or $400. His basis in ABC is $300, consisting of his share of liabilities of $400 less his negative capital account of $100.
A may believe that if he abandons his interest, he will incur a gain of $100, which is his negative capital account. However, this may not be the case.
Several recent cases illustrate how a partner may claim a loss under Sec. 165 as the result of abandoning a partnership interest. For an abandonment to occur, there must be (1) an intention to abandon and (2) an affirmative act of abandonment.
The amount of the loss is the taxpayer's basis in the property. Generally, the basis of a partnership interest is the partner's capital account balance increased by the partner's share of partnership liabilities. Therefore, even if a partner has a negative capital account in a partnership, that partner may have a basis that could generate an abandonment loss.
The nature of the loss (ordinary or capital) will depend on whether consideration has been received by the taxpayer at the time of the abandonment. If the taxpayer receives consideration, the loss will generally be a capital loss; if there is no consideration received, the loss will generally be ordinary.
Whether consideration has been received will most likely depend on the nature of the debt on the property abandoned. If the debt is nonrecourse to the taxpayer, consideration will be deemed to have been received and any loss will be capital; on the other hand, if the taxpayer is personally liable on the debt and is not relieved of the debt as the result of the abandonment, the loss may be ordinary.
In two recent cases, a partner was allowed an abandonment loss by merely orally communicating to the other partners his intent to abandon his interest. In Echols, 935 F2d 703 (5th Cir. 1991), the taxpayer had a positive capital account in a partnership owning undeveloped land. The land was subject to a nonrecourse debt. The Fifth Circuit allowed Echols to claim a capital loss. In Citron, 97 TC 200 (1991), the taxpayer had a positive capital account in a partnership formed to produce a movie. The partnership had no liabilities, an unusual situation noted by the court. The Tax Court allowed Citron to claim an ordinary loss since no consideration was received.
In Kreidle, Bankr. Colo., 1991, a taxpayer was allowed an ordinary loss as the result of the worthlessness, rather than the abandonment, of his partnership interest. A worthlessness loss was also claimed under Sec. 165 and, according to the Fifth Circuit on rehearing in Echols, was a separate but equal grounds for a loss deduction. Worthlessness generally does not require an overt act as does an abandonment. In Kreidle, the Bankruptcy Court allowed the taxpayer an ordinary loss as the result of the worthlessness on the partnership interest as the partnership was in Chapter 7 bankruptcy. The court ruled that the loss was ordinary; the taxpayer had received no consideration since he remained liable for the partnership debts.
Another recent case, although not involving an abandonment, is important in determining when consideration is considered to be received. In Weiss, 956 F2d 242 (11th Cir. 1991), the IRS contended that a taxpayer who was ousted from a real estate partnership for failure to make capital calls had a gain due to his negative capital account. However, the Eleventh Circuit held that no gain occurred as Weiss remained liable on the debts of the partnership. In other words, he received no consideration as a result of leaving the partnership.
Finally, another 1991 case, involving an abandonment of an interest in a mining venture, illustrates the importance of proving that an abandonment occurred. In Corra Resources, 945 F2d 224 (7th Cir. 1991), the taxpayer claimed an abandonment loss for a mining lease even though the taxpayer took no concrete steps to abandon the interest. It did not send a letter to anyone; it did not tell the operator of the lease to quit; it did not adopt a corporate resolution; and it did not even raise the issue until the Tax Court decided the case against it. Because of this, the Seventh Circuit disallowed the abandonment loss.
Subsequent disposition of debt
If the taxpayer claims an abandonment loss on the basis that he was not relieved of the partnership debt at the time of the abandonment, he may have cancellation of debt (COD) income if the debt is subsequently forgiven.
However, if the taxpayer is insolvent or in bankruptcy at the time of the forgiveness, there will be no COD income under Sec. 108(a). If the taxpayer subsequently has to pay his share of the debt, he cannot claim a deduction for the payment.
It should be noted that the IRS and the courts could take the position that if the abandonment and any subsequent forgiveness of the debt are not clearly separated, the taxpayer will have gain at the time of the abandonment equal to his negative capital account (see comments in Aizawa, 99 TC No. 10 (1992)).
Passive activity loss rules
A loss from a passive activity, including suspended passive activity losses, can be deducted at the time the taxpayer disposes of his entire interest in the passive activity in a fully taxable disposition. (No regulations have been issued defining the terms "disposition" or "fully taxable.")
As for abandonments, the Conference Report to the Tax Reform Act of 1986 (TRA) stated that a disposition includes an "abandonment, constituting a fully taxable event under present law, of the taxpayer's entire interest in a passive activity." The Committee Report went on to state, for example, that if the taxpayer owns rental property, which he abandons in a taxable event that would give rise to a deduction under Sec. 165(a), the abandonment constitutes a taxable disposition triggering the recognition of suspended passive losses.
Although it is not entirely clear what is meant by the term "fully taxable disposition," it would appear that based on the example in the Committee Report, an abandonment would constitute such an event.
Anyone taking this position should be aware that the IRS might argue the so-called open-transaction rule. Under this rule, the tax consequences of a transaction cannot be determined as long as any part of the transaction remains open. Thus the Service could contend that no disposition has occurred as long as the taxpayer remains liable on the partnership debt.
Should the IRS prevail on this issue, the partner could be subject to a 20% substantial underpayment penalty. The penalty will not be imposed if "substantial authority" exists for the taxpayer's position or the position is disclosed on the return. Since it is not clear whether such authority exists, the taxpayer should consider disclosing this position on his return. (For tax shelters, disclosure will not avoid the penalty.)
Conclusions from the example
In the example, if partner A walks away from his partnership interest, he may be entitled to an abandonment loss if he can show that he intended to abandon, and did abandon, his interest. Under the Echols and Citron cases, this was done by communicating this intent to the other partners. Preferably, A should write a letter to the other two partners stating that he is abandoning his interest.
If A is not relieved of his share of the debt, his loss should be equal to his basis in his partnership interest of $300. Since no consideration was received, this loss should be ordinary, rather than capital.
If A is subsequently relieved of the debt, he will have COD income of $400. Thus, A will have a net gain of $100 from the transaction, consisting of the $400 COD income less the $300 abandonment loss. If A is insolvent or in bankruptcy at the time of the forgiveness, the $400 of COD income will not be taxable.
An argument can be made that the abandonment constitutes a "fully taxable event" so that the loss of $300 is deductible in the year of the abandonment. However, the Service could argue that the loss is not deductible until A is relieved of the debt or is required to pay the debt.
Note: Before considering whether to abandon a partnership interest, legal counsel should be consulted to determine the nontax consequences. Also, the partnership agreement should be carefully read to determine if a withdrawal from the partnership could cause the withdrawing (or abandoning) partner to be allocated any partnership income items. For instance, the author is aware of at least one situation in which a withdrawing partner was allocated gross income to the extent of his negative capital account.
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|Author:||Williford, Jerry S.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1993|
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