Loss on walkaway from partnership - is it ordinary or capital?

If a taxpayer walks away from a partnership interest in which he has a positive capital account, is the loss capital or ordinary?

By walking away, it is assumed that the partner has either abandoned his interest or his interest has become worthless. Under Sec. 165, a taxpayer is allowed an abandonment or worthless loss. However, Sec. 165 does not determine the character of the loss. It may be either capital or ordinary, depending on whether or not there has been a sale or exchange. It will not necessarily depend on the nature of the property. Whether or not there has been a sale or exchange will generally depend on whether the taxpayer has received anything as a result of the walk-away.

Sec. 741 states that, in connection with the sale or exchange of a partnership interest, gain or loss will be considered as from the sale or exchange of a capital asset. (This rule applies when there are no gains or losses in connection with unrealized receivables, inventory or depreciation recapture.)

A partner may be deemed to have received something on walking away from a partnership if there are partnership liabilities. Sec. 752(b) states that there is a deemed distribution of cash to a partner when his share of partnership liabilities decreases. On the other hand, if the partner increases his share of liabilities or increases his individual liabilities by reason of assumption of partnership liabilities, under Sec. 752(a) there is a deemed contribution of cash to the partnership.

Therefore, in connection with the walkaway from a partnership interest, the partnership's liabilities must be examined.

If partnership liabilities are non-recourse, the partner's share of the nonrecourse liability is decreased. Thus, there is a deemed distribution of cash under Sec. 752(b) and the partner has received consideration. Accordingly, there is a sale or exchange and the resulting loss is a capital loss. (See Echols, 5th Cir., 1991 rev'g 93 TC 553 (1989); O'Brien, 77 TC 113 (1981); Arkin, 76 TC 1048 (1981); and Freeland, 74 TC 970 (1980).)

There same result will occur when the partnership liabilities are recourse and the partner is released from these debts when he leaves. However, this is not usually the case.

When the liabilities are recourse and the partner remains liable on these recourse liabilities after he walks away from his partnership interest, there is no sale or exchange and the loss is ordinary. See Hutchenson, 17 TC 14 (1951), and Gannon, 16 TC 1134 (1951), which involved two general partners of the same law firm who withdrew from the firm and forfeited their capital accounts. The Tax Court found that in both cases the taxpayers had ordinary losses. In O'Brien, supra, the Tax Court notes that there was no suggestion in these two cases that the withdrawing partners were relieved of nonrecourse or other partnership liabilities. (In O'Brien, the court found that a capital transaction occurred because the partnership debt was nonrecourse.)

It is interesting to note that in Zeeman, S.D.N.Y. 1967, the court allowed a limited partner to claim an ordinary loss as the result of the brokerage partnership filing for bankruptcy. According to the partnership agreement, she was not liable for any corporate debts. The court saidthat when the loss materializes from the worthlessness of the partnership interest, without a sale or exchange, the statutory requirements for capital loss treatment are not met. It would seem that Zeeman would have been "relieved of" any nonrecourse liabilities of the partnership that would have resulted in a deemed cash distribution under Sec. 752(b), and thus consideration would have been received which would have resulted in a capital loss. However, the court did not see it that way.

When the partnership has no liabilities, the partnership has no liabilities, the partner walking away has an ordinary loss. Citron, 97 TC No. 12 (1991), involved such a situation. A limited partner abandoned his partnership interest when the general partner planned to produce an X-rated movie. The court found that the limited partner had an ordinary loss. In a footnote to the case, the court stated: "Although we decide that abandonment of a partnership interest may result in ordinary, rather than capital, losses, the requirement that there be no partnership liabilities is likely to limit the pervasiveness of this holding." In light of Hutchenson, Gannon and Sec. 752(a), however, this statement seems to be too restrictive.

Therefore, it appears that a capital loss will occur when a partner abandons his partnership interest if

-- the partnership liabilities are nonrecourse, or

-- the partnership liabilities are recourse but he is relieved of his liability.

On the other hand, an ordinary loss will occur when a partner abandons his partnership interest if

-- the partnership liabilities are recourse and he remains liable on them, or

-- there are no partnership liabilities.

From Jerry S. Williford, J.D., CPA, Houston, Tex.