When a partnership interest becomes worthless.
When most types of business or investment properties are abandoned, the owners can claim a loss deduction in the year of abandonment. For assets disposed, recognition of loss is in the year of disposal. What about worthless partnership interests? When is a worthless partnership interest allowed as a deduction? Does the owner of the partnership interest have to abandon or dispose of the interest to recognize a loss?
This analysis focuses on the Echols v. Commissioner decision,(1) where the Court of Appeals held that a partner can claim a loss for worthlessness of his partnership interest without having to abandon or dispose of it. In Echols, worthlessness emerges as a user-friendly doctrine. The year of worthlessness is determined by the taxpayer's judgment call supported by "objective factors." He is not denied the loss because he may have been entitled to the deduction in an earlier year; he abandons the property in a later year; or another taxpayer would have determined that the asset is worth retaining. Is Echols breaking new ground in tax law, first, in not requiring an actual disposition or abandonment and, second, in the discretion it grants taxpayers? Does worthlessness unfreeze suspended passive losses just as if the partner had sold his interest? This article will review the Echols case and offer insight to place the decision in perspective.
Echols v. Commissioner
In 1976, Echols was a 75% partner in a partnership whose only asset was unimproved land near Houston, Texas. Originally, he hoped construction of a highway would make the property valuable for development, but the highway project was stalled by local opposition. Houston real estate values dropped. The land was worth less than the mortgage encumbering the partnership interest. A developer who had purchased 50% of the land from the partnership on the installment basis defaulted on his payments. This ended the partnership's sole outside source of income which had enabled it to carry the property. The mortgagee refused to restructure the debt. Echols advised his partner that he would make no further contributions to pay the mortgage. He offered to transfer his interest in the partnership to his partner or anyone else willing to assume the payments. Early in 1977, the mortgagee foreclosed.
Echols claimed a capital loss for 1976 under Section 165 (a) of the Code.(2) The Tax Court denied the loss. It focused on whether there was an abandonment of the partnership's property and held that an abandonment required an act apparent to nonpartners.
The 5th Circuit Court of Appeals reversed. It said whether the partnership abandoned the property in 1976 was irrelevant because Echols had abandoned his partnership interest. The tender of his interest to anyone willing to assume the mortgage payments and his declaration that he would contribute no more funds satisfied the requirement.
Importance of Echols
The real importance of the 5th Circuit decision comes in its statement that even without a declarative abandonment, Echols was entitled to a loss for the worthlessness of his partnership interest. In its opinion, worthlessness involves subjective and objective criteria: When did the taxpayer deem his interest to be worthless and was it then objectively worthless?
The taxpayer's subjective determination of worthlessness is "largely a judgment call by a taxpayer based on his own particular, highly personal set of economic factors, including tax effects." The fact other investors might have determined in an earlier year that an interest in the partnership was worthless or that other investors would have gambled additional infusions of cash into the partnership in the hope there would be a rebound are not determinative. The taxpayer must show that the asset is "essentially valueless"--"but not absolutely positively without any value whatsoever." The taxpayer is entitled to the same discretion in determining that an asset is essentially without value as he would have in abandoning an asset.
The identifiable event or completed transaction required under the Section 165(a) regulation does not have to involve the asset or include the taxpayer as a party. Thus, the purchaser's default and the inability of the partners to restructure the debt were closed and completed events that evidenced worthlessness, as was the partnership's insolvency. The Court emphasized that a loss for worthlessness or abandonment is available even if other events may have been sufficient to support a loss in a prior year.
The IRS was concerned that the flexibility in choosing the year of loss would allow manipulation in favor of taxpayers. The Court, however, thought discretion was necessary. The taxpayer had an unfair responsibility to recognize the loss. Under prior IRS rulings, the taxpayer had to abandon the asset in the year of worthlessness. Revenue Ruling 54-581(3) states that an abandonment loss is not available if the property was worthless before the year of abandonment. Therefore, if the taxpayer is late in his abandonment, a deduction for worthlessness would be lost forever.
Examples of Injustice
The injustice to taxpayers that Echols protects against is illustrated by A.J. Industries v. Commissioner.(4) In 1958, the taxpayer wrote off and abandoned capitalized expenses associated with a gold mine. The Court of Claims ruled the investment was worthless prior to 1958 and disallowed the deduction. The taxpayer then claimed the loss for 1956 and sued for refund. The Court argued there could be no loss without abandonment and that the abandonment had actually occurred the next year, 1957. This is the type of situation Echols rectified: worthlessness not coinciding with abandonment.
The Echols decision protects a taxpayer against an IRS determination that the asset became worthless in a year before the loss is claimed. The 5th Circuit distrusts abandonment as the exclusive test because of the IRS stance that abandonment must take place in the year of worthlessness. Therefore, the Court gives the taxpayer broad discretion to determine the year of loss, subject to an anti-abuse rule. The taxpayer cannot be unreasonable in its determination of the year of loss. This seeks to prevent any "warehousing" of losses. Therefore, the objective of Echols is to give taxpayers the broadest business discretion consistent with reasonableness but short of "warehousing" losses.
Although somewhat revolutionary in its finding, Echols is not the first decision to allow partnership interests to be deducted. In fact, it was not the first case permitting a loss for the worthlessness of a partnership interest, although it goes beyond earlier cases in scope. At least two other cases allowed losses on the worthlessness of a partnership interest.
Tejon Ranch Co. v. Commissioner(5) allowed a loss on the worthlessness of a partnership interest in an agricultural undertaking. The irreversible insolvency of the partnership was the completed event that justified a loss deduction. A deduction was denied for 1977 because the partnership was not in default yet on its indebtedness. There was still a possibility it could secure additional financing or sell its properties. A case could have been made for the deduction in an earlier year. In 1977 some investors declined to invest in the partnership, having concluded that the operation could not be profitable and that the partnership assets were worthless. All attempts to attain additional financing were unsuccessful and a financial consultant advised the principal lender that it was doubtful the loan would ever be repaid. The Echols interpretation of taxpayer discretion would have supported a deduction in an earlier year.
In Zeeman v. United States(6) a limited partner in Ira Haupt & Co. was allowed a ordinary loss deduction under Section 165(a) for the worthlessness of her limited partnership interest in the Haupt Brokerage House. It was being liquidated by its creditors due to insolvency of $25 million as a result of oil fraud. The partnership loss wiped out all its capital, but under the partnership agreement the loss was allocable only to general partners who then became insolvent.
Echols went substantially farther than either the Tejon or Zeeman rulings. Tejon permitted a worthlessness loss when abandonment was not possible. Echols suffered from no such disability nor had the partnership realized the loss as in Zeeman. Therefore, since Echols would have allowed worthlessness loss deductions to a general partner before insolvency, as in Tejon, and to a limited partner without abandonment, as in Zeeman, it is logical to assume that we have come a step further.
Recap of Echols
Echols is a decision that seeks to relieve taxpayers of the worst aspects of realizing losses. The taxpayer, however, cannot be permitted to warehouse losses, but its business judgment should be followed if supported by objective events. Abandonment insures the taxpayer that the loss cannot be taken in a later year. Since the loss cannot be taken in a later year, the IRS can always argue that the loss occurred in an earlier year, making it unrecognizable by the taxpayer. In the Echols decision, the 5th Circuit made it clear that short of taxpayer abuse, they are unsympathetic to such IRS games. The result is taxpayer discretion that is rarely given within the scope of tax law.
Passive Loss Recognition
After the 1986 Tax Reform Act, a more significant issue relating to the worthlessness of a partnership interest is its effect on passive losses. If worthlessness without abandonment triggers loss recognition, the worthlessness also should be a disposition under the passive loss rules. Section 469(g) states that the disposition of the taxpayer's entire interest in a passive activity in a fully taxable arm's-length transaction triggers any suspended passive losses attributable to the activity to be used against ordinary income. The Conference Committee Report for the 1986 Act treats abandonment as a sale for this purpose.(7) It states that if the worthlessness of a security is treated under Section 165(g) as a sale or exchange of the security and it represents the taxpayer's entire interest in the activity, the worthlessness is a disposition.(8)
The Conference Report assumes a disposition due to worthlessness applies only to a "security." This leaves open the possibility that a security may not be restricted to interests in corporations. Thus, while the Conference Report does not expressly rule out partnership interests as securities, it never considers the possibility of worthlessness under Section 165(g) as in Echols.
Since an abandonment is treated as a disposition under Section 469 triggering suspended losses, worthlessness as in Echols should have the same result. Under Echols the worthlessness has the same effect as a sale. Therefore, worthlessness should be treated like an abandonment, which is a sale for tax purposes. The only way to account for Echols decision properly with the passive loss rules is to treat worthlessness as a sale or exchange that releases the passive losses. Partially Worthless Partnership Interest
An interesting issue arises when considering the possibility of a "partially" worthless partnership interest. Under the disposition rules just discussed, to recognize PALs, a taxpayer must dispose of an entire interest in an "activity." What makes this relevant to worthless partnership interests is the 1986 Conference Committee Report. It states that worthlessness should be treated as a disposition.(9) In addition, Reg. Sec. 1.469-4T(o) makes it easier to dispose of an entire "activity" by allowing taxpayers to treat each undertaking as a separate activity for this purpose.
Example#1: Suppose A owns a one-third interest in a partnership that has three grocery stores at different locations. In 1993, A disposes of one of the stores. If the partnership has not made the disaggregation election, the partnership has not disposed of its entire interest. But if it has made the disaggregation election under Reg Sec. 1.469-4T(o), then the disposal of one store is treated as a disposition of an entire activity.
The importance of this regulation is that assets of the partnership may be disposed of (i.e. become worthless) and still be treated as the disposal of an entire activity. The only question is: does the worthlessness of partnership property, treated as a disposal under Sec. 165, allow each partner to claim a fraction of his/her partnership interest as worthless?
To illustrate this concept we again look at Example #1. If the one grocery store had become worthless, the result would be that the partnership is treated as partially worthless to the extent the worthless store made up the partnership assets (i.e., one-third). In addition, partner A would report one-third of the partnership interest as worthless under Sec. 165.
If each undertaking of the partnership is a separate activity, the partnership interests should be separate as well. Thus, when assets become worthless, the partnership interest also would be treated as worthless to the extent the worthless activity made up partnership assets. In addition, with the pass-through characteristic of partnerships, each partner would recognize a percentage of their interest as worthless. This would allow for the possibility that partners could treat their partnership interests as "partially" worthless. Adding this concept to the one discussed in Echols, the result is that partnership interests can become wholly or partially worthless at the taxpayer's discretion with no need to dispose of the interest in order to claim it as worthless.
1 Echols v. Commissioner, 91-2 USTC 50,360, 68 AFTR2d 91-5157 (5th Cir. 1991), rev'g, 93 T.C. 553 (1988).
2 Under Reg. Sec. 1.165-1(d)(1), a loss is allowed as a deduction in the taxable year in which it is realized as evidenced by "closed and completed transactions and as fixed by identifiable events occurring in such taxable year." 3 Revenue Ruling 54-581, 1954-2 C.B. 581.
4 A.J. Industries v. Commissioner, 508 F.2d 660 (9th Cir. 1974).
5 Tejon Ranch Co. v. Commissioner, 49 TCM 1357 (1985).
6 Zeeman v. United States, 275 F.Supp 235 (S.D.N.Y. 1967).
7 S. Rep. No. 313, 99th Cong., 2d. Sess. 725 (1986).
8 H. Rep. No. 841, 99th Cong., 2d. Sess. (Conference Report) 143, 144 (1986).
9 H. Rep. No. 841, id.
Scott J. Vickman, MBA, is a tax staff professional with Authur Andersen & Co. in Minneapolis. He earned an BBA in accounting and MBA in taxation from the University of Notre Dame.