September 9, 2020
IRC Section 741 provides that the sale or exchange of a partnership interest is treated as a sale or exchange of a capital asset, except to the extent that IRC Section 751 applies, pertaining to unrealized receivables and substantially appreciated inventory. However, IRC Section 165(a) allows a deduction for any loss sustained during the taxable year and not covered by insurance or otherwise. Further, Income Tax Regulation Section 1.165-2 provides that absent a sale or exchange, a loss that results from the abandonment or worthlessness of non-depreciable property is an ordinary loss even if the abandoned or worthless asset is a capital asset.
The abandonment of a partnership interest is not a “sale or exchange” and, therefore, can result in ordinary loss as long as no consideration is received as a result of the abandonment. Any amount of consideration received (even a de minimus amount) will result in sale or exchange treatment resulting in a capital loss. Relief of liabilities is a deemed distribution pursuant to IRC Section 752 and is a type of consideration and will result in capital loss treatment. Even if a partnership has liabilities, the abandonment of a partnership interest by a partner who does not include any portion of the liability in determining outside basis should not be a sale or exchange. Also, there should be no deemed distribution or sale or exchange, and no amount realized if the withdrawing partner remains primarily liable for their share of partnership recourse liabilities after the partnership interest is abandoned, and ordinary loss treatment should be available. In the case of nonrecourse liabilities, no partner is liable for the liability. Therefore, abandonment of a partnership interest will result in a deemed distribution and a deemed sale that will result in a capital loss since the withdrawing partner cannot be liable for the liability.
To establish the abandonment of a partnership interest, the partner must show an intent to abandon, and must overtly act to abandon the asset. In Echols, 935 F.2nd 709 (CA-5, 1991), and Citron, 97 T.C. 200, the partner showed his intent to abandon his partnership interest by announcing to the other partners of his intention not to participate further. In Rev. Rul. 93-80, the partner gave written notice to the partnership of his intention to abandon.
Note: In order to abandon, the abandonment must be permissible. Therefore, it is necessary to confirm that abandonment is not prohibited under the partnership or LLC agreement.
A recent case (MCM Investment Management, LLC, 118 T.C.M. 437) (MCMIM) illustrates that an ordinary loss for a worthless partnership interest is allowed without abandoning the partnership interest. In that case, MCMIM had a controlling interest in a lower-tier partnership, McMillin Companies LLC (Companies). Companies was in the business of home building and remodeling. When the subprime mortgage crisis began in 2007, home values declined. By 2009, the year at issue, Companies had $100 million of senior debt and $65 million of subordinate debt. These debts were personally guaranteed by MCMIM and the MCMIM class A members. In 2009, MCMIM filed its partnership tax return reflecting a loss deduction of about $41 million, based on the interest in Companies having become worthless during the year. MCMIM did not abandon its partnership interest in Companies.
MCMIM and the IRS agreed that the character of the loss would be ordinary, although no mention of liability relief was discussed. The issue for the court to decide was whether MCMIM met all of the requirements for claiming a loss pursuant to IRC Section 165(a). The court looked to both a subjective and an objective determination of worthlessness.
Subjective determination. MCMIM met this test because, first, when MCMIM filed its 2009 tax return it claimed an ordinary loss deduction for its investment in Companies, and, second, the owners and management of MCMIM credibly testified they believed the interest was worthless in 2009 based on the devastating impact of the financial crisis that began in 2007 and Companies consistent net operating losses in the years leading up to and including 2009.
Objective determination. Companies conservative cash flow projections showed its inability to pay the senior lender in full or to have any assets remaining for the owners. MCMIM asserted that its partnership interest in Companies lacked both “liquidating valve” and “potential value” and the evidence indicated that it was extremely unlikely Companies would ever recover any value.
MCMIM holds that abandonment of the underlying partnership interest is not a prerequisite for claiming a worthless deduction under IRC Section 165(a) and provides guidance for taxpayers seeking to claim a deduction for worthlessness.
Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.