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February 18, 2014

2014-Issue 7—Generally, the sale or exchange of an interest in a partnership is treated as the sale or exchange of a capital asset, and therefore resulting gains and losses are capital (IRC Section 741). This is fine if you recognize gains, but not so great for the losses. What if the loss on the disposition of a partnership interest could be ordinary? Would you have a different feeling about triggering the loss? Sure. We generally do all that we can to trigger ordinary losses instead of capital losses. In addition, even if you had built-in gain assets that could generate capital gain and absorb a capital loss, would you really want to or be able to trigger the gains in the right carry-forward period to utilize the capital losses? Fortunately, there is still an avenue to get ordinary loss treatment on the disposition of a partnership interest.

Abandonment Under IRC Section 165
A loss from the abandonment of a partnership interest can be an ordinary loss. To abandon a partnership interest (or any other intangible asset), the taxpayer must demonstrate an affirmative and overt act to abandon. For a partnership interest, perhaps the taxpayer should meet with the other partners and tender the certificate of partnership interest to them. The taxpayer should consider other affirmative and overt acts, like renouncing the right to any proceeds upon liquidation or otherwise and expressing the intent to not fund any future capital calls. The taxpayer should probably even consider disclosing to the other partners his/her intent to take an abandonment loss on the current year’s tax return. The point is, abandonment requires an affirmative and overt act, and dealing with a partnership interest means you can’t just put it in the trash and be done with it.

After establishing the abandonment, you must be sure to keep the transaction outside the purview of IRC Section 741. With regard to abandonment, any consideration received in the transaction will make the abandonment a sale or exchange transaction and take it out of IRC Section 165 and dump it into IRC Section 741. So, if the abandoning taxpayer had the economic risk of loss for a partnership liability (under IRC Section 752 and the Treasury Regulations) then the abandonment would be treated as a reduction in that partner’s share of partnership liabilities and a deemed distribution of cash to the abandoning partner. Boom, you’re in IRC Section 741 and sale or exchange land. Losses are capital.

However, if the abandoning partner had no economic risk of loss under the IRC Section 752 rules, then the transaction would not be treated as a sale or exchange. There would be no deemed consideration paid to the abandoning partner. The abandonment loss would be taxed under IRC Section 165. Specifically, Treasury Regulation Section 1.165-2 provides that absent a sale or exchange, the abandonment or worthlessness of non-depreciable property is an ordinary loss even if the asset is a capital asset like a partnership interest. As mentioned above, any consideration received that would treat the transaction as a sale or exchange either came from actual sales proceeds or from long-standing principles of debt relief (Kirby Lumber) and the Treasury Regulation regime under IRC Section 752 treating decreases in partnership liabilities as deemed distributions of cash. In the absence of actual or deemed consideration (under IRC Section 752) recognized by the abandoning partner, the abandonment of a partnership interest gives rise to an ordinary loss under IRC Section 165.

Worthlessness Under IRC Section 165
Let’s say you are a partner with economic risk of loss for a partnership liability. Clearly, an abandonment would give rise to recognizing deemed consideration from the reduction in your partnership liabilities, and the transaction would be taxed as a sale or exchange. Consider instead taking a worthlessness deduction for your basis in the partnership interest. That is just what Echols did with regard to his partnership interest (Echols v. Commissioner, 950 F. 2d 209 (5th Cir. 1991)). The Treasury, after suffering a rather nasty defeat in the Tax Court and again at the appeals level (Fifth Circuit essentially affirmed the Tax Court holding for the taxpayer), capitulated and issued Revenue Ruling 93-80, essentially setting forth what we discussed above about the potential for ordinary loss on the abandonment (without partnership liability reduction) or ordinary worthlessness deduction for a partnership interest.

In claiming the worthlessness deduction, a taxpayer’s share of partnership liabilities under Section 752 is not an issue. You are not abandoning the partnership interest. You are still liable in accordance with the legal arrangements that gave rise to the determination of your economic risk of loss. The worthlessness deduction is not abandonment. There is no decrease in your share of partnership liabilities. However, as set forth in Echols, the taxpayer must have the subjective belief that the partnership interest not only is worthless today, but also will not reasonably become valuable in the future. Also, there must be an objective determination with an identifiable event establishing the worthlessness. Getting through those hoops will enable you to take an ordinary loss on the worthlessness of your partnership interest. The determination of the year in which the partnership interest becomes worthless is important and a highly factual determination beyond the scope of this article.

Is Abandonment a Cancellation, Lapse, Expiration or Other Termination Under IRC Section 1234A?
The Tax Court recently ruled in Pilgrim’s Pride Corporation, 141 T.C. No. 17 (2013), that the taxpayer was not entitled to take an ordinary abandonment loss related to an investment in securities. Instead, the Tax Court held that IRC Section 1234A overrides the “general rules” of IRC Section 165(g) requiring an abandonment loss related to an intangible asset, like these securities, to be re-characterized as a capital loss. In so doing, the Tax Court found that the taxpayer’s abandonment of the securities was treated as a sale or exchange under IRC Section 1234A. Was Pilgrim’s Pride decided correctly? Note that in Citron, 97 T.C. 200 (1991), the taxpayer successfully abandoned his partnership interest and took an ordinary loss deduction under IRC Section 165. The Citron court provided an excellent explanation for allowing the taxpayer an ordinary loss for the abandonment of the partnership interest.

As a brief background, IRC Section 1234A was enacted in 1981 as part of the Economic Recovery Tax Act of 1981. Apparently, it was enacted to fix an inequity in the tax law dealing with futures contracts. The gain or loss on futures contracts would be capital if the contracts were held to maturity. The same would apply to contracts with losses. The contracts would close out, and the underlying commodities were deemed to be exchanged — providing the “sale or exchange” requirement. However, for loss contracts, taxpayers took the position that the extinguishment or termination prior to maturity would produce an ordinary loss — no sale or exchange has occurred. Taxpayers could have capital gains for the good futures contracts and ordinary losses if they terminated their futures contacts that were out-of-the-money prior to maturity. History surrounding the enactment of IRC Section 1234A suggests it targets these financial assets and this inequity. However, the ruling in Pilgrim’s Pride leaves some concern that IRC Section 1234A could apply to the abandonment of a partnership interest, converting the ordinary loss specifically provided for under Treas. Reg. Section 1.165-2 into a capital loss from a sale or exchange.

In any event, the taking of a worthlessness deduction under IRC Section 165 should not arise with a cancellation, lapse, expiration or other termination for purposes of IRC Section 1234A. Remember that with the worthlessness deduction, the taxpayer still maintains possession and control over the partnership certificate. No legal rights or obligations have lapsed, terminated, expired or been canceled. The taxpayer remains a partner for all purposes and is relying on the subjective determination of worthlessness and the objective factors in existence supporting that belief. By maintaining control of the partnership certificate and remaining a partner, the taxpayer can take the worthlessness deduction out of IRC Section 741 (no sale or exchange) and that should provide the same insulation from IRC Section 1234A (no sale or exchange).

Reportable Transaction and Material Advisor Disclosures
It is also important to consider certain tax return disclosure requirements. Taking a loss on a partnership interest in excess of $10 million in a single tax year or $20 million in any combination of tax years (current and five succeeding) is a loss transaction and reportable to the IRS under Treasury Regulation 1.6011-4(b)(5)(i) on Form 8886 (Reportable Transaction Disclosure Statement). In addition, any Material Advisor with regard to the loss transaction would be required to file Form 8918 (Material Advisor Disclosure Statement). You’ll file this whether the loss is ordinary or capital, whether you abandoned or took the worthless deduction. You’ll file this if you sold your partnership interest and recorded the loss under IRC Section 1001. The item that triggers the obligation is the amount of the loss claimed. The point is, consider your disclosures carefully.

Alvarez & Marsal Taxand Says:
Losses on partnership interests are a tricky area to deal with. The exceptions to the general rule of capital loss can be navigated through to produce a different answer if the facts line up. There are a few paths to take. We suggest proper and contemporaneous documentation of the worthlessness events and affirmative and overt acts of abandonment. Assess the micro-environment that might support the determination of worthlessness. Also consider getting a valuation of the partnership interest. The more evidence you can compile of worthlessness, the less you have to rely on abandonment. Abandonment might be easier to achieve, but you’ll have to deal with deemed distributions for reduction in partnership liabilities and the potential application of IRC Section 1234A. Worthlessness deductions for partnership interests are still alive and should not be ignored.

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer. 

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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