“Abandonment of a Partnership Interest,” or “When a Taxpayer Rejects Its Tax Return Position”
July 05, 2017
“Disposing” of a Partnership Interest
If the amount realized by a taxpayer upon the sale of a partnership interest to a third party is insufficient to restore to the taxpayer his adjusted basis for the interest – i.e., his unrecovered investment in the partnership – a loss is sustained to the extent of the difference between such adjusted basis and the amount realized.
In general, this loss will be treated as a capital loss.
A loss may be recognized by a partner upon the liquidation of his interest in a partnership only where no property other than money is distributed to the partner. Loss is recognized to the extent the partner’s adjusted basis for the partnership interest exceeds the amount of money distributed to the partner.
The liquidating distribution may consist of actual and deemed distributions of money by the partnership; for example, a decrease in a partner’s share of the liabilities of a partnership is considered a distribution of money by the partnership to the partner.
Any loss recognized by a partner upon the liquidation of his partnership interest is considered a loss from the sale of the interest. Thus, it is generally treated as a loss from the sale of a capital asset.
What if a taxpayer “abandons” his partnership interest instead of selling it or having it liquidated? How will the loss realized by the taxpayer on the abandonment – equal to the taxpayer’s adjusted basis – be treated for tax purposes?
A loss that results from the abandonment, as opposed to the sale, of a partnership interest is treated as an ordinary loss, even if the abandoned partnership interest is a capital asset.
In other words, the difference between an ordinary loss and a capital loss on the disposition of a partnership interest may depend upon whether the loss results from the abandonment of the partnership interest, or from the liquidation or sale of the interest.
It may be difficult, however, to avoid sale treatment and capital loss (as opposed to ordinary loss) in the case of an “abandoned” partnership interest. That is because the “successful” abandonment of an interest requires that no consideration be received by the departing partner. In other words, if any consideration is received, even as a deemed distribution pursuant to the liability-shifting rules, the transaction will be treated as a sale, and the realized loss will be treated as a capital loss.
Thus, a loss from the abandonment of a partnership interest will be ordinary only if there is neither an actual nor a deemed distribution to the partner; even a de minimis deemed distribution will make the entire loss a capital loss.
This stringent requirement can make it very difficult for a taxpayer to secure ordinary loss treatment on what the taxpayer believes to have been the abandonment of his partnership interest. One group of uninformed taxpayers realized this issue only after having filed their tax returns.
PE Acquisition & Partnership Agreement
Taxpayers founded, owned and managed Business. By 2003, it had grown into 40 locations – most of which were owned by Taxpayers – was doing $200 million in annual sales, employed hundreds, and was attracting the interest of potential buyers.
A private equity firm (“PE”) offered to purchase Business for roughly $93 million. The offer respected Taxpayers’ ownership of the real estate locations by providing that Business would remain Taxpayers’ paying tenant, and also allowed Taxpayers to manage the day-to-day operations of Business.
Taxpayers and PE formed Partnership, the exclusive purpose of which was to own Business. At the same time, Taxpayers and PE executed a purchase agreement whereby Taxpayers sold to PE an 80.5% interest in the newly formed Partnership for $93 million. Of that amount, Taxpayers reinvested approximately $8 million into Partnership in exchange for a 19.5% interest.
Taxpayers and PE entered into a partnership agreement reflecting PE’s purchase and status as the majority owner of Partnership. The agreement recognized both PE and Taxpayers as Partnership’s general partners.
The agreement also established two classes of partnership interests: preferred and common. PE’s entire 80.5% interest comprised preferred interests. Taxpayers owned common interests, amounting to 19.5% of the total Partnership interests.
Among other rights, the agreement entitled the preferred partners to guaranteed annual payments (payable until the earliest of a partnership liquidation, the conversion of preferred interests to common interests, an “exit/reorganization” transaction, or December 2008), and a retirement obligation payment. Furthermore, should Partnership enter an exit/reorganization transaction, the preferred partners were entitled to consideration determined by a formula based upon the amount such preferred partners would be entitled to receive if Partnership were liquidated (a hypothetical liquidation).
The agreement also provided the priority order for the distribution of Partnership liquidation proceeds. After the satisfaction of any Partnership liabilities, any remaining proceeds had to be used to satisfy any accrued but unpaid guaranteed and other preferred payments. Next, the agreement entitled the preferred partners to proceeds in amounts equal to their “initial capital accounts,” followed by distribution of proceeds to the common partners in amounts equal to their initial capital accounts. Only once these priority categories were satisfied would the common and preferred partners share any remaining liquidation proceeds.
PE’s initial capital account was $85.5 million, and Taxpayers’ initial capital account was $7,945,000.
PE Flips the Business
In 2006, PE began looking to sell its investment in Partnership. PE engaged an investment banker to develop a market for Partnership and vet prospective purchasers. When the market development period ended, two names surfaced as potential purchasers: P-1 and P-2.
Taxpayers had several concerns regarding P-2 as a suitor, including the fact that P-2 would probably consolidate locations. Taxpayers still retained ownership of the locations leased to Business, which provided the family with an annual income stream of $4.4 million.
A sale to P-1, however, did not present Taxpayers with the same concerns. P-1 was a private equity firm, and was attractive to Taxpayers for the same reasons PE had previously won them over: autonomy in operating Business and a continued stream of rental income.
Taxpayers voiced their opposition to a sale of the Business to P-2. They implored PE to sell to P-1 even though P-1’s bid was roughly $35 million less than P-2’s bid of $120 million.
PE sold to P-1 in 2007. The purchase agreement executed with P-1 provided a nominal purchase price of $85 million, to be adjusted upon closing, based upon closing costs and upon Partnership’s working capital and indebtedness.
At the closing, P-1 paid $87 million for the Business. Approximately $43.8 million of that amount came in the form of P-1’s payment of Partnership’s debts to Bank (this is important). Exclusive of sales expenses, P-1 paid the final $34.6 million in proceeds directly to PE, in cash by wire transfer. The common partners – including Taxpayers – received none of these final cash proceeds.
Because they had received no cash proceeds, Taxpayers reported the transaction on their 2007 federal income tax returns as an abandonment of their partnership interests that generated an ordinary loss. Interestingly, Taxpayers did not consult their tax adviser until after the closing of the transaction.
The IRS examined Taxpayers’ returns and challenged the character of the losses claimed by Taxpayers on the disposal of their Partnership interests, as well as the decision to treat the transaction as an abandonment of such interests.
In contradiction of their original return position as to the abandonment of their interests in Partnership – and probably in belated recognition of the weakness of such position – Taxpayers argued that the form of the P-1 sale, as originally documented and reported, failed to comport with its economic reality, which could only be ascertained by looking through the sale and examining the transaction as a series of component steps that included an undocumented oral agreement with PE pursuant to which Taxpayers had agreed to surrender to PE any sale proceeds due them from the sale in order to incentivize PE’s sale to P-1. Taxpayers claimed this was done with the aim of preserving their stream of rental income. They also argued that these transactions resulted in their realization of actual proceeds from the Partnership sale, and their payments of those proceeds to PE gave rise to an amortizable intangible.
Tax Court’s Response
According to the Court, when the form of a transaction does not coincide with the economic reality, the substance of the transaction rather than its form should determine the tax consequences. A taxpayer may assert substance-over-form arguments, the Court stated, but in such situations the taxpayer faces a higher than usual burden of proof. In fact, the Court continued, taxpayers must adduce “strong proof” to establish their entitlement to a new position that is at variance with a position reported in their original returns.
The Court rejected Taxpayers’ theory because it relied on the presumption that the terms of their agreement with PE gave them rights to a pro rata share of the sale proceeds. This theory, the Court stated, ignored the unambiguous terms of the partnership agreement between Taxpayers and PE.
When the parties closed the sale (which was clearly an “exit/reorganization” transaction), P-1 paid $43.8 million to Bank, extinguishing Partnership’s only debt. Assuming arguendo that Partnership owed PE no accrued but unpaid preferred payments or allocations that might have otherwise increased the total amount due PE, then PE was entitled to recover to the greatest extent possible its initial capital account of $85.5 million from the proceeds of the hypothetical Partnership liquidation.
Taxpayers’ argument, the Court stated, “begins with a conclusion: They were entitled to a pro rata share of the cash proceeds from the [P-1] sale. It ends there, too.” Taxpayers’ “conclusory presumption,” the Court continued, “runs contrary to the unambiguous wording of the agreement.” The agreement did not provide for a pro rata split; it provided PE a priority payment for its interests in the event of a transaction similar to the one at issue.
According to the Court, it was clear that these were negotiated contract provisions, meant to narrow the preferred partner’s exposure to risk. In the event the marketable value of PE’s Partnership interest slipped below its initial capital account value, these provisions operated to recover PE’s investment to the greatest extent possible, even if that recovery came at the expense of the common partners, such as Taxpayers.
Taxpayers failed to establish they were entitled to any cash proceeds from the P-1 sale. It followed, then, that Taxpayers could not offer to surrender such proceeds to incentivize PE’s sale to P-1. Accordingly, Taxpayers’ theory of an amortizable expense failed.
The Court then turned to Taxpayers’ original return position, characterizing the transaction as an ordinary abandonment loss.
Again, the Court began by noting that the IRS’s determinations are presumed correct, and that taxpayers generally bear the burden of proving entitlement to the deductions they claim.
To qualify for an abandonment loss, the Court explained, a taxpayer must demonstrate that: (1) the transaction did not constitute a sale or exchange, and (2) he abandoned the asset, intentionally and affirmatively, by overt act.
As explained earlier, when a partner is relieved of his share of partnership liabilities, the partner is deemed to receive a distribution of cash. The Code requires that liquidating distributions to partners be treated as payments arising from the sale of a partnership interest.
Thus, ordinary abandonment losses may arise only in a narrow circumstance where the partner: (1) was not personally liable for the partnership’s recourse debts, or (2) was limited in liability and otherwise not exposed to any economic risk of loss for the partnership’s nonrecourse liabilities.
The IRS determined that Taxpayers’ disposal of their Partnership interests did not fall within these narrow exceptions. Accordingly, the IRS re-characterized Taxpayers’ losses from ordinary abandonment losses to capital losses on the sale of the interests.
The Court agreed with the IRS, finding that Taxpayers had not met their burden of proof. They presented no documentary or testimonial evidence to establish their eligibility for an abandonment loss deduction. They failed to prove their individual shares of any Partnership liabilities, capital restoration obligations, or lack thereof, in the light of documentary evidence suggesting otherwise.
Thus, P-1’s satisfaction of Partnership’s indebtedness to Bank generated the deemed distribution to Taxpayers that doomed their chance of establishing an abandonment for tax purposes. Indeed, this fact may have accounted for the alternative theory proffered by Taxpayers (contrary to their tax return) in an attempt to salvage some amortization-based tax-saving deductions going forward.
Accordingly, the Court sustained the IRS’s determination.
With Sincerest Apologies to Dante
“Through me you pass into capital loss, or even capital gain. Abandon all hope of ordinary loss, ye who enter here.”
During its discussion, the Court conceded that a partnership interest, which represents an intangible “investment asset,” may be abandoned for tax purposes, though only in the absence of any shifting allocation of, or relief from, partnership or individual liability.
The apparently late realization by Taxpayers, that the satisfaction of the Bank debt generated a deemed distribution of money that cut the legs out from under their abandonment theory, forced Taxpayers to not only abandon (pun intended) their tax return position, but to argue against it, and in the process to construct a series of fictional steps that were not in any way supportable.
Although a taxpayer’s disavowal of its reported position increases the burden of proof that already rests upon the taxpayer – which is bad enough – it probably also undermines the taxpayer’s credibility.
As always, taxpayers owe it to themselves to consult their tax advisers throughout the process that comprises the sale of a business or of an interest in a business. By doing so, they may be able to structure the transaction in a tax-efficient manner and to document it accordingly. Even if they fail to influence the structure, they may be able to extract some economic concession as compensation for any tax-inefficiencies imposed upon them.
Query: Taxpayers were probably aware that the sale to P-1 would not result in their receiving a cash distribution under their partnership agreement with PE; concededly, the continuance of their rental income was important to them; but how much did the availability of a large ordinary loss figure into Taxpayers’ decision to back P-1’s offer over that of P-2, which was $35 million richer?