Partnership interests to sell or abandon
INSIGHT ARTICLE |
Sometimes it is better to structure the disposition of a partnership interest generating a loss as a sale, and sometimes it is better to structure the disposition as an abandonment, even if the economics of the two transactions are almost identical. Proper planning requires consideration of two fundamental variables:
- The partner may (or may not) have been allocated a share of the partnership’s liabilities.
- The partnership may (or may not) have built-in losses on inventory.
Given these two variables, there are four basic situations to consider:
- When there are no liabilities allocated to the partner and the partnership does not have built-in losses on inventory, abandonment should be considered as a way to obtain an ordinary loss on the disposition of the partnership interest. A sale will give rise to capital losses.
- When there are no liabilities allocated to the partner, and the partner’s loss is attributable to the partnership’s built-in losses on inventory, it does not matter whether a sale or abandonment is used. The partner’s loss, attributable to the built-in inventory loss, will be ordinary
- When there are liabilities allocated to the partner and the partnership does not have any built-in losses on inventory, it does not matter whether a sale or abandonment is used. The partner’s loss will be capital.
- When there are liabilities allocated to the partner and the partner’s loss is attributable to the partnership’s built-in losses on inventory, the disposition should be structured as a sale to ensure that the partner’s loss on sale, attributable to the partnership’s inventory, retains its ordinary character.
Why is it that sometimes a sale is better, sometimes abandonment is better, and sometimes it makes no difference? The answer lies in four key partnership loss rules, the operations of which are described below.
Partnership loss rules
Loss Rule 1: The sale of a partnership interest, like the sale of any other capital asset, generally gives rise to capital gains or losses under Internal Revenue Code (IRC) section 741. The abandonment of a partnership interest, in contrast, gives rise to an ordinary loss. This is simply the result of a statutory rule contained in section 165(a). That is why abandonments can sometimes be desirable.
Loss Rule 2: Certain transactions that may not look like sales are treated as such for tax purposes. They are not considered to be abandonments. If a partner is relieved of liabilities upon abandoning his partnership interest, the relief from liabilities is treated as a distribution of cash and, as a result, the entire transaction is treated as a sale (i.e., deemed sale.) That is why abandonments cannot be used to generate an ordinary loss if the partner is being relieved of his share of partnership liabilities.
Loss Rule 3: This loss rule deals with so-called “hot” assets. Although the sale of a partnership interest (including a deemed sale) generally gives rise to capital gains or losses, if the partner’s gain or loss is attributable to gain or loss on certain “hot” assets – like inventory or unrealized receivables – the partner’s gain or loss generally takes on the inside character of the “hot” assets and becomes, in whole or in part, ordinary. That is why abandonment may not be necessary (or appropriate as discussed in the fourth rule below) if the bulk of the partner’s outside loss is attributable to inside inventory losses.
Note that the “hot” asset rule need not be applied as an all-or-nothing affair. A partner can actually have both a capital loss and an ordinary gain, or an ordinary loss and a capital gain, from the same transaction – depending on the type of partnership assets (i.e., “hot” or not) and the portion of the gain or loss that is attributable to gain or loss on “hot” assets. The partner’s net gain or loss will always equal his economic gain or loss. But it may be comprised of partially offsetting amounts of ordinary items (attributable to unrealized gain or loss on “hot” assets) and capital items (attributable to everything else). Thus, the overall effects must be carefully computed before any planning decision is made.
Loss Rule 4: The most surprising loss rule is really a red herring that makes even less sense than all of the other rules. Where there is an abandonment or redemption that is treated as a deemed sale due to a discharge of liabilities, and there are built-in inventory losses, those ordinary losses may not be enjoyed as ordinary items by the partner. Due to a special provision of section 751(b), the “hot” asset rule does not apply for deemed sales unless the assets are substantially appreciated. Since loss assets, by definition, are never substantially appreciated, the point to remember is the taxpayer must ensure that there is an actual sale, not a deemed sale attributable solely to a technical relief of liabilities. The taxpayer must structure the transaction to ensure there is a formal sale for some amount of “good and valuable consideration” – in addition to the discharge of the partner’s share of liabilities. How much additional consideration is needed is a matter of judgment.
There may be little economic difference between a deemed sale on an abandonment and an actual sale for nominal consideration, but formalities can be very important. There is judicial support for respecting a partner’s decision to structure a transfer as a sale or as an abandonment, even if there is little or no economic difference between them.
In Foxman v. Commissioner, 41 T.C. 535, (1964), aff’d 352 F.2d 466 (3d Cir. 1965), the Tax Court explained, “Where the practical difference between a ‘sale’ and a ‘liquidation’ are, at most, slight, if they exist at all, and where the tax consequences to the partners can vary greatly, it is in accord with the purpose of the statutory provisions to allow the partners themselves, through arm’s-length negotiations, to determine whether to take the ‘sale’ route or the ‘liquidation’ route, thereby allocating the tax burden among themselves.”
Whether partners are seeking to ensure treatment as a sale or an abandonment, they should take all necessary precautions to ensure the form they have chosen is well planned, well executed, and well documented.