Tax issues

Partnership Abandonment May Not Be a Capital Offense

When selling real property, individual taxpayers generally prefer to declare the profit as a capital gain rather than ordinary income because of the lower marginal rate on capital gains. But in the case of losses, this logic often is reversed — ordinary losses generally provide a larger tax shield and more flexibility than capital losses.

When disposing of partnership interests, taxpayers can convert a capital loss to an ordinary loss by structuring it as the abandonment of a partnership interest (an ordinary loss) rather than a sale or exchange (a capital loss). Although this tax planning opportunity first was considered in the landmark case Citron v. Commissioner in 1991, it is worth revisiting in light of a recently released Internal Revenue Service Field Service Advice Memorandum supporting this position.

Abandonment or Sale?
The conflict between Internal Revenue Code Sections 165 and 741 creates the primary difficulty in determining whether or not a loss from a partnership interest disposition should be characterized as capital or ordinary. Section 165 allows a deduction for any loss sustained during the taxable year, and the characterization of the loss as ordinary or capital depends on the nature of the asset. Conversely, Section 741 defines a partnership interest as a capital asset and states that its sale or exchange should be treated as the sale or exchange of a capital asset.

How can one IRC section characterize a loss as ordinary and another call it a capital loss? It can’t — one section must pre-empt the other. The pivotal issue is to determine whether or not there is a sale or exchange. Assuming a true "abandonment" of a partnership interest, an ordinary loss will be allowed under Section 165, because Section 741 pre-empts Section 165 only in the case where a partnership interest is sold or exchanged. This is the very issue — and planning opportunity — that the court contemplated in Citron.

Conflict Resolved
In the Citron case, the taxpayer and other partners invested in Vandome, a limited partnership, to make motion pictures. Vandome’s general partner was a corporation. Vandome made a motion picture using capital contributed by the limited partners, and neither it nor its partners incurred any debt.

After the movie was completed, controversy arose over the rights to the film negative (the completed film) and Vandome could not obtain a copy of the negative to make a high-quality film for marketing and distribution. The corporation, however, obtained a work print (a copy of the negative).

After Vandome’s attorney failed to recover a suitable copy of the negative and because Vandome wanted to avoid any expensive, lengthy litigation, the general partner recommended using the work print to make an X-rated version of the movie in hopes of recovering the partners’ initial investment.

Not wanting to be connected with an X-rated production, the taxpayer and the other limited partners dissolved the partnership, receiving no consideration for their interests. The taxpayer claimed a $60,000 ordinary loss as reflected on his final partnership schedule K-1 from Vandome. The IRS disallowed the deduction as ordinary and claimed it was a less-valuable capital loss, arguing that it was generated from a sale or exchange of the taxpayer’s partnership interest. The court ruled in favor of the taxpayer, allowing the loss as an ordinary loss from abandonment, as prescribed by Section 165.

The Court’s Analysis
The court stated that the taxpayer must show two specific elements for a transaction to be considered an abandonment: an intention to abandon the asset and an affirmative act of abandonment. The court found that the limited partners’ vote to dissolve Vandome qualified the action as an abandonment.

In determining the character of the loss, the court argued that the "touchstone for a sale or exchange treatment is consideration. If, in return for assets, any consideration is received even if nominal in amount, the transaction will be classified as a sale or exchange." The relief of liabilities in conjunction with an abandonment concerned the court and it cited many cases in which debt relief constituted a sale or exchange.

After evaluating the facts in conjunction with its analysis of whether or not a sale or exchange took place, the court concluded that because the taxpayer received no consideration for its partnership interest and was not relieved of any liabilities in conjunction with the abandonment, the taxpayer was entitled to ordinary loss treatment for the $60,000 economic loss suffered in the abandonment.

Partnership Interest Update
A 1998 IRS Field Service Advice Memorandum also deals with the characterization of the losses realized in the abandonment of limited partnership interests.

Two corporations purportedly abandoned their respective partnership interests in a master limited partnership. Following logic similar to Citron, the IRS concluded that, because the taxpayer met the requirements to establish an abandonment and because no consideration was received for its partnership interests — including debt relief — the losses generated from the abandonment were treated as ordinary.

Real Estate Application
Ordinary treatment of abandonment losses of a partnership interest can provide tax benefits to real estate investors who hold their properties in partnership solution. Clearly, the tax rate arbitrage (ordinary loss vs. capital loss) makes abandonment an attractive option to real estate investors who hold their properties in partnership. However, as the case law demonstrates, taxpayers must exercise careful planning to achieve this objective.

As established by Citron and other authorities, ordinary loss treatment requires that an abandonment meet two requirements: the intention and the abandonment. Moreover, no payment may be made to the partnership interests — including debt relief. Any partnership-level debt included in the transferor’s partner’s basis will convert that ordinary loss to a capital loss from the sale or exchange of the partnership interest.

Taxpayers considering this strategy first should consult with their tax advisers.

Steven M. Friedman and Samuel H. Hoppe

Steven M. Friedman is a tax partner and Samuel H. Hoppe is a tax professional in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or steve.friedman@ey.com and samuel.hoppe@ey.com.

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