The Tax Court, in Hohl v. Commissioner (T.C. Memo. 2021-5), characterized a partner’s infusions of cash to a partnership as a loan, rather than a capital contribution, resulting in the partnership recognizing cancellation of debt (COD) income. The court found the parties consistently treated the cash infusions as loans but ultimately took an inconsistent position in pursuit of a favorable tax outcome. The case demonstrates the importance of examining all the facts of a situation when analyzing the proper tax characterization of a transaction or event.
In Hohl, a partnership, Echo Mobile Marketing Solutions, LLC (Echo), operated from 2009 to 2012 with three service partners and a fourth partner who was to provide capital, Mr. Rodriguez. The partnership agreement provided that each of the three service partners contributed no money and owned a 30% interest in Echo, and that Mr. Rodriguez contributed $265,000 in exchange for a 10% interest.
Mr. Rodriguez repeatedly transferred funds to the partnership, and the funds were recorded as loans to the partnership. The partnership’s 2009 partnership return reported a liability under “Other liabilities” for the exact amount Mr. Rodriguez provided in 2009. On the 2009 Schedules K-1, the partners were allocated their share of the liability (which was reported as a recourse liability) according to their percentage interests in the partnership, with 10% to Mr. Rodriguez, and were allocated losses in accordance with their percentage interests.
However, none of the Schedules K-1 reported any initial capital account balances. In 2010, the partnership similarly reported an increase in the liability, which reflected an additional cash infusion from Mr. Rodriguez, but allocated the liability 100% to Mr. Rodriguez. Notwithstanding the liability allocation, Echo allocated the loss in the same percentages for the previous year. In 2011, the liabilities increased again by the amount Mr. Rodriguez transferred to the partnership in 2011, and again 100% of the liability was allocated to him. Echo reported no income, deductions, or losses for 2011. The final partnership return was filed in 2012, and again the partnership liabilities were increased. The schedule K-1 for Mr. Rodriguez showed a negative capital account but no longer reported any share of partnership liabilities and none of the other partners’ schedules K-1 reported any share of the liability.
The Tax Court looked at three factors in determining the tax characterization of Mr. Rodriguez’s cash infusions: (1) the presence of a written agreement; (2) the intent of the parties; and (3) the likelihood of obtaining similar loans from disinterested investors.
The court focused on the second factor, looking at how the partnership treated the cash infusions. The initial amount paid by Mr. Rodriguez was not included in his initial capital account balance and the partnership never increased Mr. Rodriguez’s ownership percentage for his “supposed additional capital contributions.” The partnership agreement also stated that if the partnership needed more capital it would notify all partners in writing and give all partners an “equal opportunity to contribute,” which did not happen. Though there was no written loan document between Mr. Rodriguez and Echo and the operating agreement stated the first payment made by Mr. Rodriguez was a capital contribution, the Tax Court rejected the partners’ argument that these payments were capital contributions rather than loans. It found that the parties’ actions, including how they reported their activities on their tax returns and their capital accounting, evidenced their intent to treat Mr. Rodriguez’s cash infusions as a loan.
After concluding that the funds provided by Mr. Rodriguez were loans to the partnership, resulting in COD income to the partnership, the court also addressed the allocation of the income among the partners.
Hohl serves as a useful reminder that it is important to understand the parties’ intent and to know the facts of an arrangement when analyzing the tax effects thereof.
Practice Leader, Tax Technical, Washington National Tax Office
Grace Kim has more than 20 years of experience in the area of partnership taxation, which includes IRS, law firm and accounting firm positions. Her diversified experience includes working on a broad range of structuring and operational issues in a variety of industries and areas.
Washington DC, Washington DC
- Real estate and construction
- Private equity
- Strategic federal tax
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