In Watts v. Commissioner,
T.C. Memo. 2017-114 (June 14, 2017), the U.S. Tax Court rejected the taxpayer’s claim of an ordinary abandonment loss on the disposition of a partnership interest because the taxpayer failed to establish that they did not share in the partnership’s liabilities and did not offer any evidence as to how their actions constituted an intentional and overt manifestation of abandoning the partnership interest.
This case illustrates the difficulty that taxpayers may have in pursuing an ordinary loss based on abandonment of a partnership interest.
, two brothers, Edwin and Ronnie Watts, had successfully operated golf pro shops since the 1960s. In 2003, their pro shop business was acquired by a partnership when a private equity firm, Wellspring, acquired an 80.5% interest. In 2007, the disposition year in issue in the case, the brothers collectively owned less than 20% of the interests, comprised of the common interests, while Wellspring owned slightly more than 80%, comprised of the preferred interests. The partnership agreement entitled the preferred-interest holders to certain priority payments in a liquidating distribution, after which the common-interest holders would receive the amount of their initial capital account and then the common- and preferred-interest holders would share the remainder of the liquidation proceeds.
In 2006, Wellspring sought to exit from its investment in the partnership and considered two offers. The first was from Dick’s Sporting Goods, a major retailer, and the second was from Sun Capital, a private equity firm. Given their intimate knowledge of business operations, the brothers were an important factor of Wellspring’s sale of its partnership interests. Though Sun Capital’s offer was about $35 million less than Dick’s Sporting Goods’ offer of $120 million, the brothers encouraged Wellspring to sell to Sun Capital because the Sun Capital offer would provide them autonomy in operating the business and a continued stream of rental income. Ultimately, in 2007, Wellspring sold to Sun Capital. The purchase price of $87 million was for all of the interests of partnership, of which approximately $43.8 million was to be used to extinguish the partnership’s debts, $8.6 million was for fees and selling expenses, and the remaining $34.6 million of proceeds was paid directly to Wellspring. The brothers received nothing for their partnership interest.
Based on advice from their tax advisor, the brothers claimed an ordinary loss arising from abandonment of their partnership interests. Upon examination, the IRS recharacterized the loss as a capital loss from the sale or exchange of a partnership interest rather than as an ordinary loss from the abandonment of a partnership interest because the brothers had not abandoned their partnership interest.
After citing Treas. Reg. Sec. 1.165-2 and Citron v. Commissioner,
97 T.C. 200 (1992), the court explained that in order to qualify for an abandonment loss under Section 165(a), a taxpayer must demonstrate both that a transaction under review does not constitute a sale or exchange and that said taxpayer has abandoned the asset, intentionally and affirmatively, by overt act.
The court explained further that when a partner is relieved of his share of partnership liabilities, the partner is deemed to receive a distribution of cash, and Section 731(a) requires distributions to partners be treated as payments arising from the sale or exchange of a partnership interest. The court summarized that an ordinary abandonment loss may arise only in a narrow circumstance where the partner was not personally liable for the partnership’s recourse debts or was limited in liability and otherwise not exposed to any economic risk of loss for the partnership’s nonrecourse liabilities. Because the taxpayers had not presented evidence to establish that the disposal of the partnership interests fell within this narrow circumstance or how their actions constituted an intentional and overt manifestation of abandoning their partnership interests, the court held that they did not abandon their partnership interests. The court also rejected their alternative theory, which involved disavowing their form and their having orally offered to surrender their pro rata share of any sale proceeds to Wellspring in exchange for Wellspring’s agreement to sell to Sun Capital, and that upon execution of the sale, the taxpayers contributed their sale proceeds to various entities they owned which were then instantaneously paid to Wellspring pursuant to the oral agreement.
underscores the difficulty that many taxpayers face when attempting to claim an ordinary loss on the abandonment of their partnership interest. First, a taxpayer seeking to abandon his or her interest must take an intentional and overt action. However, even if such intentional and overt action is undertaken, if a partner is relieved of his or her share of partnership liabilities, a taxpayer may not take an ordinary loss on the abandonment of his or her partnership interest because a sale or exchange is deemed to occur upon a relief of partnership liabilities, even where the amount of liabilities is very small. The court’s ruling is consistent with that of Rev. Rul. 93-80, in which the IRS held that a taxpayer may take an ordinary abandonment loss as long as there is no actual or deemed distribution to the partner (e.g., a deemed distribution under Section 752(b) for the reduction in a partner’s share of partnership liabilities), or the transaction is not otherwise in substance a sale or exchange.
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