Partners’ claimed amortization deductions denied

Tax Hot Topics newsletter The Tax Court recently reiterated in Watts v. Commissioner, T.C. Memo 2020-144 (Oct. 15, 2020), that two brothers were not entitled to an amortization deduction or abandonment loss in connection with the sale of their partnership interests.

In a prior opinion, Watts v. Commissioner (Watts I), T.C. Memo 2017-114 (June 14, 2017), the Tax Court had determined that the taxpayers were not entitled to an ordinary loss for abandoning their partnership interests. In a supplemental opinion, Watts v. Commissioner (Watts II), 747 F. App’x 837 (11th Cir. 2019), on remand from the Court of Appeals for the 11th Circuit, the Tax Court applied the Danielson rule to dismiss the taxpayers’ attempt to recharacterize a sale transaction in order to secure an amortization deduction. This supplemental opinion illustrates the limits placed on taxpayers who seek to characterize a transaction for tax purposes in a manner that conflicts with the form reflected in the relevant legal documents.

The taxpayers in Watts were two brothers who held a minority, common interest in a partnership which operated a chain of golf pro shops. A private equity firm, Wellspring, held an approximately 80% preferred interest in the partnership and, under the terms of the partnership agreement, was entitled to a preferred return before the holders of the common interests would be entitled to a portion of the proceeds from the sale or liquidation of the partnership. In 2007, Wellspring and the common partners executed a purchase agreement to sell 100% of the partnership to Sun Capital, another private equity firm. All the net sales proceeds were paid directly to Wellspring. The taxpayers and the other common partners received nothing for their partnership interests. For a more in-depth description of the facts, see our story, “Tax Court rules that losses from abandonment of partnership interest are capital.

On remand, in Watts II, the taxpayers alleged that in order to induce Wellspring to sell to Sun Capital (as opposed to another potential buyer), and thereby preserve their employees’ jobs and certain rental income streams they received from the partnership, the taxpayers agreed to surrender to Wellspring funds they were entitled to receive on the sale of the partnership (referred to as the “incentive theory”). According to the taxpayers, by paying their portion of the sales proceeds to Wellspring, they created an intangible asset that they were entitled to amortize. In the alternative, the taxpayers argued that they were entitled to an ordinary loss from the abandonment of their partnership interests. Both theories were rejected by the Tax Court in Watts I.

On appeal, the taxpayers argued, and the IRS agreed, that in rejecting the incentive theory, the Tax Court incorrectly assumed certain facts about the parties’ conduct under the partnership agreement. On remand, however, the Tax Court again rejected the taxpayers’ incentive theory. According to the terms of the partnership agreement and the purchase agreement, Wellspring was entitled to 100% of the proceeds of the sale of the partnership to Sun Capital.

The 11th Circuit has expressly adopted the rule in Danielson v. Commissioner, 378 F.2d 771 (3d Cir. 1967), which generally provides that taxpayers may not challenge the form of their transaction where the agreement for a transaction unambiguously indicates how the transaction should be treated for tax purposes unless they can show that the form would be unenforceable because of mistake, undue influence, fraud, duress or the like. In Watts II, the Tax Court ruled that, under the Danielson rule, the taxpayers were precluded from arguing that they were in fact entitled to a portion of the sales proceeds for tax purposes. Because the taxpayers were not entitled to any portion of the sale proceeds, they could not have agreed to surrender those proceeds to Wellspring as suggested by the incentive theory. The Tax Court did not further consider whether, if substantiated, a payment to Wellspring would have generated an amortization deduction for the taxpayers.

While taxpayers have latitude in how they choose to structure their affairs, the Watts case demonstrates the risks faced by taxpayers and practitioners who seek to pursue a tax treatment for a transaction that is inconsistent with the unambiguous legal form agreed to by the parties in effectuating that transaction.

Grace Kim
Principal, Partnerships
Washington National Tax Office
T +1 202 521 1590

Jose Carrasco
Senior Manager, Partnerships
Washington National Tax Office
T +1 202 521 1552

Whit Cocanower
Senior Associate
Washington National Tax Office
T +1 202 521 1541

Sarah Barlow
Senior Associate
Washington National Tax Office
T +1 202 521 1505

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