Setting the Stage

Over the last couple of months, I’ve encountered several situations involving the liquidation of a partner’s interest in a partnership. Years before, the partnership had borrowed money from a third party lender in order to fund the acquisition of equipment or other property. During the interim period, preceding the liquidation of his interest, the departing partner had been allocated his share of deductions attributable to the debt-financed properties, which presumably reduced his ordinary income and, thus, his income tax liability.

The departing partner negotiated the purchase price for his interest based upon the liquidation value of his equity in the partnership. Imagine his surprise when he learned (i) that his taxable gain would be calculated by reference not only to the amount of cash actually distributed to him (the amount he negotiated), but would also include his “share” of the partnership’s remaining indebtedness, and (ii) that the amount of cash he would actually receive would just barely cover the resulting tax liability.

A recent decision by the Tax Court illustrated this predicament, and much more.

The End of a Partnership

Prior to Taxpayer’s admission as a partner, Partnership had entered into a lease for office space and had borrowed funds from Lender I for leasehold improvements.

Subsequently, Taxpayer joined Partnership as a general partner. Upon joining Partnership, Taxpayer did not sign a partnership agreement. At some point after Taxpayer joined the Partnership, the Partnership entered into a line of credit loan arrangement with Lender II.

Partnership dissolved in Year One. Upon Partnership’s dissolution, the Partnership began to wind up its affairs by collecting accounts receivable and settling pending lawsuits brought against the Partnership by its lenders and landlord.

In order to create a fund out of which to make partial payments to settle with the aforementioned creditors, Partnership’s former partners signed a settlement agreement pursuant to which Taxpayer agreed to pay a fixed dollar amount, constituting X% of the Partnership settlement fund. The settlement agreement included a provision entitled “Special Tax Allocation,” which provided:

In recognition of the contribution by each of the various Partners to the settlement of the Lawsuits, to each Partners’ allocation of income and loss for the year in which the [settlement] occurs shall be credited the percentage of loss created by the settlement and satisfaction of the Lawsuits equal to the pro-rata contribution by such Partner to the fund created by the terms of this Agreement. It is specifically recognized that this is a special allocation of losses made by the Partners in recognition of the contributions to the settlement of the Lawsuits and in lieu of and in substitution for the allocation of losses pursuant to the respective interests of the Partners in the [Partnership].

In Year Two, Partnership’s former partners entered into settlement agreements with each of its Lenders, pursuant to which Partnership agreed to pay a portion of the outstanding indebtedness to settle its debts, and the Lenders forgave their remaining balance.

Partnership filed Forms 1065, U.S. Partnership Return of Income, and Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for Years One through Two which reflected the income and tax items resulting from its operations until late Year One (the year of dissolution) and the winding up of its affairs thereafter.

Taxpayer received a Schedule K-1 from Partnership for Year One, and another for Year Two, and reported his share of Partnership income and other tax items as reflected on the Schedules K-1 on his personal income tax returns.

Taxpayer’s Year Two return reported a nonpassive loss from Partnership, but it did not report any cancellation of indebtedness income from Partnership; nor did it report any capital gains.

Some Basic Partnership Tax Concepts

In general, a partner’s adjusted basis (“investment” for our purposes) in his partnership interest reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Income

A partner must recognize his distributive share of partnership income regardless of whether the partnership makes any distribution to the partner. The amount of income so recognized is reflected as an increase in the partner’s adjusted basis in his partnership interest.

Distributions

A partnership’s distribution of cash to a partner (representing, perhaps, already-taxed income, or capital contributions) reduces the partner’s adjusted basis in his partnership interest. If a cash distribution exceeds the partner’s adjusted basis in his interest, the excess amount is taxable to the partner. Thus, a partner may withdraw cash from a partnership without realizing any income or gain to the extent of his adjusted basis.

Losses

A partner can deduct his distributive share of partnership loss to the extent of his adjusted basis in his partnership interest at the end of the partnership’s tax year in which the loss occurred (one cannot lose more than one has “invested”); in general, his adjusted basis reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Borrowed Funds

When an individual borrows money, he does not realize any income; the loan proceeds do not represent an accretion in value to the individual. However, the individual may use the borrowed funds to pay expenses for which he may claim a deduction, or he may use them to acquire an asset for which he may claim depreciation deductions.

As a pass-through entity, a partnership tries to mirror these tax consequences of borrowing by its partners. Thus, when a partnership borrows money, the indebtedness is “allocated” among the partners, as though they had borrowed the funds and then contributed them to the partnership, thereby increasing each partner’s adjusted basis by his share of the partnership indebtedness. By doing so, the partners may withdraw the borrowed funds from the partnership without recognition of income (reducing their adjusted basis in the process), and may claim deductions for expenses paid with the borrowed funds, or for depreciation deductions with respect to property acquired with the borrowed funds.

Similarly, any increase in a partner’s share of partnership liabilities is treated, for tax purposes, as a contribution of money by the partner to the partnership, thereby increasing the partner’s basis in his partnership interest.

Conversely, any decrease in a partner’s share of partnership liabilities is treated as a distribution of money by the partnership to the partner. If the amount of this decrease exceeds the partner’s adjusted basis in his partnership interest, the partner will recognize gain to the extent of the excess.

IRS Audit

After examining Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, relating to Year Two, in which it: disallowed the Partnership loss deductions claimed; determined that Taxpayer failed to report his distributive share of Partnership’s discharge of indebtedness income; and determined that Taxpayer failed to report capital gain stemming from the deemed distribution of cash in excess of Taxpayer’s basis in his Partnership interest.

Cancellation of Debt

According to the IRS, Partnership’s settlement of its indebtedness to its Lenders, with a partial payment, resulted in cancellation of indebtedness income for the balance; it eliminated the Partnership’s outstanding liabilities.

Reduced Share of Debt

As a result of these transactions, the IRS contended that Taxpayer had to include in income his X% share of Partnership’s discharge of indebtedness income.

The IRS also argued that there had been a deemed distribution of cash to Taxpayer in an amount equal to the canceled Partnership liabilities previously allocated to Taxpayer on his Schedule K-1. According to the IRS, this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest and triggered a capital gain in an amount equal to the excess, which Taxpayer had to include in income.

Insufficient Basis for Deductions

Finally, the IRS contended that because Taxpayer had no remaining basis in his Partnership interest with which to absorb his distributive share of Partnership loss for Year Two, Taxpayer was not entitled to the deduction he claimed, and had to increase his income accordingly.

Tax Court’s Analysis

Taxpayer petitioned the Tax Court to review the IRS’s determinations.

COD Income

The Court explained that gross income generally includes income from the discharge of indebtedness; when realized by a partnership, such income must be recognized by its partners as ordinary income. The recognition of such income provides each partner with an increase in the adjusted basis in his partnership interest.

Under the settlement agreement, each partner, including Taxpayer, agreed that his distributive share of Partnership income and loss for Year Two would be calculated according to the percentage of funds that each had contributed towards the settlement fund. Taxpayer contributed X% of the total; thus, Partnership allocated X% of its discharge of indebtedness income to Taxpayer on his Schedule K-1.

Taxpayer made several arguments in an attempt to avoid the allocation of this income, but the Court found they had no merit, stating that the basic principle that partners must recognize as ordinary income their distributive share of partnership discharge of indebtedness income was well-established, even as to nonrecourse debts for which no partner bears any personal liability.

In sum, Taxpayer had to recognize his X% distributive share of Partnership’s discharge of indebtedness income for Year Two, thereby increasing Taxpayer’s adjusted basis in his Partnership interest to that extent.

Deemed Cash Distribution

The Court next determined that there was a deemed cash distribution to Taxpayer as a result of the elimination of Partnership’s outstanding liabilities during Year Two when it settled with its creditors, which “relieved” Taxpayer of his share of the partnership’s liabilities. Therefore, Taxpayer received a deemed distribution of cash from Partnership in an amount equal to his share of the liabilities.

Because this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest, Taxpayer was required to recognize capital gain in the amount of the excess.

No Basis? No Deduction

Finally, having determined that Taxpayer had no remaining basis in his Partnership interest as of the end of Year Two, the Court concluded that Taxpayer was not entitled to deduct his share of partnership losses for that year.

Lessons?

One often hears about the “phantom income” realized by a departing partner when his partnership has outstanding indebtedness, part of which was allocated to him, and is then deemed distributed to him in liquidation of his interest.

Many partners equate “phantom” with “unfair,” which is itself unfair, and inaccurate. In fact, the deemed cash distribution that is attributable to the departing partner’s share of partnership indebtedness results in gain to the partner only to the extent he previously received a “tax-free” distribution of the loan proceeds or was allocated partnership deductions or losses attributable to the partnership’s use of the borrowed funds. A more accurate description, therefore, may be that the departing partner is forced to recapture the tax benefit previously realized.

Theory and semantics aside, though, can the departing partner reduce or defer any of the adverse tax consequences described above? Maybe.

For example, a partner to whom income is allocated from the cancellation of a partnership’s indebtedness may be able to exclude the income if he – not the partnership – is insolvent at the time of the discharge.

As regards the deemed distribution of cash resulting from a former partner’s share partnership indebtedness, the distribution may be deferred so long as the partner remains a partner for tax purposes (for example, where his interest is being liquidated in installments). The amount of the deemed distribution may also be reduced if the partner receives an in-kind liquidating distribution of encumbered property, thereby resulting in a netting of the “relieved” and “assumed” liabilities, with only the net amount relieved being treated as a cash distribution.

The key, as always, is to analyze and understand the tax, and resulting economic, consequences of a liquidation well in advance of any negotiations. You cannot bargain for something of which you are unaware.