Planning to obtain ordinary loss treatment for worthless debts owed by partnerships to noncorporate partners.

• Author: Ellentuck, Albert B.

Facts: Elmer Beans is the sole shareholder of Beans Real Estate, Inc., a C corporation. Beans Real Estate is the general partner of the Constabulary Limited Partnership, which constructed and is attempting to operate an upscale shopping center. Beans Real Estate was formed for the sole purpose of participating in this project. Norman Leer is also a limited partner in the partnership, owning a 25% interest in partnership profits and losses. * Constabulary has encountered difficult times, and is in need of $1 million to carry it through what will hopefully be temporary troubles. Norman believes in the perfect and is willing to lend the necessary funds, but he also is aware of the real risk that his loan will not be, or may only partially be, repaid. * Norman is concerned about the tax effects of any loss that might arise from the full or partial nonpayment of the loan and has approached his tax adviser for assistance in structuring the loan. Norman believes he has two alternatives. He could contribute or loan the money to Beans Real Estate, Inc., which would, in turn, loan the money to the partnership. Alternatively, Norman could loan the $1 million directly to the partnership. Issue: How should Norman structure the loan?

Analysis

Sec. 166 allows taxpayers a deduction for debts that become worthless during the tax year. For noncorporate taxpayers, however, this allowance is qualified; losses attributable to nonbusiness bad debts are treated as resulting from the sale or exchange of capital assets held for not more than one year (i.e., short-term capital losses). As such, they are not fully deductible.

"Nonbusiness debts" are defined as debts other than debts "created or acquired in connection with a trade or business of the taxpayer" or "the worthlessness of which is incurred in the taxpayer's trade or business."

Partner Loans as Business Debts

The character of a bad debt loss attributable to a partner's loan to a partnership appears to be governed by Butler, 36 TC 1097 (1962). Butler involved a creditor who was a limited partner of the debtor partnership. The Tax Court held that the partner's loan to the partnership was deductible as a business bad debt. It based its decision on the aggregate theory of partnership taxation, attributing the partnership's business to its partners, including limited partners. Under this reasoning, a loan made in furtherance of the partnership's business is also made in furtherance of the partner's business. The...