Taxation of worthless and abandoned partnership interests.

• Author: Schnee, Edward J.

Investors are advised to buy low and sell high. Many are also advised to establish a limit on losses and, if the investment declines to that point, to sell it. Correctly or incorrectly, investors often do not sell their investments when their value declines to that level, but instead either sell after their investments have declined to the point that they incur substantial losses or hold on until the investments have little or no value. When this occurs, for a variety of reasons, investors sometimes abandon the investments.

A few years ago, in the Pilgrims Pride case, which involved a corporation's abandonment of stock, the Tax Court held, as discussed further below, that when a corporation abandoned an investment in stock, Sec. 1234A applied and that the corporation's loss on the abandonment of the stock was a capital loss. (1) If the Fifth Circuit had not reversed, the decision would have also arguably required that losses on the abandonment of partnership interest investments be treated as capital losses under Sec. 1234A, instead of as ordinary losses. (2) Since the appeals court reversed, Sec. 1234A will not apply to a loss on the abandonment of an investment in a partnership interest, and the tax treatment of the loss will be taxed based on prior cases and rulings as well as the regulations.

This article first discusses the tax treatment of worthless or abandoned stock. It then discusses the tax treatment of worthless and abandoned partnership interests.

Sec. 165(a)

Sec. 165(a) allows a taxpayer to deduct an ordinary loss to the extent insurance does not compensate the taxpayer for the loss. Sec. 165(c) requires, in the case of an individual, that the taxpayer must incur the loss in a trade or business, in any transaction entered into for profit, or as a result of a casualty or theft not connected with a trade or business or a transaction entered into for profit, for the loss to be deductible under Sec. 165(a). A taxpayer can take a Sec. 165(a) loss for property (including intangible property, such as a partnership interest) if the property is worthless or if it is abandoned.

Pilgrim's Pride

Pilgrim's Pride Corp.'s predecessor corporation, Gold Kist, purchased preferred stock and securities of Southern States Cooperative Inc. for $98.6 million. In 2004, Southern States and Gold Kist attempted to negotiate a price to redeem the stock and securities but were unable to agree. Southern States offered $20 million, but Gold Kist asked for $31.5 million. (3) Gold Kist decided to abandon the investments because it decided that the $98.6 million ordinary loss it planned to claim on its tax return would generate more cash than the $20 million redemption plus the tax savings from the deductible capital loss.

Gold Kist claimed an ordinary loss under Sec. 165(a) on the grounds that Sec. 165(g), which provides for capital loss treatment for worthless securities, did not apply. Sec. 165(a) allows a taxpayer to deduct an ordinary loss to the extent the loss is not compensated for by insurance. (4) Under Sec. 165(g), a taxpayer treats a worthless security as a deemed sale of a capital asset on the last day of the tax year. (5) This deemed sale generates a capital loss equal to the basis of the worthless security. If Sec. 165(g) applies, Sec. 165(a) does not. A security for Sec. 165(g) purposes includes corporate stock and stock options as well as corporate or government debt that is registered or has interest coupons. (6) The securities at issue met this definition. Gold Kist did not apply Sec. 165(g) because the securities were not worthless as evidenced by the $20 million redemption option. Since Sec. 165(g) did not apply and the securities were not sold or exchanged, Gold Kist argued, the loss was not capital. Instead the result was an ordinary loss under Sec. 165(a).

The IRS argued that Sec. 165(g) does apply to the abandonment of the stock. The IRS contended that the abandoned stock was worthless, as required by the statute, and thus the abandonment should be treated as a sale resulting in a capital loss.

Although neither Pilgrim's Pride nor the IRS initially addressed whether Sec. 1234A might apply to the abandonment of the stock, the Tax Court asked both parties to file briefs discussing this issue. Sec. 1234A provides that the cancellation, lapse, expiration, or other termination of a right or obligation that would be a capital asset in the taxpayer's hands, as well as Sec. 1256 contracts, results in a deemed sale of a capital asset generating a capital loss.

The Tax Court found that Sec. 1234A applied and held in favor of the IRS. (7) The court was required to determine whether Sec. 1234A applies to actual ownership of stock, etc., as the IRS argued, or only to derivative rights, etc., and not actual ownership, as Pilgrim's Pride argued. The Tax Court reasoned that Congress's modification to Sec. 1234A, which was adopted in the Tax Relief Act of 1997, (8) was designed to prevent taxpayers from structuring transactions so that any recognition of income or loss would result in an ordinary loss or capital gain at the taxpayers' election and therefore the section applies to direct ownership of securities as well as the rights to acquire the securities. The Tax Court's holding, if it had been applied universally, would have resulted in all abandonments as well as cancellations of investments being treated as capital losses, which would have a significant impact on investors.

Pilgrim's Pride appealed the decision to the Fifth Circuit, which reversed the Tax Court. (9) The Fifth Circuit considered whether Sec. 1234A applied to capital assets and how it applied to the abandonment of corporate stock and securities, as well as partnership interests. The court found that Sec. 1234A, by its plain language, was not intended to apply to the termination of the ownership of capital assets, but only to the termination of rights or obligations with respect to capital assets, such as derivative or contractual rights to buy or sell capital assets. Therefore, Sec. 1234A did not apply to Pilgrim's Pride's case, which involved the abandonment of an actual capital asset--stock. It further found that the stock Pilgrim's Pride owned was not worthless and, as the company had originally contended, Sec. 165(g) did not apply. Thus, Pilgrim's Pride had correctly reported an ordinary loss since the securities were not sold or exchanged.

However, as the court noted, its decision will not apply to future abandonments of securities that are defined in Sec. 165(g)(2). In 2008, Treasury modified Regs. Sec. 1.165-5 so that it now states that the abandonment of a security will result in that security being treated as worthless. Therefore, in the future, abandoning corporate securities will generate a capital loss. Partnership interests, however, are not securities under Sec 165(g). Therefore, the regulation does not affect partnership interests, and consequently whether a partnership interest is treated as worthless or as abandoned will determine the tax result.

Partnership Interests: Initial Questions

In determining whether a loss for an abandoned or worthless partnership interest under Sec. 165(a) can be claimed, the partner must answer two threshold questions specific to partnership interests.

The first is whether the partnership had economic substance. This was the issue the Tax Court identified in Marinovich (10) where the taxpayers acquired an interest in a tax shelter partnership. In a previous tax shelter case that the taxpayers in Marinovich had agreed to be bound by, the Tax Court ruled that this type of partnership lacked economic substance. (11) The Tax Court concluded that to be entitled to a loss under Sec. 165(c)(2), a taxpayer must be able to prove that the partnership has economic substance and that the partner invested in the partnership to earn a profit. The fact that the investment was profit-motivated is immaterial if the partnership lacks economic substance. Therefore, a taxpayer's cash investment in tax shelter partnerships does not generate deductible losses based on Marinovich.

The second question is whether the taxpayer can prove that a partnership existed and that the taxpayer owns an interest in it. In Milton, (12) the taxpayer, who was a real estate professional, was asked...