Withdrawal from a partnership after Citron and Echols.

• Author: Kramer, Sandra S.

Two recent judicial decisions have focused renewed attention on the tax implications of withdrawal from a partnership. Until recently, there appeared to be little possibility of leaving a partnership without recognizing a capital gain or loss. However, the Fifth Circuit decision in Echols(1) and its later per curiam decision on the IRS's appeal of the original decision have highlighted the possibility of claiming a loss deduction on the worthlessness of a partnership interest without also abandoning the interest. The Tax Court's decision in Citron(2) confirmed that an ordinary loss can be taken on the abandonment of a partnership interest when the partnership has no liabilities. Further, the Tax Court's refusal to accept Rev. Rul. 76-189(3) in Citron has brought into question the IRS's position that a capital loss results from the termination of a partnership with no assets and no liabilities.

Overview

The tax consequences of an abandonment of a partnership interest or the worthlessness of that interest are not specifically stated in the Code. Instead, the Code specifies what happens when a capital asset is sold or exchanged and leaves other asset dispositions to come under the provisions of Sec. 165. Under Sec. 165(a), uncompensated losses occurring in a trade or business or in an activity undertaken for profit may be deducted, but the character of the loss is not specified. Since neither the abandonment of a capital asset nor the worthlessness of a capital asset generally constitutes a sale or exchange,(4) a disposition of a capital asset by one of these two methods should produce an ordinary loss if no other Code provision applies. Subchapter K modifies this result for a partnership interest if the partnership has liabilities.

When a partner withdraws from a partnership, the transaction generally comes under the subchapter K provisions as a sale or exchange of a capital asset so that any recognized gain or loss is characterized as capital in nature (except to the extent that Sec. 751 applies). This treatment results from the interaction of Secs. 731, 741 and 752: Sec. 741 provides that the sale or exchange of an interest in a partnership is considered the sale or exchange of a capital asset; Sec. 731(a) provides that any gain or loss recognized in a distribution is treated as if it were gain or loss resulting from the sale or exchange of the partnership interest; and Sec. 752(b) provides that any decrease in a partner's share of partnership liabilities will be considered as a distribution of money by the partnership to the partner. These sections mandate the tax results from any termination of a partnership interest when the partner had a share of the partnership's liabilities before the termination. only when the departing partner is not released from a share of the partnership's liabilities can ordinary gain or loss be recognized.(5)

Example 1: S abandons her interest in the XYZ partnership at a time when her basis is $20,000 and she has no share of partnership liabilities under Sec. 752. There is no sale or exchange of S's interest because she receives no consideration in exchange for her partnership interest. Accordingly, the capital loss provisions do not apply, and her loss is a $20,000 ordinary loss.

Example 2: B abandons his interest in the AB partnership at a time when his basis is $ 10,000 and his share of partnership liabilities is $14,000. The remaining partners assume his share of AB's liabilities. Under Sec. 752, B is considered to have received a $14,000 money distribution. The $14,000 deemed distribution is $4,000 greater than his basis in the partnership interest, so a gain must be recognized. Under Sec. 731, the gain is considered to result from a sale or exchange of the partnership interest, and Sec. 741 characterizes gains from the sale of a partnership interest as capital in nature.

Worthlessness of a Partnership Interest

Because Sec. 1222 limits capital gain treatment to the gain or loss from the sale or exchange of a capital asset, Sec. 165(g) creates a deemed sale to ensure that the loss from a worthless security is a capital loss. However, Sec. 165(g)(2) clearly defines a security to include only corporate stock, rights to subscribe to or receive corporate stock, and certain debt instruments of corporations, governments or political subdivisions of governments. There is no comparable provision for a worthless partnership interest. Accordingly, it would seem that the worthlessness of a partnership interest should result in an ordinary loss unless the worthlessness is also accompanied by a release from the partner's share of partnership liabilities.

This position is strengthened by three cases involving insolvent partnerships. In Zeeman,(6) a partner was allowed to claim an ordinary loss for her investment in a limited partnership interest when the partnership became insolvent. The district court clearly stated:

The plaintiff's loss is an ordinary loss. While an interest in a limited or general partnership is a capital asset,..., where the loss materializes from the worthlessness of the interest, without a sale or exchange, the statutory requirements for capital loss treatment are not met.(7)

In fact, the case does not mention liabilities or basis, but rather allows the partner to deduct her entire capital investment amount.

In Tejon Ranch Co.,(8) the Tax Court allowed the general partner to deduct as an ordinary loss his capital investment in a partnership in the year in which the partnership was "insolvent beyond any hope of rehabilitation." Again there was no mention of the partner's basis in his partnership interest or of any liabilities as a portion of that basis.

In a recent partnership case in bankruptcy court, In Re James D. Kreidle, Debtor,(9) the court explicitly discussed the effect of the partnership liabilities on the deduction for worthlessness. in this case, a general partner was allowed to take an ordinary loss for tax purposes equal to the amount of his partnership basis when the partnership became worthless.

In addition, the Court finds that there was no deemed distribution pursuant to [Sec.] 752 of the Tax Code to Debtor at the time the partnership interest became worthless since there was no discharge of liabilities that would have given rise to a decrease in Kreidle's share of [the partnership's] liabilities. As a general partner..., Kreidle remained personally liable on its debts.(10)

In all three cases the partner claimed a loss for worthlessness because of the insolvency of the partnership without abandoning the partnership interest. Accordingly, the partner had not been relieved of any liability that accrued to the...