Partnership Interest Abandonment or Worthlessness
Authored by: Troy Martin, CPA, Shareholder. Troy specializes in advance tax planning for individuals, businesses, estates, trusts, and pension plans.
Assessing the potential for an ordinary loss
A partner may own a partnership interest that becomes worthless (or nearly worthless). In these situations, it may be impossible to find someone to purchase or take the interest, and the partner is tempted to just “walk away” from the partnership. To the extent the partner has remaining adjusted basis in his partnership interest, he may be allowed a loss under IRC §165(a) for an abandonment or because the interest is worthless. Several factors must be considered in order for the taxpayer to properly deduct such a loss, including the following: establishing the abandonment or worthlessness of the interest, identifying the proper year of deduction, and determining the character of the loss as ordinary or capital.
Claiming a deduction
IRC §165(a) allows a loss that is not recovered through insurance or some other means of compensation to be deducted in the year sustained. Treas. Regs. §1.165-1 indicates that a loss is treated as sustained during the year that the loss occurs “… as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year.” Treas. Regs. §1.165-2 allows a deduction for the obsolescence of non-depreciable property. The loss incurred must 1) relate to a business or a transaction entered into for profit, 2) arise from a sudden termination of the usefulness of the property, and 3) be associated with either the discontinuance of the business or transaction or the permanent discarding of the property (e.g., abandonment) from use in the business. This provision does not apply to losses that are sustained upon the sale or exchange of the property.
Establishing partnership interest abandonment
In order for a taxpayer to establish the abandonment of an asset, he must show intent to abandon the asset and overtly act to abandon it. The partner should claim an abandonment loss in the year that he has intent to abandon the partnership interest and overtly communicates his intent to interested third parties (the other partners) his decision to walk away.1 In some states, withdrawal from a partnership is allowed only where provided in the partnership agreement.
Establishing partnership interest worthlessness
Although certain steps must be taken to establish an abandonment loss, there is some support that these steps are not necessary for establishing a deduction for a worthless asset. In Echols v. Commissioner, the court of appeals looked to the taxpayer’s subjective determination of worthlessness as “largely a judgment call by a taxpayer based on his own particular, highly personal set of economic factors, including tax effects.”2 The fact that other investors might have determined that the partnership interest was worthless in an earlier year or that other investors might be willing to hold on to the interest and infuse cash were not factors in determining the worthlessness of the partnership interest specific to the taxpayer. Nevertheless, it is prudent to do as much as possible to establish the worthlessness of the partnership interest.
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