You Can’t Always Get What You Want – But If You Try Sometimes, You Just Might Find an Ordinary Deduction
May 30, 2017
By Sarah E. Allen-Anthony, CPA, and Bruce J. Belman, J.D., CPA
Financial services companies sometimes end up holding partnership interests they would like to get off of their books. Options for ridding themselves of these interests and taking an ordinary loss are limited and could result in an unusable capital loss if they do not proceed with care.
Rules regarding the timing and characterization of a loss are complicated, and failure to adhere to them can leave a bank with a capital loss deduction rather than the more valuable ordinary deduction. An ordinary loss can arise from either an abandonment of the partnership interest or a declaration that the partnership interest is worthless.
The Liability Question
A bank can find itself with investments in partnerships it does not want or that have declined in value and that it no longer wishes to hold. Partnership interests often are illiquid, and, even if a market exists, it can be difficult to find a willing buyer, making a sale or exchange unlikely. Moreover, a loss on a partnership interest that results from a sale or exchange would be a capital loss.
In general, Section 165(a) of the Internal Revenue Code allows “as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Section 165(g) characterizes the loss on worthless securities to be a capital loss. However, partnership interests (unlike corporate stock) are not securities under Section 165(g), which means the losses can be capital or ordinary.
The loss might not qualify as an ordinary loss, if, by claiming the partnership interest is worthless or abandoned, the bank is relieved of its share of any partnership debt. In such a case, the debt relief is deemed to be the proceeds of a sale, and the bank can claim only a capital loss deduction.
A bank that wishes to take an ordinary loss for worthlessness or abandonment on an interest in a partnership that has allocated debt to the bank does have alternatives. For example, a bank can provide the partnership with funds to settle the debt before abandoning its interest. It also could maintain responsibility for the debt after disposing of its interest. However, a bank needs to compare the potential cost with the tax benefit to determine if it makes sense to throw new cash at a bad deal just to obtain an ordinary loss deduction. Another factor to consider is whether the bank anticipates future capital gains in order to use the capital loss.
Proving Worthlessness or Abandonment
A bank is not assured of an ordinary loss simply because it is not liable for any partnership debt. It also must satisfy the requirements for taking a loss for worthlessness or abandonment.
To take a worthlessness loss on a partnership interest, a bank must show that in the year the loss deduction is claimed, it subjectively believed the interest to be worthless and the interest must, in fact, be objectively worthless. A significant decline in value does not render a partnership interest worthless; rather, the interest must have no current or future value.
In contrast, a bank can take an abandonment loss even if the interest still has some value remaining. To take an abandonment loss the bank must show that, in the year of the deduction, it 1) intended to abandon the partnership interest and 2) engaged in an affirmative act of abandonment of the interest (for example, sending written notification to the partnership that the bank is abandoning its interest). Notably, the affirmative act must be observable to outsiders. The bank should formally abandon the partnership interest in order to meet this requirement.
Proceed With Caution
Financial services companies should tread carefully when evaluating the worthlessness and abandonment options for shedding unwanted partnership interests. Abandonment generally is a better route since establishing worthlessness can be difficult. Careful planning is essential to maximize the tax benefits of these interests, both in the timing and character of the loss.
In This Issue