Setting the Stage

Over the last couple of months, I’ve encountered several situations involving the liquidation of a partner’s interest in a partnership. Years before, the partnership had borrowed money from a third party lender in order to fund the acquisition of equipment or other property. During the interim period, preceding the liquidation of his interest, the departing partner had been allocated his share of deductions attributable to the debt-financed properties, which presumably reduced his ordinary income and, thus, his income tax liability.

The departing partner negotiated the purchase price for his interest based upon the liquidation value of his equity in the partnership. Imagine his surprise when he learned (i) that his taxable gain would be calculated by reference not only to the amount of cash actually distributed to him (the amount he negotiated), but would also include his “share” of the partnership’s remaining indebtedness, and (ii) that the amount of cash he would actually receive would just barely cover the resulting tax liability.

A recent decision by the Tax Court illustrated this predicament, and much more.

The End of a Partnership

Prior to Taxpayer’s admission as a partner, Partnership had entered into a lease for office space and had borrowed funds from Lender I for leasehold improvements.

Subsequently, Taxpayer joined Partnership as a general partner. Upon joining Partnership, Taxpayer did not sign a partnership agreement. At some point after Taxpayer joined the Partnership, the Partnership entered into a line of credit loan arrangement with Lender II.

Partnership dissolved in Year One. Upon Partnership’s dissolution, the Partnership began to wind up its affairs by collecting accounts receivable and settling pending lawsuits brought against the Partnership by its lenders and landlord.

In order to create a fund out of which to make partial payments to settle with the aforementioned creditors, Partnership’s former partners signed a settlement agreement pursuant to which Taxpayer agreed to pay a fixed dollar amount, constituting X% of the Partnership settlement fund. The settlement agreement included a provision entitled “Special Tax Allocation,” which provided:

In recognition of the contribution by each of the various Partners to the settlement of the Lawsuits, to each Partners’ allocation of income and loss for the year in which the [settlement] occurs shall be credited the percentage of loss created by the settlement and satisfaction of the Lawsuits equal to the pro-rata contribution by such Partner to the fund created by the terms of this Agreement. It is specifically recognized that this is a special allocation of losses made by the Partners in recognition of the contributions to the settlement of the Lawsuits and in lieu of and in substitution for the allocation of losses pursuant to the respective interests of the Partners in the [Partnership].

In Year Two, Partnership’s former partners entered into settlement agreements with each of its Lenders, pursuant to which Partnership agreed to pay a portion of the outstanding indebtedness to settle its debts, and the Lenders forgave their remaining balance.

Partnership filed Forms 1065, U.S. Partnership Return of Income, and Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for Years One through Two which reflected the income and tax items resulting from its operations until late Year One (the year of dissolution) and the winding up of its affairs thereafter.

Taxpayer received a Schedule K-1 from Partnership for Year One, and another for Year Two, and reported his share of Partnership income and other tax items as reflected on the Schedules K-1 on his personal income tax returns.

Taxpayer’s Year Two return reported a nonpassive loss from Partnership, but it did not report any cancellation of indebtedness income from Partnership; nor did it report any capital gains.

Some Basic Partnership Tax Concepts

In general, a partner’s adjusted basis (“investment” for our purposes) in his partnership interest reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Income

A partner must recognize his distributive share of partnership income regardless of whether the partnership makes any distribution to the partner. The amount of income so recognized is reflected as an increase in the partner’s adjusted basis in his partnership interest.

Distributions

A partnership’s distribution of cash to a partner (representing, perhaps, already-taxed income, or capital contributions) reduces the partner’s adjusted basis in his partnership interest. If a cash distribution exceeds the partner’s adjusted basis in his interest, the excess amount is taxable to the partner. Thus, a partner may withdraw cash from a partnership without realizing any income or gain to the extent of his adjusted basis.

Losses

A partner can deduct his distributive share of partnership loss to the extent of his adjusted basis in his partnership interest at the end of the partnership’s tax year in which the loss occurred (one cannot lose more than one has “invested”); in general, his adjusted basis reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Borrowed Funds

When an individual borrows money, he does not realize any income; the loan proceeds do not represent an accretion in value to the individual. However, the individual may use the borrowed funds to pay expenses for which he may claim a deduction, or he may use them to acquire an asset for which he may claim depreciation deductions.

As a pass-through entity, a partnership tries to mirror these tax consequences of borrowing by its partners. Thus, when a partnership borrows money, the indebtedness is “allocated” among the partners, as though they had borrowed the funds and then contributed them to the partnership, thereby increasing each partner’s adjusted basis by his share of the partnership indebtedness. By doing so, the partners may withdraw the borrowed funds from the partnership without recognition of income (reducing their adjusted basis in the process), and may claim deductions for expenses paid with the borrowed funds, or for depreciation deductions with respect to property acquired with the borrowed funds.

Similarly, any increase in a partner’s share of partnership liabilities is treated, for tax purposes, as a contribution of money by the partner to the partnership, thereby increasing the partner’s basis in his partnership interest.

Conversely, any decrease in a partner’s share of partnership liabilities is treated as a distribution of money by the partnership to the partner. If the amount of this decrease exceeds the partner’s adjusted basis in his partnership interest, the partner will recognize gain to the extent of the excess.

IRS Audit

After examining Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, relating to Year Two, in which it: disallowed the Partnership loss deductions claimed; determined that Taxpayer failed to report his distributive share of Partnership’s discharge of indebtedness income; and determined that Taxpayer failed to report capital gain stemming from the deemed distribution of cash in excess of Taxpayer’s basis in his Partnership interest.

Cancellation of Debt

According to the IRS, Partnership’s settlement of its indebtedness to its Lenders, with a partial payment, resulted in cancellation of indebtedness income for the balance; it eliminated the Partnership’s outstanding liabilities.

Reduced Share of Debt

As a result of these transactions, the IRS contended that Taxpayer had to include in income his X% share of Partnership’s discharge of indebtedness income.

The IRS also argued that there had been a deemed distribution of cash to Taxpayer in an amount equal to the canceled Partnership liabilities previously allocated to Taxpayer on his Schedule K-1. According to the IRS, this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest and triggered a capital gain in an amount equal to the excess, which Taxpayer had to include in income.

Insufficient Basis for Deductions

Finally, the IRS contended that because Taxpayer had no remaining basis in his Partnership interest with which to absorb his distributive share of Partnership loss for Year Two, Taxpayer was not entitled to the deduction he claimed, and had to increase his income accordingly.

Tax Court’s Analysis

Taxpayer petitioned the Tax Court to review the IRS’s determinations.

COD Income

The Court explained that gross income generally includes income from the discharge of indebtedness; when realized by a partnership, such income must be recognized by its partners as ordinary income. The recognition of such income provides each partner with an increase in the adjusted basis in his partnership interest.

Under the settlement agreement, each partner, including Taxpayer, agreed that his distributive share of Partnership income and loss for Year Two would be calculated according to the percentage of funds that each had contributed towards the settlement fund. Taxpayer contributed X% of the total; thus, Partnership allocated X% of its discharge of indebtedness income to Taxpayer on his Schedule K-1.

Taxpayer made several arguments in an attempt to avoid the allocation of this income, but the Court found they had no merit, stating that the basic principle that partners must recognize as ordinary income their distributive share of partnership discharge of indebtedness income was well-established, even as to nonrecourse debts for which no partner bears any personal liability.

In sum, Taxpayer had to recognize his X% distributive share of Partnership’s discharge of indebtedness income for Year Two, thereby increasing Taxpayer’s adjusted basis in his Partnership interest to that extent.

Deemed Cash Distribution

The Court next determined that there was a deemed cash distribution to Taxpayer as a result of the elimination of Partnership’s outstanding liabilities during Year Two when it settled with its creditors, which “relieved” Taxpayer of his share of the partnership’s liabilities. Therefore, Taxpayer received a deemed distribution of cash from Partnership in an amount equal to his share of the liabilities.

Because this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest, Taxpayer was required to recognize capital gain in the amount of the excess.

No Basis? No Deduction

Finally, having determined that Taxpayer had no remaining basis in his Partnership interest as of the end of Year Two, the Court concluded that Taxpayer was not entitled to deduct his share of partnership losses for that year.

Lessons?

One often hears about the “phantom income” realized by a departing partner when his partnership has outstanding indebtedness, part of which was allocated to him, and is then deemed distributed to him in liquidation of his interest.

Many partners equate “phantom” with “unfair,” which is itself unfair, and inaccurate. In fact, the deemed cash distribution that is attributable to the departing partner’s share of partnership indebtedness results in gain to the partner only to the extent he previously received a “tax-free” distribution of the loan proceeds or was allocated partnership deductions or losses attributable to the partnership’s use of the borrowed funds. A more accurate description, therefore, may be that the departing partner is forced to recapture the tax benefit previously realized.

Theory and semantics aside, though, can the departing partner reduce or defer any of the adverse tax consequences described above? Maybe.

For example, a partner to whom income is allocated from the cancellation of a partnership’s indebtedness may be able to exclude the income if he – not the partnership – is insolvent at the time of the discharge.

As regards the deemed distribution of cash resulting from a former partner’s share partnership indebtedness, the distribution may be deferred so long as the partner remains a partner for tax purposes (for example, where his interest is being liquidated in installments). The amount of the deemed distribution may also be reduced if the partner receives an in-kind liquidating distribution of encumbered property, thereby resulting in a netting of the “relieved” and “assumed” liabilities, with only the net amount relieved being treated as a cash distribution.

The key, as always, is to analyze and understand the tax, and resulting economic, consequences of a liquidation well in advance of any negotiations. You cannot bargain for something of which you are unaware.

In General

It is a basic principle of federal tax law that a taxpayer cannot, for purposes of determining the taxpayer’s taxable income, claim a loss with respect to an investment in excess of the taxpayer’s unrecovered economic cost for such investment. If the taxpayer invested $X to acquire a non-depreciable asset – for example, a capital contribution in exchange for shares of stock in a C corporation, or a loan to a corporation in exchange for an interest-bearing note – the amount of loss realized by the taxpayer upon the disposition or worthlessness of the asset will be based upon the amount invested by the taxpayer in acquiring the asset. Where the asset is depreciable by the taxpayer, the loss realized is determined by reference to the taxpayer’s cost basis, reduced by the depreciation deductions claimed by the taxpayer (which represent a recovery of the taxpayer’s cost), i.e., the taxpayer’s adjusted basis.

Application to S-Corps

In the case of an S corporation, a shareholder’s ability to utilize his pro rata share of any deductions or losses realized by the S corporation is limited in accordance with this principle; specifically, for any taxable year, the aggregate amount of losses and deductions that may be taken into account by a shareholder cannot exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation, and the shareholder’s adjusted basis for any bona fide loans made by the shareholder to the S corporation.

Stock Basis

Because an S corporation is treated as a pass-through for tax purposes, its income is generally not subject to corporate-level tax; rather, it is taxed to its shareholders (whether or not it is distributed to them).

In order to preserve this single level of tax, a shareholder’s initial basis for his shares of S corporation stock – which may be the amount he paid to acquire the shares from another shareholder or the adjusted basis of any property he contributed to the corporation in a tax-free exchange for such shares – is adjusted upward by the amount of income that is allocated and taxed to the shareholder; in this way, the already-taxed income may later be distributed to the shareholder without causing him to realize a gain (as where the amount distributed exceeds the stock basis).

By the same token, where already-taxed income has not been distributed to the shareholder, it remains subject to the risks of the business, and the shareholder is effectively treated as having made an “economic outlay” which may be lost in the operation of the business; this is reflected in his stock basis.

Debt Basis

In general, a shareholder’s basis for a cash loan from the shareholder to the corporation is equal to the face amount of the loan.

If the corporation’s indebtedness to the shareholder arose out of a transfer of property by the shareholder to the corporation – basically, a sale of the property in exchange for the corporation’s obligation to pay the purchase price some time in the future – the basis is equal to the face amount of the obligation less the amount of the deferred gain.

As the corporate indebtedness is satisfied, and the amount at economic risk is reduced, the shareholder’s basis in the debt is reduced.

“Necessity” as the Mother of Invention?

Because of this basis-limitation rule, S corporation shareholders, over the years, have proffered many arguments to support their ability to claim their share of S corporation losses – i.e., to increase their stock or debt basis – without having made an economic outlay. A recent decision by the U.S. Tax Court illustrates one such argument.

The Personal Guarantee

The sole issue in this case was whether Taxpayer had a sufficient basis in S-Corp., on account of his obligation with respect to S-Corp’s debt to a third party, to permit Taxpayer to deduct $X, which represented a portion of his distributive share of the corporation’s flow-through losses, on his personal income tax return.

Taxpayer was the sole shareholder of S-Corp. S-Corp. borrowed $Y from Bank, and Taxpayer personally guaranteed the loan. S-Corp. was later liquidated. At the time of liquidation, S-Corp. still owed Bank $X. S-Corp. filed its Form 1120S, U.S. Income Tax Return for an S corporation, on which it reported an ordinary business loss of $X. Taxpayer had no stock or debt basis in S-Corp. when it was liquidated.

According to the record before the Court, after S-Corp. was liquidated, the operations of the business somehow continued under its former name, S-Corp.’s loan with Bank was somehow renewed, and S-Corp. remained the named borrower of the renewed loan. Taxpayer signed the renewal note as president of S-Corp. and was the guarantor of the loan.

Also according to the record, Taxpayer made all loan payments following the liquidation of S-Corp., but the record did not indicate whether he made the payments from his personal funds or merely signed checks drawn on the account of S-Corp.

The IRS examined Taxpayer’s tax return and disallowed the $X loss deduction related to S-Corp., explaining that, because Taxpayer’s share of S-Corp.’s loss was limited to the extent of his adjusted basis for his stock, the amount of loss in excess of such basis was disallowed and was not was not currently deductible.

The Court’s Analysis

The Court began by explaining that an S corporation shareholder may take into account his or her pro rata share of the corporation’s losses, deductions, or credits. It then explained how the Code limits the aggregate amount of losses and deductions the shareholder may take into account to the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation, and (B) the shareholder’s adjusted basis in any indebtedness of the S corporation

Taxpayer conceded that he had no stock or debt basis in S-Corp. at the time of its liquidation. However, he contended that upon the liquidation, he assumed the balance due on the note as guarantor and, because he was the sole remaining obligor, this assumption was effectively a contribution to capital, allowing him to deduct the amount of S-Corp.’s losses. Further, he asserted that, following S-Corp.’s liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate basis for Taxpayer in S-Corp.

The Court rejected Taxpayer’s arguments. Merely guaranteeing an S corporation’s debt, it stated, was not sufficient to generate basis. The Court pointed out that, on many prior occasions, it had held that no form of indirect borrowing, be it by guaranty, surety or otherwise, gives rise to indebtedness from an S corporation to its shareholders until and unless the shareholders pay part or all of the obligation. “Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.” The Court also stated that a shareholder may obtain an increase in basis in an S corporation only if there was an economic outlay on the part of the shareholder that leaves the shareholder “poorer in a material sense.” In other words, the shareholder must make an actual “investment” in the corporation.

The Court recognized, however, that a shareholder who has guaranteed a loan to an S corporation may increase his or her basis where, in substance, the shareholder has borrowed funds and subsequently advanced them to the corporation. Although, as a general rule, an economic outlay is required before a shareholder in an S corporation may increase his or her basis, this rule does not require a shareholder, in all cases, to “absolve a corporation’s debt before [he or she] may recognize an increased basis as a guarantor of a loan to a corporation.” Observing that “where the nature of a taxpayer’s interest in a corporation is in issue, courts may look beyond the form of the interest and investigate the substance of the transaction.” The Court indicated that a shareholder’s guaranty of a loan to an S corporation “may be treated for tax purposes as an equity investment in the corporation where the lender looks to the shareholder as the primary obligor.”

This determination, the Court stated, was an “inquiry focused on highly complex issues of fact and that similar inquiries must be carefully evaluated on their own facts.” (For example, the testimony of a loan officer stating that the lender-bank looked primarily to the taxpayer, and not the corporation, for repayment of the loan, as well as evidence that the S corporation was thinly capitalized.)

The Court then turned to the facts in the case to determine whether Taxpayer had established that the Bank looked to Taxpayer for repayment and Taxpayer had made economic outlays in making those payments.

The Court found that Taxpayer presented no evidence to support a finding that the Bank looked primarily to him, as opposed to S-Corp., for repayment of the loan, especially given the fact that, even after the corporate liquidation, S-Corp. remained an ongoing business enterprise.

It acknowledged that, according to the stipulation of facts, “[t]he [Taxpayer] continues to make payments on the loan”, but there was no indication, it pointed out, that the loan payments were made from Taxpayer’s personal funds rather than S-Corp.’s funds with Taxpayer signing payment checks as president. Moreover, under the terms of the renewal note, the renewed loan was to S-Corp. and Taxpayer’s obligation was that of a guarantor, not the maker of the loan.

The Court next considered Taxpayer’s assertion that the renewal of the loan to S-Corp. did not affect his position that he became the primary obligor of the loan upon S-Corp.’s liquidation. Taxpayer posited that he assumed the debt at the time of S-Corp.’s liquidation and that “his status as the sole remaining obligor”, for tax purposes, caused the repayments of the loan to be treated as contributions to the capital of S-Corp. The IRS disagreed, arguing that “upon the corporation’s liquidation, the debt remained undisturbed: the corporation did not default on the debt, the terms of the debt were not altered, and payments on the debt continued.”

The Court determined that there was insufficient evidence in the record to support a finding that the loan was made to Taxpayer personally, as opposed to S-Corp., and that Taxpayer, as the borrower, advanced the loan proceeds to S-Corp. Because Taxpayer failed to establish that the Bank looked primarily to Taxpayer to satisfy the debt obligation or that Taxpayer made an economic outlay with respect to the loan, Taxpayer failed to prove he had a basis in S-Corp. sufficient for him to deduct the reported business losses.

Advice to S Corporation Shareholders

What is an S corporation shareholder to do when corporate losses have been allocated to him, but he has no basis in his shares, and he either has no outstanding loan to the corporation or at least not one in which he has any basis? What happens to these excess losses, and how can they be utilized?

The excess losses allocated to a shareholder for a tax year cannot be used by the shareholder to offset ordinary income reported on the shareholder’s tax return for that year. That being said, the shareholder must realize that the excess losses are not lost (sorry for the pun) – they are merely suspended until such time as the shareholder has sufficient basis in his stock, or in a loan made by him to the corporation, to allow the losses to flow through to him. (Even then, however, the losses have to pass muster under the “at risk” and “passive loss” rules before the shareholder can realize their full benefit.)

So, how can a shareholder facilitate or expedite the use of his suspended losses? There are some options to consider:

  • Make a capital contribution to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; paying off a corporate debt)
  • Forego distributions by the corporation in profitable years (loan the distributed funds back to the corporation)
  • Accelerate the recognition of income by the corporation
  • Defer the deduction of corporate expenses
  • Make a loan to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; substituting the shareholder’s note for the corporation’s)

Each of these options presents its own risks and issues. For example, what if the shareholder does not receive additional stock in the corporation in exchange for his capital contribution? Has he made a gift to the other shareholders? He has certainly put more of his money at risk.

Of course, the shareholder can wait until the corporation sells its business. The gain from the sale may generate sufficient basis so as to allow the use of the suspended losses for the year of the sale (though the shareholder will thereby likely realize more gain on a subsequent liquidation of his shares).

However, if the disposition of the business is effected through a sale of stock by the shareholders (without an election to treat it as an asset sale), the suspended losses will disappear. They will also be lost if all of the shares are gifted to another (other than the shareholder’s spouse or to a grantor trust) prior to any sale. The suspended losses will also be lost if the shareholder dies before having used the losses – the step-up in basis for the stock that occurs at death does not benefit the deceased shareholder.

Thus, it may behoove the shareholder to find a way to “consume” the suspended losses before it is too late, provided as always, of course, that the means chosen makes sense from a business perspective.