Capital vs Ordinary Loss When An Investment Goes SouthJuly 26, 2021 | Louis Vlahos |
If the amount realized by a taxpayer upon the sale of a partnership interest to a third party is insufficient to restore to the taxpayer their adjusted basis for the interest – i.e., their unrecovered investment in the partnership – a loss is sustained equal to the difference between such adjusted basis and the amount realized. In general, this loss will be treated as a capital loss.[i]
A taxpayer may also realize a loss upon the liquidation of their interest in a partnership if no property other than money is distributed to the taxpayer.[ii] Loss is recognized to the extent the taxpayer’s adjusted basis for the partnership interest exceeds the amount of money distributed to the taxpayer.[iii] Any loss recognized by a taxpayer upon the liquidation of their partnership interest is considered a loss from the sale of the interest. Thus, it is generally treated as a loss from the sale of a capital asset.
What if a taxpayer “abandons” their partnership interest instead of selling it or having it liquidated? How will the loss realized by the taxpayer on the abandonment – equal to the taxpayer’s adjusted basis – be treated for tax purposes?
A loss that results from the abandonment, as opposed to the sale or exchange, of a partnership interest is treated as an ordinary loss, even if the abandoned partnership interest is a capital asset. In other words, the difference between an ordinary loss and a capital loss on the disposition of a partnership interest may depend upon whether the loss results from the abandonment of the partnership interest, or from the liquidation or sale of the interest.
It may be difficult, however, to avoid sale treatment and capital loss (as opposed to ordinary loss) in the case of an “abandoned” partnership interest. That is because the “successful” abandonment of an interest requires that no consideration be received by the departing partner. In other words, if any consideration is received, even as a deemed distribution pursuant to the partnership liability-shifting rules,[iv] the transaction will be treated as a sale, and the realized loss will be treated as a capital loss. Thus, a loss from the abandonment of a partnership interest will be ordinary only if there is neither an actual nor a deemed distribution to the partner. This stringent requirement can make it very difficult for a taxpayer to secure ordinary loss treatment on what the taxpayer believes to have been the abandonment of their partnership interest, as one taxpayer recently discovered.[v]
Want to Be in Film?
Taxpayer was a wealthy investor[vi] who invested a few million dollars in the “securities” of two LLCs that owned, financed, and distributed films. In each case, the purchase agreement executed by Taxpayer warned that the investment was “highly speculative,” involved a high degree of risk, “should be considered only by accredited investors who can bear the economic risks of their investments for an indefinite period and who can afford to sustain total losses of their investments,” and should be considered only by one who was able to afford “a loss of [their] entire investment.” Taxpayer acknowledged the LLC interests were acquired for investment.
Taxpayer’s investments did not give him any control over the LLCs, both of which were controlled by Sponsor. Taxpayer did, however, have a consulting contract with one of the LLCs (LLC-1), pursuant to which that LLC-1’s parent company agreed to pay Taxpayer a relatively nominal sum every year. The consulting agreement provided that Taxpayer would chair LLC-1’s board of advisors, which Taxpayer later described as a “nonmeaningful term” because Taxpayer never held a meeting during his tenure and was unaware of any other board members. The consulting agreement permitted Taxpayer to work however many hours he chose and required Taxpayer only to be “available” to work “at a minimum of one (1) day per month.”
Taxpayer never received financial reports from either LLC.
Not Looking Good
Not many years later, a group of unrelated investors – creditors holding an undisputed, noncontingent debt, probably based on a contract – filed an involuntary bankruptcy petition[vii] against LLC-1’s parent company, which Sponsor contested. A few months later, the bankruptcy court determined that LLC-1 should be in bankruptcy. The bankruptcy trustee issued a report which Taxpayer stated formed the basis of Taxpayer’s conclusion that his investment in LLC-1 was worthless.
LLC-2 was not part of the involuntary bankruptcy. Shortly afterward, however, Sponsor sent Taxpayer a letter that LLC-2 had “wound up its operation approximately one year ago” and “has no further value.” Sponsor explained that LLC-2 had loaned all its money toward the acquisition, etc., of films owned by other subsidiaries of LLC-1’s parent company, which were all in bankruptcy. Sponsor’s letter stated there was “no chance of recovery.”
Taxpayer “Goes into Action”
Taxpayer claimed that he abandoned his interests in both LLCs through a call made to Sponsor. Taxpayer never conveyed that intent to abandon the investments to anyone else. Nor did Taxpayer send written notice to Sponsor or the LLCs, even though the LLC agreements required that all communications be made in writing.
Despite Taxpayer’s claim that he abandoned his interests in the LLCs, Taxpayer testified that he did not file a claim in the above-mentioned bankruptcy proceeding because he remained “faithful to the relationship” with Sponsor and continued to believe “that [Sponsor] would work his way out of these things, and come through and take care of me, since it was a close, personal relationship.” That hope “proved futile,” and Taxpayer never recovered “a penny” of his investment.[viii]
Taxpayer’s Tax Return
Taxpayer filed a late tax return for the taxable year in which the involuntary bankruptcy was initiated. Taxpayer claimed a net operating loss on the return based on Taxpayer’s failed investments in the two LLCs. According to the return, the investments became worthless during the year in which the bankruptcy was filed, at which point Taxpayer abandoned his interests in the LLCs.[ix]
Taxpayer sought to carry back the net operating loss to the two immediately preceding taxable years,[x] and thereby claim a refund[xi] of a portion of the tax reflected on the tax returns previously filed for those years.
The Government’s Response
The IRS denied the loss deduction and, therefore, the refund. Taxpayer timely filed a suit with the U.S. District Court seeking a refund.[xii]
The U.S. moved for summary judgment.[xiii]
The Court’s Analysis
A taxpayer may deduct “any loss sustained during the taxable year and not compensated for by insurance or otherwise.”[xiv] To deduct the loss, it “must be evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year.”[xv] The taxpayer bears the burden of showing they are entitled to a deduction.
According to the Court, even if Taxpayer suffered the losses in the year claimed, Taxpayer was not entitled to carry them back to the two preceding taxable years to claim a refund because the losses were capital (rather than ordinary) losses. Moreover, even if Taxpayer’s failed investments were ordinary losses, they were not incurred in his trade or business and thus could not be carried back as operating losses.
The Code differentiates between two kinds of losses: an ordinary loss and a capital loss. The Court explained that an individual taxpayer may carry back their excess ordinary losses incurred in their trade or business (known as a “net operating loss”) and deduct them from prior years’ income.[xvi] By contrast, the Court continued, an individual may not carry back losses from capital assets because they are not included in the calculation of the net operating loss.[xvii]
Taxpayer’s investment in the LLCs, the Court stated, was “all equity” and, therefore, was a capital asset.[xviii] As Taxpayer admitted, if “the companies had been profitable, then he would have been entitled” to his share of those profits. Both LLC purchase agreements warranted that Taxpayer was acquiring the interests for “investment purposes” and warned that the investment was “highly speculative” and could be lost in its entirety. Those are among the hallmarks of an agreement to provide capital in exchange for equity in the companies.
Therefore, Taxpayer was not allowed to carry back the losses in his equity investments because they were capital assets.
The Court also rejected Taxpayer’s argument that he should be considered a member of a partnership,[xix] which would in some circumstances allow him to treat his investment as a non-capital asset. Specifically, a loss incurred on the abandonment[xx] or worthlessness of a partnership interest is treated as an ordinary loss if sale or exchange treatment does not apply. If there is an actual or deemed distribution to the partner, or if the transaction is otherwise in substance a sale or exchange, the partner’s loss is treated as a capital loss (except as to any so-called “hot assets”).[xxi]
According to the Court, in determining whether an entity is entitled to partnership tax status “all the facts” must be examined, including the entity’s governing documents and the parties’ conduct, statements, and relationships, as well as their “respective abilities and capital contributions,” their “actual control of income and the purposes for which it is used,” along with “any other facts throwing light on their true intent.”
The Court found that the “practicalities” of Taxpayer’s relationship with the LLCs belied any assertion that Taxpayer was a member of a partnership.[xxii] Rather, Taxpayer admitted in the purchase agreements that he was acquiring the membership interests for “speculative” “investment purposes,” and did not indicate that he was joining a partnership.[xxiii] Taxpayer was not the manager of either LLC, he lacked control over how the LLCs spent their money, and testified that he never received any financial reports from the LLCs and was ignorant of their financial problems until a bankruptcy petition was filed against LLC-1. Nor was there any evidence that the LLCs filed tax returns as partnerships or represented themselves as partnerships to anyone else.
In sum, the Court found the evidence demonstrated that Taxpayer was a passive investor who relied on others to pursue profit but he was not a partner of the LLCs.
Even if Taxpayer were permitted to treat his failed investments in the LLCs as ordinary losses, the Court determined they were not incurred in his trade or business. “The distinction is important,” the Court stated, “because in calculating a net operating loss to be carried back to previous years, a taxpayer may take in full all of the deduction attributable to trade or business loss, whereas deductions not attributable to trade or business losses are only allowable to the extent the gross income is not derived from a trade or business.”[xxiv]
The Court explained that an individual is engaged in a trade or business only if they are “involved in the activity with continuity and regularity.” The record was clear that Taxpayer was not in the trade or business of making or producing films. Taxpayer claimed that he entered “the business of investing in entertainment properties.” Being an investor, however, to pursue personal profit is not a trade or business for tax purposes.
Taxpayer nonetheless claimed that his consulting agreement with LLC-1,[xxv] along with his agreement to serve as chair of its board of advisers, demonstrated that he was in the trade or business of producing films, particularly given the salary he was to be paid for the few hours per week that he worked. The record, however, reflected that Taxpayer’s role as chairman was “nonmeaningful” and involved no work, and that he spent little time doing any work as a consultant. Indeed, Taxpayer admitted that on his tax returns he characterized a different loan he made to the LLC as “nonbusiness” debt, which is “the antithesis of an investment made in a taxpayer’s trade or business.”
In any event, Taxpayer’s losses were not “the result of operating a trade or business” with the LLCs. The Court stated that a taxpayer’s motive must be assessed at the time of his investment. Taxpayer made his initial investment in LLC seven months before he had any consulting relationship with the company, and he invested the additional amount in the LLC on the same day he entered into the consulting agreement and became the chair of the board of advisers (which apparently had no other members and held no meetings).
Even with respect to Taxpayer’s consulting role, the furnishing of management services to a business entity for a reward no different from that flowing to an investor is not a trade or business. In any case, there was no evidence that Taxpayer was ever actually paid (or sought to collect) the amount he was owed under the consulting contract. In other words, any returns that Taxpayer hoped to receive from the LLC were no different “from that flowing to an investor.”
The undisputed facts, the Court stated, made plain that Taxpayer was a mere investor for profit and was not investing pursuant to a trade or business.
Finally, the Court addressed how to characterize a taxpayer’s losses when the taxpayer was both an employee and an owner of the company to which the taxpayer had made a loan. The key issue in that context was whether the taxpayer made the loan to protect their ability to earn an income as an employee (in which case the loss would be an ordinary loss incurred in the taxpayer’s trade or business) or if, instead, the loan was intended to support the taxpayer’s equity interest (and thus should be treated as a capital loss).
The Court observed that whether the debt was incurred for business or nonbusiness reasons was directly relevant to whether the loss could be carried back as a net operating loss.
The Court explained that, to claim a loss was made in a taxpayer’s trade or business, the taxpayer must show their “dominant” motive for making the loan (or other investment?) was to protect their salary rather than to protect their equity investment in the company. The “dominant-motivation test strengthens and is consistent with” the Code’s distinction between personal and business losses. The Court stated that, when determining a taxpayer’s motive, one should compare the size of the taxpayer’s salary payable by the entity with their equity investment in the entity and their access to other funds.
The Court pointed out that Taxpayer’s pre-tax consulting salary was less than 2 percent of his total investment in the LLCs. Moreover, given Taxpayer’s substantial net worth and annual income, it would “defy belief,” the Court stated, “to conclude that Taxpayer invested any of this money to protect his meager salary rather than to engage in speculative investing.”
In sum, Taxpayer was not entitled to carry back the losses attributable to his investments because the investments were capital assets. Even if the investments were non-capital assets, they were not incurred in Taxpayer’s trade or business. Thus, even if Taxpayer suffered the loss in the year claimed, he was unable to carry back that loss and claim refunds for earlier years.
With that, the Court decided the U.S. was entitled to summary judgment.
Do Not Forget
Query how much Taxpayer spent in pursuing his refund claim. The cost of preparing the tax return on which the loss was claimed, the cost of amending the prior year returns to which the loss was carried back to form the basis for the refund claim, the cost of responding to the IRS refund examiner’s inquiries, the cost of an IRS Appeals conference following the issuance of the examiner’s preliminary findings, the cost of preparing and filing a refund suit with the District Court following the IRS’s issuance of a statutory notice of claim disallowance, and the cost of carrying on the suit itself.[xxvi] The dollars, time and frustration add up.
Although no investor will go into a venture for the purpose of losing money, a prudent investor will recognize the very real possibility of doing so – see the warnings given to Taxpayer with respect to his investments in the two LLCs, above – and will consider their exit strategy, including its tax treatment, for the purpose of reducing the economic impact of such a loss.
With that in mind, what if Taxpayer had focused more attention and effort on the act of establishing the worthlessness of his investment and the abandonment thereof? For example, what if Taxpayer had filed a claim in the bankruptcy proceeding, had sent written notice of the abandonment to all interested parties, and had not testified that he thought Sponsor would take care of him?
It’s too late for Taxpayer. Water under the bridge. Spilled milk. Who let the dogs out? You get my meaning.
[i] IRC Sec. 741.
[ii] IRC Sec. 731(a)(2).
[iii] The liquidating distribution may consist of actual and deemed distributions of money by the partnership; for example, a decrease in a partner’s share of the liabilities of a partnership is considered a distribution of money by the partnership to the partner. IRC Sec. 752.
[iv] IRC Sec. 752.
[v] Swartz vs United States No. 17-cv-5914 (EDNY, July 20, 2021).
[vi] For the year at issue, Taxpayer stated that his net worth was above $50 million and that he had gross income of over $1 million.
[vii] 11 U.S.C. Sec. 303. (I can’t believe I’m citing that lesser code known as Title 11 or the Bankruptcy code. Yes, the lower case “c” is intentional. I’m sorry, Kristina.)
[viii] How will these idioms be adapted for the Bitcoin or other cryptocurrency age to come, I wonder?
[ix] Although not discussed by the Court, Rev. Rul. 2004-58 states that to establish the abandonment of an asset for purposes of IRC Sec. 165, a taxpayer must show both an intention to abandon the asset and an affirmative act of abandonment.
A deduction is not allowable if the taxpayer intends to hold and preserve the property for possible future use or to realize potential future value from the property. The “identifiable event” required by Reg. Sec. 1.165-1(b) and (d)(1) must be observable to outsiders and constitute some step which irrevocably cuts ties to the asset. A taxpayer need not relinquish legal title to property in all cases to establish abandonment, provided there is an intent to abandon and an affirmative act of abandonment.
[x] IRC Sec. 172. The carryback was eliminated by the 2017 Tax Cuts and Jobs Act (P.L. 115-97) but was reinstated on a limited basis by the 2020 CARES Act (P.L. 116-136) in response to the economic downturn that accompanied the pandemic.
[xi] Taxpayer had income for the earlier years, on the basis on which he paid tax. By carrying back the loss from the later year to the earlier years, the taxable income for the earlier years would have been reduced. As a result, Taxpayer would have been treated as having overpaid his tax liability for the earlier years. The excess amount of taxes paid would have been refundable to Taxpayer or could have been applied against his tax liability for subsequent years.
[xii] The filing of a refund claim is a prerequisite to a taxpayer’s filing a suit to pursue the claimed refund. In general, however, no suit may be filed before the expiration of 6 months after the filing of the claim, nor more than 2 years after the disallowance of the claim. The suit may be brought in a Federal District Court or in the Court of Federal Claims. IRC Sec. 7422 and Sec. 6532.
[xiii] Summary judgment may be granted only “if the movant shows that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.” Where the non-movant (Taxpayer, in this case) bears the burden of proof at trial, the movant’s initial burden at summary judgment can be met by pointing to a lack of evidence supporting the non-movant’s claim. Once the movant meets its initial burden, the non-moving party may defeat summary judgment only by producing evidence of specific facts that raise a genuine issue for trial. For details, see the Federal Rules of Civil Procedure, Rule 56.
[xiv] IRC Sec. 165(a).
[xv] Reg. Sec. 1.165-1(b).
[xvi] IRC Sec. 172(b)(1)(A) and 172(c).
[xvii] IRC Sec. 165(f) 172(d)(2)(A) and 1212(b). An individual’s capital losses, however, may be carried forward indefinitely (until exhausted or until the taxpayer dies). It should be noted that the capital loss may be applied against $3,000 of ordinary income every year (in the case of a joint return). IRC Sec. 1211(b).
[xviii] Equity means membership interest means partnership interest, right? Not according to the Court, for some reason I don’t understand.
[xix] Again, the Court does not provide much of an explanation – at least not one that I follow.
[xx] Abandonment of an asset for purposes of IRC Sec. 165 requires (1) an intention to abandon the asset, and (2) an affirmative act of abandonment.
See my article on the internet: “Abandonment of a Partnership Interest,” at https://www.taxlawforchb.com/2017/07/abandonment-of-a-partnership-interest-or-when-a-taxpayer-rejects-its-tax-return-position/
[xxi] Rev. Rul. 93-80; IRC Sec. 751.
[xxii] How is this reconciled with the Court’s earlier statement that Taxpayer invested in “equity”?
[xxiii] Query why this made a difference to the Court.
[xxiv] See IRC Sec. 172(c) and (d)(4). Net operating losses may carry over under Sec. 172 from the year in which they were incurred to another year only if the losses were the result of operating a trade or business.
[xxv] Taxpayer never had any business or consulting relationship with the second LLC other than his investment.
[xxvi] See IRM 4.10.11.
- Louis Vlahos