I suspect that most taxpayers know that there is a difference between long-term capital gains and ordinary income. Long-term capital gains receive a lower tax rate, incentivizing one to prefer long-terms gains, if at all possible.
Capital
losses are not as useful. Capital losses offset capital gains, whether
short-term or long-term. If one has net capital losses left over, then one can
claim up to $3,000 of such losses to offset non-capital gain income (think your
W-2).
That $3,000 number
has not changed since I was in school.
And there is
an example of a back-door tax increase. Congress has imposed an effective tax
increase by not pegging the $3,000 to (at least) the rate of inflation for the
last how-many decades. It is the same thing they have done with the threshold amount
for the net investment income or the additional Medicare tax. It is an easy way
to raise taxes without publicly raising taxes.
I am looking
at a case where two brothers owned Edwin Watts Golf. Most of the stores were
located on real estate also owned by the brothers, so the brothers owned two
things: a golf supply business and the real estate it was housed in.
Why did they
keep the real estate? Because the golf businesses were paying rent, meaning
that even more money went their way.
The day
eventually came when Wellspring wanted out; that is what private equity does,
after all. It was looking at two offers: one was with Dick’s Sporting Goods and
the other with Sun Capital. Dick’s Sporting
already had its own stores and would have no need for the existing golf shop
locations. The brothers realized that would be catastrophic for the easy-peasy rental
income that was coming in, so they threw their weight behind the offer by Sun
Capital.
Now, one
does not own a private equity firm by being a dummy, so Wellspring wanted
something in return for choosing Sun Capital over Dick’s Sporting.
Fine, said
the brothers: you can keep our share of the sales proceeds.
The brothers
did not run the proposed transaction past their tax advisor. This was
unfortunate, as there was a tax trap waiting to spring.
Generally
speaking, the sale or exchange of a partnership interest results in capital
gain or loss. The partners received no cash from the sale. Assuming they had
basis (that is, money invested) in the partnership, the sale or exchange would
have resulted in a capital loss.
Granted, one
can use capital losses against capital gains, but that means one needs capital
gains. What if you do not have enough
gains? Any gains? We then get back to an obsolete $3,000 per year allowance.
Have a big enough loss and one would need the lifespan of a Tolkien elf to
use-up the loss.
The
brothers’ accountant found out what happened during tax season and well after
the fact. He too knew the issue with capital losses. He played a card, in truth
the only card he had. Could what happened be reinterpreted as the abandonment
of a partnership interest?
There is
something you don’t see every day.
Let’s talk
about it.
This talk gets
us into Code sections, as the reasoning is that one does not have a “sale or
exchange” of a partnership interest if one abandons the interest. This gets the
tax nerd away from the capital gain/loss requirement of Section 741 and into
the more temperate climes of Section 165. One would plan the transaction to get
to a more favorable Code section (165) and avoid a less favorable one (741).
There are
hurdles here, though. The first two are generally not a problem, but the third
can be brutal.
The first
two are as follows:
(1) The taxpayer must show an intent to
abandon the interest; and
(2) The taxpayer must show an affirmative act of
abandonment.
This is not
particularly hard to do, methinks. I would send a letter to the tax matters or
general partner indicating my intent to abandon the interest, and then I would
send (to all partners, if possible) a letter that I have in fact abandoned my
interest and relinquished all rights and benefits thereunder. This assumes
there is no partners’ meeting. If there was a meeting, I would do it there. Heck,
I might do both to avoid all doubt.
What is the
third hurdle?
There can be
no “consideration” on the way out.
Consideration
in tax means more than just receiving money. It also includes someone assuming debt
you were previously responsible for.
The rule-of-thumb
in a general partnership is that the partners are responsible for their
allocable share of partnership debt. This is a problem, especially if one is
not interested in being liable for any share of any debt. This is how we got to
limited partnerships, where the general partner is responsible for the debts
and the limited partners are not.
Extrapolating
the above, a general partner in a general partnership is going to have issues
abandoning a partnership interest if the partnership has debt. The partnership
would have to pay-off that debt, refinance the debt from recourse to
nonrecourse, or perhaps a partner or group of partners could assume the debt,
excluding the partner who wants to abandon.
Yea, the
planning can be messy for a general partnership.
It would be
less messy for a limited partner in a limited partnership.
Then we have
the limited liability companies. (LLCs). Those bad boys have a splash of
general partnership, a sprinkling of limited partnership, and they can result
in a stew of both rules.
The third
plank to the abandonment of a partnership interest can be formidable, depending
on how the entity is organized and how the debts are structured. If a partner wants
an abandonment, it is more likely than not that pieces on the board have to be
moved in order to get there.
The brothers’
accountant however had no chance to move pieces before Wellspring sold Edwin
Watts Golf. He held his breath and prepared tax returns showing the brothers as
abandoning their partnership interests. This gave them ordinary losses, meaning
that the losses were immediately useful on their tax returns.
The IRS
caught it and said “no way.”
There were multiple
chapters in the telling of this story, but in the end the Court decided for the
IRS.
Why?
Because the
brothers had the option of structuring the transaction to obtain the tax result
they desired. If they wanted an abandonment, then they should have taken the steps
necessary for an abandonment. They did not. There is a long-standing doctrine
in the Code that a taxpayer is allowed to structure a transaction anyway he/she
wishes, but once structured the taxpayer has to live with the consequences.
This doctrine is not tolerant of taxpayer do-overs.
The brothers
had a capital and not an ordinary loss. They were limited to capital gains plus
$3 grand per year. Yay.
Our case
this time for the home gamers was Watts, T.C. Memo 2017-114.
No comments:
Post a Comment