Investments in partnerships are usually made with the expectation that a partnership will generate income, make distributions, and increase in value over time. While this expectation is reasonable, sometimes it does not go to plan.

What are the tax implications when a partnership interest is sold at a loss?

When recouping the investment in a partnership interest becomes very unlikely, selling at a loss may seem like the next logical step. When a partnership interest is sold at a loss, the transaction receives capital loss treatment. Many taxpayers anticipate that this loss will reduce taxes due on other sources of income such as wages, tips, interest, dividends and ordinary business income.

Unfortunately, these types of ordinary income can be offset by only a limited amount of capital loss. In 2021, the annual limit for individuals is $3,000. Capital losses can generally be used to offset other types of income, provided that income receives the appropriate capital treatment.

Are there more favorable tax treatment alternatives to selling at a loss?

When a partner is considering selling their partnership for pennies on the dollar, making a claim for ordinary loss treatment through worthlessness or abandonment is an alternative to consider. In certain situations, ordinary loss treatment may be available to produce a much greater tax benefit than capital loss treatment. Ordinary losses can be used to offset wages, tips, interest, dividends and ordinary business income. To receive ordinary loss treatment for worthlessness or abandonment, one must carefully consider individual fact and circumstances before determining whether this treatment is available.

How do you claim ordinary loss treatment for worthlessness?

To claim ordinary loss treatment for worthlessness,

• The partnership must have no current or future value. Current value can be determined by a variety of factors including insolvency, claims from creditors, and potential bankruptcy. Future value looks to whether the business will not be re-organized, restructured, purchased, or do anything that might produce future income.
• The partner’s disposition must not be considered a sale or exchange. To avoid sale or exchange treatment, no actual distribution, or deemed distribution, for the current partnership interest, or future partnership interest can be received. This includes relief of partnership of liabilities.

How do you claim ordinary loss treatment for abandonment of interest?

To claim ordinary loss treatment for abandonment of interest,

• The partner must formally abandon their interest in a manner which is not considered a sale or exchange. To formally abandon the interest, generally a statement is issued notifying the partnership but may also need to be sent to the other partners or third parties.

The sale or exchange requirement is similar to the aforementioned conditions under worthlessness, which includes relief of partnership liabilities. While the relief of liabilities can create a deemed distribution, there may be planning opportunities that alleviates this issue.

Questions? We can help. Don’t forget to download our Year End Tax Planning Guides for Businesses and Individuals.