Taxation of Worthless and Abandoned Partnership Interests

By Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D.

Taxation of Worthless and Abandoned Partnership Interests
Photo by joshuaraineyphotography/iStock

Note: The Tax Court case described here, Pilgrim’s Pride Corp., 141 T.C. 533 (2013), was reversed on appeal (Pilgrim’s Pride Corp., 779 F.3d 311 (5th Cir. 2015)).



  • Taxpayers who have investments in corporations or partnerships may be able to take losses if the investments become worthless or are abandoned.
  • To take a loss on a partnership interest, the partnership itself must have economic substance.
  • To take a loss for worthlessness of a partnership interest, a taxpayer must show that in the year the loss deduction was claimed the taxpayer subjectively believed the interest was worthless and that objectively the interest was worthless.
  • To take a loss for abandonment of a partnership interest, a taxpayer must show that in the year the loss deduction was claimed, the taxpayer intended to abandon the partnership interest and that there was an affirmative act of abandonment of the interest.
  • Under Rev. Rul. 93-80, the character of a loss on abandonment of a partnership interest depends on whether the partner was allocated partnership liabilities at the time of abandonment.

Investors are advised to buy low and sell high. Many are also advised to establish a limit on losses and, if the investment declines to that point, to sell it. Correctly or incorrectly, investors often do not sell their investments when their value declines to that level, but instead either sell after their investments have declined to the point that they incur substantial losses or hold on until the investments have little or no value. When this occurs, for a variety of reasons, investors sometimes abandon the investments.

A few years ago, in the Pilgrim's Pride case, which involved a corporation's abandonment of stock, the Tax Court held, as discussed further below, that when a corporation abandoned an investment in stock, Sec. 1234A applied and that the corporation's loss on the abandonment of the stock was a capital loss.1 If the Fifth Circuit had not reversed, the decision would have also arguably required that losses on the abandonment of partnership interest investments be treated as capital losses under Sec. 1234A, instead of as ordinary losses.2 Since the appeals court reversed, Sec. 1234A will not apply to a loss on the abandonment of an investment in a partnership interest, and the tax treatment of the loss will be taxed based on prior cases and rulings as well as the regulations.

This article first discusses the tax treatment of worthless or abandoned stock. It then discusses the tax treatment of worthless and abandoned partnership interests.

Sec. 165(a)

Sec. 165(a) allows a taxpayer to deduct an ordinary loss to the extent insurance does not compensate the taxpayer for the loss. Sec. 165(c) requires, in the case of an individual, that the taxpayer must incur the loss in a trade or business, in any transaction entered into for profit, or as a result of a casualty or theft not connected with a trade or business or a transaction entered into for profit, for the loss to be deductible under Sec. 165(a). A taxpayer can take a Sec. 165(a) loss for property (including intangible property, such as a partnership interest) if the property is worthless or if it is abandoned.

Pilgrim's Pride

Pilgrim's Pride Corp.'s predecessor corporation, Gold Kist, purchased preferred stock and securities of Southern States Cooperative Inc. for $98.6 million. In 2004, Southern States and Gold Kist attempted to negotiate a price to redeem the stock and securities but were unable to agree. Southern States offered $20 million, but Gold Kist asked for $31.5 million.3 Gold Kist decided to abandon the investments because it decided that the $98.6 million ordinary loss it planned to claim on its tax return would generate more cash than the $20 million redemption plus the tax savings from the deductible capital loss.

Gold Kist claimed an ordinary loss under Sec. 165(a) on the grounds that Sec. 165(g), which provides for capital loss treatment for worthless securities, did not apply. Sec. 165(a) allows a taxpayer to deduct an ordinary loss to the extent the loss is not compensated for by insurance.4 Under Sec. 165(g), a taxpayer treats a worthless security as a deemed sale of a capital asset on the last day of the tax year.5 This deemed sale generates a capital loss equal to the basis of the worthless security. If Sec. 165(g) applies, Sec. 165(a) does not. A security for Sec. 165(g) purposes includes corporate stock and stock options as well as corporate or government debt that is registered or has interest coupons.6 The securities at issue met this definition. Gold Kist did not apply Sec. 165(g) because the securities were not worthless as evidenced by the $20 million redemption option. Since Sec. 165(g) did not apply and the securities were not sold or exchanged, Gold Kist argued, the loss was not capital. Instead the result was an ordinary loss under Sec. 165(a).

The IRS argued that Sec. 165(g) does apply to the abandonment of the stock. The IRS contended that the abandoned stock was worthless, as required by the statute, and thus the abandonment should be treated as a sale resulting in a capital loss.

Although neither Pilgrim's Pride nor the IRS initially addressed whether Sec. 1234A might apply to the abandonment of the stock, the Tax Court asked both parties to file briefs discussing this issue. Sec. 1234A provides that the cancellation, lapse, expiration, or other termination of a right or obligation that would be a capital asset in the taxpayer's hands, as well as Sec. 1256 contracts, results in a deemed sale of a capital asset generating a capital loss.

The Tax Court found that Sec. 1234A applied and held in favor of the IRS.7 The court was required to determine whether Sec. 1234A applies to actual ownership of stock, etc., as the IRS argued, or only to derivative rights, etc., and not actual ownership, as Pilgrim's Pride argued. The Tax Court reasoned that Congress's modification to Sec. 1234A, which was adopted in the Tax Relief Act of 1997,8 was designed to prevent taxpayers from structuring transactions so that any recognition of income or loss would result in an ordinary loss or capital gain at the taxpayers' election and therefore the section applies to direct ownership of securities as well as the rights to acquire the securities. The Tax Court's holding, if it had been applied universally, would have resulted in all abandonments as well as cancellations of investments being treated as capital losses, which would have a significant impact on investors.

Pilgrim's Pride appealed the decision to the Fifth Circuit, which reversed the Tax Court.9 The Fifth Circuit considered whether Sec. 1234A applied to capital assets and how it applied to the abandonment of corporate stock and securities, as well as partnership interests. The court found that Sec. 1234A, by its plain language, was not intended to apply to the termination of the ownership of capital assets, but only to the termination of rights or obligations with respect to capital assets, such as derivative or contractual rights to buy or sell capital assets. Therefore, Sec. 1234A did not apply to Pilgrim's Pride's case, which involved the abandonment of an actual capital asset—stock. It further found that the stock Pilgrim's Pride owned was not worthless and, as the company had originally contended, Sec. 165(g) did not apply. Thus, Pilgrim's Pride had correctly reported an ordinary loss since the securities were not sold or exchanged.

However, as the court noted, its decision will not apply to future abandonments of securities that are defined in Sec. 165(g)(2). In 2008, Treasury modified Regs. Sec. 1.165-5 so that it now states that the abandonment of a security will result in that security being treated as worthless. Therefore, in the future, abandoning corporate securities will generate a capital loss. Partnership interests, however, are not securities under Sec 165(g). Therefore, the regulation does not affect partnership interests, and consequently whether a partnership interest is treated as worthless or as abandoned will determine the tax result.

Partnership Interests: Initial Questions

In determining whether a loss for an abandoned or worthless partnership interest under Sec. 165(a) can be claimed, the partner must answer two threshold questions specific to partnership interests.

The first is whether the partnership had economic substance. This was the issue the Tax Court identified in Marinovich,10 where the taxpayers acquired an interest in a tax shelter partnership. In a previous tax shelter case that the taxpayers in Marinovich had agreed to be bound by, the Tax Court ruled that this type of partnership lacked economic substance.11 The Tax Court concluded that to be entitled to a loss under Sec. 165(c)(2), a taxpayer must be able to prove that the partnership has economic substance and that the partner invested in the partnership to earn a profit. The fact that the investment was profit-motivated is immaterial if the partnership lacks economic substance. Therefore, a taxpayer's cash investment in tax shelter partnerships does not generate deductible losses based onMarinovich.

The second question is whether the taxpayer can prove that a partnership existed and that the taxpayer owns an interest in it. In Milton,12 the taxpayer, who was a real estate professional, was asked to join with an unrelated business contact and his son in acquiring an existing business. The taxpayer gave her contact $90,000 to acquire the business. After a couple of years, she decided to dispose of her relationship with the acquired business to avoid hurting her real estate business because the other business was not being run well. The Tax Court rejected her claimed abandonment loss because she was unable to prove that a partnership actually was formed and that she owned an interest in it. Although it is possible to orally form a true business partnership, valid documents are necessary to obtain tax deductions.


If the threshold requirements discussed above are met, a taxpayer may be able to take a loss for a worthless partnership interest. Although owning an interest in a partnership is in many ways similar to owning shares in stock of a corporation, a partnership interest is not a security under the definition in Sec. 165(g)(2). The fact that it is treated as a security by the SEC does not make it a security for tax purposes.13 Therefore, the deduction for a worthless partnership interest will be determined under Sec. 165(a), not under the rules for worthless securities under Sec. 165(g).

Regs. Sec. 1.165-1(b) states that for a loss under Sec. 165(a) to be allowed "[the] loss must be evidenced by closed and completed transactions, fixed by identifiable events . . ." Regs. Sec. 1.165-1(d) states that the loss is sustained "during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifying events occurring in such taxable year." Therefore, a deduction for worthlessness must be established under these standards. A decline, even if it is severe, in the asset's value does not result in a worthless asset deductible under Sec. 165.14 Instead, to be worthless, the asset must have no current or future value.15

The absence of current value can be demonstrated by insolvency, claims from creditors, and potential bankruptcy. However, the cessation of operations does not prove that the partnership interest is worthless.16 Proving that the asset has no future value is more difficult. Since the taxpayer still owns the asset, the taxpayer must prove that the business will not be reorganized, restructured, purchased, or engage in any other activity that might produce future income.

The determination of worthlessness would seem to be an objective test, but the Fifth Circuit in Echols17found it to be both objective and subjective. The court said abandonment "is obviously an objective test. Not so the test for worthlessness."18 The court went on to state, "the test for worthlessness is a mixed question of objective and subjective indicia."19 On the subjective end, the taxpayer must prove that he or she determined that the asset became worthless in the year the deduction is claimed. Since this is a personal opinion, no specific set of facts or actions is required. However, the fact that the taxpayer believes the asset is worthless (the subjective test) is insufficient. The taxpayer also needs to prove the existence of objective facts or actions to confirm the worthlessness of the asset. The court confirmed this statement by stating, "the subjective determination of worthlessness . . . cannot be the sole determinant of worthlessness . . ."

One of the first cases that considered the objective tests that prove worthlessness was Tejon Ranch.20 Simplifying the facts, Tejon created a limited partnership in 1972. It contributed land to the partnership in exchange for the general partner's interest and sold the limited partnership interests to investors. It also loaned cash to the partnership and had the partnership borrow funds from Hancock and Citibank. In 1976, when the partnership had cash flow problems, it tried to borrow more cash from Hancock and Citibank, but they refused. Tejon then loaned the partnership more money. Tejon's auditor required it to write off the loans and investment on its financial statements to obtain an unqualified audit opinion.

In 1977, the partnership tried to borrow more funds from various creditors but failed. An advising firm that Tejon hired decided that the partnership needed an additional $20 million equity. In 1978, the partnership ran out of cash. To reduce its losses, Hancock agreed to make an additional loan provided it was authorized to manage the partnership and receive any available funds before anyone else. Tejon deducted the loans and partnership interest on its tax return as worthless in 1976, but the IRS objected. The taxpayer challenged the IRS's adjustments in Tax Court, and the court considered if the partnership was worthless and, if so, in which year.

The Tax Court ruled that the partnership was not worthless in 1976 or 1977, but in 1978. The fact that Tejon did not abandon or dispose of its interest was immaterial, as was the fact that the partnership stayed in existence and had not filed for bankruptcy. The court decided that the changes Hancock made in 1978 were sufficiently identifiable events to prove the worthlessness occurred in 1978 so that Tejon was entitled to a deduction that year. Although the Tax Court did not mention it, the decision confirms the requirement of both subjective and objective events. Tejon subjectively found the partnership worthless and deducted a loss. Hancock's actions objectively confirmed it.

As previously mentioned, in another case, the Fifth Circuit held that the taxpayer in Echols21 was entitled to a loss as a result of worthlessness, but the court actually found that the taxpayer was entitled to a loss because the asset was both worthless and abandoned. In response, the IRS requested the court reconsider allowing the loss for worthlessness but did not request the court to reconsider the abandonment loss. The reason the IRS requested reconsideration was to prevent future loss deductions based on worthlessness, without an identifiable event such as abandonment, termination, or bankruptcy. In other words, the IRS wanted the court to reject deductions when taxpayers still owned an investment. The circuit court rejected the IRS's request.22 Based in large part on Tejon, the court ruled that an abandonment or other comparable event was not needed to meet the requirement for a loss based on worthlessness under Sec. 165(c). Factors can exist that meet the "event" requirement.

It appears that the IRS has accepted the court's decisions. In Rev. Rul. 2004-58, the IRS denied the taxpayer a deduction because of "the absence of any affirmative act of abandonment or showing of worthlessness . . ." Therefore, a taxpayer can claim a loss either by abandoning its partnership interest or proving the interest is worthless. If a taxpayer claims a deduction because the property is worthless, it will have to be able to identify an event that confirms the interest is worthless.

The two-step approach can cause a different problem. In Rev. Rul. 54-581, the IRS ruled that if an investment became worthless in a year before the taxpayer abandoned it, the taxpayer was required to deduct the loss in the earlier year. Consequently, if a taxpayer delays claiming a loss for a partnership interest until the interest is abandoned, the tax year in which the taxpayer should have taken a deduction for worthlessness may be closed, resulting in a loss of the deduction. As a result, a taxpayer needs to consider if, and when, worthlessness occurs. When this is uncertain, it is probably in the taxpayer's best interest to claim the deduction in the earliest year that the taxpayer subjectively determines the asset is worthless. As discussed above, however, objective facts and events must exist to confirm the taxpayer's subjective decision.


A partner can also claim a loss for a partnership interest based on abandonment of the partnership interest. If the partner can show that the interest has been abandoned, the partner can take a loss even if the interest has some value left.

Abandonment was defined in one case "as a permanent disposition, not sold, never to be used again and not retrieved for sale, exchange, or other disposition."23 A two-part test must be satisfied before a taxpayer can take an abandonment deduction for property.24 First, the taxpayer must show an intent to abandon the property, which is a subjective test. Second, the taxpayer must show an affirmative act of abandonment, an objective test.

Application of the Two-Part Test

Because a partnership interest is intangible property, a partner must show intent to abandon the partnership interest by an overt act that makes clear to the partnership, other partners in the partnership, and third parties that the taxpayer intends to abandon the property. This can be accomplished by the taxpayer's declaration of an intent to abandon the property or other affirmative actions that show this intent or a combination of a declaration and other actions.

The affirmative act of abandonment must be an act that is observable to outsiders, through which the partner cuts its ties with the partnership interest. The partner, however, does not have to give up legal title to the partnership interest. Because the act must be observable to outsiders, internal communications or decisions concerning the abandonment of a partnership interest within a partner organization will not suffice.

Because of the intangible nature of a partnership interest, the evidence that proves the two requirements for abandonment of a partnership interest have been met will often be the same act or acts, as in Citron25 and Echols.26 In Citron, the court found that a limited partner had met both requirements by communicating to the general partner that he would not contribute additional funds to or have anything else to do with the partnership, and voting to dissolve the partnership. In Echols, the court found both an intent to abandon and an affirmative act of abandonment when a partner called a partnership meeting at which he tendered his 75% partnership interest to another partner, or anyone else who would assume his portion of the nonrecourse payment obligation, and announced that he would contribute no further funds to the partnership.

Practice tip: To establish that a taxpayer meets the second test, the taxpayer should write to the general partner (and if practical all the other partners) that he or she is abandoning the partnership interest. The taxpayer should not attempt to receive a distribution or collect amounts due from the partnership after notifying the other partners that he or she is abandoning the interest.27 The letter should also state that the former partner does not expect or want any future earnings or allocations from the partnership. The letter should also ask the general partner to send a confirmation that the abandonment was accepted and that the partnership will no longer treat the taxpayer as a partner.

Determining the Tax Outcome

If a taxpayer meets the two-part test for abandoning the partnership interest, the taxpayer should determine the tax outcome by applying Rev. Rul. 93-80. In this revenue ruling, the IRS agreed that a taxpayer could abandon a partnership interest. It then established the tax outcome of the abandonment through two situations. In situation 1, the taxpayer abandoned a one-third general partnership interest with an outside basis of $180. The partnership was subject to $120 in nonrecourse liabilities allocated equally among the partners. In situation 2, the taxpayer abandoned a limited partnership interest with an outside basis of $200.

In its analysis section, the ruling discussed two prior rulings. The first was Rev. Rul. 70-355, which involved a partnership that dissolved. Since the taxpayer in question did not receive any cash or property distributions upon the dissolution, the ruling concluded that the taxpayer was entitled to an ordinary loss equal to his or her outside basis. The second ruling discussed was Rev. Rul. 76-189, which also involved a partnership that terminated and a taxpayer that did not receive a distribution. This ruling, however, concluded that the taxpayer was entitled to a capital loss equal to outside basis.

In Rev. Rul. 93-80, the IRS concludes that the taxpayer in situation 1 is treated as having received a cash distribution under Sec. 752(b) equal to the reduction in liabilities that the partnership allocated to the taxpayer. Since this is a deemed cash distribution, Sec. 731(a) applies. Under Sec. 731(a), if a taxpayer receives only cash in exchange for a partnership interest, then the taxpayer is treated as having sold the interest for the cash received. Applying Sec. 731(a) to situation 1 results in the taxpayer having sold the interest for the cash deemed received because of the elimination of the liabilities allocated to the taxpayer. The result is a capital loss equal to $140 ($180 basis minus $40 deemed cash received).28

In situation 2, the taxpayer was not allocated any liabilities, and therefore there was no deemed cash distribution under Sec. 752(b). Without a cash distribution, Sec. 731(a) does not apply. Accordingly, the IRS concluded that the taxpayer was entitled to an ordinary loss deduction ($200 in situation 2).

Based on these conclusions, Rev. Rul. 93-80 revoked Rev. Rul. 76-189 and clarified and superseded Rev. Rul. 70-355. The bottom line is that the outcome is determined by the existence or nonexistence of an actual or a deemed distribution arising from liabilities allocated to the partner abandoning the interest under Sec. 752.


Rev. Rul. 93-80 cites Citron as support for the proposition that the reduction in liabilities caused a deemed sale, resulting in a capital loss. Citron mentions that the cases decided under the 1939 Code held the loss to be ordinary and that the 1954 Code did not contain any revisions to those earlier Code sections. Citron also cites post-1954 cases in which taxpayers were found to have capital losses because they were relieved of their liabilities by means of their abandonment resulting in a sale or exchange, including O'Brien,29 in which the court reasoned that deemed distributions were sales or exchanges of a partnership interest within the meaning of Sec. 731(a), resulting in capital gain or loss under Sec. 741.30

Avoiding Reduced Liabilities

Taxpayers normally prefer ordinary losses to capital losses. To incur an ordinary loss as opposed to a capital loss from the abandonment of a partnership interest, based on Rev. Rul. 93-80, a taxpayer needs to eliminate the deemed sale resulting from a reduction in a liability allocated to the taxpayer under Sec. 752.

In Hirsch31 and Weiss,32 the taxpayers were able to convince the courts that their requirements to pay a partnership liability were not canceled when they disposed of their partnership interests. Therefore there was no deemed cash distribution. These decisions were based on state law treatment of the partnerships that the taxpayers' personal liability continued. In addition, the remaining partners had not agreed to assume the liabilities. It may be possible for a taxpayer to avoid the deemed reduction in liability by including a statement in the abandonment letter that the taxpayer recognizes that the existing creditors may require payment from the taxpayer.

Assuming the taxpayer is successful in avoiding a cancellation of the partnership debt on abandonment of a partnership interest, the question arises of the tax effect when the liability is paid or canceled in the future. If the taxpayer does not pay the liability, it is reasonable to expect the taxpayer to be considered to have received income equal to the amounts of the liability allocated to the taxpayer. The income should be recognized in the tax year in which the liability is paid or canceled by someone other than the taxpayer. This income will most likely be ordinary either because the transaction does not meet the definition of a sale or exchange necessary for a capital gain or because of the application of Secs. 61 and 108. The fact that the taxpayer is required to report ordinary income is not detrimental since the taxpayer claimed an ordinary loss and not a capital loss in a previous year.

Understandably, most taxpayers will not agree to remain liable for a partnership liability after disposing of their interest in the partnership. These taxpayers should consider eliminating the liabilities to produce an ordinary loss under Rev. Rul. 93-80. A simple way to accomplish this outcome would be for the taxpayer to contribute cash to the partnership under Sec. 721 and have the partnership pay off the liability before the taxpayer abandons the interest. Although distinguishable, the taxpayer may want to refer to Citron. In that case, liabilities existed at the start of the tax year. The partnership paid off the liabilities before the abandonment. The court based its ruling on the fact that no liabilities existed at the time of the abandonment. However, in these situations, the IRS may attempt to apply the reasoning in Mas One Limited Partnership33 to convert the loss to a capital loss.

Mas One addresses whether a partnership received a nontaxable contribution or taxable cancellation-of-debt (COD) income when the former partner paid off a partnership liability. Since the partner in that case abandoned his interest, the reasoning in the case may apply to the partner and not just the partnership. There is an important fact in the case. The taxpayer abandoned his interest and then paid the debt personally because he had guaranteed the payment of the liability. Therefore, it is not surprising that the court ruled that the transaction was not a Sec. 721 nontaxable contribution to the partnership, but a debt cancellation.

If the taxpayer contributes the cash and has the debt paid before the abandonment, he or she can argue that Mas One does not apply. The longer the time between the contribution/debt payment and the abandonment, the more likely that the situation will not be considered an abandonment of an interest with an existing allocated liability. If the taxpayer is successful, then he or she will recognize an ordinary loss equal to the amount of loss without the contribution. This will occur because the payment of the debt will reduce the taxpayer's outside basis by an amount equal to the increase resulting from the contribution. In other words, the taxpayer's outside basis will not change in these situations.

This plan will work only if the partnership can pay off all the partnership's debts allocated to a taxpayer who abandons his or her interest. If the taxpayer is a limited partner in a limited partnership, this is likely to be possible. If the taxpayer is a member of an LLC, it may be less likely. Unless other members guarantee all the debt of the LLC, nonrecourse liabilities will exist.34 These are allocated to all members using a three-step approach. First, nonrecourse liabilities equal to the Sec. 704(b) minimum gain chargeback will be allocated to the members that will recognize the gain if the property securing the liability is claimed by the creditor in payment of the debt.

The second step is similar to the first but allocates the liability to a member who contributed the property that is subject to the nonrecourse liability assumed by the partnership. The third step allocates the remaining nonrecourse liabilities to the members based on their profit-sharing ratio. For a member of an LLC not to receive any allocation of a nonrecourse liability, the member must not be subject to any minimum gain chargeback, and the remaining nonrecourse liabilities allocated under the third step must be allocated exclusively to the other members based on a partnership agreement that validly allocated them to the other members. This is unlikely to occur. Therefore, most members of LLCs that abandon their interests will report capital losses.

Sec. 751(b)

If the partner recognizes an ordinary loss because no liabilities are allocated to the partner, no special adjustments are necessary. However, if the partner recognizes a capital loss because of the deemed cash distribution, Rev. Rul. 93-80 states that Sec. 751(b) may result in an adjustment to the loss recognition.

Sec. 751(b) applies if (1) the partnership owns Sec. 751 assets and (2) the partner receives a disproportionate distribution. A disproportionate distribution is one in which the partner receives more or less Sec. 751 assets in exchange for non-Sec. 751 assets.

There are two classes of Sec. 751 assets for distribution. The first class is unrealized receivables. Unrealized receivables are items of income that have been earned but not recognized. This category applies primarily to cash-method partnerships. Unrealized receivables also include recapture items under Secs. 1245 and 1250 as well as certain foreign corporate tax items. ­Unless the fair market value (FMV) of all depreciable property of a partnership is less than its basis, some unrealized receivables will exist.

The second class of Sec. 751 assets associated with disproportionate distributions is substantially appreciated inventory. Inventory includes items for sale in the ordinary course of business as well as other ordinary income items. Substantially appreciated inventory is inventory worth more than 120% of its basis. If a taxpayer is abandoning its interest, it is unlikely that the inventory is substantially appreciated. Normally, the value of the depreciable property would not exceed the basis of the property and therefore no unrealized receivables would exist. However, if the depreciable property secures a nonrecourse liability, then the value of the asset is no less than the amount of the nonrecourse liability. The result is that a partnership may have Sec. 751 assets.

Since the abandoning partner is deemed to have received solely cash, it will have received some of the cash in exchange for the Sec. 751 assets. The partner will have to recognize ordinary income equal to the amount of gain that it would recognize if it had received its share of the Sec. 751 assets and sold them for their FMV. If the partner would have recognized a loss absent Sec. 751, it will then recognize a capital loss equal to the outside basis (reduced by the amount allocated to the deemed distributed Sec. 751 assets) minus the cash received (reduced by the amount received from the deemed sales of Sec. 751 assets). Since the taxpayer will recognize ordinary income and increased capital loss, Sec. 751(b) will result in an increase in the negative effect of the deemed sale of the partnership interest that was abandoned.

Secs. 734 and 754

As previously mentioned, most abandonments of partnership interests will result in the recognition of a capital loss because the reduction in liabilities allocated to the abandoning partner is treated as a cash distribution. This deemed cash distribution results in a loss if it is less than the partner's outside basis under Sec. 731.

If the partnership has made a Sec. 754 election or if it makes one based on the deemed cash distribution, the partnership must make Sec. 734 basis adjustments. These adjustments affect the basis of the assets for all remaining partners. Under Sec. 734, when a partner recognizes a loss as a result of the distribution, the adjustment reduces the basis of remaining partnership assets. Under Regs. Sec. 1.755-1(c)(1)(ii), the adjustments are assigned exclusively to capital gain property. If the partnership does not own capital gain property, or if the basis of the property is less than the adjustment, the adjustment is carried forward and used to reduce the basis of capital gain property acquired by the partnership in the future. If any of the property that receives a negative adjustment is depreciable, the adjustment will affect the depreciation deductions over the remaining life of the asset.35

The American Jobs Creation Act36 modified Sec. 734 to require the adjustment even if a Sec. 754 election has not been made, if the distribution results in a substantial basis adjustment. A substantial basis adjustment is one that exceeds $250,000. Therefore, if the abandoning partner recognizes a loss in excess of $250,000, the partnership must reduce the basis of its assets by the amount of the loss recognized even if a Sec. 754 election was not made.


Under current rules, the worthlessness or abandonment of corporate stock will result in a capital loss. Therefore, the timing is very important. The taxpayer should consider claiming a loss for worthless stock as soon as he or she decides that the stock has no current or future value. To be entitled to this loss, an event proving worthlessness is necessary. Abandoning the stock, although not necessary, will provide the needed event. If the taxpayer decides to abandon the stock, notifying the entity and the other owners would be beneficial.

The loss on the abandonment or worthlessness of a partnership interest will be affected by whether the taxpayer has been allocated any of the partnership's liabilities. If any of the liabilities are allocated to the taxpayer, the loss is capital. If no liabilities are allocated to taxpayer, the loss is ordinary. If liabilities are allocated to a taxpayer, the taxpayer can recognize an ordinary loss either by maintaining responsibility to settle the debt after disposing of the interest or by paying off the debt before disposition. Settling the liability normally will be preferred to maintaining the debt.  

Editor's note: This article won The Tax Adviser's best article award for 2016.


1Pilgrim's Pride Corp., 141 T.C. 533 (2013).

2Pilgrim's Pride Corp., 779 F.3d 311 (5th Cir. 2015).

3In its financial statements, Gold Kist listed these assets as having a value of $38.8 million.

4If the taxpayer is an individual, Sec. 165(c) limits the loss deduction to business losses, losses incurred in transactions entered into for profit, and casualty or theft losses.

5If the securities are issued by an affiliated corporation, the loss would be ordinary under Sec. 165(g)(3).

6Sec. 165(g)(2).

7Pilgrim's Pride Corp., 141 T.C. 533 (2013).

8Tax Relief Act of 1997, P.L. 105-34.

9Pilgrim's Pride Corp., 779 F.3d 311 (5th Cir. 2015).

10Marinovich, T.C. Memo. 1999-179.

11Krause, 99 T.C. 132 (1992), aff'd sub nom. Hildebrand, 28 F.3d 1024 (10th Cir. 1994).

12Milton, T.C. Memo. 2009-246.

13Draper, 62 Fed. Cl. 409 (2004).

14Regs. Sec. 1.165-4(a).

15Morton, 38 B.T.A. 1270 (1938), aff'd, 112 F.2d 320 (7th Cir. 1940); Rev. Rul. 77-17.

16CCA 200637032.

17Echols, 935 F.2d 703 (1991).

18Id. at 707.


20Tejon Ranch Co., T.C. Memo. 1985-207.

21Echols, 935 F.2d 703 (1991).

22Echols, 950 F.2d 209 (1991).

23LeBlanc, 90 Fed. Cl. 739 (2009), quoting Kraft, Inc., 30 Fed. Cl. 739 (1994).

24A.J. Industries, Inc., 503 F.2d 660 (9th Cir. 1974).

25Citron, 97 T.C. 200 (1991).

26Echols, 935 F.2d 703 (1991).

27CCA 200637032.

28It is possible that the partner's outside basis is less than the amount of liabilities allocated to him or her. In this case the result would be a capital gain (except as provided in Sec. 751(b)).

29O'Brien, 77 T.C. 113 (1981).

30In Citron itself, there was an abandonment of a partnership interest; however, no liabilities existed. Therefore the Tax Court did not decide if the existence of liabilities would result in a capital loss.

31Hirsch, T.C. Memo. 1984-52.

32Weiss, 956 F.2d 242 (11th Cir. 1992).

33Mas One Limited Partnership, 390 F.3d 427 (6th Cir. 2004).

34These general liabilities of an LLC are referred to as exculpatory liabilities. Most practitioners accept that they are treated as nonrecourse liabilities. For a discussion of these rules, see New York State Bar Association Tax Section, Report on the Treatment of Exculpatory Liabilities for Purposes of Section 704 and Section 752 (June 17, 2015).

35Regs. Sec. 1.734-1(e)(2). There is a different result if the adjustment is an increase. In these cases, the adjustment is treated as newly acquired property for depreciation purposes.

36American Jobs Creation Act of 2004, P.L. 108-357.



Edward Schnee is the Hugh Culverhouse Professor of Accounting at the University of Alabama in Tuscaloosa, Ala. Eugene Seagois the Curling Professor of Accounting at Virginia Polytechnic Institute and State University in Blacksburg, Va. For more information about this column, contact Prof. Schnee at


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