Tax Court denies ordinary abandonment losses in taxpayers’ disposition of partnership interests

By Nicole Ngai, CPA, San Francisco

Editor: Mark G. Cook, CPA, CGMA

When the disposal of a partnership interest results in a loss, taxpayers might not be aware that the loss could qualify for an ordinary loss deduction instead of capital loss treatment. This ordinary loss deduction is permissible under the provisions of Sec. 165(a) when property, such as a partnership interest, is abandoned. However, the burden of proof ultimately rests with the taxpayer. In June 2017, the Tax Court affirmed the IRS's decision to recharacterize the loss of a partnership disposition from ordinary to capital when the taxpayers failed to provide evidence of abandonment (Watts, T.C. Memo. 2017-114).


In 1968, two brothers, Edwin and Ronnie Watts, founded Edwin Watts Golf Shops in Fort Walton Beach, Fla. Edwin Watts Golf grew successful and profitable over the years, creating a strong brand in the region and attracting investors. In 2003, the Watts brothers arranged with Wellspring, a private-equity firm, to form a partnership that would exclusively own Edwin Watts Golf. After the execution of the purchase and partnership agreements, Wellspring owned an 80.5% interest in the partnership in exchange for $93 million and received preferential rights as a preferred partner. Edwin Watts owned the remaining 19.5% as a common interest. Through the years, the common ownership changed, resulting by 2007 in Edwin Watts holding a 9.7% interest and Ronnie Watts holding a 7.76% interest.

Wellspring eventually wished to sell its interest in the partnership. After discussions with the Watts brothers, the entire partnership was sold to Sun Capital, another private-equity firm, for $87 million in 2007. Sun Capital paid $34.6 million of the cash proceeds to Wellspring. The remainder of the proceeds were used to settle the partnership's debts as well as fees and selling expenses. The Watts brothers received none of the proceeds.

When the Watts brothers' longtime accountant prepared their 2007 tax returns, he treated their disposal of the partnership interests as an abandonment, which generated ordinary losses. The accountant concluded this treatment was appropriate after reviewing the relevant sale documents and learning the brothers received none of the cash. When the brothers' tax returns were selected for examination, the IRS recharacterized the disposition as capital losses. The Watts brothers disagreed and took their case to Tax Court.

Capital loss (Sec. 741) vs. ordinary loss (Sec. 165)

In general, Sec. 741 treats all gains and losses from the sale or exchange of a partnership interest as capital gains and losses. Thus, unless there are unrealized receivables and inventory (Sec. 751) or the transaction is not a sale or exchange, the partnership interest is considered a capital asset under Sec. 741. For individual taxpayers with a gain, the capital treatment could be beneficial, due to favorable capital gain rates (Sec. 1(h)(1)). However, if the transaction resulted in a capital loss, individual taxpayers may deduct these losses only to the extent of capital gain and up to $3,000 of ordinary income (Sec. 1211(b)). The unutilized loss, if any, would carry forward to the next year, but these taxpayers generally would remain dependent on realizing capital gains to fully use the loss (Sec. 1212(b)).

Instead of recording a capital loss, taxpayers may treat losses as ordinary under Sec. 165(a) if the transaction they arise from is considered an abandonment. Regs. Sec. 1.165-2 specifies that the termination of the usefulness of nondepreciable property, such as the disposition of an intangible partnership interest, is deductible as a loss in the year sustained, so long as a sale or exchange of property has not occurred. If the transaction is determined to be a sale or exchange, it would not qualify as an abandonment loss and would be regarded as a capital loss under Sec. 741.

In Rev. Rul. 93-80, the IRS provided further clarification on abandonment of partnership interests and directed attention to the effect of partnership liabilities on the characterization of the loss. Under the ruling, abandonment is established when taxpayers can substantiate their intent and overt actions in abandoning the asset. Once abandonment is established, taxpayers should ensure they have neither personal liability for a partnership's recourse debts nor economic risk of loss for a partnership's nonrecourse debts. Otherwise, any relief of a partnership debt is considered a deemed cash distribution from the partnership to the partner under Sec. 752(b) and constitutes a sale or exchange event under Sec. 731(a). Sec 731(a) recognizes any distribution of money, actual or deemed, in liquidation of a partner's interest as connected to a sale or exchange. Even if no actual cash is received, the reduction of the partner's share of the liabilities jeopardizes the abandonment criteria in Regs. Sec. 1.165-2 and could cause the disposition of a partnership interest to be categorized as a capital loss instead of as an ordinary loss.

Tax Court's resolution

During the Tax Court proceedings, the Watts brothers failed to present any documentary or testimonial evidence to support their eligibility for ordinary abandonment losses. The court found that they had not provided any evidence or analysis to show how their intentions and actions in the disposition signified an abandonment. It further found they had neglected to prove their shares of partnership liabilities and capital restoration obligations, despite there being documentary evidence suggesting they had both. As a result, the Tax Court sided with the IRS and upheld the recharacterization of the partnership interest disposal from ordinary loss to capital loss. Nevertheless, the Tax Court did waive the assessment of Sec. 6662 accuracy-related penalties, as the Tax Court believed the Watts brothers acted reasonably and in good faith by relying on their longtime accountant, who had advised the brothers on tax matters for over 30 years and based his determination on the facts originally given to him.


Tax practitioners should be aware of the qualifications and exceptions when claiming abandonment of a partnership interest. Taxpayers should be ready to prove their intent and actions in abandonment if questioned and be able to show that no event during the course of disposition, including the relief from partnership liabilities, would trigger a sale or exchange. With proper planning, it is possible for a taxpayer to have an ordinary loss instead of a capital loss from the disposition of a partnership interest.


Mark G. Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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