Nonresident Limited Partners Lose Entire Investments but Still Subjected to Large PA Tax Bills

by McNees Wallace & Nurick LLC

[author: James L. Fritz]


On August 16, the Commonwealth Court upheld its perplexing January 2012 decisions that nonresident limited partners who lost their entire investments in a partnership owning Pennsylvania real estate, and who apparently had no tax benefit from their shares of the partnership’s operating losses over a period of years, could somehow be subject to substantial amounts of Pennsylvania Personal Income Tax on their shares of the partnership’s “gain” on forgiveness of indebtedness resulting from foreclosure on a non-recourse mortgage.  Robert J. Marshall, Jr., et al. v. Commonwealth, No. 933 F.R. 2008; Thomas Shaker v. Commonwealth, No. 932 F.R. 2008; John K. Houssels, Jr. v. Commonwealth,  No. 757 F.R. 2008; Ernest & Beverly Wirth v. Commonwealth, No. 424 F.R. 2008.  [One of the January 2012 decisions is reported at Robert J. Marshall, Jr. v. Commonwealth, 413 A.2d 67 (Pa. Cmwlth. 2012).]


The underlying real estate was purchased by the partnership for $360 million, of which $308 million was financed with the non-recourse mortgage.  Under the terms of the loan, interest was imposed at 14.55% and, if not paid, was deferred and compounded.  At the time of foreclosure, the total owed was $2.6 billion - $308 million of principal and $2.32 billion of accrued interest.  According to the lone dissenting opinion in these cases: 


There is nothing in the record to suggest that the property was worth anywhere near $2.6 billion, or for that matter, that even the original purchase price could have been recovered.

We would have to fill more than one entire newsletter to walk readers through the court’s full analysis.  Instead, we will simply note that these cases probably will be appealed to the Pennsylvania Supreme Court and point out a few of the issues of general concern which presumably will be further addressed by the Supreme Court.

First, the Commonwealth Court’s decision leaves in place a substantial disparity in treatment of the partnership’s nonresident investors as compared to the investors who resided in Pennsylvania, and this disparity seems to result from an apparent inconsistency between the court’s analysis of the Commonwealth’s constitutional ability to tax the nonresident investors and its ability to tax the nonresident investors’ particular gains and losses.

Analytically, the partners here had two taxable events.  One was their proportionate share of the deemed gain on forgiveness of indebtedness resulting from the foreclosure.  A second was each partner’s loss on liquidation of the partnership, which here occurred in the same tax year as the foreclosure.

The Pennsylvania resident partners were permitted to offset the gain on foreclosure with the loss on liquidation.  However, the nonresident partners were not permitted to recognize the loss on liquidation for Pennsylvania tax purposes.  The court’s explanation for this was that intangible assets, such as a limited partnership interest, are deemed to reside where the holder is domiciled, with the result that any gain or loss respecting the disposition of a limited partnership interest owned by a nonresident is not sourced to Pennsylvania.  The disparity, therefore, in the eyes of the court, resulted from constitutional limitations on Pennsylvania’s ability to impose extra-territorial taxation.

This, however, seems to clash directly with the court’s conclusion that the nonresident investors in these cases could constitutionally be subjected to tax on the partnership’s income precisely because they held the limited partnership interests.  The court held that Due Process was not violated in treating the nonresident taxpayers as being taxable in Pennsylvania because they had intentionally invested in a partnership whose only investment was Pennsylvania real estate.  While the court certainly cited to relevant precedent in reaching its disparate conclusions, one would think that our country’s founders might cringe if they knew their founding principles had been applied in such manner as to justify a state’s imposition of hundreds of thousands of dollars of income tax on nonresident investors while allowing other investors to escape such tax where the only factual distinction is that they were residents of the state.  The result in this case seems to turn the principles underlying the United States Constitution on their head.

A second issue which hopefully will be addressed by the Pennsylvania Supreme Court is the fundamental question of what constitutes “income” for Pennsylvania Personal Income Tax purposes.  In these cases, the taxpayers lost their investments.

Inasmuch as the indebtedness eliminated in foreclosure was nonrecourse, the investors really received no benefit from the forgiveness.  They had no obligation to pay the debt to begin with and they received no distribution in cash or otherwise as a result of the foreclosure.  Furthermore, the partnership itself never made a profit on operations and lost its only significant asset in foreclosure.  The bank which made the loan to the partnership assumed virtually the entire risk that it would never collect what it was owed.  The bank relied entirely on the value of the real estate and, although the record before the court does not seem to clearly address the issue, it would appear that the real estate was not worth anything near the value which the bank allowed to accrue before it foreclosed.

In common sense terms, how can an investor be subject to “income” tax when he or she lost their entire investment and received no other benefit as a result of their investment?  Could the Legislature ever have intended to impose tax in this circumstance?  As noted by the dissent in these cases, there is prior precedent suggesting an approach more focused on economic realities.  It will be interesting to see whether the Pennsylvania Supreme Court, which in many past tax cases has rejected “technical” arguments by taxpayers, will follow the technical approach taken by the Commonwealth Court majority or will look for a “substance over form” approach which reaches for a more common sense result.

The third issue we wish to highlight is the “tax benefit rule.”  The Commonwealth Court has ruled that the taxpayers in these cases are not entitled to relief under this rule. The writer of this article has found the guidance provided by the Department of Revenue respecting the scope and application of this rule in the Pennsylvania context to be confusing.  The Commonwealth Court’s ruling in these cases does little to clarify the confusion - if anything, the court’s application of the rule adds to the complexity.

In very general terms, it seems to the writer of this article that the tax benefit rule is a rule which addresses inequities resulting from artificial constructs utilized in computing tax on the annual basis.  For example, a taxpayer may take a depreciation deduction for an asset which has not depreciated at all in value.  In other cases, there may be some diminution in value but the depreciation deduction may be more than that amount.  When an asset is sold, it may generate a “profit” solely because its basis was reduced by depreciation for tax purposes - not because the asset has sold for more than the taxpayer paid for it.  If the taxpayer realized some “benefit” from the depreciation deduction he or she took (e.g., offsetting other income), then it seems fair to tax the artificial gain on the sale of the asset which was depreciated for tax purposes.  However, if the taxpayer received no benefit from the depreciation deductions and the asset is sold for less than was paid for it, common sense suggests there is no actual gain which should be taxed.

In these cases, if the taxpayers had benefitted from partnership losses recorded on an accrual basis, then they should, perhaps, have been taxed on the “gain” experienced when the partnership’s sole asset was foreclosed.  However, the cases here suggest that the taxpayers realized no “benefit” from the interest and other deductions generated by the partnership.  Furthermore, at the partnership level, only a small fraction of interest deductions actually offset operating receipts.  Inasmuch as they lost their investments and otherwise actually realized no real gain on the foreclosure, why would the taxpayers be taxed on their partnership’s relief from paying the accrued interest?  Shouldn’t the courts apply some sort of “tax benefit rule” here to reach a more logical result?

The Commonwealth Court actually rejected eleven distinct objections (“exceptions”) lodged by the taxpayers against the court’s original, January 2012 decision.  Any reader desiring to review copies of the Commonwealth Court’s decisions in these cases may contact a member of the McNees SALT group.  We look forward to reporting the Pennsylvania Supreme Court’s decision when it is rendered.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© McNees Wallace & Nurick LLC | Attorney Advertising

Written by:

McNees Wallace & Nurick LLC

McNees Wallace & Nurick LLC on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.