Good news for taxpayers who have, or who are considering, abandoning an interest in an underperforming partnership.  Earlier this week the Fifth Circuit overturned the Tax Court’s 2013 decision in Pilgrim’s Pride, clearing the way for abandonment losses to once again be ordinary losses. 

Section 165(a) of the Internal Revenue Code has long been viewed as providing ordinary loss treatment when a taxpayer abandons an interest in a partnership.   However, in Pilgrim’s Pride case, the Tax Court abruptly stopped this treatment when it determined that Section 1234A applied, thereby causing the abandonment loss to be capital in nature.  The Tax Court’s decision was highly criticized, as Section 1234A appears on its face to apply only to the termination of options.  Furthermore, the application of Section 1234A was not initially raised by the Internal Revenue Service, but rather was raised by the Tax Court.  While many considered the Tax Court’s decision to be wrong, the decision was nonetheless an obstacle preventing taxpayers from claiming abandonment losses as ordinary losses.  This obstacle was removed earlier this week though, when the Fifth Circuit unequivocally rejected the Tax Court’s application of Section 1234A and reversed the Tax Court’s decision. 

Why is this good news for taxpayers?  In many situations, abandoning an interest in an underperforming partnership may provide a better result on an after-tax basis.  By abandoning the interest, a taxpayer may be able to claim an ordinary loss under Section 165(a) in an amount equal to the taxpayer’s basis in the interest (see last paragraph for important exception).  This ordinary loss could be used to offset the taxpayer’s ordinary income. If the taxpayer instead sold or liquidated its interest, the resulting loss would generally be capital in nature and could only offset capital gain.  Capital loss treatment is much less desirable, as shown in the following example.  An individual taxpayer holds an interest worth $2 million and a basis of $20 million.  If the taxpayer abandons his interest, he has an ordinary loss of $20 million, which the taxpayer could utilize to offset ordinary income.  Assuming a 39.6% federal income tax rate, the taxpayer recognizes a $7,920,000 after-tax benefit by abandoning his interest.  If instead he sells his interest for $2 million, he has $2 million in cash plus a capital loss of $18 million.  In the best case scenario where the taxpayer has $18 million of capital gains, the tax benefit of utilizing the loss is only 23.8% or $4,284,000.  If the taxpayer does not have capital gains, the net after-tax benefit would only be $2 million.  In either case, the taxpayer is in a better position, on an after-tax basis, if he abandons his interest. 

But don’t count your chickens before they hatch … while abandonment can be a powerful tax planning tool, it is not always available.  If the taxpayer has been allocated any partnership liabilities under Section 752 of the Code, the Internal Revenue Service’s position is that the liabilities result in the abandonment being treated as a deemed sale or exchange of the partnership interest.  Accordingly, the resulting loss would generally be treated as a capital loss.