Squeeze that Worthless Partnership Interest for Some Lemonade
Ordinary losses almost always provide a better tax benefit than capital losses. A partnership interest is considered a capital asset. A sale of a partnership interest at a loss will generate a capital loss. However, an abandonment, forfeiture or worthlessness of a partnership interest can create an ordinary loss.
In 2013 Darlene invested $500,000 in Auto Sports, LLC. In 2018, her tax basis in the LLC is $300,000, however her interest is only worth $1,000. Darlene is not allocated any of the LLC liabilities. Darlene’s federal marginal income tax rate on ordinary income is 40.8%, and her marginal capital gains rate is 23.8%. For 2018 she is expecting total net long term capital gains from other sources of $100,000.
Sale – If Darlene sells her interest in 2018, she will generate a $299,000 capital loss. She will only be able to use $103,000 or her loss in 2018, the balance of $196,000 will be carried forward to 2019. The sale will save Darlene $25,024 of federal income tax in 2018.
Abandonment – Alternatively Darlene could abandon her interest in 2018. In 2018 Darlene takes all the steps necessary to affect a proper abandonment, including written notification to the partnership. Darlene obtains a $300,000 ordinary loss from abandonment of her interest in Auto Sports, LLC, saving her $122,400 of federal income tax in 2018.
Having a liability in the partnership can prevent the capital loss from being converted to an ordinary loss due to the relief of your liabilities being considered as deemed distributions. This issue can be solved by abandoning your interest in the partnership and remaining liable for the partnership debt or claiming a worthless loss, but remaining as a partner.
Abandoning a low value partnership interest could also benefit a corporate partner facing a potential net capital loss limitation.
We recommend that you review your partnership interests that have a low value and significant unrealized tax losses to determine if abandonment would be preferable to selling or continuing to hold the investment.
In addition, these rules could be useful for future business or investment planning. For example, would it be preferable to hold a risky business venture or investment through a partnership?
Feel free to contact us to discuss how this planning opportunity may apply to your situation.