In a real estate workout involving a partnership or limited liability company (LLC) interest consideration has to be given to either (i) conveying the interest to the creditors of the entity or (ii) abandoning the interest. The tax consequences of each action are considered below.

Conveying to Creditors

An involuntary or voluntary conveyance of the interest will generally involve the same tax consequences of such a conveyance at the partnership or LLC level. Where an individual partner is personally liable with respect to any indebtedness of the partnership (i.e., in the case of recourse debt), an involuntary conveyance of his interest will produce cancellation of indebtedness income (COD Income) to the extent his relief from liability exceeds the fair market value (FMV) of his interest. The partner may, however, be able to avail himself of either the bankruptcy or insolvency exceptions to COD Income found in Section 108 to exclude all or a part of the COD Income from his gross income.

The applicability of these exceptions is determined at the partner rather than the partnership level. As a result, if a partner knows that he will fall within one of these exceptions, he can time his conveyance accordingly, but must be cognizant of the fact that certain of his other tax attributes will be reduced unless he elects to reduce his basis in depreciable property first.

Transferring the Interest to a Controlled Corporation. The transfer of a partnership or LLC interest to a controlled corporation attempts to shift the phantom income being generated to the corporation. There is the possibility of immediate gain recognition under either Section 357(c) (if the basis in the contributed interest is less than the liabilities transferred) or Section 357(b) (if the liabilities were assumed by the corporation to avoid federal income tax or without a bona fide business purpose).

In Noonan v. C.I.R.,1 the Tax Court disregarded a corporation formed solely to hold limited partnership interests where it was apparent that the corporation was not engaged in any business activity and was formed for the sole purpose of allowing the taxpayer to escape taxation.

For purposes of applying the rules of Section 357(c) to the transfer of partnership or LLC interests to a corporation in an exchange to which Section 351 applies, Revenue Ruling 66-1422 provides that in exchanges involving multiple transferors the provisions of Section 357(c) apply separately to each transferor. Thus, Section 357(c) gain to each transferor, if any, is the excess of the sum of the amount of his liabilities assumed over the adjusted basis of all property transferred by him pursuant to the exchange determined without regard to the adjusted bases and liabilities of any other transferor.

This concept was applied to the transfer of a partnership interest in Revenue Ruling 80-323,3 in which the limited partners of a motion picture partnership transferred their partnership interests to a corporation in exchange for the corporation’s stock in a transaction that qualified under Section 351. In many instances, the share of nonrecourse partnership liabilities that had been allocated to a limited partner pursuant to the Section 752 regulations exceed the limited partner’s adjusted basis in his partnership interest. The IRS ruled that each partnership interest exchanged for the stock of the new corporation was subject to its share of partnership liabilities as determined under Section 752 and that Section 357(c) gain would be recognized to each transferor partner to the extent that each partner’s share of partnership liabilities exceeded his adjusted basis in the partnership interest transferred.

In Technical Advice Memorandum 87150003 (Nov. 7, 1986), partners in several partnerships transferred their interests in the partnerships along with their share of the partnership liabilities of those partnerships to a corporation in a transaction to which Section 351 applied. The IRS ruled that for purposes of determining gain under Section 357(c) for each transferor partner that transferred his partnership interests and liabilities, the amount of gain equaled the excess of that transferor partner’s total share of all liabilities (assumed or taken subject to) transferred in the transaction over the total adjusted basis of all the property (including the partnership interests) transferred by that transferor partner. Accordingly, the sum of a transferor partner’s share of liabilities of several partnerships assumed must be compared to the sum of the transferor partner’s basis in his or her several partnership interests transferred for purposes of computing gain under Section 357(c).


A partner or member in a financially troubled real estate entity who will recognize a capital loss if the property is foreclosed on, and the partnership or LLC subsequently liquidated, may be able to avoid the limitations on deducting capital losses by abandoning his interest prior to the foreclosure. Such a result is possible if there is neither an actual nor a constructive distribution to the partner or LLC member as a result of the abandonment.4

In order to claim an abandonment loss, a taxpayer must manifest an intent to abandon his interest by some overt act or statement reasonably calculated to give a third party notice of the abandonment.5 In Echols v. C.I.R., a taxpayer owned a limited partnership interest in a partnership whose sole asset was an unimproved tract of land. The land was encumbered by a nonrecourse mortgage which was greater than the land’s FMV. The partnership attempted to restructure its nonrecourse debt, but failed and the land was subsequently foreclosed on by the lender. In the taxable year preceding the foreclosure, the taxpayer called a meeting of the partners and announced that he was walking away from his partnership interest and that he would no longer contribute his share of additional funds needed by the partnership for the nonrecourse mortgage and ad valorem tax payments due on the land.

The U.S. Court of Appeals for the Fifth Circuit, reversing the Tax Court, held that the taxpayer’s declarations, coupled with his overt acts, were more than sufficient to constitute an abandonment of his partnership interest for which he could claim a loss pursuant to Section 165(a). In addition, the Fifth Circuit found that the taxpayer had demonstrated the “worthlessness” of his partnership interest during the taxable year and that, alternatively, the taxpayer could claim a loss for such interest under Section 165(a) relying on that ground as well.

Similarly, in Citron v. C.I.R.,6 the taxpayer was a limited partner in a motion picture partnership. After production of the movie, the partnership could not obtain the completed film from the producer. The taxpayer was advised that an expensive and lengthy lawsuit would have to be brought against the producer in order to recover the film. In addition, it was suggested that with additional investment an X-rated version of the movie could be made from prints that might allow the recovery of a portion of taxpayer’s investment in the partnership.

The taxpayer decided not to continue to participate in the partnership and advised his fellow partners that he did not wish to advance more money or participate in any of the proposed future activities of the partnership. Thereafter, the taxpayer, along with the other limited partners, agreed to dissolve the partnership and the taxpayer had no further dealings with the partnership. The taxpayer claimed an ordinary loss under Section 165(a) equal to his cash investment in the partnership alternatively as either a theft or embezzlement loss, or as a loss due to abandonment.

The Tax Court held that the taxpayer failed to show that a theft and/or embezzlement had occurred under state law and denied the loss on that ground. The Tax Court did find, however, that the taxpayer manifested his intent to abandon his partnership interest by an overt act of abandonment to his fellow partners and by having no further dealings with the partnership. Accordingly, the Tax Court held that the taxpayer was entitled to claim an ordinary abandonment loss under Section 165(a).

It should be noted that the partnership in Citron had no liabilities and that the Tax Court relied on this fact in holding that the taxpayer had an ordinary loss from an abandonment as opposed to a capital loss from a sale or exchange. The Tax Court found that because there was no relief from liability, the taxpayer had not received consideration for the surrender of his partnership interest and, as such, the abandonment could not be converted into a sale of a capital asset. By contrast, in Echols, because the partnership had nonrecourse debt against the property and owed back real estate taxes, the taxpayer claimed a capital instead of an ordinary loss.

The IRS has taken the position following Citron in Revenue Ruling 93-80,7 that ordinary loss treatment is only available where there is no actual or deemed distribution to the partner from the partnership. In Revenue Ruling 93-80, an ordinary loss was deemed to occur upon the abandonment by a limited partner of his interest in a partnership where the partner bore no economic risk of loss for any of the partnership’s liabilities and was not entitled to include a share of such liabilities on the basis of his partnership interest.

Peter M. Fass is a partner at Proskauer Rose.


1. 52 T.C. 907 (1969).

2. 1966-1 C.B. 66.

3. 1980-2 C.B. 124.

4. Rev. Rul. 93-80, 1993-38 I.R.B. 1.

5. See, Echols v. C.I.R., 935 F.2d 703 (5th Cir. 1991); Beus v. C.I.R., 261 F.2d 176 (9th Cir. 1958). (“The mere intention alone to abandon is not, nor is non-use alone, sufficient to accomplish abandonment”). An affirmative act to abandon is ascertained from all the facts and surrounding circumstances. United California Bank v. C.I.R., 41 T.C. 437, (T.C. 1964).

6. 97 T.C. 200 (1991).

7. 1993-2 C.B. 239.