If you’ve gone into business with a partner, only to find that due to unforeseen circumstances, the value of that partnership has become next to nothing, then you do have some financial recourse. Unfortunately, this frequently happens in business, especially with ventures in risky fields, like restaurants.
At Cook Martin Poulson, P.C. we’ve helped people learn about and understand how partnership abandonment loss can help in this situation. Below we explain what partnership abandonment loss is and the tax deduction available for this very purpose.
What Exactly is Partnership Abandonment Loss?
Partnership abandonment loss is a term for when a business partnership is nearing its end. For example, if you went into business with another person, and both of you put in an equal amount of money, then you’re equal partners. Even if you allow that other person to run the business, while you simply add in your opinion here and there when necessary, you still have an ownership stake in that company.
When everything is fine with the business, you have nothing to worry about. You might even be making a small profit now and then. But, if that turns around and the business ends up in financial trouble, then you have what’s called partnership abandonment loss. This is a financial stake in a business that’s worth practically nothing.
Your Options are Limited
When your financial stake in a business partnership becomes worthless, or just about worthless, then you only have a few options:
Option 1: You can try to sell your interest.
This means that someone else would purchase your stake in the business. They might be willing to try to turn things around or hope that business will improve in the future, making their ownership portion worth more than they paid for it. This is a very risky move on the part of the new buyer, especially if the business is in a field known for financial distress.
Option 2: Give up your interest.
If you won’t sell it, you can just give it to someone who wants it, usually for free. The other partner in the business may want it, but it really depends on whether or not they think that the company’s finances will improve. In some cases, they may not, but the other partner is willing to risk it.
Option 3: Walk away.
This means that you’re abandoning the partnership. This is what “partnership abandonment loss” refers to. When you walk away from your stake in the business, you might be entitled to a tax deduction in the amount of that loss. While there’s some paperwork involved as part of the abandonment process, in the end, you could end up saving money on your taxes. It may not be as much money as you’ve put into the company, but all of that depends on the situation and the accounting involved.
The Abandonment Process
In order to effectively abandon your share in a business partnership, there are three things that you need to do.
First, you need to intend to abandon your share clearly. This is loosely defined, but as long as you understand what you’re doing, then you have nothing to worry about. It’s the equivalent of going to your accountant and lawyer and saying “I want to abandon my share in this company, as it’s currently worthless.” The intent needs to be obvious. You cannot accidentally abandon your shares of the company.
The second thing that you need to do is fulfill the “affirmative act of abandonment.” This means that you need to fill out (or have your accountant or lawyer fill out) whatever paperwork is required. You need to take this step in order to abandon your ownership in the company legally. The process needs to be done to the letter, meaning that you must follow all legal instructions. We’ll get into this in a bit more detail later.
Finally, you need to let everyone involved know about your actions. If you plan on completely abandoning your ownership once and for all, then everything must be informed, either verbally, in writing, or in both formats. You’ll have to tell your business partner or partners, as well as their lawyers and accountants, and any members of an overseeing board, if you have one in place.
Tax Deductions for Loss
Once you’ve declared that you’re abandoning your partnership, you might be able to claim any losses for the previous year on your tax returns. This requires you to claim the loss under IRC §165(a) because of the abandonment.
If the interest (your ownership stake in the business) is worthless, then this falls under that same heading. In order to do this, you must establish the abandonment or worthlessness (which we have already discussed), determine which year that losses should be deducted from, and then figure out whether or not the loss is a capital loss or an ordinary loss.
Making the Partnership’s Worthlessness Clear
If you plan on proving that your share in the business is worthless (and you aren’t abandoning it), then you have to go through a number of important steps. These were determined by a court case, Echols v. Commissioner, in which the court of appeals examined whether or not the taxpayer in question could make the worthlessness determination.
They found that it was “largely a judgment call by a taxpayer based on his own particular, highly personal set of economic factors, including tax effects.” What does this mean? Well, it means that you – the taxpayer – has the ability to determine whether or not your shares in the business is worthless.
On top of this, the other factors in that case, including other investors who also believed that it was worthless, those who wanted to hold onto the interest and keep infusing cash into the company, did not matter in this case. It all comes down to the specific taxpayer and his or her opinions on the business and its worth. The court decision wound up protecting this right.
In summary, the partnership loss process requires several steps, as well as some paperwork that must be completed by an expert. If you are unsure whether or not your partnership loss qualifies for the deduction, please give us a call at (435) 750-5566. We at Cook Martin Poulson, C.P. can walk you through the necessary steps and legal actions.