The partnership in the case of Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5[1] attempted to claim that amounts it received from a partner it had treated in prior years as loans were actually capital contributions in the final year of the partnership. However, both the IRS and the Tax Court did not agree, finding that amount represented cancellation of indebtedness income in the final year of the partnership.

Three of the partners had contributed no funds to start the partnership, but were paid guaranteed payments each year. They each were treated as having a 30% interest. Eduardo Rodriguez put up $265,000 of cash for a 10% interest. In later years, Mr. Rodriguez advanced the partnership money that was treated as loans to the partnership, money used for partnership operations.

The partnership lost money each year, with each of the partners who had contributed no cash or property to the partnership being allocated a portion of the debt from Mr. Rodriguez as recourse debt on their K-1, using that basis to claim their share of the losses.

The partnership ceased operations in 2012. As the opinion describes the facts:

Echo’s 2012 Form 1065 was marked as its final return. Echo reported no income, deductions, losses, or guaranteed payments. Echo’s liability increased by $14,184, to $653,506, but unlike past years’ liabilities the amount was recorded as “Loans from partners”, not as “Other liabilities.”

The Schedules K-1 for 2012 reflected Echo’s limited operations that year. Echo did not allocate any income, losses, deductions, or guaranteed payments to Mr. Hohl, Mr. Blake, or Mr. Bowles. Their Schedules K-1 each reported negative capital account balances, unchanged from 2011, of $178,210. Mr. Rodriguez’ Schedule K-1 reported a negative capital account balance of $59,404, but no longer reported any share of partnership liabilities.

…

In summary, Echo’s 2012 return showed a liability remaining on its balance sheet of $653,506, but no partner reported an allocation of any share of that liability. The partnership did not report any income, such as income from the discharge of indebtedness, nor did Echo allocate to any partner any share of any such income. Mr. Hohl and Mr. Blake reported no partnership income for 2012.[2]

The IRS had issues with this final return that simply left the unpaid liability by itself on the final balance sheet. For the two taxpayers in this case, the opinion notes:

In each notice the Commissioner adjusted the taxpayer's Schedule E income upward by $178,210, the amount of the partner's negative capital account balances, representing the partner's share of cancellation of indebtedness income. The explanation of the adjustment stated: “It is determined that your share of income from the partnership known as Echo Mobile Marketing for taxable year 2012 is $178,210.00 instead of $0.00 as reported on your return. Therefore, taxable income is increased $178,210.00 for tax year ended December 31, 2012.” Each couple timely filed a petition with our Court.[3]

Since the IRS position was that there was cancellation of indebtedness income, the Tax Court first looked at whether the amounts advanced by Mr. Rodriguez were debts of the partnership or not. The taxpayers argued that Mr. Rodriguez had actually provided capital contributions.

The Court found that the amounts advanced were debts:

We do not find credible petitioners' argument that Mr. Rodriguez made capital contributions. While the absence of a written loan document might support petitioners as to the first factor, the partners clearly intended to treat, and did treat, the amounts received from Mr. Rodriguez as loans.

Echo's partners' actions suggest that they considered Mr. Rodriguez' cash infusions to be loans. Echo reported the amounts as liabilities each year it operated. The Schedules K-1 Echo sent to its partners reported the amounts as liabilities every year and allocated a share of those liabilities to each partner in 2009. Mr. Hohl and Mr. Blake each filed individual returns accepting and benefiting from their characterization of these amounts as debt. If Mr. Rodriguez had made a capital contribution of $265,000 in 2009, paragraph 4.4 of the operating agreement would have required Mr. Rodriguez to include that contribution in his initial capital account balance. He did not do so. And according to the agreement, if the partnership needed additional capital contributions, Echo had to notify all partners in writing and give them an equal opportunity to contribute. We have no evidence of any such notices. The record also does not include any explanation as to why Mr. Rodriguez' ownership percentage did not change as a result of his supposed additional capital contributions. Mr. Rodriguez did not testify.

As for the third factor, the record includes no evidence that Echo could not have obtained loans from third parties.

The amounts Echo received from Mr. Rodriguez were loans.[4]

So now the question becomes if there was cancellation of debt income in 2012 or another year. The Court notes that the test for when such cancellation occurs is as follows:

When a taxpayer realizes income from cancellation of indebtedness is a question of fact. Discharge of a debt occurs when it becomes clear that the debt will never be repaid. We look for “[a]ny 'identifiable event' which fixes the loss with certainty.”[5]

The Tax Court determined that, in fact, 2012 was the year the cancellation of indebtedness took place:

It became certain in 2012 that Echo would not repay its debt to Mr. Rodriguez, and thus Echo had income from the discharge of debt for that year. The partners testified that Echo would pay Mr. Rodriguez when the venture became profitable. When Echo ceased operations, it became clear it would never be profitable. Echo ceased operations when it filed its final return in 2012. Echo's termination in 2012 is when the debt became uncollectible.

The Hohls and the Blakes argue that Echo ceased operations in 2011. But the partnership had ongoing activity in 2012, evidenced by Mr. Rodriguez' lending the partnership an additional $14,184 in that year. Echo therefore did not terminate in 2011.[6]

Being a partnership, the next question is how such income will be allocated among the partners. While the partnership had an operating agreement that purported to provide for how the income and losses would be allocated, the Tax Court found that operating agreement in fact had never been followed—and thus the allocations found in it did not have substantial economic effect:

To have substantial economic effect, allocations must be consistent with the underlying economic arrangement of the partners. The allocations made by Echo's operating agreement (based on capital accounts) do not have substantial economic effect. In all other respects, the partnership and its partners shared items 30-30-30-10, instead of following the formula provided by the operating agreement. This course of conduct makes clear that Echo did not adhere to the allocations in the operating agreement and instead allocated losses on the basis of the partners' 30%, 30%, 30%, and 10% ownership interests. The partners also did not follow the operating agreement's provisions for contributing capital or maintaining capital accounts.[7]

The Tax Court then determined the proper allocation, based on the partners’ interests in the partnership:

Because the allocations provided by the operating agreement do not have substantial economic effect, the partners' distributive shares of income are determined according to their interests in the partnership. A partner's interest in the partnership depends on the facts and circumstances.23 In these cases, during all four years Echo operated, it allocated losses according to the stated 30%, 30%, 30%, and 10% ownership interests. Allocation of the income in 2012 should follow the allocation of losses for each other year of the partnership's existence. Mr. Hohl and Mr. Blake should each have included a 30% share of the income from the discharge of indebtedness in their income for 2012.[8]

This case is an excellent example of what tends to happen to taxpayers whose view of the true nature of a transaction changes from year to year and ends up aligning with what happens to be the most favorable outcome in each year. Courts are skeptical of claims like the one we had in this case where, after relying on the treatment of the transaction as a loan for years to allow the partners to deduct the losses, the taxpayers attempt to argue for a different treatment in the one year that a loan treatment proves disadvantageous. And, most often, the Court rejects this change of treatment, forcing the taxpayers to live with the consequences of the view they had taken for years when that view was advantageous.

[1] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5, January 13, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/partners-received-income-from-discharge-of-partnership-debt/2drcj (retrieved January 15, 2021)

[2] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5, pp. 7-8

[3] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5, p. 8

[4] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5, pp. 11-12

[5] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5, p. 13

[6] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5, p. 14

[7] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5, p. 15

[8] Michael Hohlet ux. et al. v. Commissioner, TC Memo 2021-5,