Please note: The law has changed since this post has been published. Please click here for more information on the updated law.
While nobody invests in a fund with the intention of losing his or her investment, inevitably, it sometimes happens. Fund investments, like any other investment, can decline substantially in value. When substantial losses occur investors need to make the best out of a bad situation. Often this entails achieving the best and most valuable use of the loss for tax purposes.
Unlike publicly traded securities, fund interests often have limited and/or restricted liquidity. This fact can make crystallization of the tax loss extremely difficult. But even if the fund interest has immediate liquidity, investors may want to stop and consider their tax options for the loss.
A sale or redemption of a fund interest is typically treated as a capital loss to the investor (assuming the partnership interest was held as a capital asset, which is generally the case). Capital losses for a U.S. individual are limited to capital gains plus $3,000 per year as a deduction against ordinary income. Since capital gains are taxable at 20% (assuming a high income earner, plus 3.8% net investment income tax), while ordinary income is taxable at 39.6%, it is usually more advantageous to take the loss as an ordinary loss as opposed to a capital loss.
Investment losses can be taken in several ways depending on the nature of the investment and magnitude of the loss. Fund interests can be sold or redeemed, declared worthless, or simply abandoned. As stated above, an outright sale (to a third-party or via redemption), is typically treated as a capital loss. Likewise, a worthless security deduction will generally result in a capital loss if the security is a capital asset in the taxpayer’s hands. However, in order to claim a worthless security deduction the investor must be able to demonstrate that the security has no demonstrable monetary value. Simply showing a large or even catastrophic decrease in value is not enough. The security must be devoid of value. This is typically demonstrated by some objective event such as bankruptcy, default, revocation of licenses, etc.
Historically, an investor with a large loss in a fund interest (but one that still has some value), could affirmatively abandon its fund interest and claim an ordinary loss for the full amount of tax basis. The IRS had ruled that this was the correct tax treatment in Revenue Ruling 93-80. The investor would abandon its interest by notifying the partnership in writing that it no longer wished to be treated as a partner and was giving up any and all rights to its capital and profits interest to the partnership.
Recently, the U.S. Tax Court ruled that an abandonment loss was more properly treated as a capital loss than an ordinary loss. Pilgrim’s Pride Corp. v. Commissioner, 141 T.C. No. 17 (2013). The Tax Court found that pursuant to Internal Revenue Code Section 1234A the abandonment resulted in a termination of a right with respect to a capital asset and thereby resulted in a capital loss. Many practitioners think the case is wrong on the law but investors need to be aware. This case is good precedent in the Tax Court, however is yet unclear if the IRS will elect to pursue the court’s line of reasoning in its audit process. The IRS did not affirmatively utilize a Section 1234A attack on the transaction at issue in Pilgrim’s Pride. Rather, the issue was briefed at the request of the Tax Court judge. The taxpayer has requested a review of the case by the full court.
The Pilgrim’s Pride case involved the abandonment of stock rather than a partnership interest, but it would be incredibly difficult to distinguish the case in a way that its analysis would not be equally applicable to partnership interests. For those investors that have taken an abandonment loss as an ordinary loss in the recent past or who are considering such action now, a full analysis of this case and its potential adoption by the IRS should be considered.
For more information regarding the utilization of losses or other tax planning matters please contact your local WithumSmith+Brown advisor.
– Tony Tuths