IRC section 721(a) says a partnership or any of its partners will not have to recognize gain or loss for contributing property to the entity in exchange for a partnership interest. Such a capital contribution increases a partner’s basis. IRC section 752(a) says “any increase in a partner’s share of the liabilities of a partnership, or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership.” Likewise section 752(b) says a decrease in a partner’s share of partnership liabilities is considered a distribution to that partner. In a recent case the court held that a substantial payment a limited partner made when abandoning a partnership interest was taxable income rather than a capital contribution.
MAS One Limited Partnership was formed in Ohio as a limited partnership to own and operate an office building in Florida. The sole general partner was MAS One Generals. The sole limited partner was the Midland Mutual Life Insurance Co. In 1989 MAS One amended its limited partnership agreement to expand the partnership’s purpose to include constructing and operating a second office building, Clearwater Tower. MAS One borrowed $14.5 million from Huntington National Bank to fund construction. Midland Mutual executed two guarantee agreements associated with the Tower debt. In the first Huntington required Midland to repay $2.5 million of the principal upon substantial completion of the building. The second agreement was a debt service guarantee of all interest payments for the life of the loan.
In 1994 Midland decided to demutualize and become a stock company. It sought to divest itself of its investment in MAS One. The debt service agreement, however, made it difficult for the insurer to withdraw from the partnership. Midland’s negotiations with the debt holder to terminate the agreement were unsuccessful. It then orchestrated a plan through which the partnership would sell Clearwater Tower, credit the proceeds toward the loan balance and Midland would pay any outstanding balance after the sale.
Midland abandoned its interest on December 28, 1994. The next day MAS One sold the Clearwater Tower for $4.1 million, with the proceeds going directly to service the debt. On the same date Midland paid the lender $8,388,824.47—the remaining balance on the office building loan.
On December 27, 1994, 1105 Corp. had purchased a 1% interest in MAS One. The parties amended the partnership agreement to continue Generals as the sole general partner with a 98% interest while 1105 Corp. would be a 2% limited partner. 1105 Corp. contributed $10 with no future obligation to contribute capital.
On its 1994 form 1065 income tax return, MAS One claimed a $7.3 million loss on the sale of the Clearwater Tower, which the partnership allocated 98% to Generals and 2% to 1105 Corp. The partnership treated Midland’s $8.3 million payment to Huntington as a capital contribution, not as income to the partnership. The IRS sent Generals a notice requiring MAS One to claim Midland’s $8.3 million payment as income on its 1994 return.
MAS One filed a complaint alleging the IRS notice was erroneous. Both parties filed motions for summary judgment. MAS One argued Midland’s payment was a capital contribution and as such not taxable as income. The government argued that because Midland was no longer a partner when it made its payment, the money could not have been a capital contribution. Rather it was either gross business income or discharge of indebtedness income. The IRS also argued the court should apply the step transaction doctrine to collapse Midland’s abandonment of its partnership interest and the sale of Clearwater Tower into a single transaction occurring on the same day. Under this doctrine Midland, not MAS One, would be entitled to claim a loss on the sale of the Clearwater Tower under the limited partnership agreement.
Result. For the IRS. The court cited Twenty Mile Joint Venture, PND, Ltd. (2000-1 USTC 50,124) in its decision. In that case, the Tenth Circuit Court of Appeals decided a departing partner’s forgiveness of a loan constituted discharge of indebtedness income to the partnership rather than a capital contribution. The Twenty Mile court emphasized substance over form in finding that the departing partner wanted to disassociate itself entirely from the partnership, not contribute capital. Likewise, Midland’s $8.3 million payment was not representative of any amount it owed MAS One. Since Midland did not seek a new interest in the partnership, the payment was income to the partnership, not a capital contribution.
The court also held the step transaction doctrine did not apply to this case because the substance and the form of the transactions in question did not differ in any meaningful way. The tax consequences of each step would have been the same whether they were viewed as a whole or as a series of isolated steps.
MAS One Limited Partnership, 271 FSupp2d 1061 (SD Ohio 2003).
Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accountancy, Arkansas State University, Jonesboro.