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Partnership Can Deduct Worthless Interest in Family Partnership

When it comes to basic principles of federal taxation, I tell my students to start with these truths: Everything is income unless it isn’t, and nothing is deductible unless it is.

In a recent Tax Court case, MCM Investment Management, LLC, v. Commissioner, a partnership was able to take a large deduction despite the fact that it was for a worthless investment in a family business—among the most scrutinized types of write-offs. The case involved a failed real estate business operating during the economic downturn in 2007-2009. MCM Investment Management, LLC (MCM) was owned by four members of a family. The LLC held a 20% interest in McMillin Companies, LLC, a real estate business involved in single-family homebuilding, master-planned communities, and commercial development and management in California and Texas. The other 80% of McMillin Companies was owned by the same four family members as individuals.

How McMillin Became Worthless

McMillin held investments in 73 project entities, 11 management services entities, and 3 investment-holding companies and was highly leveraged. By 2009, it had $100 million in senior debt and $65 million in subordinate debt. The debts were personally guaranteed by the four family members and by MCM. In 2008, the family members created a new entity, Holdings, LLC, to purchase the subordinated debt for $16 million. The next steps get complicated, with Holdings contributing the subordinate debt to McMillin in exchange for a preferred equity interest and a liquidation preference of $65 million.

The real estate market continued to deteriorate, and McMillin’s 2009 liquidation analysis showed that, if it liquidated completely, it would have only $54 million to pay towards more than $71 million in outstanding senior debt. Based on this scenario, the owners concluded that McMillin would not fully repay its senior debt, Holdings would not recover its equity interest, and MCM’s interest was worthless. As a result, in 2009, MCM reported on its Form 1065 partnership return an ordinary loss of $41.4 million from its worthless investment in McMillin. The IRS disallowed the loss.

Loss Deduction Rules

Under Code Sec. 165, taxpayers may deduct “bona fide” losses sustained during the year that are not compensated by insurance or otherwise. Losses are only allowed for closed and completed transactions, fixed by identifiable events, according to the regulations. Previous cases have established that property becoming worthless can be considered a closed transaction, and courts have allowed deductions where partnership interests became worthless during the year. To prove worthlessness, a taxpayer can make a subjective determination that property is without value that must be backed up by objective factors that confirm the determination of worthlessness.

The Issue of Worthlessness

In the MCM case, the IRS challenged the deduction on several grounds, including that MCM did not prove the worthlessness of its interest in McMillin because no foreclosures had occurred on McMillin’s real property interests encumbered by recourse mortgages. The IRS further argued that there had been no expert valuation finding that the partnership interest held by MCM had no liquidation or potential future value. Finally, the IRS said MCM’s partnership interest was not worthless because McMillin’s balance sheet showed it was solvent.

The U.S. Tax Court rejected each of the IRS’s arguments, finding that MCM had proven worthlessness and an entitlement to the deduction. The Court said no foreclose was necessary to prove a closed transaction, and an expert valuation would be helpful but was not required. The Court also observed that, although the balance sheet of McMillin showed solvency, MCM’s interest was subordinate to the senior debt obligation and to other preferred interests and thus MCM was not in a position to receive any liquidating distributions. The Court said balance sheet insolvency is not required, citing an earlier case which held that a subordinate equity interest may become worthless if the company cannot satisfy a preferred equity interest holder’s preferential claim in liquidation.

The Court listed the objective factors that confirmed that MCM’s partnership interest lacked any potential future value at the end of 2009.

  • The severe recession caused by the subprime mortgage crisis in 2007-2009 adversely affected the potential future value of McMillin Companies and its projects.
  • Audited financial statements depicted the dire financial condition of McMillin in 2008 and 2009 and reflected continued large operating losses.
  • McMillin’s cashflow forecasts reflected a significant decline in expected cashflow from operations and supported a conclusion that MCM’s junior partnership interest had no potential future value by the end of 2009.
  • The owners’ decision in 2009 to wind down the entity over five years was an identifiable event fixing MCM’s loss.

Observations

The taxpayers in this case who held interests in the MCM partnership obtained a very favorable decision, despite the fact that the case involved related parties and proof of worthlessness, two high bars for a loss deduction. The taxpayers were able to persuade the Court that their subjective determination of worthlessness was backed up by facts—the hopelessness of their subordinate debt position and the market conditions that made it impossible for the McMillin company to improve its financial position. Just because the parties were related did not mean that the loss was not bona fide, under this set of facts.


Lucia Nasuti Smeal is an attorney and a tax professor with the School of Accountancy at Georgia State University’s J. Mack Robinson College of Business, and the former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker on current tax developments.

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