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Hohl, et al. v. Commissioner (T.C. Memo. 2021-5)

On January 13, 2021, the Tax Court issued a Memorandum Opinion in the case of Hohl, et al. v. Commissioner (T.C. Memo. 2021-5). The issue presented in Hohl was whether failure to repay loans provided to a partnership by a partner, which the partnership treated as contributions upon dissolution, resulted in cancellation of indebtedness income.

Background

Hohl, Blake, and Bowles were partners in a partnership from which they reported guaranteed payments. ¼ partner, Rodriguez, regularly infused money into the partnership, which the partnership and the partners generally treated as loans. When the partnership ceased operation in 2012, however, the partners treated Rodriguez’s loans as contributions, and the partners were not called on to repay their respective shares of the loans.  The IRS issued notices of deficiency to the partners determining COD income for 2012, on account of the funds provided by Rodriguez being loans to the partnership, and the partnership’s liability being allocated among the partners.

Can You Hear Me Now?

The four partners created Echo Mobile Marketing Solutions, LLC (“Echo”) in 2009.  Rodriguez provided capital while the other three conceived of the business.  The partnership agreement provided for a 30-30-30-10 split in ownership interests, and it further provided that the partners’ capital accounts would be established and maintained in accordance with Treas. Reg. § 1.704-1(b)(2)(iv).  A formula for allocating profits and losses was based on such capital accounts. Over Echo’s short life, Rodriguez lent $650,000 to Echo.

The Partnership Returns

Although the opinion delves deeper into the returns, what is most important is that in 2009 through 2011, Echo reported the funds received from Rodriguez as “other liabilities” of the partnership.  On the 2012 final Form 1065, the funds received from Rodriguez were listed as “loans from partners” and not as “other liabilities.”  Ultimately, the 2012 Form 1065 show the liability remaining on Echo’s balance sheet of $650,000, but no partner reported an allocation of any share of that liability.

Loans or Capital Contributions

Whether to treat amounts put into a partnership by a partner as capital contributions or loans is a question of fact for the court. Schnitzer v. Commissioner, 13 T.C. 43, 60 (1949), aff’d, 183 F.2d 70 (9th Cir. 1950). Among the factors that the Tax Court considers are: (1) the presence of a written agreement; (2) the intent of the parties; and (3) the likelihood of obtaining similar loans from disinterested investors. Greenberg v. Commissioner, T.C. Memo 1992-292.

A fourth element, the Tax Court’s opinion teaches, is how the partnership and its partners treat the funds. In Echo’s case, the partnership consistently reported Rodriguez’s infusions of money as loans on their Forms 1065 as “other liabilities.” This is further evidenced by the fact that the Schedules K-1 Echo sent to its partners reported the amounts is liabilities every year, and if Rodriguez had made capital contributions, he failed to disclose them on his own tax return.

Discharge of Debt = COD Income

Gross income generally includes income from the discharge of indebtedness. IRC § 61(a)(12). The rationale for this inclusion is that the cancellation of indebtedness provides the debtor with an economic benefit that is equivalent to other forms of income. United States v. Kirby Lumber, 284 U.S. 1 (1931).  Stated differently, when a taxpayer receives a loan, he incurs an obligation to repay that loan at a future date. Because of this obligation the loan proceeds do not qualify as income to the taxpayer. Because of the obligation to repay, the taxpayer is entitled to include the amount of the loan in computing his basis in the property. If the repayment obligation is canceled, and the debtor is relieved of his responsibility to repay the sum he originally received, the debtor/taxpayer must account for the proceeds of the obligations he has received tax-free in his basis.  Commissioner v. Tufts, 461 U.S. 300, 307, 312-313 (1983).

When a taxpayer realizes income from cancellation of indebtedness is a question of fact. Policy Holders Agency, Inc. v. Commissioner, 41 T.C. 44, 47 (1963). Discharge of a debt occurs when it becomes clear that the debt will never be repaid. Cozzi v. Commissioner, 88 T.C. 435, 445 (1987). The Tax Court looks for “[a]ny ‘identifiable event’ which fixes the loss with certainty.” Id.; see also Treas. Reg. § 1.6050P-1(b)(2)(i), (iv) (providing an exclusive list of eight identifiable events under which a debt is discharged for information reporting purposes including the expiration of a 36-month nonpayment testing). The Tax Court found that when Echo ceased operations, it was clear that Rodriguez would never be repaid; therefore, the 2012 termination of the partnership was when the debt became uncollectible.

(T.C. Memo. 2021-5) Hohl v. Commissioner

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