Rev. Rul. 93-80: Tax Loss on Partnership Abandonment

When a partner decides to leave a partnership, the departure is not always a simple sale of the partner’s interest. If the business is struggling, a partner may choose to walk away from their investment. This act of “abandonment” creates a loss for the partner, but how that loss is treated for tax purposes is a matter of consequence. The Internal Revenue Service (IRS) provided guidance in Revenue Ruling 93-80, which establishes the framework for determining the tax character of a loss from abandoning a partnership interest. This ruling clarifies how the presence or absence of partnership debt alters the outcome for the departing partner.

The Definition of Partnership Interest Abandonment

Abandoning a partnership interest requires more than ceasing to participate in the business’s activities or deciding the investment is worthless. For tax purposes, abandonment is a specific event that must be clearly established. The IRS and courts have held that a taxpayer must demonstrate two elements to formalize the act. The first is a clear intent to abandon the asset, which means the partner must unequivocally decide to terminate their ownership.

This intention must be coupled with a definitive, affirmative act of abandonment. This act serves as the physical manifestation of the partner’s intent, providing clear evidence that they have walked away. Examples of such an act include providing a formal written notice of abandonment to the other partners or to the partnership. Merely neglecting duties or being inactive does not meet this standard; there must be a clear, overt action that puts the other partners on notice.

Tax Outcome for Abandonment Without Liabilities

The first scenario addressed by Revenue Ruling 93-80 involves a partner abandoning their interest in a partnership that has no outstanding liabilities. In this situation, the ruling concludes that the loss incurred is an ordinary loss, which can be used to offset various types of income, such as wages or business income. The reasoning hinges on the concept of a “sale or exchange.”

For a loss to be classified as a capital loss, a sale or exchange must occur. According to the ruling, when a partner abandons their interest and receives nothing in return—no cash, no property, and no relief from debt—the transaction does not meet the definition of a sale or exchange. However, this position has been complicated by a separate tax code provision that treats losses from the termination of a right to a capital asset as a capital loss.

Because a partnership interest is a capital asset, this rule could potentially override the guidance in the revenue ruling. Courts have been divided on the issue, though a significant appellate court case has sided with taxpayers, upholding the ordinary loss treatment. Despite this favorable ruling, the IRS has not issued formal guidance to clarify the conflict, creating a degree of uncertainty for partners in this situation.

Tax Outcome for Abandonment With Liabilities

The tax consequences change when a partner abandons an interest in a partnership that has liabilities. When a partner is relieved of their share of partnership liabilities, the IRS views this relief as a “deemed distribution” of money to the partner. This principle states that any decrease in a partner’s share of liabilities is treated as a distribution of cash.

This deemed cash distribution is the factor that alters the tax character of the loss. The relief from debt is considered a form of consideration received by the abandoning partner. The presence of this deemed distribution transforms the abandonment into a “sale or exchange” for tax purposes. Consequently, the resulting loss is no longer an ordinary loss but is instead treated as a capital loss.

Revenue Ruling 93-80 provides a clear example of this principle. A partner with an adjusted basis of $18,000 in a partnership abandons the interest, and that basis includes a $10,000 share of the partnership’s liabilities. Upon abandonment, the partner is relieved of this $10,000 share of debt, which is treated as a deemed cash distribution. This deemed payment means a sale or exchange has occurred, and the partner’s capital loss is their basis ($18,000) minus the deemed distribution ($10,000), resulting in an $8,000 capital loss. Even a minimal amount of liability relief will trigger this capital loss treatment.

Substantiating the Act of Abandonment

To claim a loss from abandonment, a taxpayer must be prepared to prove that the abandonment occurred in a specific tax year. The burden of proof rests on the taxpayer, who must provide sufficient evidence of both the intent to abandon and the affirmative act of abandonment. This documentation is essential to withstand potential scrutiny from the IRS.

The most effective evidence is a formal, written statement delivered to the partnership declaring the partner’s intent to abandon the interest as of a specific date. Other forms of documentation can include minutes from partnership meetings where the abandonment was discussed and formally acknowledged by the other partners. An amended partnership agreement that removes the departing individual as a partner also serves as powerful proof.

A taxpayer cannot simply decide after the fact that an interest was abandoned in a prior year to gain a tax advantage. The actions and documentation must align to show a definitive and final decision to walk away from the asset. Without this clear substantiation, the IRS could disallow the loss deduction entirely.