Joint and Several Liability

[Nashville]

The question involves basis, losses, etc. and is best posed by giving an example:

Larry, Moe, and Curly each contribute 5,000 to begin a partnership with equal sharing of profits and losses. Almost immediately, the partnership begins to flounder, and have losses. However, the partners are able to take the losses because they all borrow money to cover, and personally guarantee the loans. These loans increase the basis of the partners to the extent that there is always enough basis to take the losses.

It is important for this example that the creditor insists that the partners are jointly and severally liable, meaning any of the partners could be liable for the repayment of the entire loan should any partner not have the funds for repayment. Let's put this in the back of our mind for a moment.

After 5 years, the partnership has lost $405,000. The loan principle has amount has soared to $390,000. However, each partner (being equal) has split the $390,000 in additional basis three ways, and each partner has 1/3 of this amount, or $130,000 added to the original contribution of $5,000.
This totals $135,000. But each partner has taken the full amount of $135,000 in losses over the years, and exhausted their basis.

The next year, the partnership is unable to repay the loan, so the creditor proceeds against the partners. Larry is unable to pay anything, so the bank collects $60,000 from Moe, and is able to collect $330,000 from Curly. Remember the terms of repayment are that each partner is jointly and severally liable for the associated debt of the other partner(s), and the bank doesn't really care which partner has to cough up the money.

Now the question: What is the effect on each partner due to changes in basis and how does anyone else ever find out under the K-1 matching process? (note the partners' "new" bases still includes their original $5000 which has been left intact)

1. Larry's basis goes from $135,000 to $5,000, so is he required to report a $130,000 GAIN?
2. Moe's basis goes from $135,000 to $65,000, so is he required to report a $$70,000 GAIN?
3. Curly's basis goes from $135,000 to $335,000, so is he entitled to a $200,000 LOSS?
4. If Curly is entitled to a $200,000 LOSS, is this subject to the capital loss limitation of $3,000/year?

[Snaggletooth]

Would Like to Know

One of my most effective ways to communicate a subject is to give an example. Unfortunately, some of the reading becomes lengthy, and readers do not have the time to get bogged down in the subject matter.

It's possible this has happened with the above subject. Hope someone will venture an opinion.

[mactoolsix]

One more bump back up - also hoping for a response from the "more learnered" on this board.

[DaveO]

Wouldn't Curly's loss be ordinary unless the partnership owned a capital asset?

[buzzardbreath]

One Possibility

I heard privately from an astute accountant on this one, who suggests the following:

At the point of Curly's payment:
1. Larry has $130,000 income from Cancellation of Debt
2. Moe has similar income of $70,000 from Cancellation of Debt
3. Curly may deduct a business bad debt of $200,000.

I'm assuming since the partnership is not responsible for reporting basis, that there is
no disclosure of the transaction on the 1065, these would be reportable entirely on
personal returns.

[Gary2]

I heard privately from an astute accountant on this one, who suggests the following:

At the point of Curly's payment:
1. Larry has $130,000 income from Cancellation of Debt
2. Moe has similar income of $70,000 from Cancellation of Debt
3. Curly may deduct a business bad debt of $200,000.

I'm assuming since the partnership is not responsible for reporting basis, that there is
no disclosure of the transaction on the 1065, these would be reportable entirely on
personal returns.

That answer seems reasonable, but I wonder.... Here's a different scenario:

Two unrelated people buy a house together, both names on deed and mortgage, hence joint and several liability. After many years, they've paid down the mortgage equally until $20K remains on the mortgage. One of them gets a big bonus and decides to pay down the remaining $20K.

Is that a non-taxable gift of $10K (which isn't even subject to gift tax, being below the annual limit)? Or is it $10K cancellation of debt income? Intuition says the former, perhaps because the debt wasn't actually canceled; it was paid.

So returning to the main question, are we sure about the answer? Indeed, are we sure about the premise? In the absence of any other agreement between the partnership and the partners, or among the partners, was it proper to treat the loan as basis equally divided between the three partners? Is guaranteeing a loan the same as co-signing for this purpose? Suppose that when they first started out, the partners knew that either the loan would be paid off through the success of the partnership, or they knew that Curly (the only one with sufficient money) would be the one who'd wind up paying it off. Perhaps there was nothing in writing to back this, but circumstances made it obvious. Were they still justified in splitting the basis three ways?

If we could wind back the clock, would they have been justified in verbally choosing to treat it as if Curly were the only one liable for the loan, and thus he would treat it as entirely his basis? Would paperwork recording this be necessary, or merely useful to prove it in an audit?

[Golden Rocket]

Equal Division

Gary has brought up a question which should have been dormant in the minds of all partners. In real-life, it was probably well-known from the beginning that Curly was in better solvancy than the other partners. And in the event of calling the loan, it would be Curly to shoulder the lion's
share of the payment.

Had this been known from the beginning (and it probably was), Gary asks if it was proper to equally split the losses, as the deductibility of those losses was dependent on borrowed money. Had a more economic division been available, it would have avoided the sudden income and loss which occurred upon default.

Unless it was otherwise specified in the partnership agreement, equal sharing of profits and losses implies equal responsibility for indebtedness as well. And if a more economic division were available, how on earth would it be calculated? No entities, regardless how absurd, should be assumed to have a profit motive, and the continued operation of losses assumed to turnaround to profit. I think we have to assume this profit motive, even with a preposterous business model.

Given this assumption, I don't think any alternative to equal division from the beginning is proper. Again, the treatment of basis is not incumbent upon the 1065 or K-1s, but upon the partners' themselves, meaning the numbers forthcoming annually from the K-1s will be 33/33/33/regardless of the fateful foreclosure for the bank.

Interesting question from Gary - and if such a division based on economic reality is possible, we might discuss the development of machinery to bring it about. Unless we can rely on such machinery and develop conditions under which it can be invoked, I will stick to the 33/33/33 annually and the ultimate rectification of basis in the year Curly has to cough up the money.

Incidentally, horrible timing event for those involved in tax planning. In the above example, if Larry is broke and can't pay the bank, how is he going to pay taxes on $130,000 in one year?

[Gary2]

In the above example, if Larry is broke and can't pay the bank, how is he going to pay taxes on $130,000 in one year?

Assuming canceled debt is the proper classification, and he's broke, then he presumably qualifies for the insolvency exclusion.