Pritchett v. Commissioner

¶1dissenting: If the facts as found support the alternative analysis posited in Judge Simpson’s concurring opinion, and I am not certain that they do, then the majority may have inadvertently reached the right result, although for the wrong reasons. But I strongly disagree with the majority’s deference to State law characterizations of general and limited partners, with the majority’s approach to the application of section 4651 and finally with the majority’s conclusion that the liability of the limited partners is contingent. With respect to the "contingent” issue, I agree with Judge Cohen’s analysis and have joined in her dissent.

¶2Generally, under State law, it is only a limited partner whose personal liability can be confined to that amount of property which he contributed or is required to contribute to the partnership;2 a general partner is liable for all recourse obligations of the partnership. Personal liability exposes the personal assets of the responsible person to payment of the obligation; it stands in contrast to limited liability, which exposes only the collateral pledged as security for satisfaction of the obligation.3 Neither requires that the liability be presently payable. State law definitions envision a clear distinction as to the presence or absence of personal liability in connection with third party obligations. While State law must be applied in determining the rights and liabilities of partners to each other and to third parties, it is Federal law that controls the manner in which these rights and liabilities are to be taxed. Lyeth v. Hoey, 305 U.S. 188 (1938); Helvering v. Stuart, 317 U.S. 154 (1942). Labels, whether mandated by State law or adopted by the parties, are unimportant. This is especially true when undertaking to determine basis and applying the "at risk” rules to partners.

¶3We are concerned here with Federal taxation of a limited partner who has made himself personally liable in a capacity analogous to that of a general partner with respect to a particular partnership obligation. In that situation, one commentator has suggested:

that the courts should not attempt to pigeonhole a limited partner who is liable as a general partner into one category for all purposes of taxation, rather, they should determine the underlying congressional policy of the operative Code provision and make a de facto analysis on a case-by-case basis.[4]

¶4From a practical as well' as an economic point of view, a limited partner who has assumed a pro rata part of a partnership recourse liability is the equivalent of a general partner, especially where, as here, the general partner, with respect to the same liability, has limited his liability by the contractual call upon the limited partners.5

¶5On the facts before us, both general and limited partners are personally liable for a pro rata portion of the partnership’s recourse obligation to Fairfield. Being similarly situated, they should be treated equally for Federal tax purposes unless the statute compels us to do otherwise, which it does not. Consequently, to the extent that the majority opinion distinguishes between, and turns upon, State law characterizations of general and limited partners, it may be correct for State law purposes,6 but for Federal tax purposes the majority ignores both form and substance and unduly extends section 465.

¶6The majority’s application of section 465 fails to recognize the relationship between the basis and the "at risk” provisions. Section 465 merely suspends what would otherwise be an allowable deduction. S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 86. The amount of depreciation or other deductions which a partner is permitted to take is initially limited to the amount of his basis in the partnership. Sec. 704(d). Kingbay v. Commissioner, 46 T.C. 147, 151 (1966). Thus, in the absence of basis, there is no deduction to suspend. A determination of basis, therefore, is a prerequisite to the application of the "at risk” provisions.

¶7A partner’s share of partnership liabilities is treated as a contribution of money by the partner to the partnership resulting in an increase in the partner’s adjusted basis. Sec. 752. Each partner’s share of recourse liabilities is initially determined in accordance with the ratio in which the partners share losses under the partnership agreement. Sec. 1.752-l(e), Income Tax Regs. A limited partner’s share of recourse liabilities, however, may not exceed the difference between his actual contribution to the partnership and the total contribution that he is obligated to make under the limited partnership agreement. Sec. 1.752-1(e), Income Tax Regs. Consequently, a limited partner’s basis in his partnership interest can be increased by his share of partnership recourse obligations to the extent that he is obligated to make additional contributions to the partnership.

¶8At page 588, the majority states that "the cash call, as provided for in the certificates of limited partnership, is not an 'unpaid contribution’ which would make the limited partners personally liable under the ulpa.”7 While there may be situations in which a contingency is so remote that an obligation lacks substance and should be ignored, this is not one of them. Under the majority’s contingency analysis, the limited partners would acquire basis only when the cash call is complied with, a position contrary to the import of respondent’s regulations and inconsistent with the congressional intent to allocate basis to those parties who will be required to utilize their own assets to retire partnership liabilities if the partnership incurs losses. Thus the majority suspends a deduction under section 465 which its own analysis would never have allowed the limited partners to claim under section 752. The majority should, therefore, have forced the parties to focus on basis, rather than deciding the case on an issue which, under the majority analysis, could not be reached. However, as Judge Cohen demonstrates, the limited partners do have personal liability for their respective shares of the recourse liability. Hence, the liability should be included in basis and the loss should be allowed unless otherwise suspended pursuant to section 465. For the reasons articulated by Judge Cohen, the section 465 requirements are met.

¶9As discussed above, the tax consequences under section 465 of transactions involving similarly situated taxpayers should be the same. If a general partner is "at risk” as to a partnership’s recourse obligation by virtue of his liability, then a similarly situated limited partner should also be considered "at risk.” Each party is "ultimately liable” on the obligation. See Smith v. Commissioner, 84 T.C. 889 (1985). Moreover, if the limited partner is not at risk for his share of the obligation, would the majority allocate that part of the debt to the general partner’s basis and include it in his amount "at risk”? We think not. The Senate report and section 465(b)(3) restrict the general partner to his own pro rata part of the Fairñeld note:

A taxpayer’s capital is not "at risk” in the business, … to the extent he is protected against economic loss of all or part of such capital by reason of an agreement or arrangement for compensation or reimbursement to him of any loss which he may suffer. Under this concept, an investor is not "at risk” … if he is entitled to reimbursement for part or all of any loss by reason of a binding agreement between himself and another person. [S. Rept. 94r-938, 1976-3 C.B. (Vol. 3) 49, 87.]

¶10Consequently, no general partner’s amount "at risk” can be increased to the extent of the limited partner’s cash call obligations. See Brand v. Commissioner, 81 T.C. 821 (1983). This could not have been Congress’ intent.

¶11The allocation of "at risk” amounts should accrue to the benefit of the partner ultimately bearing the economic risk of default. Any partner, whether general or limited, who is obligated to make good on a partnership’s recourse obligation in the event of default is personally liable for purposes of the "at risk” provisions to the extent that he is not otherwise protected against loss. Each partner will be required to use his personal assets only if the partnership assets prove inadequate. The adequacy of the partnership assets, however, does not of itself constitute a contingency affecting a partner’s amount "at risk.” On these facts, each partner was "at risk” in an amount equal to his pro rata share of the unpaid recourse obligation as of the close of each taxable year.

¶12I recognize that the "at risk” inquiry is an annual one on the basis of facts existing at the end of each taxable year. S. Rept. 94-938, 1976-3 C.B. (Vol. 3) 49, 86.1 further recognize that at the end of each of the years in issue, the actual amount which any of these partners may be required to contribute pursuant to the cash call cannot be definitively determined. In theory, no contribution might be required. However, a partner may be personally liable on a recourse obligation which is not presently payable. As to recourse obligations, the test remains whether, and to what extent, a partner is personally liable on the obligation in the event of default.

¶13For these reasons, I would hold that the limited partners have basis and are "at risk” to the extent of their pro rata share of the Fairfield note unless Judge Simpson’s speculation should turn out to be accurate.

¶21dissenting: I respectfully dissent. The Court majority, in my opinion, makes an errant approach to the problem presented. Section 465 was enacted to prevent loss deductions in excess of economic investment arising from certain tax shelter activities. The arrangement petitioners entered into appears to have substance, although the at risk value of the Fairfield note is problematical. If so, as Judge Simpson’s concurring opinion relates, then we should limit the at risk value of the Fairfield note rather than extend the at risk provisions to situations where cash call requirements within the partnership agreement present additional economic risk to limited partners.

¶22Furthermore, I share Judge Simpson’s view, and that of Judge Cohen, that the Court’s "at risk” analysis, as applied here, should be firmly focused on and limited to Fairfield’s role in the transaction as a person having an interest in the activity other than that of a creditor. Sec. 465(b)(3). The majority approach which focuses on the partnership agreement cash call requirements Creates a bad precedent for genuine business transactions structured through limited partnership arrangements. See 1 W. McKee, W. Nelson & R. Whitmire, Federal Taxation of Partnerships and Partners, par. 8.03, at 8-11 to 8-12 and par. 10.11 [2][b], at 10-78 to 10-79 (1977). It is my view that the limited partners here were on par with general partners as far as liability on the Fairfield note is concerned. I, therefore, concur with Judge Cohen’s dissent.

¶23dissenting: I respectfully dissent. As Judge Whitaker states, the issue is one of Federal tax law. Although we may look to State law to determine the substantive rights and liabilities of the various parties to the transactions, in my view the majority focuses excessively upon the purported uncertainty of creditors’ remedies under California law.

¶24The result reached by the majority may indeed be correct on the facts. I share Judge Simpson’s impression that Fairfield appears to be a person having an interest in the activity, other than that of a creditor, under section 465(b)(3), and that the absence of a provision for interest on the notes adds an element of economic unreality to the transactions. This should be explored further by the finder of facts. I cannot, however, join the majority’s reasoning that the liability of the limited partners on the notes to Fairfield is "contingent” for the purpose of the "at risk” rules.

¶25The majority cites two reasons for its conclusion at page 588:

the requirement [to make an additional capital contribution] was merely a contingency since it was not known in 1976 or 1977 (a) whether there would or would not be sufficient partnership revenues to satisfy the Fairfield note prior to or on maturity of the note, or in the event the Fairfield note was not satisfied in full on maturity, the amount of the capital contributions needed to cover the deficiency, or (b) if the general partners would in fact exercise their discretion to make the cash call if an unpaid balance on the Fairfield note were to exist on December 31, 1992. * ■…

¶26I agree that the second contingency, if it existed, might ultimately negate the liability of the limited partners to make the cash call; in that event, they would not be at risk on the liability to Fairfield. Nowhere does the majority find, however, that the general partners had the unilateral discretion to waive the express undertaking of the limited partners to make the additional contributions if the notes were not satisfied through partnership operations by the maturity date. Such a result would indeed be anomalous as a matter of State law. The references to State law in the majority opinion strongly suggest, and indeed the entire opinion implies, that Fairfield could, at maturity, force the limited partners to make the additional contributions to satisfy the notes.

¶27Thus the determinative "contingency” found by the majority can only be that the partnerships might generate sufficient revenues to satisfy, in full or in part, the notes to Fairfield prior to their maturity date. Whether this possibility renders petitioners’ liability "contingent” can best be examined by assuming for a moment that such "contingency” did not exist, i.e., that the notes to Fairfield merely required a single balloon payment on the maturity date and that cash from partnership operations was currently distributable to the partners. Under this assumed scenario, the limited partners’ obligations to contribute the additional funds and thereby satisfy the notes on maturity would be certain: the possibility that interim partnership revenues could discharge that liability would not exist.

¶28The "contingency” relied upon by the majority is thus merely the acceleration of payment on the notes, as compared with the posited scenario. If the limited partners are not considered at risk solely because of such "contingency,” it is doubtful that any liability could pass muster under section 465. Any indebtedness might be satisfied through cash generated by the leveraged activity or asset. Bona fide investors incurring valid, recourse debt typically hope such will be the case. Section 465(b)(2), however, specifically contemplates that certain borrowed amounts are to be included as amounts at risk.

¶29In enacting the rules under examination, Congress intended to prevent a taxpayer from deducting an amount for which he is not at economic risk. S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 85. The paradigm situation to which the "at risk” rules apply is where the investor incurs nonrecourse debt, on which he has no personal liability and will suffer no economic detriment if the activity generates insufficient revenues to satisfy the debt. S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 87-88. The majority thus distorts and unduly extends the "at risk” rules. Instead of limiting the taxpayer’s deduction where the liability is payable only out of revenues generated by or assets used in the activity, the majority extends section 465 to situations where the liability may be so paid. As the term is used by Congress, whether an investor is at risk depends upon the nature of the taxpayer’s obligation if the activity is an economic failure, not if it is a success.

¶30The majority apparently attributes significance to the general partners’ discretion over distributions to the limited partners. (See note 14.) Because the partnership agreements prescribed specific ratios for partnership distributions, however, the discretion of the general partners merely related to the timing of the distributions. It is incongruous that the possibility that funds would remain in the partnership and not be distributed immediately to the limited partners could render the limited partners not at risk. Distributions from a partnership reduce a partner’s initial amount at risk. Sec. 7.465-2, -5, Income Tax'Regs.; S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 89.

¶31The majority states that the limited partners were not liable on the Fairfield notes as of the years in issue because "Fairfield had no established recourse on its notes against petitioners.” (Page 589.) This statement confuses the existence of liability with the timing of payment thereon and the means of enforcing such payment. A taxpayer who must make payments on a debt on or before the maturity date has personal liability, and hence is at risk, even though the creditor cannot enforce payment before maturity.

¶32Congress could have prescribed the result reached by the majority by prohibiting deductions with respect to all indebtedness, recourse and nonrecourse alike, or by dealing with various types of debt in greater detail. As we have so frequently said, however, it is not for us to rewrite the statute as enacted.