Closing a Business May Result in Cancellation of Debt Income by Robert Horwitz and Tenzing Tunden
Posted by Hochman Salkin Toscher Perez P.C. 
Posted on Wednesday, February 03, 2021
Many businesses either have closed or will be forced to close due to the lockdowns imposed during the COVID-19 pandemic, Closing a business can result in the loss of jobs, a loss of the business owner’s livelihood and the destruction of the business owner’s credit rating. It can also have adverse tax consequences in the form of Cancellation of Debt (“COD”) income. This was brought home by the recent Tax Court case of Hohl v. Commissioner, T.C. Memo. 2021-5 where the Court held that the partners of a defunct partnership owed tax from the cancellation of debt.
COD income is recognized as gross income under Internal Revenue Code §61(a)(12), but Congress has created many exceptions to the recognition of COD income. Discharge of a debt occurs when it becomes clear that the debt will not be repaid or when the creditor forgives all or part of the debt. Whether there was in fact a debt and, if so, when the debt became discharged are determined by the facts and circumstances of the case.
The partnership in the Hohl case, Echo Mobile Marketing Solutions, LLC, was formed in 2009 and ceased operations in 2012, having sustained losses in each year of operation. It had four partners, three of whom, Michael Hohl, Braden Blake, and James Bowles, operated the business and a fourth, Eduardo Rodriguez, who funded the business. Although Mr. Rodriguez was the only one who provided funds for the business, the three operating partners each had a 30 percent ownership interest in the partnership while Mr. Rodriguez had a 10 percent ownership interest.
The IRS audited the individual partners’ 2012 tax returns and determined that each of the three operating partners had $178,210 of COD income. The three operating partners filed petitions with the Tax Court to challenge the IRS’s determination. The taxpayers claimed that funds provided by Mr. Rodriquez were capital contributions. They pointed to Echo’s operating agreement, which termed Mr. Rodriquez’s initial infusion of funds ($265,000) as a capital contribution, to the lack of any written loan agreement, and to the lack of any collection or repayment activity.
The Tax Court found the taxpayer’s argument unconvincing because Echo’s tax returns treated the funds provided by Mr. Rodriguez as loans. These loans were allocated among the partners, giving the three operating partners basis in the partnership. Consistent with the advances being loans, Mr. Rodriquez’s capital account was not credited with any of the funds he advanced to Echo. Additionally Echo never gave written notice to the partners that it needed additional capital contributions, as required by the operating agreement. Thus, the Court held that all the funds advanced by Mr. Rodriguez were loans and not capital contributions and that the partnership had COD income when it ceased operation.
This led to the next issue: the allocation of the COD income among the partners. Under IRC §704(a), a partner’s distributive share of income is determined by the partnership agreement. If the partnership agreement does not provide for the partner’s share, or if the allocation made by the agreement does not have substantial economic effect, IRC §704(b) provides that the partner’s distributive share of income is determined “in accordance with the partner’s interest in the partnership (determined by taking into account all facts and circumstances).” To have substantial economic effect, allocations must be consistent with the underlying economic arrangement of the partners. Treas. Reg. §1.704-1(b)(2)(ii)(a).
Echo’s operating agreement allocated distributive shares of income and losses to its partners according to a formula based on the partner’s capital accounts. Echo, however, had never followed the formula in allocating its losses among the partners. Instead, on each year’s tax return it allocated to each of the operating partners 30% of the losses and to Mr. Rodriquez 10% of the losses. The Court held that the allocations made by Echo’s operating agreement thus did not have substantial economic effect. The Court therefore upheld the IRS’s allocation of 30% of the COD income to each of the operating partners.
The taxpayers made several additional arguments that aren’t germane to the cautionary tale of this blog: First, when a business closes due to financial losses, the owners may discover unexpectedly that they had income due to unpaid debts owed by the business. Second, the failure of a partnership to follow the partnership agreement for the treatment of advances by partners and for the allocation of partnership items can lead to the IRS challenging the way the partnership allocated income, losses, gain and credits during an audit. Of course, what would have happened had Echo treated Mr. Rodriguez’s advances as capital contributions and followed the terms of the partnership agreement for allocating profits and losses? First, the three operating partners would have had zero basis in the partnership, instead of basis from treating the advances as loans allocated among the partners on a 30-30-30-10 basis. Second, the operating partners would not have been able to deduct the losses (if any) that should have been allocated to them had they followed the partnership agreement, since a partner cannot deduct losses in excess of basis. So the net tax effect of the case was the same as it would have been had the partnership treated the advances as capital contributions with the operating partners being unable to deduct losses but not having COD income.
