PAYMENT OF INSOLVENT PARTNERS' DEBTS BY SOLVENT PARTNERS RESULTS IN DEDUCTION.

Index Nos.: 0166.10-00, 0707.00-00, 0731.00-00, 0752.02-00

November 1, 1979

Whether a bad debt deduction may be claimed by P for 1975 where, upon termination of P, the Solvent Partners made contributions to P to pay for the Insolvent Partners' shares of P's losses and neither P nor the Solvent Partners was able to recover from the Insolvent Partners the amounts claimed as bad debts.

FACTS:

P was a limited partnership providing services. The partnership agreement provided for the sharing of gains and losses from the partnership business in accordance with each partner's respective share of the partnership. The percentage of P owned by each partner varied from year to year. In 1975, when P ceased operation of its active business and began to wind up its activities, there were m general partners of whom the Solvent Partners had positive balances in their partnership capital accounts, and the Insolvent Partners had negative balances in their partnership capital accounts.

In the first part of 1975 and during the three years immediately preceding 1975, P incurred losses from its operations. The losses consisted of debts owed to numerous creditors. P was able to pay most of those creditors by means of a loan from B, an unrelated party. Cash realized from the sale of P's assets was insufficient to pay the debt owed by P to B and other creditors.

During 1975 and the three preceding years, P sought contributions from its general partners to pay its debts in accordance with their respective shares of the losses as required by the partnership agreement. During those years, the Solvent Partners made contributions to P in proportion to their varying interests in P for each of those years. However, the Insolvent Partners (as well as the estates of certain deceased partners) did not make contributions to cover their respective shares of the debts. The total contributions owed by the Insolvent Partners (and the estates of certain deceased partners) was $c. Therefore, during 1975 (before and after P's cessation of active business) and in the three preceding years the Solvent Partners contributed $c to P which paid the creditors, including B. The $c also was the combined amount of the negative capital accounts of the Insolvent Partners. P then sought reimbursement of the $c from the Insolvent Partners. In 1975, after considering the financial statements of the Insolvent Partners and their respective abilities to make the necessary payments due in accordance with the partnership agreement, P settled the debts with the estates of the deceased partners and all but one of the Insolvent Partners in the total amount of $d. The insolvency of the Remaining Insolvent Partner was disputed and action was begun to obtain that partner's contribution. Settlement between the Remaining Insolvent Partner and P was accomplished in a later year.

A bad debt deduction of $e ($c less $d) has been sought by P for the taxable year 1975 which was equal to the contributions due from the Insolvent Partners for their shares of the debts of P that were unpaid when the Insolvent Partners debts to P were settled.

APPLICABLE LAW:

Section 166 of the Internal Revenue Code provides that in computing taxable income, a deduction shall be allowed in respect of bad debts owed to the taxpayer. Section 1.166 -- 1(c) of the Income Tax Regulations provides that only a bona fide debt qualifies for purposes of section 166. A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. Section 166(d)(2) of the Code indicates that a business bad debt is (A) a debt created or acquired in connection with a trade of business of the taxpayer, or (B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.

Section 752(b) of the Code provides, in part, that any decrease in a partner's share of the liabilities of a partnership, shall be considered as a distribution of money to the partner by the partnership.

Section 707(a) of the Code provides that if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction will generally be considered as occurring between the partnership and one who is not a partner. Under section 1.707 -- 1(a) of the regulations, a loan of money by the partnership to the partner is considered to be such a transaction. However, a transfer of money by the partnership to the partner as a distribution is not considered as a transaction which the partner enters into in a capacity other than as a partner.

Section 1.731 -- 1(c)(2) of the regulations provides that the receipt of money by a partner from the partnership under an obligation to repay the money is a loan rather than a distribution. For purposes of section 707(a) of the Code and the regulations thereunder, however, a loan by a partnership to a partner is considered to have been made only where the partner is under an unconditional and legally enforceable obligation to repay a sum certain at a determinable date. Rev. Rul. 73-301, 1973 -- 2 C.B. 215.

Rev. Rul. 57-318, 1957 -- 2 C.B. 362, concerns the determination of basis of a partner's interest in a partnership where a partner sells his partnership interest to his co-partner at a time when his capital account has a deficit which he is obligated to pay. Rev. Rul. 57-318 notes that if the transaction also results in cancellation of the deficit in his capital account, the amount thereof will be considered as a distribution of money which will be treated as a capital gain. However, Rev. Rul. 73-301 clarifies the implication in Rev. Rul. 57-318, that the selling partner is subject to an unconditional and legally enforceable obligation to repay the deficit in his capital account and that the withdrawals giving rise to the deficit represented loans made by the partnership to the partner in a capacity other than as a member of such partnership. Rev. Rul. 73-301 states that Rev. Rul. 57-318 should not be interpreted as suggesting that the mere existence of a deficit in a partner's capital account creates a loan of money within the meaning of section 1.707 -- 1(a) of the regulations.

In Rev. Rul. 72-505, 1972 -- 2 C.B. 102, where prior to its dissolution a partnership had borrowed money to be used in the trade or business of the partnership, and after its dissolution one of the partners paid the entire amount of the debt while the estate of the other partner was insolvent, the partner who paid the deceased partner's debt was entitled to a bad debt deduction under section 166 of the Code. Rev. Rul. 72-505 states that partners are individually liable for partnership debts. However, there exists the right of contribution among partners. When the taxpayer made payment in full of the partnership's obligation, he was entitled to a contribution from the deceased partner's estate for its share of the total obligation. This right of contribution from the partner's estate created a bona fide debt which arose from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed sum of money. Since the partner's estate was insolvent, the debt was worthless.

State Law of F provides, in part, that the rights and duties of the partners in relation to the partnership shall be determined, subject to any agreement between them, by the following rules: (a) Each partner shall be repaid his contributions, whether by way of capital or advances to the partnership property, and share equally in the profits and surplus remaining after all liabilities, including those to partners, are satisfied; and must contribute towards the losses, whether of capital or otherwise, sustained by the partnership, according to his share in the profits. (b) The partnership must indemnify every partner in respect of payments made and personal liabilities reasonably incurred by him in the ordinary and proper conduct of its business, or for the preservation of its business or property. State Law of F also provides, in pertinent part, that in settling accounts between the partners after dissolution, the partners shall contribute the amounts necessary to satisfy the (foregoing) liabilities; but if any, but not all, of the partners are insolvent, or, not being subject to process, refuse to contribute, the other partners shall contribute their share of the liabilities, and in the relative proportions in which they share the profits, the additional amount necessary to pay the liabilities. It is further provided that any partner shall have the right to enforce the contributions specified in settling accounts between partners after dissolution, to the extent of the amount which he has paid in excess of his share of the liability. Amended State Law of F, applicable to years following 1975 contains substantially the same provisions.

RATIONALE:

In 1975, prior to termination of P's active conduct of business, and in the three years preceding 1975, the incidence of negative capital accounts did not, at the time of their occurrences, have the effect of creating bona fide debts owed by the Insolvent Partners within the meaning of section 166 and the regulations thereunder. When the Insolvent Partners' shares of P's liabilities were paid by P through contributions made by the Solvent Partners, corresponding decreases should have been made in the respective Insolvent Partners' capital accounts, reflecting the decreases in their shares of the liabilities of P, and should have been considered as deemed distributions of money to each of the Insolvent Partners by P. Section 752(b) of the Code. This would have created the negative capital accounts of the Insolvent Partners.

The deemed distributions under section 752(b) of the Code would not be considered a loan of money to such partners within the meaning of section 707 of the Code, since section 1.707 -- 1(b) of the regulations notes that the transfer of money by P to the Insolvent Partners as a distribution would not be considered as a transaction which such partners entered into in a capacity other than as partners. Thus, although section 1.731 -- 1(c) of the regulations provides that the receipt of money by a partner from the partnership under an obligation to repay the money is a loan rather than a distribution, under section 707(a) of the Code, a loan by a partnership to a partner is considered to have been made only where the partner is under an unconditional and legally enforceable obligation to repay a sum certain at a determinable date.

In the instant case, therefore, when payments were made by the Solvent Partners to P prior to the cessation of P's active conduct of business in 1975, and P paid the Insolvent Partners' shares of the outstanding debts, no legally enforceable obligation to repay a sum certain at a determinable date was incurred. Rev. Rul. 73-301. Thus, although there were loans of money deemed made to the Insolvent Partners, such loans were not in the nature of bona fide debts for purposes of section 166.

Accordingly, the mere existence of negative partnership capital accounts of the Insolvent Partners would not give rise to a deductible loss by P or the Solvent Partners. Rev. Rul. 57-318 as clarified by Rev. Rul. 73-301.

When the cessation of P's active business occurred in 1975 and the Solvent Partners thereafter made contributions to P in order to pay not only their own shares of the outstanding partnership debts, but also to pay for the shares of the Insolvent Partners of such debt, P, on behalf of the Solvent Partners, was entitled to contribution from the Insolvent Partners for their shares of the obligations paid after the cessation of P's active business, pursuant to State Law of F. This right of contribution from the Insolvent Partners created a bona fide debt which arose from a debtor-creditor relationship based upon valid and enforceable obligations to pay fixed sums of money. Rev. Rul. 72-505. Since the Insolvent Partners could only pay $d, the balance of such debts owed by the Insolvent Partners for their shares of the debts paid by the Solvent Partners after P terminated its active business, became worthless at the time settlement was made in 1975.

With respect to the Insolvent Partners' shares of liabilities that were paid through contributions of the Solvent Partners in the three years preceding 1975 and in 1975 prior to cessation of P's active business, a transformation of the nature of such liabilities occurred upon the cessation of P's active conduct of business. Although these amounts would not have been considered bona fide debts for purposes of section 166 of the Code, when the Solvent Partners advanced funds to P on behalf of the Insolvent Partners, at the termination of P's active conduct of business State Law of F then required the Insolvent Partners to repay the Solvent Partners. A valid claim against the Insolvent Partners would then exist for such debts. To the extent that the Insolvent Partners were unable to pay their shares of such debts, the Solvent Partners through P would be entitled to a bad debt deduction as of the time when the balances owing on such debts became worthless. The settlements reached in 1975 with the Insolvent Partners, except for Remaining Insolvent Partner, indicates that 1975 is the appropriate taxable year when the balances owed from the Insolvent Partners (except for Remaining Insolvent Partner) became bad debts within the meaning of section 166. Such bad debts would be considered business bad debts within the meaning of section 166(d)(2) of the Code.

Since the shares of liabilities owed by Remaining Insolvent Partner were not settled in 1975, no determination could be made in that taxable year as to whether all, some or none of that partner's share of the debts were worthless. Such determination could be made in the taxable year when final settlement between P (and/or Solvent Partners) and Remaining Insolvent Partner is made. The appropriate business bad debt deduction, if any, could be allowable in such year of final settlement.

CONCLUSION:

The amount of $e, representing the net unpaid liabilities of the Insolvent Partners contributed by the Solvent Partners through P after cessation of P's active conduct of business and those liabilities of the Insolvent Partners to P (and the Solvent Partners) which ripened into debts upon termination of P's active conduct of business, were deductible from income by P in 1975 as business bad debts within the meaning of section 166 of the Code, except to the extent such liabilities may have represented amounts owed by Remaining Insolvent Partner which were not settled until a taxable year later than 1975. The net uncollected liabilities of Remaining Insolvent Partner would be deductible by P in such year as final settlement was made between P and Remaining Insolvent Partner.