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How to walk away from a partnership without leaving empty-handed.

Everyone who’s ever started a business will tell you that any new business venture involves risks. Sometimes it’s the risk of losing the startup capital you invested, or sometimes it’s the risk of spending countless hours trying to build something that just won’t stand on its own. Sometimes it’s the risk that your relationship with the people you’re starting the business with will ultimately sour, creating problems that extend well beyond the board room.

[Read: What Did You Get Yourself Into? (Understanding Partnerships)]

If you find yourself in this position and don’t want to keep throwing good money (or energy, or emotional capital…) after bad but you’re worried about recouping at least some of your investment, there’s a little-known tax provision that might help make your decision easier.

A bit about taxes

Before we get into how walking away from a business can lead to big tax breaks, it’s important to first understand how you’re normally taxed when you sell a business interest. When you put money into a partnership (or an LLC taxed as one), this is typically called a capital contribution. Any time you make a capital contribution, it increases your “basis” in the part of the business you own. Certain things can increase or decrease your basis (e.g., contributions of additional capital or property, distribution of profits, depreciation deductions, other losses), so it’s important to keep track of your basis. When it comes time to sell your interest in the company, the IRS generally treats the excess of the sale price over your basis as taxable gain — specifically capital gains, as stocks and other business ownership interests are considered capital assets. You’ll typically pay tax on long-term capital gains (gains from the sale of an asset held for more than one year) at the capital gains rate (either 0%, 15%, or 20%, depending on the circumstances) and on short-term capital gains (gains from the sale of an asset held for less than one year) at your ordinary marginal tax rates.

But what happens when you sell a capital asset at a loss?

A tax loss arises when you sell an asset for less than your basis in it — for example, if your basis in the shares or units of your own company is $100,000 (based on the capital contributions you made to it) but you sell your company for $60,000, you suddenly have a $40,000 capital loss. A capital loss can be deducted/used to offset capital gains up to the amount of the capital loss and/or can be used to offset up to $3,000 of ordinary income per year. Ordinary income includes income not resulting from the sale of a capital asset and can include wages, salaries, commissions, interest income, and gain from the sale of non-capital assets (e.g., business inventory, depreciable real property or rental property, and most intellectual property).

While a capital loss can only be used to offset capital gains (and/or up to $3,000 of ordinary income per year), an ordinary loss is a tax loss that can be deducted/used to offset ordinary income without limit. It can also be used to offset capital gains. Because most income tends to be ordinary income and because ordinary income is taxed at higher rates than long-term capital gains (up to 35% under the new federal tax laws plus up to 13% for state income tax), ordinary losses are usually much, much more valuable.

[Read: Do I have to file income taxes if I have a pass-through entity?]

What do taxes have to do with it?

For every $100,000 of ordinary income you’re earning at the highest marginal rates, you could be paying $48,000 in income taxes on it.

With a few exceptions, you pay taxes on all the income you receive — especially ordinary income. Depending on how much income you receive in a given year, you could be paying as much as 48% (up to 35% in federal income taxes and up to 13% in state income taxes) on ordinary income above a certain dollar amount. So, for every $100,000 of ordinary income you’re earning at the highest marginal rates, you could be paying $48,000 in income taxes on it. So, if you had $100,000 in ordinary losses to offset that income, you would pay $0 in income taxes on it — and save that $48,000. A tax loss doesn’t mean you fully recover what you invested, but it can certainly save you a lot of money that you would otherwise pay in taxes. It might also be the most valuable form of recovery if your business investment is worthless or nearly so.

Isn’t a capital loss the only loss I can get?

Let’s say you invested $100,000 into a partnership (or an LLC taxed as one) and, two years later, sell your partnership/membership interest for $10,000. You’ll have recovered $10,000 of your investment and will typically have a $90,000 long-term capital loss. However, if you abandon your interest — meaning you simply walk away from it altogether without selling it — you could have a $100,000 ordinary loss under Internal Revenue Code ยง 165(a), which would allow you to deduct up to $100,000 against your ordinary income — and potentially save up to $48,000 in taxes you would have paid on your otherwise taxable income. As counter intuitive as it seems, this is a situation where it might be more advantageous to walk away than to sell.

There are a few important things to keep in mind about Section 165. First, you must abandon your interest in the company through an overt and intentional act. Simply disappearing from the partnership and claiming the loss won’t suffice. You also cannot receive any consideration in exchange for your partnership/membership interest, and consideration in this scenario includes compensation as well as relief from any liabilities of the partnership (or LLC taxed as one).

Is this approach right for me?

A Section 165(a) abandonment can be tricky. There are rules that need to be complied with, and, because of the immense tax benefits when compared to a typical capital loss, the IRS tends to scrutinize these transactions pretty thoroughly. That said, it may be a financially advantageous “out” that will get you some recovery (and perhaps more recovery than you’d get from a buyout) and let you move on with your life.

As is usually the case with anything tax-related — and especially a tax issue as heavily scrutinized as this — we strongly recommend you speak with a qualified accountant, tax attorney, or other tax professional to go over your unique situation and craft a solution that works for you. Here at Law 4 Small Business, our tax attorneys are happy to sit down with you and come up with creative, effective solutions to your partnership dispute.

If you have questions or want to speak with a tax attorney, Contact us today to set up an appointment.

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