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to acquire. Thus, the expenses did not the husband’s S corporation was the taxpayer ever being required to satisfy
qualify under Sec. 162. The court held original partner. The court ruled that the guaranty was so remote that the
that at most the expenses would be the S corporation’s partnership interests guaranty for the commercial debt also
Sec. 195 startup expenses, but since the had been redeemed and the husband should be disregarded.
taxpayer never started a business, the had invested individually before the loss The court examined a number of is-
expenses were not deductible under was recognized. sues that would distinguish whether the
Sec. 195 either. subordinate debt was debt or equity for
Disguised sale tax purposes. Based on its examination,
Theft loss deduction In a case that involved the Chicago the court determined that the subor-
In Vennes,21 taxpayers claimed Cubs, Tribune Media Co.,22 the Tax dinate debt should be characterized as
passthrough theft loss deductions for Court addressed whether an exception equity; thus, the portion of the distri-
losses from the husband’s S corporation to the disguised-sale rules applied. The bution attributable to the subordinate
and related partnership interests. The taxpayer formed an LLC with another debt cannot offset the taxpayer’s recog-
losses were sustained from a massive member. The taxpayer contributed the nized gains from the disguised sale. The
Ponzi scheme, which was orchestrated baseball team, and the other member other debt guaranty was bona fide even
by a longtime acquaintance using an contributed cash. As part of the trans- if the probability the taxpayer would be
electronics resale company to solicit action, the LLC entered into two debt required to make a payment is remote.
loans in exchange for fictitious notes. contracts, one with a commercial lender Thus, the portion of the distribution
The husband participated in the and the other with the other member. attributable to the other debt guaranty
scheme. However, he was not charged The loan from the other member was is a nontaxable debt-financed distribu-
with knowledge of the underlying subordinate to the commercial loan. tion, the court held.
fraud. The taxpayers claimed theft The taxpayer guaranteed both debts.
losses from the S corporation and the The LLC then distributed cash to the Sec. 754 election
related partnerships on their personal taxpayer. Neither party disputed that When a partnership distributes prop-
tax return when the scheme collapsed. this type of transaction is a “disguised erty or a partner transfers his or her
The IRS disallowed the losses be- sale,” which is taxable under Sec. 707(a) interest, the partnership can elect under
cause the taxpayers failed to properly (2)(B). However, there are exceptions Sec. 754 to adjust the basis of partner-
substantiate the losses and could not to the disguised-sale rules, including ship property. A Sec. 754 election
show there was no reasonable prospect the debt-financed distribution rule. The allows a step-up or step-down in basis
of recovery in the year the losses were debt-financed distribution rule permits under either Sec. 734(b) or Sec. 743(b)
claimed when considering overall cir- a partner to receive a debt-financed to reflect the FMV at the time of the
cumstances, including assets potentially distribution of property from a partner- exchange. This election has the advan-
available or the possibility of obtaining ship as part of a disguised sale tax-free tage of not taxing the new partner on
legal restitution via other avenues. up to the amount of debt allocated to gains or losses already reflected in the
The Tax Court agreed with the IRS that partner. purchase price of his or her partnership
with regard to the loss from the S cor- Because the taxpayer guaranteed interest. The partnership must file the
poration because the safe-harbor relief both debts and thus was ultimately election by the due date of the return
provided in Rev. Proc. 2009-20 was responsible for the debts, the taxpayer for the year the election is effective,
not available as to the S corporation, took the position that the distribution normally with the return.
because the qualified loss and quali- met the debt-financed distribution Currently, if a partnership inadver-
fied investor requirements of the safe exception and therefore was not taxable. tently fails to file the election, the only
harbor were not met. However, those The IRS argued that the debt funded way to remedy the failure is to ask for
requirements were met with respect to by the other LLC member was not relief under Regs. Secs. 301.9100-1 and
the partnerships in which the husband bona fide debt but rather was disguised -3 either through automatic relief if the
held a partnership interest. Thus, the equity. Thus, the subordinate debt error is discovered within 12 months
court allowed deductions for his al- should be disregarded for the debt- or through a private letter ruling. To
locable share of the partnership losses. financed distribution rule. The IRS be valid, the election must be signed by
These losses were allowed even though also argued that the likelihood of the a partner.

21. Vennes, T.C. Memo. 2021-93. 22. Tribune Media Co., T.C. Memo. 2021-122.

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