A partnership had to report taxable income in the US when one of its partners repaid a loan from a bank. The partner had guaranteed part of the loan.
The partnership borrowed $18.3 million to build an office building. The project was a bust. The partnership sold the building three years after it was built for only $4.1 million. Some of the bank debt had been repaid by then. One of the limited partners had guaranteed the bank that it would receive ongoing monthly interest payments on the loan. The loan was to be repaid largely in a balloon payment at maturity. A settlement was worked out with the bank where the bank took the $4.1 million in sales proceeds and $8.3 million from the partner who guaranteed part of the debt in satisfaction of the loan.
The partnership told the IRS that it had a loss from the sale of the building and an $8.3 million capital contribution from one of its partners.
The IRS said the $8.3 million had to be reported as taxable income by the partnership, and a US appeals court agreed in mid-November.
A borrower ordinarily has income when a third party pays his debts. The partnership had two arguments for why it should not have to report the $8.3 million as income. It argued that the partner was paying a debt the partner owed directly to the bank on the guarantee. The court rejected this. The partner had only guaranteed ongoing interest payments. It made the payment to get a release from the guarantee. The partnership then argued that the partner had made a capital contribution to the partnership. Partnership do not have to report capital contributions as income. However, the problem in this case was the partner formally withdrew from the partnership shortly before the payment was made.
The case is a warning to be careful of the tax consequences when payments are made by guarantors. The case is Mas One Limited Partnership v. United States.