Court Recaptures Partner Deductions under At-Risk Rules – Subscription Note Disregarded

The Tax Court has held that an individual partner was subject to at-risk recapture with regard to prior partnership losses when the taxpayer’s obligations under a partnership subscription note were subsequently disregarded.  In Zeluck v. Commissioner, T.C. Memo 2012-98, the taxpayer invested in an oil and gas partnership by contributing cash and giving the partnership a subscription note.  The partnership subsequently pledged the taxpayer’s subscription note as collateral for its payment obligations under a drilling contract.

In the year of his investment, the taxpayer included the cash and the value of the note in his amount at-risk in the partnership, and he took tax deductions based on this amount.  Initially, the taxpayer made his scheduled payments on the note, but after a year, he stopped making his payments and made no plans to pay the note.  The partnership never took any action against him, and when the partnership terminated without having paid the drilling company in full, the drilling company who held the taxpayer’s note as collateral also failed to enforce payment of the note.

Although the Court regarded the note as originally a true obligation of the partner, the Court found the note terminated once the parties failed to respect the terms of the note.  Therefore, while the value of the note was properly included in the taxpayer’s amount at-risk in the partnership when the note was genuine, the taxpayer’s amount at-risk was reduced below zero by the value of the note when it ceased to be genuine.  As a result, Code Section 465(e) required the taxpayer to recapture his prior deductions based on the note.  The Court also applied a 20% accuracy penalty.