## Facts

- W. D. Holbrook and M. D. Childers were limited partners in a partnership venture; they were not general partners and did not run the business.
- Over time, the partnership generated operating losses that were allocated to the limited partners.
- Holbrook and Childers claimed their distributive shares of those partnership losses as ordinary deductions on their individual income tax returns.
- The loss deductions reduced each partner’s adjusted outside basis in his partnership interest.
- The partners later sold their limited partnership interests to the partnership’s general partner.
- The stated purchase price for each interest was approximately equal to the partner’s original investment (capital contribution).
- Because their bases had been reduced by the prior loss deductions, the amount realized on the sale exceeded adjusted basis, producing gain.
- The partners reported the gain from the sale of their partnership interests as capital gain.
- The Commissioner determined deficiencies, asserting that the portion of the sales proceeds exceeding adjusted basis represented a recovery of previously deducted losses and therefore had to be taxed as ordinary income under the tax-benefit rule.

## Issues

1. Whether, under the tax-benefit rule, gain recognized on the sale of a limited partnership interest must be treated as ordinary income to the extent it reflects prior partnership losses previously deducted as ordinary deductions.

## Decision

- The Tax Court held that the partners’ gain from selling their limited partnership interests was capital gain.
- The Tax Court rejected the Commissioner’s attempt to apply the tax-benefit rule to convert that gain into ordinary income merely because the partners’ bases had been reduced by prior ordinary loss deductions.
- The asserted deficiencies were not sustained insofar as they depended on recharacterizing the sale gain as ordinary income.

## Legal Principles

- Gain or loss from the sale or exchange of a partnership interest is generally treated as gain or loss from the sale of a capital asset (subject to statutory exceptions).
- A partner’s outside basis in a partnership interest is reduced by the partner’s distributive share of partnership losses and deductions; gain on disposition is computed as the amount realized minus adjusted outside basis.
- The tax-benefit rule can require inclusion in income when a taxpayer later recovers an item previously deducted, but it does not automatically change the character of gain realized in a separate sale or exchange when the transaction is otherwise governed by the capital-gain rules for partnership interests.
- Absent a specific statutory rule that recharacterizes gain as ordinary income, the character of gain from a sale of a partnership interest follows the general capital treatment for such sales.

## Conclusion

Holbrook and Childers sold their limited partnership interests for amounts roughly equal to their original investments, but because prior loss deductions had reduced their bases, they recognized gain; the Tax Court treated that gain as capital gain and declined to use the tax-benefit rule to reclassify the gain as ordinary income based solely on the earlier ordinary loss deductions.


Holbrook v. Commissioner, 34 T.C.M. 1283, T.C. Memo 1975-294 (1975)