## Facts

- William and Sandra Sennett filed a joint federal income-tax return; William Sennett became a limited partner in Professional Properties Partnership (PPP) in December 1967, contributing $135,000 for a 33.5% interest.
- PPP reported a large ordinary loss for 1967. Sennett deducted $135,000 on his 1967 return as his allowable distributive share, reducing his adjusted basis in the partnership interest to zero.
- In 1968, Sennett withdrew from PPP and sold his entire partnership interest back to the partnership effective December 1, 1968.
- The original buyout agreement contemplated that PPP would pay Sennett for his partnership interest and that Sennett would repay PPP the losses allocated to the surrendered interest.
- In 1969, the parties carried out the economic terms of the separation. PPP executed a promissory note to Sennett for $240,000, and Sennett paid PPP $109,061, representing his share (as computed under the agreement) of PPP’s 1967–1968 losses.
- On the Sennetts’ 1969 return, they reported a $240,000 long-term capital gain from the disposition of the partnership interest and claimed an additional $109,061 ordinary loss deduction, characterizing that amount as a partnership-loss carryover under I.R.C. § 704(d).
- The Commissioner disallowed the $109,061 ordinary loss deduction because Sennett was not a partner in PPP in 1969. The Commissioner treated the $109,061 payment as part of the overall sale transaction and recomputed Sennett’s 1969 result as a net long-term capital gain (approximately $131,000).
- The Tax Court sustained the Commissioner’s determination, and the Sennetts appealed to the Ninth Circuit.

## Issues

1. May a former partner, who is no longer a partner in the deduction year, claim an ordinary loss deduction in that year under I.R.C. § 704(d) for partnership losses that were previously limited by basis and later paid to the partnership as part of the withdrawal/buyout arrangement?

## Decision

- The Ninth Circuit affirmed the Tax Court in a per curiam opinion.
- The court held that § 704(d) does not permit a taxpayer to deduct partnership losses in a year when the taxpayer is no longer a partner and has no adjusted basis in a partnership interest to which the limitation and carryover can apply.
- The court accepted the Commissioner’s treatment of Sennett’s 1969 payment as part of the economics of disposing of the partnership interest (affecting the capital-gain computation), rather than as a separate ordinary loss deduction under § 704(d).
- The court relied on Treas. Reg. § 1.704-1(d) as a reasonable interpretation of § 704(d) and noted that a Treasury regulation is not invalid merely because the statutory language could also support a different reading.

## Legal Principles

- I.R.C. § 704(d) limits a partner’s distributive share of partnership loss to the adjusted basis of the partner’s partnership interest at the end of the partnership year; disallowed losses may be carried over only subject to that same partner/basis limitation.
- Under Treas. Reg. § 1.704-1(d), § 704(d) carryovers operate in years in which the taxpayer remains a partner and has basis against which the losses can be allowed; once the taxpayer has disposed of the entire partnership interest, the carryover mechanism no longer applies.
- Payments made after withdrawal that arise from the buyout arrangement are treated as part of the disposition transaction for tax-character purposes; they generally adjust the amount realized (or otherwise affect gain/loss from the sale) rather than creating a new, post-withdrawal ordinary deduction under § 704(d).
- Courts will uphold Treasury regulations that reasonably construe ambiguous statutory text, even if another interpretation is possible.

## Conclusion

Because Sennett had fully withdrawn from PPP before 1969 and therefore had no partnership interest (and no basis in such an interest) in 1969, § 704(d) did not authorize an ordinary loss deduction for his 1969 payment to PPP; the payment instead was properly taken into account in computing the long-term capital gain from the buyout of his partnership interest, and the Ninth Circuit affirmed the Tax Court’s ruling for the Commissioner.


Sennett v. Commissioner, 752 F.2d 428 (1985)