In private letter ruling no. 9728002, the Internal Revenue Service ruled that legal and accounting fees resulting from a lawsuit filed by limited partners against a company's general partners could be deducted only as a miscellaneous itemized deduction.
The taxpayers, who were involved in the real estate business on a full-time basis, were limited partners in a partnership that owned and operated a shopping center. When the limited partners purchased the partnership interest, the general partners had agreed to purchase all unsold limited partnership interests and to fund any negative cash flows. However, the partnership was unable to sell all its limited partner shares, and the general partners failed to perform as promised. As a result, the partnership did not have sufficient capital to operate and filed for bankruptcy.
The next year the partnership filed its final tax return after its lender fore-closed on all its operating assets. Consequently, with their negative capital accounts increased to zero, the taxpayers recognized a phantom gain for that year.
The limited partners sued the general partners for failing to fulfill their agreement. A settlement was reached and the taxpayers sought to deduct their legal and accounting fees as ordinary and necessary business expenses under Internal Revenue Code section 162.
According to the letter ruling, the IRS said the settlement proceeds were payments solely for the limited partners' investment losses. …