Ordinary versus capital losses.

Two recent cases highlighted the difficulty in determining whether a business-related investment produces an ordinary loss or a capital loss. The results of capital loss status can be harsh: Individuals are allowed only a $3,000 annual offset against other ordinary income, and corporate taxpayers are permitted only an offset against capital gains.

The Court of Appeals for the Fifth Circuit has affirmed an earlier Tax Court case holding that a company incurred a capital loss when it purchased an employee's home and later sold it at a loss. Even though there was a business purpose to this transaction based on requirements of an employee contract, the asset was not used directly in the company's business and therefore fell into capital asset status. (Azar Nut Co., no. 90-4462, CA-5 of 5/15/ 91, affirming 94 TC no. 26)

Conversely, a convenience store chain was successful in claiming an ordinary loss arising from the sale of its 10% ownership of an oil company's stock. The taxpayer was able to show that it acquired the oil stock to ensure an adequate supply of gasoline for its stores. This was based on contractual agreements that effectively allowed the taxpayer a hedge position by potentially converting its share of the oil company's production into gasoline for its stores. (The Circle K Corp. v. U.S., Cl. Ct., 5/16/91)

Observation: In 1988, the U.S. Supreme Court's Arkansas Best decision greatly narrowed the ability to qualify a business hedging transaction as an ordinary loss, leading to increasing uncertainty in the tax law. This issue has been identified by the House Ways and Means Committee staff as an item for study, potentially leading to legislative clarification.