Deducting losses on worthless or abandoned assets.
As a result of the prolonged economic recession in the United States, numerous businesses have been generating operating losses. However, these reported losses are only part of the problem. Many of these businesses may also own assets that have declined in value to a point where the assets have little or no value.
Businesses that own worthless assets should consider the possibility of taking a loss deduction under Sec. 165. To the extent allowed, this deduction would give rise to either current or future tax benefits. The rules for taking the loss deduction vary greatly, depending on the type of asset involved and the taxpayer's actions. This article will cover the litigation that has clarified some, but not all, areas of the law; review the requirement for claiming a loss deduction for worthless nondepreciable business assets; and discuss the characterization of the loss.
General Rule of Sec. 165
Sec. 165(a) provides that the taxpayer "shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise." The amount of the loss equals the adjusted basis of the property calculated under Sec. 1011 as if the asset had been sold or exchanged at a loss.(1) The loss must be adjusted for any salvage value or compensation received.(2) If the loss arose from a capital asset, Secs. 1211 and 1212 (relating to the capital loss limitation and carryover) restrict the deductibility.(3) A deduction is not permitted under Sec. 165 if the loss results from a sale or exchange of property.(4) In addition, if the loss was incurred by an individual, it must have been incurred in a trade or business, in a transaction entered into for profit or from an event classified as a casualty or theft.(5)
The loss is deductible in the year sustained. However, it cannot be deducted if there is a reasonable prospect of recovery.(6) The possibility of recovery is a question of fact that must be determined by the particular circumstances involved. The recovery need not be complete to delay the deduction. The fact that the possibility of any recovery exists will delay the deduction until it can be determined with reasonable certainty that the recovery will be less than the loss sustained. In those cases in which the recovery would result from an action against a third party, the taxpayer will have to demonstrate that a favorable judgment would be insufficient to provide full reimbursement. It will be hard to establish this proof if a lawsuit has been filed for all damages sustained.(7)
Sec. 165 applies to nondepreciable business assets and to worthless securities, but not to inventory (covered by Sec. 471) or depreciable property (Sec. 167), or losses from debts not evidenced by a security.(8)
Sec. 166(a) allows a deduction for any debt that becomes worthless during the tax year provided the debt is not evidenced by a security.(9) Since Sec. 165(g)(2) defines a security as either a share of stock or a note, Sec. 166 applies only to accounts receivable. The Sec. 166 deduction is permitted in the year the debt becomes completely worthless even if it is not deducted for financial statement purposes.(10) If the debt is a nonbusiness debt, the loss is a short-term capital loss rather than an ordinary loss.(11) The IRS may allow a deduction for partially worthless debts, but only if it is satisfied that there will be only partial recovery and only if the part claimed has been charged off.(12)
Nondepreciable Business Assets
The proper treatment of losses from nondepreciable business assets is found in the regulations to See. 165 and the case law thereunder since the Code does not provide specific guidance. In A.J. Industries,(13) the Ninth Circuit clearly noted that a loss is not deductible as the result of a decline in value of the asset. Regs. Sec. 1.165-1(b) and (d) state that the loss is deductible when "evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year." Under Regs. Sec. 1.165-2(a), the deduction of a loss is permitted for "the sudden termination of the usefulness in such business or transaction of any nondepreciable property, in a case where such business or transaction is discontinued or when such property is permanently discarded from use therein ...."
It appears clear from the regulations that a loss on a nondepreciable asset other than securities can be claimed even though it is not worthless. The criteria used to determine when a loss can be deducted in cases other than worthlessness are (1) the occurrence of a closed and completed transaction coupled with the termination of the asset's usefulness; (2) the discontinuation of the use of the asset; or (3) the discontinuation of the business. An action that appears to meet either or both of the latter two conditions qualifies as the abandonment of an asset.
For a business to abandon an asset, there must be the intent to abandon, plus an act designed to accomplish that intent.(14) Both aspects must exist; neither the intent nor the act alone is sufficient. The actual proof of the abandonment will be determined from all the facts and circumstances.
The deductibility of a loss due to an abandonment comes from the requirement in Regs. Sec. 1.165-2(a) that the taxpayer discontinue the use of the asset or the business in which the asset is used. Early cases concluded that this requirement is based on management's opinion.(15) Since the regulation requirement that gave rise to the abandonment standard is based on the taxpayer's judgment, the intent part of the rule should be based on management's subjective opinion. Of course there needs to be a reasonable basis for management to reach its conclusion, plus an overt act to effectuate the intention.(16)
There is an important limitation on a taxpayer's right to claim a loss due to an abandonment of the asset. Regs. Sec. 1.165-2(a) states that "the taxable year in which the loss is sustained is not necessarily the taxable year in which the overt act of abandonment, or the loss of title to the property, occurs." As the Ninth Circuit pointed out in A.J. Industries, this is known as the real estate exception. It was created in earlier cases to prevent taxpayers who owned worthless real estate from being disadvantaged because they could not expeditiously divest themselves of title. Under this exception, the deduction can be claimed prior to actual abandonment. In Middleton,(17) the Tax Court clarified that the deduction is permitted even if the mortgagee failed to institute foreclosure proceedings. This exception has been used by the IRS to prevent tax avoidance. In Superior Coal Co.,(18) the court required the taxpayer to claim the loss in the year the property became worthless rather than the later year in which it divested itself of title. The Treasury sanctioned this anti-avoidance use of the exception in Rev. Rul. 54-581,(19) saying that an abandonment loss is deductible only in the year sustained and not a later year in which the actual act of abandonment occurs.
As IRS Letter Ruling 9220003(20) illustrates, the ability to claim the loss before actual abandonment can be used by the taxpayer. A public utility was permitted a loss deduction for the abandonment of a nuclear power plant in spite of the fact that the taxpayer had not transferred ownership of the plant, had employees on the premises and had not been granted permission to transfer the plant. The loss was allowed because of the difficulty in abandoning a nuclear power plant and the fact that the taxpayer had taken all the steps necessary to abandon the plant and could not reverse course to recover the property. The ruling stated that "the act necessary to evidence the intent to abandon property need only be appropriate to the particular circumstances. The actual transfer of title is not a requirement for abandonment." This conclusion should apply to any taxpayer who encounters legal or other restrictions on his ability to physically abandon property.
In Brountas,(21) the First Circuit clarified the application of the general abandonment rule in a case involving an oil and gas leasehold. The court started with the two-part abandonment test (intent plus act). It went further by stating that in the case of a mineral lease, a geological determination of worthlessness coupled with the cessation of lease payments will establish abandonment. However, the taxpayer must abandon the entire lease.
In Massey-Ferguson, Inc.,(22) the Tax Court extended the abandonment cases to intangible assets such as goodwill and going concern value. The taxpayer had acquired another business in order to expand its operations into a related line. At the same time, the company developed competing products at a separate location. Eventually, the taxpayer abandoned the acquired plant and some of the intangibles. The Tax Court permitted the loss deduction for the acquired business as well as its going concern value, even though the company continued in the same line of business at the separate location. In addition, the court allowed the deduction for some of the intangibles even though the taxpayer did not abandon all of them. The court required only that the taxpayer present credible evidence of the allocation of the original purchase price to the various assets acquired and subsequently abandoned.
This case should be of great interest to many taxpayers. Currently, many businesses are experiencing losses as the result of prior acquisitions and expansions. The decision in Massey-Ferguson permits them to abandon and deduct part of the acquisition price when they close down part or all of the acquired business. To ensure the deduction, there must be a true abandonment of the business and not just a shifting of it to a new location. Downsizing of the business will most likely not qualify as an abandonment unless it results in the termination of a complete operation or of individual lines of business. In addition, the taxpayer will be required to prove the amount paid for the assets abandoned. This proof can be established by the allocation of the purchase price if the taxpayer presents credible evidence.(23)
The Massey-Ferguson case may be of greater interest following the Supreme Court's decision in INDOPCO.(24) The Court required INDOPCO to capitalize the costs associated with a friendly takeover. It rejected the taxpayer's argument that only costs that create or enhance a separate asset are capitalizable. As a result, taxpayers that acquire other businesses may find that they have to capitalize a greater proportion of the costs. Even firms that do not acquire other businesses may find that they have to capitalize costs that they previously deducted as a result of INDOPCO.(25)
The INDOPCO decision should not prevent the loss deduction on an abandonment. The Bankruptcy Court allowed the taxpayer in In the Matter of Federated Department Stores, Inc.(26) to deduct the costs of an unsuccessful effort to fight off a hostile takeover. The costs related to an abandoned transaction that attempted to effectuate a white knight merger. Although the planned transaction would have been capitalized if consummated, the costs were deductible as a loss under Sec. 165(a) when the transaction was abandoned. The Bankruptcy Court found the appellate level decision (the Bankruptcy Court handed down its decision 18 days before the Supreme Court decision) in INDOPCO to be inapplicable because it "dealt with the denial of deductibility of expenses incurred in a successful friendly takeover."(27) (Emphasis supplied by the court.)
There is an important caveat in Federated that must be considered. If the taxpayer abandons a contract that is capital in nature to enter into another capital contract, the costs will not relate to an abandonment and thus qualify as a deductible loss. Instead, they will be capitalized as part of the new contract. Therefore, only when a transaction is abandoned instead of replaced can a Sec. 165 deduction be taken.
The Phillips Petroleum(28) court reached a different conclusion. Once again the Tax Court was confronted with a taxpayer attempting to claim a loss on the abandonment of an oil and gas lease. The court began by citing A.J. Industries and Brountas for the two-part abandonment test. However, it went on to state: "Furthermore, deductibility of an abandonment loss requires that there be a commercially reasonable determination of worthlessness."(29) This can be viewed as an additional requirement. Alternatively, it can be viewed as part of the intent to abandon test. As previously discussed, intent is based on management's judgment. However, there must be a reasonable basis in fact for management to reach its decision. The requirement of a "commercially reasonable determination of worthlessness" can be viewed as the facts behind management's decision rather than as a separate requirement. This view is reasonable given the fact that a lessee does not have title to property or even a physical asset that can be abandoned in the ordinary sense of the word.
One of the earliest cases in a line of cases involving partnership interests was Zeeman.(30) The taxpayer was permitted a loss deduction for a limited partnership interest in the year preceding the year in which the partnership and general partners went into bankruptcy. The court reasoned that since the partnership and general partners were hopelessly insolvent, the taxpayer was entitled to the loss. The court did not mention abandonment of the interest. Instead, the entire, albeit limited, discussion focused on the worthlessness of the interest. The court, in effect, treated the partnership interest as if it were a security.
In Tejon Ranch Co.,(31) the Tax Court cited Zeeman for the conclusion that the taxpayer is entitled to a Sec. 165(a) loss deduction on the worthlessness of a partnership interest. The government argued against the loss deduction on the grounds that there was no closed transaction. Abandonment was not mentioned directly. However, by referring to the regulation's requirement of a closed transaction (which was part of the basis prior cases relied on when adopting the abandonment standard], the court indirectly raised this issue. It concluded that the hopeless insolvency of the partnership was the closed transaction justifying the deduction, again citing Zeeman. In effect, the court permitted the deduction based on worthlessness not abandonment.
One of the most recent cases in this area is Echols.(32) The taxpayer was a 75% partner in a real estate partnership. Following unsuccessful attempts to sell the real estate, he notified his partner that he was not going to continue making mortgage and tax payments. The taxpayer claimed a Sec. 165(a) loss in 1976 when he announced his decision. The mortgagee foreclosed on the mortgage in 1977. The Tax Court denied the deduction on the grounds that the taxpayer failed to abandon the property in 1976. Instead, the loss should have been claimed in 1977 when the property was foreclosed.
The Tax Court applied the abandonment standard to the partnership interest. It did not address the issue of worthlessness as a reason for the deduction. In addition, it did not cite Zeeman or Tejon Ranch, but instead, referred to Middleton, which involved the direct ownership of real estate.
The Fifth Circuit reversed this decision for two reasons. First, it believed the taxpayer had abandoned his interest in the partnership. Unlike the Tax Court, which focused on the real estate and the actions by the partnership, the Fifth Circuit examined the taxpayer's actions. As previously stated, the taxpayer announced that he would no longer make the mortgage payment. In addition, he offered his interest to anyone who would take over the payment. No one accepted. Therefore, the taxpayer did all he could to abandon his interest and was entitled to the loss deduction.
Second, the interest was worthless. As a general rule, the determination of worthlessness is made by the taxpayer, provided it does not contradict obvious facts. In this case, the taxpayer indicated that he believed the interest was worthless when he refused to make additional payments. The fact that no one would accept the interest in exchange for a promise to make the mortgage payments verified the lack of value. Therefore, the taxpayer was entitled to the loss in the year he determined the interest was worthless.
The government petitioned the court for a rehearing. It had acquiesced on the abandonment issue, but wanted the court to reverse its conclusion on worthlessness. In denying the petition, the court stated that to accept the government's position would, in effect, make abandonment the only avenue to a loss deduction; it believed both abandonment and worthlessness were available. The court noted that, contrary to the worthlessness route, abandonment permits a deduction when the property has not become completely worthless. However, this conclusion does not give the taxpayer the right to deduct a loss whenever he wants. The taxpayer must still meet the regulation requirement of a closed transaction. In this case, the inability to either sell the property or restructure the debt were the closed transactions. Other events can be used to signal a closed transaction. For example, the court cited Tejon Ranch, in which insolvency was determined to be a suitable event. The result is that the taxpayer is entitled to a loss either on worthlessness or abandonment.
The Tax Court does not appear convinced. In Citron,(33) it allowed the taxpayer to claim a loss on abandonment of a partnership interest. The court cited the Fifth Circuit's decision in Echols solely for the proposition that the determination of abandonment is based on the partner's action and not the partnership's. It did not mention worthlessness at all.
The Fifth Circuit in Echols was the first to definitely state that both abandonment and worthlessness are reasons for deducting Sec. 165 losses. As previously discussed, however, it is not the first court to allow a deduction for a worthless intangible asset.(34) Taxpayers must await future litigation to see if Echols will be followed by the other circuits and whether it also applies to nondepreciable tangible property.
Character of Loss
The loss allowed by Sec. 165(a) can be capital or ordinary.(35) If the asset is an ordinary income asset, the loss will be ordinary. If the asset is a capital asset, the loss will be capital only if the transaction qualifies as a sale or exchange. An abandonment will be characterized as a sale if the taxpayer is relieved of a liability. In that event, the liability can be either recourse or nonrecourse.(36)
In the unusual case in which no liabilities exist, the loss from abandonment will be ordinary.(37) In addition, if the liability is recourse, exchange treatment will not occur and the loss will be ordinary unless the abandonment extinguishes the debt.(38) Whether the debt is extinguished is a question of fact. in Lockwood,(39) the taxpayer attempted to argue that there was no release of a liability. instead, he argued the debt discharge was a purchase price reduction. The court rejected the taxpayer's contention. The facts indicated a unilateral act by the taxpayer - the abandonment of the property. Therefore, the liability was simply extinguished. It will take creditor involvement to treat the debt discharge as a purchase price adjustment.(40) In most cases it will be difficult to argue that the taxpayer convinced the creditor to reduce the debt to zero and then abandoned the property. Only in those cases in which the taxpayer is still liable for the entire debt or no debt exists will the taxpayer obtain an ordinary loss from the abandonment of a capital asset.
In addition to authorizing a deduction for nondepreciable assets used in a business, Sec. 165(g) allows a deduction for the loss sustained by a taxpayer resulting from the worthlessness of a security.(41) For purposes of this section, a security is defined as a share of stock, a right to acquire a share of stock, or a bond, note or other evidence of indebtedness.(42) The loss from a security is treated as resulting from a sale or exchange on the last day of the tax year. In most cases this will result in a long-term capital loss.
The loss will be treated as ordinary if it is the security of an affiliated corporation.(43) To be affiliated the corporation must own stock possessing at least 80% of the voting power and at least 80% of each class of nonvoting stock. In addition, the subsidiary must obtain over 90% of its gross receipts from active sources.
Many businesses have suffered severe losses in the past few years and many more losses are predicted in the near future. One way that a company can minimize its economic loss is by obtaining a tax deduction for the loss in value of its assets. The Code allows a taxpayer a deduction for any loss sustained during the year not compensated for by insurance; this includes the worthlessness or abandonment of assets.
The requirements that must be met in order to enjoy the benefits of such a deduction under Sec. 165 vary greatly depending on the type of asset involved. However, the general theme for all assets is that the taxpayer must be able to prove that either a partial or full decline in the value of the asset has occurred during the current year. Because such a decline relies on a question of fact, the taxpayer - and not the IRS - has the burden to prove the change of circumstances. Several factors can be helpful in determining an "identifiable event" that signals the change. The timing of the deduction is also important, since the law allows a deduction only in the year the asset is deemed worthless. The courts have repeatedly disallowed deductions claimed too early or too late. Because of this tight interpretation of the rule, taxpayers do not have the flexibility of planning in which year the loss would be most advantageous. They also do not have much control concerning the characterization of the loss. Although Sec. 165(a) allows either an ordinary deduction or a capital loss, in most cases it will be a capital loss. Under certain limited fact situations, taxpayers will be entitled to ordinary losses. In addition, the worthlessness of a security will generate a capital loss unless the security mects one of the special exceptions provided in the Code.
(1) Sec. 165(b). (2) Regs. Sec. 1.165-1(c)(4). (3) Regs. Sec. 1.165-1(c)(3). (4) Regs. Sec. 1.165-2(b). (5) Sec. 165(c). (6) Regs. Sec. 1.165-1(d)(2)(i). (7) See, e.g., Phillip Applegate, TC Memo 1992-156. (8) A complete discussion of inventory and depreciable property is beyond the scope of this article. (9) Sec. 166(e). (10) prior to 1986, taxpayers were permitted to deduct a reserve for bad debts. Sec. 585 (as well as, e.g., Secs. 448(d)(5) and 593) still permits banks to establish a reserve for loan losses. (11) Sec. 166(d). (12) Sec. 166(a)(2). (13) A.J. Industries, 503 F2d 660 (9th Cir. 1974)(34 AFTR2d 74-5932, 74-2 USTC [paragraph] 9710), rev'g and rem'g C.D. Cal., 1972 (30 AFTR2d 72-5315, 72-2 USTC [paragraph] 9645). The case also discussed the 1939 Code, since the taxpayer was entitled to the loss under either Code. (14) Id., at 74-2 USTC 85,299-85,300, citing numerous prior cases. (15) See, e.g., The S.S. White Dental Mfg. Co., 55 F Supp 117 (Ct. Cl. 1944)(32 AFTR 804, 44-1 USTC [paragraph] 9301), discussing the predecessor to this regulation. (16) See the discussion of Phillips Petroleum Co. and Affiliated Subsidiaries, TC Memo 1991-257, accompanying notes 28 and 29. (17) Milledge L. Middleton, 77 TC 310 (1981). (18) Superior Coal Co., 2 TCM 984 (1943), aff'd, 145 F2d 597 (7th Cir. 1944)(33 AFTR 83, 44-2 USTC [paragraph] 9541), cert. denied. (19) Rev. Rul. 54-581, 1954-2 CB 112. (20) IRS Letter Ruling (TAM) 9220003 (10/28/91). (21) Paul P. Brountas, 692 F2d 152 (1st Cir. 1982)(50 AFTR2d 82-5900, 82-2 USTC [paragraph] 9626), vac'g and rem'g 73 TC 491 (1979), cert. denied. (22) Massey-Ferguson, Inc., 59 TC 220 (1972). (23) If the original allocations were supported by valuations and made using Sec. 1060 or Temp. Regs. Sec. 1.338(b)-2T, the allocations should be respected. (24) INDOPCO, Inc., 112 Sup. Ct. 1039 (1992)(69 AFTR2d 92-694, 92-1 USTC [paragraph] 50,113). (25) See, e.g., IRS Letter Ruling (TAM) 9240004 (6/29/92), in which the Service concluded that the costs of asbestos removal should be capitalized rather than deducted as a repair. (26) In the Matter of Federated Department Stores, Inc., 135 BR 950 (S.D. Ohio 1992)(69 AFTR2d 92-731, 92-1 USTC [paragraph] 50,097). (27) 1d., at 92-1 USTC 83,395. (28) Phillips Petroleum, note 16. (29) Id., at 91-1270, citing Gulf Oil Corp., 87 TC 135 (1986), aff'd, 914 F2d 396 (3d Cir. 1990)(66 AFTR2d 90-5552, 90-2 USTC 950,496). (30) Audrey L. Zeeman, 275 F Supp 235 (S.D. N.Y. 1967)(21 AFTR2d 679, 67-2 USTC [paragraph] 9565), aff'd and rem'd on other issues. (31) Tejon Ranch Co. and Subsidiaries, TC Memo 1985-207. (32) John C. Echols, 93 TC 553 (1989), rev'd in part and rem'd in part, 935 F2d 703 (5th Cir. 1991)(68 AFTR2d 91-5157, 91-2 USTC [paragraph] 50,360), rehearing denied per curiam, 950 F2d 209 (5th Cir. 1991)(69 AFTR2d 92-433, 92-1 USTC [paragraph] 50,046). (33) B. Philip Citron, 97 TC 200 (1991). (34) However, the prior cases that used worthlessness did so either to prevent a taxpayer who could not expeditiously abandon property from being disadvantaged or to prevent a taxpayer from delaying the year of the deduction. (35) 5See Citron, note 33, at 213. (36) See James W. Yarbro, 737 F2d 479 (5th Cir. 1984)(54 AFTR2d 84-5774, 84-2 USTC [paragraph] 9691), aff'g TC Memo 1982-675, rehearing denied, 742 F2d 1453 (5th Cir. 1984), cert. denied; and Robert A. Daily, 81 TC 161 (1983). (37) Citron, note 33. (38) See Frank S. Lockwood, 94 TC 252 (1990). (39) Id. (400 It is important to note the IRS's stated position that a purchase price reduction can occur only if the debt is owned by the original seller or is the result of an infirmity that clearly relates to the original sale. Rev. Rul. 92-99, 1992-2 CB 35. (41) A full discussion of this issue is beyond the scope of this article. (42) Sec. 165(g)(2). (43) Sec. 165(g)(3).
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|Author:||Burton, Hughlene A.|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 1993|
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