Given the recent economic downturn, lingering losses still plague the balance sheets of many companies holding debt. As if an anemic economic recovery were not enough, these companies must contend with uncertain tax rules that can produce different results among taxpayers that are in identical situations in all material respects. The inconsistencies in the tax rules have long drawn criticism, and practitioners and academics alike have suggested modifications, but to no avail.

This edition of Tax Advisor Weekly focuses on uncollectible business debts held by taxpayers that can be described as “occasional lenders,” those that (1) are not in the business of lending or hold “dealer” status and (2) hold secured or unsecured debt investments that are not “securities” within the meaning of IRC Section 165(g). Taxpayers in this category may include a private equity fund loaning capital to its portfolio company, a real estate investment trust (REIT) investing in real estate mortgages, an investor acquiring a regular real estate mortgage investment conduit (REMIC) interest, or an organization that occasionally engages in private lending transactions with related or unrelated parties.

Our objectives are (1) to raise awareness about the ambiguity and disjointedness within the tax rules governing this area and (2) to alert occasional lenders about ways to avoid a costly mistake. Amid all the uncertainty, what is clear is that tax consequences are driven by how a lender chooses to wind-up its distressed debt. Depending on the chosen approach, the wind-up may generate a bad debt deduction, a capital loss or a combination thereof. Thus, taxpayers seeking to obtain a particular characterization can increase the likelihood of success by understanding the peculiarities of the rules and adopting the requisite policies and procedures.

The Framework

The character of uncollectible debt losses is governed by three statutes: IRC Sections 165(g), 1271(a)(1), and 166. To understand the pecking order of these statutes, first consider that debt instruments can be divided into three buckets: (1) ordinary assets, (2) capital assets that are securities and (3) capital assets that are not securities.

The first two buckets are fairly straightforward to identify and analyze for tax purposes. If a lender can escape capital asset characterization through one of the statutory exceptions under Section 1221, losses will be characterized as ordinary. For the lender holding debts that are capital assets that qualify as securities, the treatment of losses is governed by a well-established body of law under Section 165(g), including a carve out from the bad debt rules under Section 166(e).1

The character issue arises through unresolved conflicts created within the third and last bucket. Depending on how a debt in this bucket is settled or extinguished, the transaction may be treated as either a “retirement” under Section 1271(a)(1) or a bad debt under Section 166.

Statutory Conflict

Under Section 1271(a)(1), any amount received by the holder on retirement of any debt instrument will trigger “sale or exchange” treatment. The term “retirement” for this purpose is broadlyinterpreted to include nearly every type of payment, whether such payment is in partial or full extinguishment of the debt. Given the sale or exchange treatment, the character of the asset in the hands of the holder will typically determine the character of the loss. Companies that are not in the business of lending will generally have capital treatment for all assets that do not fall into one of the exceptions under Section 1221.2

On the other hand, Section 166 allows a deduction for business bad debts that become wholly or partially worthless and applies where Section 165(g) does not apply. Furthermore, the underlying regulations for Section 166 allow bad debt treatment for secured debt transactions where a deficiency remains after the pledged or mortgaged collateral is sold (e.g., foreclosure sale.)3

So what is the problem? A conflict arises because there are no explicit ordering rules within the statute to resolve conflicts when both Sections 1271(a)(1) and 166 overlap. Like other complex areas of the Internal Revenue Code, this conflict is largely attributable to each rule being enacted at different times, Congress’s underlying policy objectives, and the inevitable patchwork of fixes to eliminate unintended results. The origin of sale or exchange treatment for retired debts dates back to 1934 when Congress attempted to create parity between the treatment of “sales” and “retirements” of securities. Over the next 50 years, the scope of “sale or exchange” slowly expanded until it included virtually all types of debt obligations held as capital assets. In addition, the tax authorities adopted a new line of thinking that assets held and used by a business in the conduct of its day-to-day activities could be viewed as capital assets.4 Currently, the sale or exchange rule could apply to all business debts held as capital assets. Meanwhile, a statutory expansion of the inapplicability of the bad debt rules to all capital assets (beyond just securities under Sec. 165(g)) has not occurred.

Consider, for example, an occasional lender that holds unsecured business debts (as capital assets) and accepts partial payment in complete satisfaction of the debt. How should the lender treat the unpaid balance? Under a Section 166 construct, one can argue that the debt extinguishment should be viewed as two distinct events: a dollar-for-dollar partial satisfaction of the debt followed by forgiveness of the remaining balance on the basis of worthlessness. This approach is easier to rationalize for recourse debts where the creditor still has a legal claim against the debtor for any deficiency. Whether debt is secured or unsecured, any uncollected balance would need to meet the requirements of Section 166 for an ordinary bad debt deduction. Under Section 1271(a)(1), however, the transaction would likely be viewed as an integrated transaction whereby the debt was sold or exchanged for partial payment. The character of loss attributable to the unpaid amount would depend on the asset’s character in the hands of the lender.

The Judicial Perspectives

The dearth of case law addressing the interplay of Sections 166 and 1271(a)(1) further clouds any tax analysis. The Supreme Court addressed the issue in 1941 in McClain v. Commissioner,5where the taxpayer surrendered debt instruments held as capital assets for less than full payment. The Court held that the settlements constituted retirements within the meaning of Section 117(f), the predecessor to Section 1271(a)(1). As a result, the ordinary loss deductions claimed were ultimately disallowed. The Court held “it is plain that Congress intended … to take out of the bad debt provision certain transactions and to place them in the category of capital gains and losses.”6 This holding was particularly disturbing for the taxpayer, who received a consideration of five dollars for each $1,000 debenture. The taxpayer argued that had he simply refused the consideration offered as part of the bankruptcy reorganization plan, the entire amount could have been charged off as a bad debt. The Court was not moved by this argument and simply opined that the statute must be applied as it is stated, leaving to Congress the responsibility to correct any inconsistencies and inequalities in the statutes.

More recently in 2011, the negotiated debt settlement issue was addressed in Dagres v. Commissioner7. In this case, the Tax Court held that a venture capitalist was permitted an ordinary bad debt deduction when debt was settled for less than its principal. The Service challenged the ordinary deduction on the basis that the debt was a nonbusiness debt (which would give rise to a capital loss), but did not raise Section 1271(a)(1). As a result, neither the court nor the government cited McClain. Even though the court held that the debt was a business debt, there were no facts indicating that the taxpayer was in the trade or business of lending or that the debt instrument was held as an ordinary asset.

When examining these two cases, we are left to infer their implications to resolve the overlap issue. Many believe that the McClain decision stands for the position that Section 1271(a)(1) trumps Section 166 in the case where a debt obligation is extinguished for less than full consideration. Meanwhile, it remains curious why the McClain decision has not been cited by a federal tax case (including Dagres) or IRS administrative pronouncement for over 30 years. Could this reflect a pivot by the government or an interpretation blunder that led to an oversight?

The Service’s Perspective

The Service has provided some level of guidance over the interplay of Sections 1271(a)(1) and 166, but the overlap issue is not addressed head on. As highlighted below, there are instances where one rule trumps the other, and vice versa, without robust explanations to reconcile the different outcomes.

Rev. Rul. 80-56:8 A REIT in the business of lending acquired collateral through a foreclosure process. The Service stated that the REIT was entitled to a bad debt deduction for the excess of the basis over the bid price of the property. The Service further stated that if the REIT had not been in the lending business (such that its loans were capital assets), a bad debt deduction would still be proper since the taxpayer acquired the collateral property through a foreclosure sale. Interestingly, the Service applied Reg. Sec. 1.166-6(b) (governing the sale or pledge of collateral property for less than the debt amount) to both situations, thereby sanctioning a bad debt deduction for a loss related to a capital asset. There is no mention of retirement in the analysis.

Rev. Rul. 80-57:9 A REIT in the business of lending accepted a deed in lieu of foreclosure as partial payment and extinguishment of a debt. Citing McClain, the Service stated that the transaction constituted a retirement that created an ordinary loss. The Service further stated that if the debt had been a capital asset, a capital loss would have resulted.

Rev. Rul. 2003-125:10 A parent company “may be” entitled to a bad debt deduction for debt owed by its insolvent liquidating subsidiary where the fair market value of the subsidiary’s assets are less than the parent’s basis in the debt. The prevailing logic from the Service’s prior rulings dealing with deed in lieu of foreclosure transactions and the holding in McClain would seem to support retirement treatment, so this conclusion is not easily reconciled.

The few examples above illustrate the elusive pattern that the Service has created for taxpayers to follow. For those that are uncomfortable operating within the "gray," there is a strategy worth considering.

The Silver Lining — Partial Worthlessness

The occasional lender’s route to an ordinary bad debt deduction may best be achieved prior to any future retirement event by availing itself of the partial worthlessness rules. This strategy typically requires a bit of planning, awareness of the performance of the debt, and visibility into how the debt is being accounted for on the books and records. In general, the lender should be allowed an ordinary bad debt deduction if it “charges off” some a portion of the debt and can demonstrate the extent to which the debt was partially worthless. There is little guidance on what constitutes a valid charge-off for this purpose, but this can actually work to a taxpayer’s favor. The courts have historically applied this requirement liberally by allowing mere “notations” in sub-ledgers or other “shadow” accounting systems as long as such notation is with respect to a specific debt. Unlike for wholly worthless debts, the charge-off does not have to be the same year that the partial worthless determination is made. However, care must be taken to distance the charge-off from any debt extinguishment event to mitigate the risk of being rolled together and treated as part of an integrated retirement transaction.

What Does This Mean for Me?

In light of the unresolved conflicts we have addressed, the tax professional is left with the challenging task of getting it “right,” whether for financial statement reporting of taxes, tax return reporting, strategic planning or managing the organization’s tax risk. This article is not intended to interpret, speculate or suggest changes to resolving the problem, but rather to promote awareness of the issue and pose questions that could be relevant to those finding themselves in the middle of it all:

• How do I get comfortable that the character of the loss is properly reflected on my tax returns, given conflicts within the statute?
• How do I resolve these conflicts when identifying and measuring uncertain tax positions for financial reporting purposes?
• How do I stay aware of the performance of specific loans and potential debt settlements to strategically avoid unwanted character consequences?
• If ordinary loss treatment is desired, does my organization have the necessary processes and procedures in place to properly support a partial worthlessness position? If no, what types of changes should be adopted to secure ordinary loss treatment?
• How do I influence my accounting department to partially charge-off specific debts before the debt has been retired or settled?
• If capital loss treatment is desired in a particular instance (e.g., as the result of a capital gain that resides within the three-year carryback period applicable to C corporations), how should the process be managed to achieve this result?

Alvarez & Marsal Taxand Says:

The conflict within the statute has been with us for some time, and questions remain as to the direction the Service is heading. If your organization is an occasional lender with distressed debt, the best bet to mitigate risk of capital loss characterization is to be proactive and rely on partial worthlessness provisions, keeping in mind the need for sufficient temporal difference between the partial charge-off and the retirement. As the old idiom goes, “the best defense is a good offense.” Educate your team about potential missteps, their adverse consequences and the need to keep the tax department informed of impending losses. Lastly, do not minimize the importance of documentation. Even the best planned write-offs may be susceptible to challenge if they are not properly memorialized.