2015-Issue 8—In a previous article, we discussed the ability to claim an ordinary loss on the abandonment of a partnership interest or upon the worthlessness of the partnership interest (see Tax Advisor Weekly 2014-7). Remember, we discussed that the worthlessness deduction under Section 165 should give rise to an ordinary loss without regard to the fact that the partner bears the economic risk of loss for certain partnership liabilities. We also discussed that a worthlessness event should not be treated as a lapse or termination of rights such that Section 1234A would apply to make the loss capital. The hanging issue at that time was the Tax Court’s decision inPilgrim’s Pride holding that a taxpayer’s abandonment of securities was a lapse or termination of rights under Section 1234A. The Tax Court’s decision in Pilgrim’s Pride seemed to stretch the intent and application of Section 1234A, providing the IRS with another attack on ordinary losses with respect to capital assets.
Pilgrim’s Pride Refresher
In Pilgrim’s Pride, the taxpayer had acquired securities, and rather than sell them later at a steep loss, which would have resulted in a capital loss, the taxpayer instead abandoned the securities and claimed an ordinary loss under Section 165. Upon audit, the IRS issued a notice of deficiency asserting that the loss claimed was capital even if the abandonment was effective. The IRS did not rely on Section 1234A in making its argument. The Tax Court ordered both parties to file supplemental briefs addressing whether Section 1234A(1) would apply to the abandonment. Without surprise, the IRS argued that Section 1234A applied and rendered the abandonment a deemed sale or exchange of a capital asset subject to capital loss treatment. The Tax Court agreed, and Pilgrim filed a motion for reconsideration and then, ultimately, an appeal to the Fifth Circuit leading to this decision.
The Fifth Circuit Considers the Issue
The Fifth Circuit noted that in order to have a capital loss, there must be an actual sale or exchange or a deemed sale or exchange of a capital asset. In an abandonment of a security, there is no consideration generally for the abandonment (deemed consideration can come from relief of liabilities pursuant to a Section 752 analysis or under general Kirby Lumber principles). Abandonment is generally a unilateral action taken without receiving consideration. The court then noted that the Internal Revenue Code has various provisions that direct certain transactions to be treated as if they were sales or exchanges. Section 1234A is one of those provisions that requires capital loss treatment for any loss “attributable to the cancellation, lapse, expiration, or other termination of — (1) a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer” (I.R.C. Section 1234A(1)). The Fifth Circuit reiterated that Section 1234A was designed to curb an abuse relating to the early termination of derivative contracts that are out-of-the-money. Taxpayers were terminating loss derivative contracts prior to maturity and taking the position that the loss was ordinary because the contract did not mature and there was no deemed exchange of property under the derivative contract. (See S. Rep. No. 97-144, at 171 (1981).)
The primary question for the Court in this case was whether Section 1234A(1) applies to a taxpayer’s abandonment of a capital asset. The Fifth Circuit answered “no.” The Court held that Section 1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g., derivative or contractual rights to buy or sell capital assets). It does not apply to the termination of ownership of the capital asset itself.
The Court also entertained an interesting argument from the IRS that the Court dismissed based on grounds of statutory construction and giving plain meaning to the words chosen by Congress in writing tax laws. The Court refused to find that a termination in rights to a capital asset occurs under Section 1234A upon the abandonment of the asset itself. The Court noted that it “cannot ascribe to Congress ‘an extravagant preference for the opaque’” in relation to the argument requiring the Court to interpret the statute in a convoluted manner. Had Congress intended Section 1234A to apply to a taxpayer’s abandonment of a capital asset, it would have drafted the statute to say so explicitly.
The Fifth Circuit has continued to get it right in allowing ordinary losses for abandonment and worthlessness with respect to capital assets under the Code and Treasury Regulations. Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991) — allowing an ordinary loss for abandonment of a partnership interest where there was no economic risk of loss for partnership liabilities — continues as precedent and was even the basis for Rev. Rul. 93-80, in which the IRS held that a taxpayer can take an ordinary loss for the abandonment of a partnership interest even if the partnership interest is a capital asset. The Fifth Circuit also got it right in Pilgrim’s Pride. Section 1234A was not intended to apply to an abandonment of a capital asset, nor was it intended to apply to a determination of worthlessness. We might have to wait for another case on that point, however.
Alvarez & Marsal Taxand Says:
In spite of the attack by the IRS on claiming ordinary losses for capital assets that are abandoned or determined to be worthless, taxpayers with the stomach to fight continue to win. It is not appropriate to assume that capital assets produce capital losses. Under the right set of circumstances, taxpayers can claim ordinary losses on the abandonment or worthlessness of a capital asset.
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