Loss deductions for abandonment of intangible assets

Editor: Mark G. Cook, CPA, CGMA

Sec. 165(a) provides that a taxpayer is allowed a deduction for any loss the taxpayer sustained during the tax year if the loss is not compensated for by insurance or otherwise. Abandonment losses, which are not explicitly mentioned in Sec. 165, are realized losses that occur when a taxpayer deliberately gives up possession and ownership and discontinues his or her use of property, without transferring title of the property to another person or entity.

There is no shortage of Tax Court cases dealing with the issues surrounding the deductibility of abandonment losses. Numerous examples include Massey-Ferguson, Inc., 59 T.C. 220 (1972); CRST, Inc., 92 T.C. 1249 (1989); Buda, T.C. Memo. 1999-132; Citron, 97 T.C. 200 (1991); JHK Enterprises, Inc., T.C. Memo. 2003-79; and Milton, T.C. Memo. 2009-246. The deductibility of an abandonment loss in excess of $30 million was a central issue in a more recent case, Greenberg, T.C. Memo. 2018-74.

Greenberg

In 1997, David Greenberg, a tax accountant, and William Goddard, an attorney, formed a partnership called GG Capital. The taxpayers claimed that GG Capital was in the business of engaging in digital-option spread investments in foreign currencies for themselves and their clients. Not many facts were presented to support this claim. Over the course of the tax years in question, 1997, 1999, 2000, and 2001, the taxpayers were able to bring about millions of dollars in tax savings for themselves and their clients through their investments in the complex option spreads. The taxpayers claimed the business model of GG Capital was completely unrelated to creating tax losses.

Another facet of the case involved the fact that the taxpayers were shifting income into GG Capital from their day jobs as a tax accountant and an attorney. The IRS found that this practice was an attempt by the taxpayers to offset ordinary income from their day jobs with fabricated losses in GG Capital. While several other issues were presented in the case, one major issue involved the deductibility of an abandonment loss claimed by GG Capital on its 2000 tax return.

According to the taxpayers, in 1997 GG Capital acquired a 20% interest in a company called DBI Acquisitions II (DBI) and was assigned a capital account of $4 million. Then, through a series of complex and lengthy transactions involving several parties, the taxpayers claimed that GG Capital’s basis in DBI increased to roughly $34 million by 1998. No documentation supported the taxpayers’ claims for the step-up in basis by means of the various transactions.

The taxpayers went on to claim a $3.2 million loss on GG Capital’s California tax return for the year 2000, contending that this loss resulted from the abandonment of GG Capital’s interest in DBI. The loss was not separately stated on GG Capital’s federal tax return, and it was not clear where the abandonment loss was reported, but the IRS believed that the taxpayers camouflaged the abandonment loss on the federal return by including it within a $15.85 million Sec. 988 loss that was reported. The taxpayers argued that the actual abandonment loss they were entitled to was $34 million, which represented GG Capital’s adjusted basis in DBI immediately before GG Capital’s abandonment of its interest in DBI.

The IRS focused on the taxpayers’ lack of documentation to support the actual abandonment of property and to substantiate GG Capital’s reported $34 million basis in DBI. Although the Tax Court ultimately sided with the IRS and disallowed the loss due to lack of documentation, reference was made to the three-prong test for abandonment losses on intangible assets.

Three-prong test

For a taxpayer to claim a deduction for the abandonment of property, particularly intangible assets such as partnership interests, the taxpayer must prove:

• Ownership of the property prior to abandonment;
• An intent to abandon the property; and
• Affirmative action to abandon the property.

These conditions have been referred to in numerous Tax Court cases, including those mentioned near the beginning of this item. In the case of a partnership interest, it is typically wise to retain copies of the partnership agreement from the time the taxpayer became a partner in the partnership. Schedules K-1 issued to the taxpayer by the partnership should also be kept. In addition, it may be prudent to retain purchase agreements and other legal documentation from the time the taxpayer became a partner in the partnership. These types of documents may perhaps be the best form of evidence to support the taxpayer’s ownership of a partnership interest.

The second and third criteria are typically determined based on the facts and circumstances surrounding the abandonment and are often more difficult to prove. For the abandonment of tangible assets such as a partnership interest, “express manifestation” is required (Citron, 97 T.C. 200 (1991)). To prove intent, it may be prudent to document conversations the taxpayer has with his or her CPA, legal counsel, and the partnership at the time of abandonment. Dates of conversations, as well as the actual date at which the partnership interest was abandoned, should be maintained and well-documented. It may also be sensible to have a document the taxpayer signed that informs the partners in the partnership that the taxpayer has abandoned his or her interest in the partnership.

As the Tax Court has held, for a taxpayer to claim an abandonment loss deduction, particularly for the abandonment of intangible assets such as partnership interests, the taxpayer must show an intent to abandon the property and an act of abandonment on the taxpayer’s part (Massey-Ferguson, Inc., 59 T.C. 220, 225 (1972)). The burden of proof rests with the taxpayer to show entitlement to any claimed deduction. In addition, taxpayers should have detailed documentation regarding the amount claimed as a deduction for the abandonment of property. In the case of a partnership interest, basis schedules should be retained to support the taxpayer’s basis in his or her partnership interest.

It is evident that only after careful consideration and the collection of sufficient documentation should a taxpayer claim a deduction for an abandonment loss. Once a taxpayer has presented solid evidence for claiming a loss deduction for abandonment of property, the taxpayer and his or her tax practitioner will need to determine the appropriate treatment and reporting for the tax return.

Tax treatment of abandonment losses

According to IRS Publication 544, Sales and Other Dispositions of Assets, abandonment losses from business or investment property are generally deductible as ordinary losses, as long as the abandonment is not treated as a sale or exchange. Abandonment of property held for personal use is typically nondeductible. Special rules apply in the case of an abandonment of property that is secured by debt. The appropriate tax treatment depends on whether the taxpayer is personally liable for the debt (recourse) or not personally liable (nonrecourse). Since abandonment losses are generally treated as ordinary losses, the reporting is typically done on Part II, line 10, of Form 4797, Sales of Business Property. It is important to note that gains from abandonment of property are possible if the amount (if any) realized by the taxpayer is greater than the taxpayer’s adjusted basis in the property.

It is evident that careful consideration, planning, and thorough documentation should occur when claiming a deduction for an abandonment loss of property, particularly intangible property. Tangible property can be physically relinquished, but abandonment of intangible property should be established by detailed documentation. Documentation should be retained from the time of the taxpayer’s initial ownership of the property to the time of abandonment, at a minimum. Further, it is typically prudent to retain documentation and files to support items reported on the tax return until the statute of limitation has expired.

EditorNotes

Mark G. Cook, CPA, CGMA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.