Editor: Kevin D. Anderson, CPA, J.D.
Sec. 165(a) generally permits an income tax deduction for any loss sustained during the tax year for which a taxpayer does not receive compensation in the form of insurance proceeds or other reimbursement. The loss may be ordinary or capital, depending on the circumstances. The regulations provide that in order to be allowable as a deduction, a loss must be evidenced by a closed and completed transaction, fixed by identifiable events, and actually sustained during the tax year (Regs. Sec. 1.165-1(b)).
In order to satisfy these requirements, a taxpayer must generally walk away from or abandon the property. Alternatively, a taxpayer can pursue a loss deduction under Sec. 165(a) for worthlessness. In a recent Tax Court case, MCM Investment Management LLC, T.C. Memo. 2019-158, the taxpayer successfully proved it was entitled to a Sec. 165(a) loss deduction for worthlessness of a partnership interest. This case provides a road map for establishing the legal requirements needed to sustain a deduction for worthlessness, and reinforces the position that actual abandonment of a partnership interest is not required to claim a loss under Sec. 165(a).
The IRS had historically taken the position that a worthlessness deduction was not allowed without abandonment of the underlying partnership interest. Premised on the idea that only worthless securities would qualify for such a deduction, this position ran contrary to some prior court decisions (see, e.g., Zeeman, 275 F. Supp. 235 (S.D.N.Y. 1967), aff'd in part and remanded in part on other issues, 395 F.2d 861 (2d Cir. 1968); Tejon Ranch Co., T.C. Memo. 1985-207; and In re Kreidle, 146 B.R. 464 (Bankr. D. Colo. 1991)).
Eventually, this issue was addressed in Echols, 935 F.2d 703 (5th Cir. 1991), where the Fifth Circuit rejected the IRS's position and reversed the Tax Court. The appeals court held that a married couple who owned an interest in a real estate partnership could take a loss deduction under Sec. 165(a) on grounds of worthlessness, even if the partnership's sole asset (an unimproved tract of land) was not abandoned.
In arriving at this conclusion, the court emphasized that the determination of worthlessness is based on a mix of objective and subjective criteria. If a property, objectively, has substantial value, it obviously cannot be treated as worthless for tax loss purposes. The subjective component relates to the important question of when a property becomes worthless. A taxpayer is entitled to exercise judgment and discretion in determining when an asset has become worthless to him or her, even if someone else might have considered the asset in question virtually valueless in a prior year or might have been willing to gamble that the value could be restored in a future year. The taxpayer's subjective determination of worthlessness must be accompanied by a reasonable showing that the asset was in fact essentially valueless at the time selected by the taxpayer, as confirmed by objective evidence.
While the IRS did not acquiesce to Echols (1993 FSA Lexis 353 (Aug. 31, 1993)), a few months later Rev. Rul. 93-80 was issued. In this ruling, the IRS addressed whether a loss incurred in connection with the abandonment or worthlessness of a partnership interest would generate an ordinary or capital loss. While the determination of character is significant, an interesting aspect of this ruling is that the IRS appeared to conclude that a worthlessness deduction may be available without an actual abandonment of the underlying partnership interest. Given the Service's nonacquiescence in Echols, this revenue ruling raised questions as to the position the IRS would take in future cases claiming Sec. 165(a) deductions for worthless but not abandoned partnership interests.
MCM Investment Management LLC
The facts of the 2019 Tax Court case involved an upper-tier partnership, MCM Investment Management LLC (MCMIM), that had a controlling interest in a lower-tier partnership, McMillin Companies LLC (Companies). Companies was in the business of home building and remodeling. When the subprime mortgage crisis began in 2007 and home values declined, Companies' business went severely "underwater." By tax year 2009, the year at issue, Companies' cash flow forecasts showed that an orderly winding down of the business over five years would produce more available cash to pay off the remaining senior debt of $70 million, but, unfortunately, leave nothing to pay the preferred interest holders or other owners of Companies upon liquidation.
Because of the decision in 2009 to begin liquidating Companies and the forecasts showing that the owners would not receive any value for their ownership interest once the liquidation was complete, MCMIM filed its 2009 partnership return reflecting a loss deduction of approximately $41 million, based on the interest in Companies having become worthless during the year.
The taxpayer and the IRS agreed that the character of the disputed loss would be ordinary (although no mention of liability relief was discussed). The issue for the court to decide was whether the taxpayer met all the requirements for claiming the Sec. 165(a) deduction for 2009. Because MCMIM did not abandon its partnership interest in Companies, the court determined whether the taxpayer was entitled to a deduction because the interest became worthless in 2009
Subjective determination of worthlessness
Applying the two-part test from Echols, the court analyzed whether MCMIM subjectively believed its partnership interest in Companies was worthless in 2009. The court found that MCMIM did subjectively believe the interest was worthless for two reasons. First, the court found that MCMIM's belief that the interest was worthless was indicated by its filing of a 2009 partnership return claiming a loss deduction for worthlessness.
Second, the owners and management of MCMIM credibly testified they believed the interest was worthless in 2009 based on the devastating impact the financial crisis was having on the real estate market. Furthermore, Companies' cash flow projections showed its inability to pay the senior lender in full or to have any assets remaining for the owners and its decision to gradually wind down Companies over a period of years was only made to maximize available cash to pay the creditor.
Objective determination of worthlessness
The court then analyzed whether the objective evidence confirmed the taxpayer's subjective determination that the partnership interest was worthless in 2009. In determining if the objective test was met, the court relied, by analogy, on the principles for determining the objective worthlessness of corporate stock, as set forth in Morton, 38 B.T.A. 1270, 1278-1279 (1938), aff'd, 112 F.2d 320 (7th Cir. 1940):
The ultimate value of stock, and conversely its worthlessness, will depend not only on its current liquidating value, but also on what value it may acquire in the future through the foreseeable operations of the corporation. Both factors of value must be wiped out before we can definitely fix the loss. If the assets of the corporation exceed its liabilities, the stock has a liquidating value. If its assets are less than its liabilities but there is a reasonable hope and expectation that the assets will exceed the liabilities of the corporation in the future, its stock, while having no liquidating value, has a potential value and cannot be said to be worthless. The loss of potential value, if it exists, can be established ordinarily with satisfaction only by some "identifiable event" in the corporation's life which puts an end to such hope and expectation.
There are, however, exceptional cases where the liabilities of a corporation are so greatly in excess of its assets and the nature of its assets and business is such that there is no reasonable hope and expectation that a continuation of the business will result in any profit to its stockholders. In such cases the stock, obviously, has no liquidating value, and since the limits of the corporation's future are fixed, the stock, likewise, can presently be said to have no potential value. Where both these factors are established, the occurrence in a later year of an "identifiable event" in the corporation's life, such as liquidation or receivership, will not, therefore, determine the worthlessness of the stock, for already "its value had become finally extinct."
In MCMIM's case, Companies was able to provide conservative projections based on market conditions that indicated an immediate liquidation of the assets would result in the senior creditor's receiving only 40% of its loan balance with nothing remaining to pay the preferred interest holder, or MCMIM. The court noted that balance sheet insolvency at the entity level was not necessarily required when preferred equity interests (such as preferred stock or preferred partner interests) are involved. A subordinate equity interest may become worthless if the company cannot satisfy a preferred equity interest holder's preferential claim in liquidation (Mahler, 119 F.2d 869 (2d Cir. 1941)). The court concluded that the combination of Companies' debt and the effects of the financial crisis and recession relating to the real estate market established the absence of liquidating value, both currently and in the foreseeable future.
Facts and circumstances guide the outcome
MCMIM was successful in claiming a loss deduction as a result of the severe decline in the real estate market combined with Companies' contemporaneous documentation of worthlessness in the form of projections and forecasts. It was the lack of liquidating value of the preferred and nonpreferred interests, along with the absence of future value, that led the court to conclude that the subjective and objective factors needed to sustain a worthlessness deduction were met.
This case provides excellent guidance for taxpayers seeking to claim a deduction for worthlessness. Further, in the context of a partnership interest, the decision again reinforces the notion that abandonment of the underlying partnership interest is not a prerequisite for claiming a worthlessness deduction under Sec. 165(a). It is always important to carefully analyze the facts and circumstances to ensure the appropriate criteria are matched with the respective method of claiming a Sec. 165 loss deduction.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.