[IMGCAP(1)]Nobody likes making a bad investment, or starting a business that loses money, but it happens.
Not all assets will increase in value. Sometimes investments depreciate and businesses go under. While ordinary losses associated with these events are stressful in themselves, not being able to deduct a loss for federal tax purposes can put a crippling strain on a taxpayer, according to Brett Beveridge, CPA, Esq., special counsel in the Atlanta office of Chamberlain Hrdlicka.
He cited the Madoff case and Santa Fe Pacific Gold as two examples where desirable ordinary loss treatment was not a routine matter.
“In general, a loss of an investment from an open market purchase due to fraudulent activity is treated as a capital loss,” he noted. “However, a theft loss is not a capital loss. The IRS, after public pressure, issued a favorable revenue ruling holding that a loss from a Ponzi scheme similar to Madoff was a theft loss.”
“In Santa Fe, the taxpayer paid a $65 million termination fee,” he said. “The IRS argued that the fee should be capitalized and not amortized. The Tax Court held that the fee was deductible under both Code sections 162 and 165.”
There are things you can do to help your client get an ordinary loss, Beveridge advised. “Don’t limit your alternatives,” he said. “Rather, consider all legal theories that support a loss and see if your loss can be covered by more than one.”
Abandonment, worthlessness and retirement are the three main ways to recover business losses, he indicated. “Although these alternatives are often considered very similar, they have different rules and requirements. They provide three alternative ways to claim a loss, and better yet, a loss which should be considered ordinary and fully deductible.”
“When you have a loss, try to fit it into one legal theory, but we recommend that you be creative,” he said. “Even though it happened in the past, think like an advocate, and consider all the facts and circumstances. Try to fit the theory into more than one loss category.”
Most are familiar with abandonment and worthlessness, he noted, but not permanent retirement. “Each one is different, even though the IRS has had the tendency to collapse abandonment into worthlessness and treat them as one,” he said.
A recent Tax Court memo illustrated the fact that a taxpayer’s loss for worthlessness on mortgaged property requires worthlessness of the taxpayer’s equity in the property.
In Tucker v. Commissioner, T.C. Memo 2015-185 (September 22, 2015), the taxpayer claimed that the properties held by his solely owned S corporation became worthless when it became impossible to develop them or pay off the debt on them due to the decline in the real estate market. The Tax Court disagreed.
“When a taxpayer’s real property is secured by a recourse obligation, the taxpayer is not entitled to a loss deduction until the year of the foreclosure sale, regardless of whether the taxpayer claims to have abandoned the property in a prior year or claims the property became worthless in a prior year,” the court stated.
“The loss must be evidenced by a closed and completed transaction and fixed by identifiable events,” Beveridge commented. However, he noted, it is not necessary to show there is literally no value. “A de minimis value is permissible,” he noted, citing the Fifth Circuit in its 1991 decision in Echols.
Beveridge recommends taking the loss in the earliest year possible. “But develop alternative positions for later years,” he cautioned. “File protective refund claims. If you wait, the IRS may argue the property was worthless in a year closed by the statute of limitations.”
“Abandonment, permanent retirement, and worthlessness are three separate theories,” he emphasized. “They are similar, but they have different criteria, and they give you more options. An asset need not be worthless to be abandoned; a worthless asset does not have to be abandoned; and an asset that is permanently retired need not be abandoned or worthless, nor must notice be given to outside parties.”
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