Although the Tax Code is not overly complex in its approach to deductible losses, careful planning is a must to maximize their effect on a business return. The basic rule of thumb in structuring transactions that might lead to a loss is that ordinary losses are good, while capital losses are not so good. 

“You’re better off from a deduction standpoint to have an ordinary loss where you can offset ordinary income than to have a capital loss that has limits on what can be claimed, particularly if it’s the only loss you have for that year,” said Roger Harris, president of Padgett Business Services.

“There are all types of transactions that can be one or the other,” he said. “For corporations, the current-year deduction for a capital loss is allowed only to the extent of capital gain, with the possibility of carrybacks and carryforwards, while ordinary losses have a better chance of being fully deducted in the year that they are incurred.”

“In C corporations, once you get to zero you have eliminated the loss for that year, but ordinary losses can be carried forward or carried back. In a pass-through, the ordinary loss can be used to offset salary or other business income. So in an S corporation or another pass-through, the ordinary loss can be carried over to the personal return and used to offset any other ordinary income, whereas a capital loss is limited to $3,000,” he continued. “Capital gains have limited deductibility and can only be deducted against other capital gains, whereas ordinary income has greater opportunities to be deducted currently and can be claimed against more types of income. In a perfect world, you want capital gains and ordinary losses. Of course, there are rules, and you don’t get to pick.”

 

DESIRABLE TREATMENTS

Nevertheless, in the case of bad assets, there are things you can do to help your client get an ordinary loss, according to Brett Beveridge, CPA, special counsel in the Atlanta office of Chamberlain Hrdlicka.

Beveridge cited the Madoff case and Santa Fe Pacific Gold as two examples where the desirable ordinary loss treatment was not a given. “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’s was a theft loss,” he said.

In Santa Fe, the taxpayer paid a $65 million termination fee. “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,” said Beveridge.

“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. Each one is different, even though the IRS had the tendency to collapse abandonment into worthlessness and treat them as one. They provide three alternative ways to claim a loss, and better yet, a loss which should be considered ordinary and fully deductible.”

“Don’t limit your alternatives,” Beveridge advised. “Rather, consider all legal theories that support a loss and see if your loss can be covered by more than one.”

A loss is only allowed in the tax year in which it is incurred, he observed. “Therefore, it is critically important to deduct a loss in the right year. Otherwise, the IRS may come along years later and assert that a loss was incurred in an earlier period that may be closed by the statute of limitations. To avoid having a loss that may be permanently disallowed, taxpayers should deduct any loss in the earliest year possible.”

Substance, and not mere form, determines whether there has been a bona fide loss, Beveridge noted. “Only real economic losses are permitted. This rule is often thought of as imposing a limitation. But it can also be viewed as favorable,” he said. “For example, a personal loss is nondeductible. But, what if it could be treated as a theft loss?” Under Code Section 165, individuals’ losses must have arisen from a trade or business, a transaction entered into for profit, or from a casualty or theft.

 

THE CHEVRON INCIDENT

Beveridge cited Pennzoil’s use of Section 1033 for the reinvestment of their $3 billion settlement payment from Texaco as an example of a taxpayer using a planning perspective with regard to a past loss transaction.

In 1984, Pennzoil had an oral contract to buy 43 percent of Getty Oil, but was blindsided at the last minute by a better offer from Texaco. Pennzoil sued, and was awarded a $10.5 billion judgment which they later settled for $3 billion when Texaco filed for bankruptcy. Pennzoil used the proceeds from the settlement to buy Chevron stock. “Pennzoil took the position that this was part of a tax-free reinvestment under Section 1033,” said Beveridge. “The apparent argument was that Pennzoil had a property interest in Getty Oil that was involuntarily converted by theft and that a reinvestment of the proceeds into Chevron stock would be tax-free. Pennzoil later settled with the IRS by paying $454 million after the IRS had originally asserted $906 million in back taxes and interest.”

An abandonment loss has two requirements — an intent to abandon, and an affirmative act of abandonment, Beveridge indicated. “There is no requirement for a taxpayer to relinquish title in order to establish a loss if such loss is reasonably certain in fact and ascertainable in amount,” he said. “This rule is intended to keep taxpayers from selecting the loss year they prefer.”

As to the second requirement, taxpayers will find it easier to show affirmative acts of abandonment for tangible property, he observed. “Tangible property can be moved, or returned, or thrown away. Intangible property presents different challenges as it cannot be easily thrown away or scrapped.”

An abandonment loss is generally ordinary, unless there is a sale or exchange involved. “While the general rule is that an abandonment loss is ordinary, special rules apply if the property is subject to debt because the taxpayer can be treated as having received something in exchange for the property. If there is recourse debt, sale or exchange treatment will generally not occur until the liability is lost through foreclosure or abandoned,” Beveridge said.

 

APPROACHING RETIREMENT

An asset can be permanently retired, which is defined as the permanent withdrawal of depreciable property from the trade or business or production of income. Mere non-use of property is not a permanent retirement.

“Unlike an abandonment or worthlessness loss in which the loss is equal to the remaining tax basis, in a permanent retirement the amount of the loss is equal to the asset’s adjusted basis less any salvage value or fair market value. The use of salvage value implies that there can be some residual value and that the asset may even be held out for sale for a nominal value,” he said.

Worthlessness is a mix of objective and subjective tests, according to Beveridge. “In testing worthlessness, the Fifth Circuit has stated that, ‘We must determine subjectively just when it was that the taxpayers deemed their partnership worthless, then determine objectively whether that interest was valueless at such time.’ Property does not have to be abandoned in order to be worthless, and there is no requirement for loss of title.”

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, the taxpayer claimed that the properties owned 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.?“Abandonment, permanent retirement, and worthlessness are three separate theories,” Beveridge summed up. “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.”

“Although taxpayers should take a loss in the earliest year possible, they should develop alternative positions for later years,” Beveridge 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.” 

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