Taxpayer Cannot Attribute Loan Servicing Activities Performed by Subsidiary in Mortgage-Backed Securities Transaction to Use Mark to Market Accounting

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By David I. Kempler, Esq., Elizabeth Carrott Minnigh, Esq., Christine Bowers, Esq.

Buchanan Ingersoll & Rooney PC, Washington, D.C.

In CCA 201423019, the IRS Chief Counsel's Office advised that a
holding company with a majority ownership interest in a partnership
that originated and purchased mortgage loans was not a dealer under
§475, even though the partnership was a dealer.  The Chief
Counsel's Office concluded that, although the partnership was a
flow-through entity, it was not a disregarded entity, so none of
its activities were attributable to its majority owner.

Section 475(a) requires a dealer in securities to use a mark to
market method of accounting for any securities it holds. Under the
mark to market method as set forth in §475(a)(2), any securities
not held as inventory as of the end of the year are treated as sold
at their fair market value on the last business day of the year,
and any gain or loss is recognized. Section 475(c)(1) defines a
dealer in securities as a taxpayer who regularly purchases
securities from or sells securities to customers in the ordinary
course of a trade or business, or regularly offers to enter into,
assumes, offsets, assigns or otherwise terminates positions in
securities with customers in the ordinary course of a trade or
business. Under §475(c)(2)(C) and §475(c)(1)(A), a mortgage loan is
considered to be a security for purposes of the mark to market
rules, and purchasing securities includes originating mortgage
loans for this purpose. Section 475 does not define the term
"customer" for purposes of the dealer-customer relationship that is
necessary to be a dealer in securities, and Reg.
§1.475(c)-1(a)(2)(ii) provides that the determination of whether a
taxpayer is transacting business with a customer is based upon all
the facts and circumstances. In order to elect under §475(f) to use
the mark to market method of accounting, Rev. Proc. 99-49, 1999-2
C.B. 725 provides that a taxpayer must file a statement with its
federal income tax return for the taxable year immediately
preceding the election year.

Taxpayer was a holding company that held interests in a
partnership (the "Partnership") and other operating companies. The
Partnership was engaged in the business of originating and
purchasing mortgage loans on the open market and also participated
in mortgage-backed securitization transactions. In general terms,
the Partnership contributed mortgage loans to Delaware statutory
trusts that it had established (the "Trusts"), and the Trusts
issued notes to third party investors as mortgage-backed
securities.  The Partnership retained "Residual Equity
Interests" in the securitization transactions, and used a mark to
market method under §475 for its securities. The Partnership did
not use the mark to market method for a certain percent of mortgage
loans it continued to hold for investment.

In connection with the securitization transactions, the parties
entered into servicing agreements. Pursuant to a "Master Servicer
Agreement," a bank agreed to act as the "Master Servicer" and
supervise the servicing of the mortgage loans on behalf of the
Trusts. The Trusts also entered into another servicing agreement
with another bank to act as the "Servicer" and perform certain loan
servicing functions on behalf of the holders of the notes and
residual interests. Servicer then subcontracted with a
"Subservicer" to collect principal and interest payments for the
mortgage loans, monitor property taxes and insurance and foreclose
on securing properties, but Subservicer generally could not modify
the terms of the loans except in situations to avoid imminent
default.  These agreements specifically provided that the
Master Servicer, the Servicer and Subservicer were to act as
independent contractors.

Subservicer originally was a limited liability company and a
wholly owned disregarded entity of the Partnership.  The
Partnership contributed its interest in Subservicer to another
partnership ("Partnership Z") in exchange for an ownership interest
in Partnership Z and then transferred that interest to
Taxpayer.  As a result, Taxpayer directly owned a majority
interest in Partnership Z, which owned Subservicer as a disregarded
entity, and unrelated investors owned the remaining interests in
Partnership Z.

On the same date that the Partnership transferred its interest
in Subservicer to Taxpayer, Partnership also sold its Residual
Equity Interests in the Trust to Taxpayer. For tax purposes, the
parties treated the transaction as the sale of the mortgage loans
underlying the Trusts and an assumption by Taxpayer of the
nonrecourse liability associated with the Notes. In calculating its
basis in the mortgage loans, Taxpayer increased its basis by the
value of the mortgage loans on the sale date plus the amount of the
excess liabilities and cash paid by it to Partnership X.

In a subsequent tax year, Subservicer engaged in significant and
loan workout activity. Taxpayer claimed that as a result of this
loan workout activity, certain loans were significantly modified to
the extent that taxable exchanges occurred. Taxpayer recognized
gain on the modifications and then took the position that it was
entitled to mark to market all of the mortgage loans held at the
end of the year, which allowed it to claim a loss on its tax
return.  Taxpayer argued that Subservicer's involvement in
making the significant loan modifications to certain of the
mortgage loans held by the Trusts resulted in new loans and
constituted dealer activity for Subservicer.  Taxpayer further
argued that because it held the Residual Equity Interests in the
Trusts, Subservicer's dealer activities were attributable to
Taxpayer, allowing it to mark to market the mortgage loans and
claim a loss.

The Chief Counsel's Office stated that in order for Taxpayer's
position to be correct under the mark to market rules, Taxpayer
must be treated as making loans to customers and be regularly
engaged in the trade or business of making loans, and the
modifications must have been within its ordinary course of
business. According to the Chief Counsel's Office, this meant that
the loan modifications made by Subservicer must have risen to the
level of dealer activity and be attributable to Taxpayer.

Firstly, the Chief Counsel's Office concluded that Partnership's
dealer status was not attributable to Taxpayer because Taxpayer did
not obtain the Residual Equity Interests in Trusts until after all
of the mortgage loans had already been originated by the
Partnership; further, the mortgage loans collateralizing the notes
were with customers of Partnership and not Taxpayer's. Taxpayer's
ownership of an interest in Partnership caused the character of
gains and losses of the Partnership to flow through to Taxpayer but
Partnership's dealer activities did not.

Secondly, the Chief Counsel's Office concluded that
Subservicer's loan modification activities were not attributable to
Taxpayer. In reaching its conclusion, the Chief Counsel's Office
reasoned that because Subservicer was a disregarded entity of
Partnership Z and not of Taxpayer, and because Partnership Z was
not a disregarded entity, the activities of Subservicer could not
be attributable to Taxpayer, despite Taxpayer's majority ownership
interest in Partnership Z.

Thirdly, the Chief Counsel's Office concluded that Subservicer's
activities did not meet dealer requirements. The Chief Counsel's
Office identified three issues: whether the loan modifications
should be considered as originating loans for purposes of §475,
whether Subservicer had customers in the loan modification
transactions (or whether the mortgage loan holders were customers
of the Partnership), and whether the loan modification activity
regularly occurred in the ordinary course of Subservicer's trade or
business. As for the first issue, the Chief Counsel's Office
acknowledged that although some of the loan modifications may have
been an exchange of debt for debt under §1001, the IRS could argue
that Subservicer did not originate new loans for §475 purposes. The
Chief Counsel's Office noted that Subservicer's activities showed
that it was in the business of servicing the loans, and although it
could make loan modifications to stop default proceedings, whether
it regularly engaged in loan modifications in the ordinary course
of its trade or business of servicing loans was questionable.
According to the Chief Counsel's Office, the fact that Subservicer
may occasionally engage in some loan modifications did not make it
a mortgage loan originator. As for the second issue, the Chief
Counsel's Office concluded that the debtors likely remained
customers of the Partnership, and not Subservicer, on the basis
that Subservicer's purpose for the mortgage loan modifications was
to preserve the collateral for the notes issued by the Trust, and
Taxpayer's investment in the loans, rather than to sell, purchase,
or make loans to customers.

Fourthly, the Chief Counsel's Office concluded that Subservicer
was not acting as Taxpayer's agent. Applying the agency factors in
National Carbide v. Commissioner, 336 U.S. 422 (1943), and
Commissioner v. Bollinger, 485 U.S. 340 (1988), to the
facts, the Chief Counsel's Office reasoned that the following facts
supported its conclusion: Subservicer did not operate in the name
of or for the account of Taxpayer; Subservicer was only entitled to
act as agent for Trusts in perfecting foreclosure claims but was
named as an independent contractor for all other purposes;
Subservicer never transmitted money received to Taxpayer;
Subservicer's compensation was not attributed to Taxpayer's
employees or assets, as Taxpayer did not hold legal title to any
part of the mortgage loans; Subservicer Agreement specifically
provided that Subservicer was to perform servicing functions as an
independent contractor.

Finally, the Chief Counsel's Office stated that in order to use
the mark-to-market method, Taxpayer had to have filed an election
statement with its prior year's tax return. Taxpayer failed to do
so, and the Chief Counsel's Office noted that the courts have
consistently upheld that IRS's position to disallow late
elections.  Thus, the Chief Counsel's Office advised that
Taxpayer was not entitled to use the mark to market accounting

This CCA highlights the importance of making a timely election
under §475(f), because, under Rev. Proc. 99-17, the taxpayer cannot
file a late or retroactive election. Moreover, the CCA highlights
that the specific ownership structure and specific terms of the
inter-party agreements will be closely scrutinized where a taxpayer
seeks attribution.

For more information, in the Tax Management Portfolios, see
Connors, 543 T.M.
, The Mark-to-Market Rules of Section 475,
 and in Tax Practice Series, see ¶1810, Transactions in
Stock, Securities, and Other Financial Instruments.