Losses at the Forefront - Recent Guidance Under Section 165

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Annette M. Ahlers, Esq.
Pepper Hamilton LLP, Washington, D.C.

It was inevitable that the guidance coming out of the IRS would begin to focus on addressing the numerous tax issues raised by business events resulting from the declining economy. Taxpayers are incurring significant losses by selling or disposing of worthless assets, and/or walking away from debts that they either cannot pay (as the debtor),1   or are informed that the obligation will not be paid (as the creditor). These events generate tax losses that generally may be considered for deduction under §165.2  This article provides a high-level overview of certain recent administrative rulings across disparate factual situations, and is not intended to be a comprehensive review of all relevant guidance that has been issued. For example, the IRS has issued an LMSB Coordinated Issue Paper that is very specific to the banking industry, which involves a limited application of the tax treatment related to supervisory goodwill. Supervisory goodwill is a very complex concept and is beyond the scope of this article.  The issue paper is included, however, to highlight certain potential issues that relate to a taxpayer's ability to sustain a tax position supporting a deduction under §165.

Section 165

In general, §165 allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. Under an abandonment or discontinued operations situation, Regs. §1.165-2(a) provides that a loss is a deductible loss under §165(a) if it is incurred in a business or in a transaction entered into for profit and arising from the sudden termination of the usefulness in such business or transaction of any non-depreciable property, when the business or transaction is discontinued or when such property is permanently discarded from use. A second application of §165(a) occurs when property is sold or exchanged for a loss.3 

A recent Chief Counsel Advice Memorandum highlights some of the nuances that must be considered when determining whether a loss incurred on a transaction will be considered an abandoned transaction for tax purposes, and thus, whether costs associated with the transaction will be deductible under §165(a).

CCA 201025047

In CCA 201025047, the taxpayer received a private letter ruling (and supplemental ruling) 4  on various aspects of the terms of a forward contract on the taxpayer's stock that was part of a financing package that included the issuance of debt and other investment units. On its tax return for the relevant years, the taxpayer originally allocated all the costs associated with the financing package to the debt portion of the package, which were then amortized over the life of the debt.  On exam, however, the taxpayer and the IRS agreed to allocate a portion of the financing arrangement costs to the forward contract portion of the overall financing transaction. After this new allocation, the taxpayer attempted to deduct the portion of the financing arrangement costs allocated to the forward contract as an abandonment loss when the taxpayer ultimately settled the forward contract for cash and incurred a loss. The IRS did not agree with the taxpayer's attempts to take the loss on the settlement of the forward contract.

Upon examination, the taxpayer argued that it was entitled to a §165 deduction for the costs associated with the forward contract, because the taxpayer did not, in fact, issue its stock pursuant to the forward contract, but instead settled the forward contract with cash. The taxpayer's primary argument was that because they did not issue stock pursuant to the terms of the forward contract, the stock settlement aspect of the forward contract was abandoned, and thus, the costs associated with that aspect of the overall financing arrangement could be properly deducted as abandonment costs under §165. The IRS exam determined, however, that the forward contract costs were costs associated with raising capital and were associated with the actual completion of the forward contract by its terms, which specifically allowed the contract to be settled for cash. In fact, the subject of the IRS PLR was that §1032 would apply to the cash settlement of a forward contract. Under the IRS exam's view the costs associated with the completed forward contract were merely part of the overall plan to obtain financing, and thus, were an offset to the proceeds received from the overall capital raised in the financing arrangement.5  Under this view, any changes or modifications to the terms of payment on the forward contract were merely modifications and did not cause the overall financing arrangements to be abandoned.

The issue before the IRS in the CCA was whether or not the fact that the IRS provided the taxpayer with a ruling that the settlement of the forward contract in cash instead of stock was a §1032 transaction provided support for the taxpayer's position that the cash settlement in lieu of the stock issuance created an abandonment transaction, and that the costs associated with the forward contract could be deducted. Presumably, to find that the original forward contract arrangement was terminated, the IRS would need to agree to a bifurcation of the overall financing arrangement into certain component pieces. Once the components were identified, they would then receive their own tax characterization. Thus, when the terms of the payment of the forward contract were modified, the taxpayer could then argue that the original "transaction" was abandoned, and a new one was entered into. The IRS did not, however, conclude that the forward contract was severable from the original financing transaction. The IRS stated that the §1032 ruling did not provide the taxpayer a basis for a §165 deduction, and instead repeated its long-held view that the cash settlement of a forward contract is the equivalent of issuing the stock for the contract price and then selling the stock for cash. The tax consequences are the same.  Therefore, in order to avoid potential whipsaw to the government, the IRS treats these transactions in the same way. Thus, not only was the forward contract not abandoned, it was settled for cash pursuant to its terms, and therefore, no abandonment of the "transaction" occurred, even with the described modification in the terms of the forward contract. Thus, the changes in the terms of the forward contract that the taxpayer pointed to in its argument were disregarded, and the IRS concluded that, "[c]hanges in a transaction do not constitute abandonment."6 

In distinguishing those circumstances in which a transaction is abandoned, the IRS stated that "[a] loss deduction is allowed for costs incurred for a transaction when the taxpayer is left without any value to show for the costs incurred," citing Rev. Rul. 79-2,7  where "individual taxpayers were allowed a Section 165(c) loss when they abandoned the public offering of their corporation."8 

As a third argument, the taxpayer cited Regs. §1.263(a)-5(1), Ex. 3, which describes four potential transactions being considered by a taxpayer. When only one is pursued, the costs associated with the remaining three may be recovered under §165 because they are costs associated with abandoned transactions. The CCA concludes that the §263 regulations are not the appropriate place to look to determine whether or not a transaction is abandoned, but that the law under §165 must be evaluated to make that determination.  In addition, the IRS found that the example in the §263 regulations was factually distinguishable from the taxpayer's facts in the CCA, in that the taxpayer in the CCA actually executed the forward contract and received value according to the revised terms of the transaction.

LMSB4-1109-042—IRS LMSB Revised Coordinated Issue Paper on Supervisory Goodwill in Savings, Loan Industry

On May 11, 2010, the IRS issued LMSB4-1109-042, which answers the question, among others, of "[w]hether taxpayers are entitled to losses under I.R.C. §165 with respect to supervisory goodwill based upon worthlessness, abandonment or confiscation." This issue paper was generated by the IRS's concern that after the enactment of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) taxpayers began taking the position that a tax asset called "supervisory goodwill" was created under the §597 definitions of property and assistance under §406 of the National Housing Act. Using these definitions, which generally provided that supervisory goodwill was an asset for certain regulatory purposes, taxpayers proceeded to claim tax losses under §165 because the supervisory goodwill was abandoned, confiscated, or made worthless as a result of FIRREA's enactment.

In finding that taxpayers are not allowed a deduction with respect to worthless or abandoned supervisory goodwill, the position paper provides that supervisory goodwill is an accounting concept that does not qualify as "money or other property under §597." Thus, no abandonment or worthlessness deduction can be asserted because there is no tax basis for supervisory goodwill, and even if such a tax basis could be established, a taxpayer would be unlikely to be able to prove that the asset has been affirmatively abandoned with no reasonable hope of recovery. The IRS stated that the "mere diminution in the value of property is not enough to establish an abandonment loss."9  There must be a closed and completed transaction and an identifiable event in order to sustain a deduction under §165.10 

LMSB4-0210-008—IRS Coordinated Issue Paper on Distressed Asset Trust (DAT) Tax Shelters for All Industries

On March 23, 2010, the IRS issued LMSB4-0210-008 that addresses a version of the DAT tax shelter that uses distressed assets (including creditors interest in debt) to shift economic losses from a tax-indifferent party to a U.S. taxpayer with no other economic interest, except a desire to use the loss. While the issue paper focuses on the use of debt instruments and §166 losses, it states that "[a]s of the date of this paper, the field has only seen DAT transactions involving business bad debt deductions under I.R.C. §166.  However, if a sale or exchange triggers the loss, an analysis regarding lack of profit motive under I.R.C. §165 might apply to disallow the loss." The issue paper continues the prior theme of the IRS in the authorities discussed above and focuses on when the asset became worthless and how the taxpayer can prove its tax basis in the asset.

Pepper Perspective

As discussed above, it is understandable that significant administrative rulings under §165 are being issued because abandonment or loss issues arise on a very routine basis, and in particular, in a depressed or downsizing economy. While all of these rulings address very different situations and industries, one common theme is apparent. A §165 deduction will not be allowed without significant documentation of the asset's tax basis and value at the time of the proposed deduction. In particular, taxpayers need to keep good records that establish a tax basis in the assets they are in a position to abandon or dispose of at a loss. In addition, they must show an actual event that establishes the fact of worthlessness and they must document that the assets (or transaction) provide no other benefit to the taxpayer (or that the abandoned transaction is part of a larger transaction).

 For more information, in the Tax Management Portfolios, see McCoy, 527 T.M., Loss Deductions,  and in Tax Practice Series, see ¶2350, Losses.

1 This article will not address the specific tax implications of the guidance on the debtor, but it will instead focus on the tax consequences to the creditor or owner.


2 References to Code Sections are to the Internal Revenue Code of 1986, as amended, unless otherwise stated.


3 Numerous provisions of the Code address the timing and ability of a particular taxpayer to take a loss for federal income tax purposes. A comprehensive discussion of allowable losses is beyond the scope of this article and no inference should be made by any omission or inclusion of any facts or law or any discussion in this article as to whether or not a loss will be allowed for a particular taxpayer in a particular situation, other than as discussed herein.


4 PLR 200450016 and PLR 2005188062.


5 CCA 201025047, citing to McCrory v. U.S., 651 F.2d 828 (2d Cir. 1981); Barbour Coal Co. v. Comr., 74 F.2d 163 (10th Cir. 1934); Affiliated Capital Corp. v. Comr., 88 T.C. 1157 (1987).


6 The IRS cited FRGC Investment, LLC v. Comr., T.C. Memo 2002-276, to support its position in this regard.


7 1979-1 C.B. 98.


8 The IRS also cited Rev. Rul. 77-254, 1977-2 C.B. 63, which allowed a deduction for costs associated with an abandoned purchase of a business.


9 LMSB4-1109-042 (May 11, 2010), page 3. The IRS cites Kraft Inc. v. U.S., 30 Fed. Cl. 739, 785-86 (1994); Lakewood Associates v. Comr., 109 T.C. 450, 456 (1997), aff'd without published opinion, 173 F.3d 850 (4th Cir. 1998); and U.S. v. S.S. White Dental Mfg. Co., 274 U.S. 398, 401 (1927).


10 Regs. §1.165-1(b).



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