If the U.S. government allows a taxpayer to call a liability an asset and then acts to make the asset worthless, can the taxpayer take a tax loss for the loss of the so-called asset? The Citigroup, Inc. v. United States, No. 15-953T (Ct. Cl. 2018) court case addresses this fact pattern. The case gets to one of the most difficult aspects of business purchases and sales, namely, how do you allocate tax basis to intangible assets.
Facts & Procedural History
Citigroup acquired Glendale Federal Bank (“Glendale”) in 2012. Glendale Federal Bank was a California bank. Glendale Federal Bank had previously acquired First Federal Savings and Loan of Broward (“Broward”), a Florida bank.
Glendale acquired Broward in the savings and loan crisis in the 1970-80s as part of an agreement with the United States government. The acquisition was part of the government’s program to have larger banks acquire smaller banks to prevent runs on the banks by their customers.
Given the financial crisis, banks such as Glendale were allowed to count the amount paid as “supervisory goodwill” on their books for purposes of complying with bank reserve requirements. This goodwill was essentially the liability the U.S. government would have incurred had Glendale not stepped in to acquire Broward.
After the financial crisis had passed, Congress changed the law for “supervisory goodwill” for bank reserve purposes. Given that its “supervisory goodwill” suddenly had no value for bank reserve purposes, Glendale had to sell its banks to meet the bank reserve requirements.
Glendale’s “supervisory goodwill” asset was $798 million. This amount was derived using the purchase method of accounting. With this method of accounting, Glendale did not have to report the liabilities it assumed for Broward as liabilities on its balance sheet. It was allowed to treat the liabilities as a goodwill “asset” on its balance sheet.
Glendale sued the U.S. government in 1990 to recover the losses it sustained as a result of this change. In 1999, the courts awarded Glendale almost $1 billion in damages. On appeal, this was reduced to $308 million in 2002.
Glendale attempted to deduct the loss to its “supervisory goodwill” asset on its 1994-1997 and 2000-2002 tax returns. The IRS denied these deductions as the litigation and possibility of recovery was ongoing.
Glendale filed another tax refund claim in 2005 when the time for appeal in the lawsuits expired.
This court case involved the IRS’s disallowance of the 2005 refund claim.
The General Tax Loss Rules
The general rule is that taxpayers are entitled to tax losses when a business asset becomes worthless. The amount of the loss is limited to the taxpayer’s tax basis in the worthless asset. This is generally the cost or amount paid for the asset (plus any amounts expended on improvements). The law generally says that any liabilities the buyer assumes in acquiring the property is included in the buyer’s tax basis for the asset. These rules were not really at issue in the court case. The court case focuses on what asset was actually lost.
Supervisory Goodwill as an Asset
For bank regulatory purposes, Glendale was allowed to use purchase method accounting. Presumably Glendale recorded two types of assets on its books, namely, the individual assets Glendale acquired as part of the deal and “supervisory goodwill” asset acquired as part of the deal.
While “supervisory goodwill” was an asset allowed on on Glendale’s balance sheet for bank regulatory purposes, it does not appear to be an asset per se. It appears to be a liability that, given the unusual circumstances, was allowed to be recorded as an asset for non-tax purposes.
This was one of the IRS’s arguments. It argued that Glendale acquired several intangible assets from Broward, such as the right to have bank branches in Florida, etc.
The court agreed. The court said it was not bound to follow accounting rules, as tax is different. It noted that the “supervisory goodwill” liability added tax basis that was to be added to the basis of all of Broward’s assets that Glendale acquired:
The tax laws look at the transaction as a whole. Thus, in order to know the true value of any deduction that Glendale is owed for the loss of one intangible asset, we must know Glendale’s basis in all other intangible assets acquired as part of the same deal. A calculus can then be made to reduce the value of the supervisory goodwill by the value of the surviving intangible assets.
The court cites Treas. Reg. 1.61-6, which says:
When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part.
This general tax basis allocation rule (while off topic, it should be noted that the regulation uses the word “equitably” rather than “ratably”…). While its difficult to apply the language to a liability, the concept seems sound that the liability tax basis should somehow be allocated to some asset.
It does seem that some loss is allowable given the facts. There was an economic outlay that was not and will not be recouped. But the question is what assets did Glendale actually acquire, what assets lost their value, and how do you allocate the supervisory goodwill liability to those assets to compute gain or loss for tax purposes?
The court did not have to address these issues yet, as the opinion merely concluded that summary judgment was not appropriate at this point in the litigation. If it results in a final court opinion, the case would address several valuation and tax basis allocation issues that often come up in business purchases and sales.