The complexities surrounding tax loss deductions can be particularly challenging for taxpayers.
While claiming tax losses for worthless securities may seem like a straightforward process, the IRS often scrutinizes these deductions, raising questions about the timing and character of the loss. In many instances, the IRS challenges the year in which the loss is allowed, which can make it difficult for taxpayers to determine when the loss should be taken. This can be especially tricky when dealing with assets that are gradually losing value over time, as determining the exact moment when an asset becomes worthless can be a complicated task.
The recent Forlizzo v. Commissioner, T.C. Memo. 2018-137, case provides a real-world example of the legal hurdles and complexities involved in establishing and documenting a tax loss for worthless securities. This case highlights the importance of careful tax planning and accurate documentation when claiming tax losses, particularly when it comes to determining the timing and character of the loss.
Facts & Procedural History
It is never good if you start a tax article this way, but in this case, the taxpayer was a real estate and tax attorney. The IRS makes examples out of attorneys.
The tax attorney held limited partnership interests in multiple real estate entities. These entities were responsible for commercial loans, and the taxpayer acted as a guarantor. The taxpayer filed an amended tax return for the 2008 tax year in 2010 to claim a tax loss for the worthless partnership interests. However, the audited the tax returns and IRS disallowed the losses, and the matter resulted in litigation. While unfortunate, this case provides valuable insights into the complexities and legal hurdles involved in establishing and documenting a tax loss for worthless securities.
It is never good if you start a tax article this way, but the taxpayer is a real estate and tax attorney. He held limited partnership interests in several real estate entities. The entities were liable for commercial loans, as was the taxpayer as a guarantor. The taxpayer filed an amended return in 2010 for the 2008 tax year to deduct a tax loss for the worthless partnership interests. The IRS disallowed the losses and litigation ensued.
The Tax Loss Rules
Section 165 provides a deduction for certain losses that are sustained during the tax year. As relevant here, subsection (g) provides for a loss when a capital asset consisting of a security becomes worthless.
The term “security” is defined as corporate stock, etc. The definition does not seem to include a partnership interest. But on audit, the IRS generally allows losses for worthless partnership interests. The courts have done the same. The leading case is Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991), which is cited in the present case.
Questions about tax losses often involve challenges to the character of the loss (i.e., whether the loss can offset capital gains or ordinary income) and the timing of when the losses are allowable. This case involved the timing issue.
The timing issue focuses on whether there was an identifiable event. The court cases refer to this as a “closed and completed transaction.”
Closed and Completed Transaction
The “closed and completed transaction” term comes from the regulations. It reads as follows:
A loss shall be allowed as a deduction under section 165(a) only for the taxable year in which the loss is sustained. For this purpose, a loss shall be treated as sustained during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year.
The court cites the Boehm v. Commissioner, 326 U.S. 287 (1945), which itself notes that even in 1945 that this this requirement was in the regulation “long continued without substantial change.”
Despite being part of our law for nearly 100 years, there are still quite a few disputes as to whether there is a closed and completed transaction. This case is an example.
Taxpayer: Partnership Interests are Worthless
In this case, the taxpayer owned an interest in various partnerships. As of 2008, the partnerships held real estate that had value. Presumably, the partnerships were also subject to offsetting debts. It is not clear from the court’s opinion whether the debts were greater than the value of the assets.
But the taxpayer’s argument is that the partnership interests were worthless, not that the partnerships held assets worth no value. Put another way, the taxpayer’s position was that if he had listed the partnership interests for sale in 2008, no one would buy his partnership interests. Given the mortgage crisis and ensuing downturn in the economy, that is probably true.
Court: Partnership Interests Worth Something, but Less
But the court did not focus on the value of the partnership interests. It focused on the fact that the partnerships themselves held real estate that apparently had some value. This focus may have been misplaced as the facts cited in the opinion suggest that separate partnerships, which are separate taxpayers, had to be liquidated to pay for other partnerships. But the court noted there was a lack of evidence in the case. This probably had a lot to do with the holding.
But despite how it got there, it the court may have reached the right result. Applying Echos, absent a method in state law saying how you abandon a partnership interest, generally there has to be some sort of overt act of abandonment. In Echos, the overt acts to abandon the partnership interest included holding a meeting and offering to transfer the interest to anyone who would take over the loans, refusing to put in additional capital, and the partnership failing to pay its property taxes. The court concluded that these overt acts were sufficient.
Compare that to the present case. The evidence indicates that there were similar meetings as those in Echols. The difference is that in this case, unlike Echols, there was evidence that the partnerships may have had a way to turn things around and a plan for doing so.
Perhaps evidence of a strategically timed offer to sell or transfer or some other action would have brought this case in line with Echols. But, as noted by the court, the evidence was not present here. As such, the court concluded that there was no closed and completed transaction sufficient for a tax loss in 2008.
Taxpayers who want to claim a tax loss for worthless securities must establish several elements to secure the benefit of the deduction. While the IRS often challenges tax loss deductions, the focus of the challenge could involve the character or timing of the loss. Th court in this case focused on the timing issue and whether there was an identifiable event, which is often referred to as a “closed and completed transaction.” The court found that absent evidence of an overt act of abandonment, there was no closed and completed transaction sufficient for a tax loss in 2008. Therefore, taxpayers should ensure that they have sufficient evidence to prove a closed and completed transaction if they want to claim a tax loss for worthless securities. Those with losses should take note of this as they report tax losses on their income tax returns.
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