Case — Abandonment of Stock -– Capital or Ordinary Loss?

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TL Case Summ

THE QUESTION

When a corporation voluntarily surrenders securities for no consideration, is the loss capital or ordinary?

THE DISPUTE

Taxpayer Says: The loss is an ordinary loss due to abandonment, and is deductible in full on the current year tax return.

Internal Revenue Service Says: The loss is a capital loss, and is not fully deductible on the current year return.

THE LAW

From Internal Revenue Code Section 165(a): Allows as a deduction any loss sustained during the taxable year that is not compensated for by insurance or otherwise.

From Internal Revenue Code Section 165(f): A loss from the sale or exchange of a capital asset is subject to the limitations on capital losses under sections 1211 and 1212.

From Internal Revenue Code Section 1211: In the case of a corporation, capital losses from sales or exchanges of capital assets are allowed only to the extent of capital gains from sales or exchanges of capital assets.

From Internal Revenue Code Section 1234A: GAINS OR LOSSES FROM CERTAIN TERMINATIONS. Gain or loss attributable to the cancellation, lapse, expiration, or other termination of–(1) a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or (2) a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer, shall be treated as gain or loss from the sale of a capital asset. The preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation arrangement).

THE CAUSE OF THE DISPUTE

Generally, when your corporation sells or exchanges stock owned as an investment (such as stock in an outside company), the gain or loss is reported as a capital gain or loss instead of ordinary income from your trade or business. Your tax deduction for a capital loss due to the sale or exchange of the asset may be limited.

However, the code section governing the treatment of capital losses does not specifically apply to a loss resulting from a disposition that is not a “sale or exchange.” That means if your disposition of a capital asset is not a “sale or exchange” (or required by statute to be treated as such), the loss allowable is an ordinary loss.

The dispute in this case is whether the loss from abandonment of stock owned by the taxpayer is actually a loss from a sale or exchange under code section 1234A (see above).

The taxpayer, a corporation, owned shares of preferred stock in an unrelated company. The shares were purchased for $98.6 million in 1999. The unrelated company stopped making dividend payments in 2002. In 2004, the unrelated company offered to redeem the stock for $20 million.

The taxpayer’s board of directors rejected the offer and instead chose to abandon the stock, believing the ordinary loss from abandonment would provide a tax benefit greater than the $20 million offering price. At the time of abandonment, the stock was valued at $38.8 million on the taxpayer’s financial statement.

The taxpayer reported an ordinary loss of $98.6 million on its 2004 federal income tax return. The taxpayer believes that section 1234A does not apply, because section 1234A refers to only the derivative rights under a contract, not the actual asset.

The IRS says the loss was ordinary, not capital. The IRS argues the surrender of the securities terminated all of the taxpayer’s rights with respect to those capital assets, and therefore section 1234A requires that the loss be treated as a loss from the sale or exchange of capital assets.

WHAT WOULD YOU DECIDE?

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THE COURT’S DECISION

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. Taxpayer is not entitled to a deduction for an abandonment loss pursuant to section 1.165-2(a), Income Tax Regs., on the surrender of the securities, because the losses are treated as losses from a sale or exchange pursuant to section 1234A. See sec. 1.165-2(b), Income Tax Regs. However, pursuant to section 165(f), taxpayer is entitled to a capital loss on the surrender of the securities, as allowed by IRS. Editorial note: The tax year in question was 2004. In 2008, the IRS amended Treasury Regulation 1.165-5(i) to clarify that code section 1234A applies to abandonments of securities.
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