Editor: Frank J. O’Connell Jr., CPA, Esq.
Gains & Losses
Over the past several years, the financial crisis has resulted in significant impairment for investors in debt and equity securities. For corporate and other business investors, these impairment losses are often highlighted on the financial statements as “other than temporary impairment,” which is deemed to be a permanent reduction in the value of these securities and establishes a new cost basis for GAAP.
While these impairment losses can be deducted for tax purposes under some circ*mstances, taxpayers will often find that the tax statutes governing deductible losses on worthless securities are much more restrictive than the GAAP standards for recording these losses and, consequently, the GAAP impairment losses are often not currently deductible. This is evidenced by the increasing frequency of recorded deferred tax assets related to impaired securities in the financial statements of business investors.
Understanding the rules for deducting losses on worthless securities is necessary to determine the correct timing of the loss deduction. Special rules apply to certain taxpayers, and advance planning may avail some taxpayers of loss deductions sooner than they would otherwise be allowed. These rules are summarized below.
Sec. 165
The general rule for deducting losses on worthless investment securities is found in Sec. 165(g), which permits a loss deduction for a security that becomes worthless during the tax year, but only if the security is a capital asset in the taxpayer’s hands. The loss amount is determined by treating it as having resulted from a hypothetical sale or exchange of the security on the last day of the tax year in which the security becomes worthless. This deduction can be considered where the taxpayer is unable or unwilling to sell or otherwise dispose of the security in a taxable transaction. Otherwise, the loss could obviously be deducted upon such a disposition of the security under Sec. 1001.
Sec. 165(g)(2) defines a security as any of the following: a share of stock in a corporation; a right to subscribe for, or receive, a share of stock in a corporation; or a bond, debenture, note, or certificate, or other evidence of indebtedness issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form. With respect to debt securities, standard investment-grade securities that are offered for sale on the public markets will likely be issued in registered form and will therefore qualify as securities for purposes of deducting worthless securities losses. Sec. 165(j) denies a deduction for losses on securities that are required to be issued in registered form but are not registered. However, numerous exceptions and special rules apply to the registration requirements, as set forth in Sec. 163(f). An unregistered debt instrument may constitute a loan, in which case the deduction for worthlessness may be governed by Sec. 166 as a bad debt.
To determine whether a loss is governed by Sec. 165(g), the taxpayer must determine whether the security is a capital asset. This determination is routine for most taxpayers, as nearly all investment securities are capital assets for both business and individual taxpayers. However, under some circ*mstances the investment securities held by certain taxpayers are not capital assets. For example, investment securities held by a securities broker as inventory are expressly designated as ordinary (i.e., not capital) assets (Sec. 1221(a)(1)). Likewise, debt securities owned by a bank are expressly accorded ordinary gain or loss treatment (Sec. 582(c)). Sec. 165(g)(3) generally holds that stock in an affiliated corporation is not treated as a capital asset for purposes of applying Sec. 165(g).
While Sec. 165(g) addresses worthless loss deductions only on securities that are capital assets, Regs. Sec. 1.165-5(b) clarifies that worthless securities losses that would be ordinary losses in the hands of the taxpayer are deductible under Sec. 165(a) in the year the securities become worthless. Nevertheless, as illustrated above, ordinary losses on investment securities are often governed by other Code sections, as those losses generally result from special rules applicable to certain taxpayers.
Once it is determined that the securities in question are capital assets and losses on them are therefore governed by Sec. 165(g), the taxpayer must contend with the restrictive loss allowance provisions of this section, which allow a loss deduction only when a security becomes completely worthless. No deduction is permitted for partial impairment, even if it is determined that the partial impairment is permanent. Likewise, no deduction is permitted for downward fluctuations in the market value of the securities, regardless of the reason for the downward valuation. These restrictions may frustrate taxpayers that are required to issue GAAP-based financial statements reflecting the securities’ impairment but that cannot claim a current tax deduction for those losses.
The loss deduction for worthless securities must be claimed in the tax year in which the securities are deemed to have become completely worthless. The taxpayer is responsible for making this determination. Worthlessness is often presumed to result from an identifiable event, such as bankruptcy, liquidation, or termination of business activities. However, such an event is not necessarily required for making a claim of worthlessness if the business is completely insolvent. While the determination of worthlessness is often subjective, the courts have generally upheld it when there is no reasonable possibility that the investors will receive anything of value (see, e.g., Drachman, 23 T.C. 558 (1954)).
Regs. Sec. 1.165-5(i) allows taxpayers to solidify their loss claim on worthless securities by formally abandoning the securities. To abandon a security, the taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for it.
Example 1: Corporation A owns bonds issued by Corporation B and holds them for investment purposes. At their original issuance, the bonds were offered to the general public and were issued in registered form. Assume the bonds are subordinated to a superior class of debt issued by Corporation B in a prior offering. Corporation A’s basis in the subordinated bonds is $100,000.
B experiences significant erosion in its business sales and falls behind on its payments to creditors, including interest payments on its outstanding bonds. These events cause a downgrade in the public ratings of Corporation B bonds, and Corporation A records a corresponding loss of $40,000 against the bond investment on its GAAP-based financial statements.
In year 2, Corporation B experiences even further financial difficulties and its creditors initiate foreclosure proceedings to protect their interests in loans made to Corporation B. Corporation A determines that it is likely to recover only $5,000 of its principal in the Corporation B bonds and writes the bonds down to this amount on its financial statements. However, as of the end of year 2, Corporation B had not yet initiated a formal bankruptcy filing.
In year 3, Corporation B files for bankruptcy protection, and it is then determined that there is no reasonable possibility the subordinated bondholders, including Corporation A, will receive any value in the bankruptcy settlement.
Conclusion : Corporation A is not entitled to loss deduction in years 1 and 2 because the bonds had not yet become completely worthless during those tax years. Consequently, the valuation losses recorded on Corporation A’s financial statements with respect to the bonds give rise to a deferred tax asset in years 1 and 2. It is not until year 3 that the bonds become completely worthless as a result of the bankruptcy filing and the projection that the subordinated bondholders will not receive anything in the bankruptcy settlement. Consequently, a $100,000 capital loss must be claimed by Corporation A in year 3, and this loss is deemed to have occurred on the last day of the tax year.
Special Rules for Banks
For various policy reasons, banks (as defined in Sec. 581) enjoy a substantial advantage over other taxpayers in deducting losses on partially worthless debt securities. Sec. 582(a) provides that, with respect to debt securities as defined in Sec. 165(g)(2), losses for worthlessness are governed by Sec.166 as bad debts, rather than by Sec. 165(g), described above. This is a significant advantage because Sec. 166(a)(2) permits a current deduction for partially worthless debts, provided the taxpayer charges off the worthless portion of the debt as uncollectible. Thus, unlike Sec. 165(g), which requires the deduction to be delayed until the security becomes completely worthless, Sec. 166 permits partial impairment to be deducted as it occurs. However, no deduction is allowed for mere fluctuations in fair market value (FMV) that do not relate to credit-quality issues.
In addition, Sec. 582(c)(1) holds that losses (and gains) on debt securities held by a bank are ordinary, rather than capital. However, these benefits do not extend to a bank’s investment in equity securities, such as shares of stock in a corporation. For those investments, banks are generally governed by the same rules of Sec. 165(g) that apply to other taxpayers.
Example 2: Assume the same facts as Example 1, but assume that Corporation A is a bank.
Conclusion: Corporation A is entitled to a $40,000 bad debt deduction in year 1, a $55,000 bad debt deduction in year 2, and a $5,000 bad debt deduction in year 3. All of these deductions would be ordinary deductions rather than capital losses.
Mark-to-Market Rules
For certain taxpayers in the financial services sector, the mark-to-market rules of Sec. 475 may offer a more liberal means of deducting losses on financial assets than the restrictive loss provisions of Sec.165(g). This is because Sec. 475 permits a current deduction for declines in the market value of securities, including fluctuations in FMV not related to credit-quality issues. However, to apply the mark-to-market rules, the taxpayer must meet the definition of a “dealer in securities” in Sec. 475(c)(1) and must properly elect to apply these rules to its investment securities by way of the identification requirements laid out in Sec. 475. Only certain taxpayers can meet this definition: “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, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.”
While these activities certainly appear to describe those of a securities broker, the statutory application is expansive. It includes any taxpayer that regularly acquires or sells securities, provided these activities are conducted with customers and are not merely undertaken on the taxpayer’s own account. For example, a taxpayer that regularly originates loans for resale on the secondary market is considered to be a dealer in securities. However, a taxpayer involved in active securities trading on its own account is not.
While this broad application has extended to many banks (i.e., due to their activities of originating loans to be sold to third-party investors), other taxpayers involved in similar activities may also fall within the definition. For example, a nonbank lender that performs the same function may qualify as a dealer in securities, as might a taxpayer with an active securities brokerage division. However, a statutory clarification provided in Sec. 475(c)(4) prevents the dealer-in-securities status from applying to a taxpayer that sells its own trade receivables if those trade receivables originated from the taxpayer’s sale of nonfinancial goods or services.
Sec. 475(c)(2) generally defines “security” broadly to include a share of stock in a corporation; a partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; a note, bond, debenture, or other evidence of indebtedness (other than a trade receivable as described above); an interest rate, currency, or equity notional principal contract; an evidence of an interest in, or a derivative financial instrument in, any of the securities described above or in any currency; and certain hedges.
Taxpayers that fall within the definition of a dealer in securities can apply the mark-to-market rules narrowly to inventoried securities only, very broadly to all securities owned (including those held for investment), or selectively to any specific security or group of securities. Sec. 475(a)(1) requires inventoried securities to be marked to market, and Sec. 1221(a)(1) renders the resulting gain or loss ordinary in character. Sec. 475(a)(2) requires securities held for investment or not held for sale also to be marked to market, unless the taxpayer properly chooses to identify those securities as exempt from the mark-to-market rules under Sec. 475(b). The opportunity to identify noninventory securities as exempt from the mark-to-market rules generally requires the identification to be made before the close of the day on which the securities are acquired. However, by purposefully failing to identify the securities as exempt, a dealer in securities can effectively apply mark-to-market accounting to these securities as desired.
Due care and planning must be undertaken when deciding whether to apply mark-to-market accounting to investment securities. Once a taxpayer elects to apply mark-to-market accounting to noninventory securities, the taxpayer must continue with this application until the securities mature or are otherwise disposed of. While mark-to-market accounting may enable the taxpayer to accelerate deductions for losses and downward valuations, it can also accelerate taxable income on unrealized gains that would otherwise not be taxed until disposition.
The identification requirements and the requirement to continue the application of the mark-to-market rules prevent opting in and out of these rules as the value of the securities rises and falls. Furthermore, the rules cannot be applied to deduct declines in value that occur before the mark-to-market rules are applied, as only prospective application is permitted. Thus, to successfully accelerate deductions under the mark-to-market rules, the taxpayer has to successfully predict which of its investments will lose value.
Prop. Regs. Sec. 1.475(a)-1(f) contains ordering rules for adjusting the basis of noninventory debt obligations upon which deductible bad debts may be claimed by dealers in securities under Sec. 166. These rules clarify the order of the deductions to be claimed and the associated basis adjustments by stating that any deductible bad debt is claimed first, with a corresponding reduction to tax basis, followed by a mark-to-market adjustment for the difference between this adjusted basis and FMV. The proposed regulation specifies that a wholly worthless debt is deemed to have a tax basis of zero (after applying the deductible bad debt loss) for purposes of calculating the mark-to-market adjustment.
Another consideration that requires caution in the application of the mark-to-market rules to noninventory securities is the character of the gain or loss resulting from the mark-to-market adjustment. Sec. 475(a)(2) states that the mark-to-market gain or loss of noninventory securities is determined as if the security were sold for its FMV on the last business day of the tax year. This presumed sale does not change the character of the resulting gain or loss (see Sec.475(d)(3)(B) and Regs. Sec. 1.475(d)-1(a)). Thus, if the securities are capital assets in the hands of the taxpayer, the resulting mark-to-market gain or loss is a capital gain or loss. Accelerating large capital losses without the ability to offset them with capital gains (especially for corporations, which generally must do so within a limited three-year carryback/five-year carryforward period) may be more problematic than deferring the loss deduction until the security is sold or becomes worthless under Sec. 165(g), as the timing of the losses may be more predictable under the latter scenarios.
Example 3: Assume the same facts as Example 1, but assume that Corporation A qualifies as a dealer in securities under Sec. 475(c)(1) and had identified its investment in the Corporation B bonds as subject to the mark-to-market rules on the date the bonds were acquired. Also assume that the bonds are a capital asset in the hands of Corporation A.
Conclusion: Corporation A is entitled to a $40,000 mark-to-market deduction in year 1, a $55,000 mark-to-market deduction in year 2, and a $5,000 worthless debt deduction in year 3 (i.e., the worthless debt is presumed to have a basis of zero for purposes of applying the mark-to-market rules). These deductions would also be available if the decline in value of the securities was related to market fluctuations other than those due to creditworthiness, as the mark-to-market rules do not distinguish among potential sources of market value decline. These allowable losses would be capital losses because the underlying investments are capital assets in the hands of Corporation A.
Example 4: Assume the same facts as Example 3, but that Corporation A is a bank. Consequently, its gain or loss resulting from the investment in the Corporation B bonds is ordinary rather than capital (Sec. 582(c)(1)), and a current deduction is available under Sec. 166 for partial worthlessness.
Conclusion: Corporation A is entitled to the same deductions as those determined in the conclusion to Example 3, but each of the losses is a bad debt deduction, as opposed to a mark-to-market loss, under the ordering rule of Prop. Regs. Sec. 1.475(a)-1(f), i.e., because the deductible loss is permitted under Sec. 166. These deductions are ordinary in character. This is the same result as Example 2. However, unlike the conclusion in Example 2, these deductions are allowed regardless of whether the losses resulted from credit quality issues or from other market-driven fluctuations in the value of the bonds (including interest rate fluctuations).
Conclusion
A decline in the value of investment securities has caused many taxpayers to suffer economic losses in recent years. Moreover, while taxpayers continue to hold these securities, their opportunity to claim a current deduction for these losses is limited. Certain taxpayers, such as banks, enjoy more liberal rules for claiming current deductions, but most taxpayers will have to defer the loss deductions until the securities are sold or become completely worthless. For certain taxpayers that are able to meet the definition of a dealer in securities under Sec. 475, the ability to apply the mark-to-market rules may provide an attractive opportunity to accelerate the recognition of tax losses on these assets, but they must plan for and carefully consider associated risks.
EditorNotes
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or frank.oconnell@crowehorwath.com .
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.
