CHAPTER NINE

Tax Consequences to Creditors of Loss from Debt Forgiveness

§ 9.1 Introduction

§ 9.2 Nature of Losses

(a) Security Losses

(b) Loan Guarantees

§ 9.3 Business and Nonbusiness Losses

(a) Introduction

(b) Noncorporate

(c) Debt or Equity

(d) Business Motive

(e) Corn Products Doctrine

(f) Small Business Exception

(g) Affiliate Corporation

(i) Background

(ii) Rite Aid

(iii) Notice 2002-11

(iv) Treas. Reg. Sections 1.337(d)-2T and 1.1502-20T(i)

(v) Notice 2004-58 and Treas. Reg. Section 1.1502-20T(i)

(vi) Treas. Reg. Section 1.337(d)-2

(h) Impact on Earnings and Profit

§ 9.4 Determination of Worthlessness

(a) Introduction

(b) Meaning of Worthlessness

(c) Burden of Proof

(d) Security as Debt

(i) Identifiable Event

(e) Impact of Insolvency

(f) Impact of Liquidation Proceedings

(g) Impact of Bankruptcy Reorganization Case or Out-of-Court Settlement

(h) Other Factors

(i) Business Bad Debts (Section 166)

(i) Financial Institutions

(ii) Cash-Basis Taxpayer

(iii) Worthlessness

§ 9.5 Secured Debt

(a) Introduction

(b) Foreclosure

(i) Third-Party Purchase

(ii) Nonvendor Purchase: Two-Step Transaction

(c) Section 1038: Vendor–Mortgagee Reacquisition

(i) Nature of Gain

(ii) Basis of Property

(iii) Examples

(d) Voluntary Conveyance and Abandonment

(i) Debtor Personally Liable

§ 9.6 Reorganization

(a) Debt for Debt/Stock

(i) Debt Not Classified as Security

(ii) Debt Classified as Security

(b) Stock for Stock

§ 9.1 INTRODUCTION

The tax problems arising from debt cancellation are generally thought to be less complicated for the creditor than for the debtor. The cancellation generally results in a deduction for bad debts. The tax consequences can become quite involved, however, where the debt is a nonbusiness debt, a security, or a secured debt. Some of these complications are examined in this chapter.

§ 9.2 NATURE OF LOSSES

Internal Revenue Code (I.R.C.) section 165 deals with losses in general, and I.R.C. section 166 deals with bad-debt losses. These sections are mutually exclusive.1 Most losses that originate from the failure of the debtor to pay debts fall under the provisions of I.R.C. section 166, not under I.R.C. section 165.

(a) Security Losses

In I.R.C. section 165(g), there is one major exception to the general provision that a bad-debt loss is a section 166 loss. Section 165(g) provides that, when any security that is a capital asset becomes worthless, it is to be deducted in the year in which it becomes worthless and is to be treated as a loss from sale or exchange on the last day of the taxable year.2 Securities include stock, the right to subscribe to or receive stock, and any bond, debenture, note, 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. Two exceptions to the provisions of I.R.C. section 165(g) are (1) worthless securities held by a bank, which are considered to be bad debts,3 and (2) securities held by a dealer, which must be treated according to the rules governing inventory.4 See also section 166(e), which provides that section 166 bad debt treatment does not apply to a debt which is evidenced by a security as defined in section 165(g)(2)(C).

Losses are deductible under I.R.C. section 165 if three requirements are satisfied:

Losses deductible under I.R.C. section 165 include theft, casualty, operating, and disaster losses, in addition to losses from debts evidenced by a security. However, for the latter type of loss to be deductible, the security must be deemed completely worthless.

In general, the closed transaction requirement creates the most problems for taxpayers. I.R.C. section 165(a) provides that “there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.” A deductible loss is sustained when there is a completed and closed transaction.5 A closed transaction normally involves, among other things, giving up something, completing requirements of a contract, or abandoning property.6 In other words, it is an event that has been consummated. Thus, for example, a transaction is completed with respect to securities when they become completely worthless or are exchanged or sold. Treasury Regulations (Treas. Reg.) indicate that substance and not mere form shall govern in determining a deductible loss.

The term “sustained” has not been defined by Congress. Sustained does not mean accrued, because all events need not occur to fix the date of the loss, and it does not mean paid, because a disposition is not required. Commentators have suggested that “sustained” might be defined as some identifiable event that fixes the actual loss and the amount thereof.7 This definition might allow a deduction for a business security where there is a permanent decline in value. However, the courts have not viewed “sustained” in this manner. The Internal Revenue Service (IRS) has maintained that, until the security is sold or some other disposition of property has occurred, there remains a possibility that the taxpayer may recoup the adjusted basis of the property.8

(b) Loan Guarantees

In Uri v. Commissioner,9 the Tenth Circuit held that loan guarantees do not increase the shareholder’s basis in S corporation stock.10 Cathaleen Uri and Stevens Townsdin were shareholders in an S corporation formed to renovate an old opera house. The corporation borrowed money from a bank and had the loan secured by the corporation’s assets and personally guaranteed by Uri and Townsdin. The corporation lost money, and the Small Business Administration sent Uri and Townsdin a demand for satisfaction on their personal guarantees. They each filed chapter 7 bankruptcy petitions, and their personal guarantees were discharged in bankruptcy. Eventually, the corporation failed, and it filed a chapter 7 petition.

The basis of Townsdin and Uri’s stock in the corporation was consumed by pass-through losses that were claimed on their 1981 returns. However, on their returns for 1982 and 1983, they claimed their pro rata share of the corporation’s losses to the extent of their pro rata share of loans that were guaranteed by them. The IRS disallowed the losses, and Uri and Townsdin contested the deficiencies determined against them. The Tax Court held that their personal guarantees did not increase their basis in the S corporation stock. The Tenth Circuit affirmed the decision of the Tax Court. Citing its decision in Goatcher v. United States,11 the Tenth Circuit declined to recharacterize the loan-guaranteed transaction as a loan to Uri and Townsdin.

A Tax Court decision denying a nonbusiness bad debt deduction claimed by a taxpayer that purchased real property at a bankruptcy sale and thus discharged a note that had been personally guaranteed, was affirmed by the Fifth Circuit.12

The Fifth Circuit found no admissible proof sufficient to vary the form of the agreement from the satisfaction of a guarantee. The court noted that the taxpayer, because of his control over the corporation and the joint venture, was the de facto owner of the property during this entire scenario and that the taxpayer just improved his position as property owner as a result of the bankruptcy sale. According to the Fifth Circuit, the sale made it possible for him to get the financing required to satisfy his previous obligation.

Other circuits have taken a different approach and have concluded that a shareholder in an S corporation who personally guarantees a debt of the corporation may increase his or her basis in the corporation by the amount of the debt where the facts demonstrate that, in substance, the shareholder has borrowed funds and subsequently advanced them to her corporation.13

More recent cases holding that a shareholder in an S corporation does not get to increase basis in the corporation when the shareholder simply guarantees an obligation of the corporation. Without an actual economic outlay, there is no increase in basis.14

§ 9.3 BUSINESS AND NONBUSINESS LOSSES

(a) Introduction

A creditor generally is entitled to a deduction for the settlement of a debt for less than the creditor’s basis in the debt. The deduction is either a bad debt deduction under I.R.C. section 166 or a loss under I.R.C. section 1271(a)(1). Section 166 provides corporations with an ordinary deduction for any debt that becomes wholly worthless during the taxable year, and allows the Secretary discretion to allow a corporation a deduction for a debt that is partially worthless to the extent the debt is “charged off” during the taxable year. Section 1271(a), however, provides that amounts received by the creditor on “retirement” of any debt instrument shall be considered as amounts received in exchange thereof. In this case, the creditor would receive capital loss treatment. Thus, whether a corporate creditor is entitled to an ordinary deduction or a capital loss for the settlement of a debt is somewhat ambiguous and the treatment may depend on whether the debt is considered to be charged off or retired.15

(b) Noncorporate

For an individual or partnership, the loss is deductible as an ordinary loss only if the creditor can show that the debt was acquired or created in connection with the creditor’s trade or business.

There is no authoritative definition of what constitutes a trade or business. Two tests have emerged from the voluminous case law: (1) the activity in issue must be regular and continuous, as opposed to isolated, and (2) it must be intended to result in a profit. Additionally, the intent of the taxpayer is important in deciding whether certain activities constitute a trade or business.16

Business bad debts give rise to ordinary business losses, and therefore they may be carried back 3 years and forward 15 years if the taxpayer’s income is insufficient to absorb the deduction in the year the loss is realized. When the loss fails to qualify as a business bad debt, it is deductible as a short-term capital loss. The nonbusiness bad debt is considered with other short-term capital losses and is used first to offset the individual’s capital gains. Any balance may then be used to reduce ordinary income up to a maximum of $3,000 per year. Any unused balance may be carried forward for the individual’s lifetime.

In order to establish a bad debt as a business loss for an individual or partnership, the taxpayer must first show that the transaction created an obligation. For example, if it can be shown that the transaction was a gift or a contribution of capital, any subsequent loss will not be allowed as a business bad debt.17 Any loss from a transaction construed as a capital contribution would be subject to the loss provisions of I.R.C. section 165.

The bankruptcy court held that an individual is not entitled to bad debt deductions for the bad business losses, because his only connection to the businesses was in the form of investments or loans.18 The court concluded that the debt (investment) did not satisfy section 166’s requirement that the debt arise in connection with the taxpayer’s business and that capital contributions disguised as loans do not qualify.

(c) Debt or Equity

In certain instances, the IRS will contend that debt is really an equity interest and will deny the shareholders the tax advantages of debt financing. If the debt instrument has too many features of stock, it may be treated as a form of stock, and principal and interest payments will be considered dividends.19

In determining whether a debtor–creditor relationship or a shareholder–corporation relationship exists, the courts will consider both substance and form. The debt should be in proper legal form, should bear a legitimate rate of interest, should have a definite maturity date, and should be repaid on a timely basis. Payments should not be contingent on earnings, and the debt should not be subordinated to other liabilities.20 The Sixth Circuit21 identified 11 factors that should be considered in determining if the instrument should be classified as debt or equity:

These factors have also been adopted by courts22 in bankruptcy proceedings to determine if the debt should be reclassified as equity for purposes of claim or interest classification. Additionally, two other factors were identified in Outboard Marine Corp.23 as being relevant for bankruptcy purposes:

The statutory and regulatory approach to this issue (I.R.C. section 385) is discussed in § 7.7(a).

(d) Business Motive

Once it is ascertained that the transaction gave rise to real debt, it is then necessary to show that the motive behind the debt was business. In United States v. Generes,24 the Supreme Court held that, for a loss to qualify as a business bad debt, the taxpayer had to show that the “dominant” motive for the undertaking which gave rise to the debt was attributable to the taxpayer’s business; a mere “significant” motive was inadequate to establish the required “proximate” relationships.25

It is not uncommon for individual owners to lend money to their troubled corporation or make payments on debt they personally guaranteed. The question that often arises in such cases is whether the worthless loan or payment of a guarantee is a business debt, a nonbusiness debt, or a contribution to capital. This is the problem the Tax Court dealt with in Slater v. Commissioner.26

In Slater, the taxpayers’ company had obtained loans in February 1979, which the taxpayers had to personally guarantee. The company was insolvent by August 1979, and the Slaters paid $450,000 of principal from their personal account. The taxpayers declared bankruptcy, did not include themselves as creditors of the company, and were aware that they would not be reimbursed for amounts paid to the creditors. The taxpayers later altered the company’s books, changing the loan paid in 1980 from a debt to the bank to a debt to themselves. On their original 1980 return, the taxpayers claimed a $446,290 nonbusiness bad debt deduction because the account was worthless. Later, the taxpayers filed an amended return changing the characterization of the debt from a nonbusiness to a business bad debt.

The IRS disallowed the deductions, arguing that the debtor–creditor relationship and the amount, timing, and character of the debt were not established. The IRS claimed that the advances were to capital. The Tax Court held that the payments for the company’s debts were contributions to capital and not deductible bad debts under I.R.C. section 166.

The court rejected the taxpayers’ arguments, based on Generes, that the advances were made to protect their salary income and, therefore, should be classified as business bad debts. The Tax Court noted that the taxpayers failed to prove either a fixed date or reasonable expectation of repayment, did not offer notes or other evidence of indebtedness, and had no provision for interest.27 Generally the taxpayer must show that he or she entered into a valid debtor–creditor relationship, that the loans were not contingent, and that the loans were made with a reasonable expectation, belief, and advance that the loans would be repaid. Funds advanced based on the condition that the funds will be repaid only when the entity becomes financially stable does not constitute a loan. If, however, while there is risk, the entity may not have funds to repay the debt, the entity has an obligation to make the loan payments anyway and there is no express or implicit agreement between the parties that the repayment was contingent on the financial success, it has been ruled the advances were debt.28

In Baggao v. Commissioner,29 the Tax Court held that an amount that had been advanced to the attorney on behalf of the business was for nonbusiness purposes.

James and Norma Baggao purchased a hotel in Odessa, Texas, and formed Golden West Enterprises, Inc., transferring the hotel to it. The Baggaos were the sole shareholders and officers of Golden West. They operated the hotel and were paid salaries by Golden West. The hotel was not successful, and when Golden West was threatened with foreclosure of the hotel property, a chapter 11 petition was filed in December 1991. Golden West retained Wylie James as counsel, and the Baggaos paid $22,000 to James on behalf of Golden West. They expected to be repaid on the sale of the hotel. The plan of reorganization provided for the sale of the property, which occurred after the plan was confirmed, and the proceeds were used to pay creditors. The plan did not provide for the payment of the $22,000 advance to the attorney. As a result, the Baggaos deducted $22,000 as a bad debt from sales on Schedule C of their 1982 joint federal income tax return.

The Tax Court held that the $22,000 payment was a nonbusiness bad debt that could be claimed only as a short-term capital loss pursuant to I.R.C. section 166(d)(1)-(B). The court reasoned that the Baggaos’ dominant motivation in making the payment was to protect their investment in Golden West by slowing down the foreclosure process and not to reorganize Golden West’s business for continued operations.

The court also held that the Baggaos were liable for a substantial understatement penalty because they did not show substantial authority for their position. The court also noted that they did not disclose adequate facts with respect to the payment on their return.

The Ninth Circuit30 also examined a deduction claimed by a taxpayer for bad debts relating to losses from a partnership in which the taxpayer held an interest. The Ninth Circuit concluded that the taxpayer failed to show that the partnership’s dominant motive for advancing the funds was connected to the trade or business of the partnership, or that the loss from the bad debt was incurred in the partnership’s trade or business.

(e) Corn Products Doctrine

When a security that is a capital asset becomes worthless, it is deducted as a capital loss and not as an ordinary loss. One major exception to this rule was established in Corn Products Refining Co. v. Commissioner.31 The Supreme Court ruled that the disposition, at a loss, of stock acquired for the purpose of obtaining a source of raw materials resulted in an ordinary loss. The principle established in this case suggests that a loss on the disposition of property that normally would be classified as a capital asset and considered as an investment, but which was in fact acquired for a business purpose, would give rise to an ordinary loss.

Cases subsequent to Corn Products have established that stock held to generate business,32 to obtain a selling agency account or to ensure a source of supply,33 and to expand into a related line of business34 is not a capital asset. The IRS issued Revenue Ruling (Rev. Rul.) 78-9435 in an attempt to use the court’s decision in W.W. Windle Co. v. Commissioner36 to broaden the meaning of capital asset in order to reduce the opportunity for the taxpayer to have an ordinary loss. The Windle court held that “stock purchased with a substantial investment purpose is a capital asset even if there is a more substantial business motive for the purchase.”37

In Notice 87-68,38 the IRS announced that it would suspend all revenue rulings based on Corn Products, pending the outcome of Arkansas Best and Subsidiaries v. Commissioner39 in the Supreme Court. In Arkansas Best, the Court of Appeals for the Eighth Circuit reversed the Tax Court and held that a holding company sustained capital losses on all its sales of stock in a bank subsidiary. The Eighth Circuit concluded that capital stock that is not held by a dealer (or otherwise within the exceptions listed in I.R.C. section 1221) is always a capital asset under section 1221, regardless of the taxpayer’s business purpose in acquiring or holding the stock. This decision created a conflict in the circuit courts, virtually assuring a Supreme Court resolution.

As the IRS had predicted in Notice 87-68, the Supreme Court did significantly limit the application of the Corn Products doctrine in Arkansas Best. The Court held that a taxpayer’s motive in acquiring stock that the taxpayer later sold was not relevant in determining the nature of the loss—ordinary or capital. The Court held that the stock was a capital asset, because it did not fall under the statutory exceptions under I.R.C. section 1221.40 Thus, contrary to the suggestion in Corn Products, stock acquired for business purposes could not be subject to ordinary loss treatment.

(f) Small Business Exception

Under I.R.C. section 1244, an individual is allowed to deduct a loss on sale, exchange, or worthlessness of qualifying stock as an ordinary loss rather than as a capital loss. To qualify under section 1244, which was enacted to help attract financing for small businesses, the corporation must, among other requirements, qualify as a small business corporation and issue stock for money or other property (other than stock and securities). Only the first $1 million of stock may qualify as section 1244 stock. The ordinary loss treatment is allowed for a loss of up to $50,000 ($100,000 on a joint return). Any excess is considered a capital loss. Ordinary loss treatment is available only to the original owner of the stock. If the stock is transferred to another party, the stock loses its section 1244 character. The Tax Reform Act of 1984 amended I.R.C. section 1244 to allow the issuance of preferred stock. Stock issued prior to July 18, 1984, had to be common stock.

(g) Affiliate Corporation41

I.R.C. section 165(g)(3) provides that losses from a security (debt or equity) of a corporation that is an affiliate corporation are ordinary losses to which the limitations on capital losses do not apply.

In the case in which an affiliated group files a consolidated income tax return, the intercompany obligation rules42 apply to the discharge of intercompany obligations (i.e., when one member of the consolidated group is the creditor and another member is the debtor). The intercompany obligation rules generally prevent the group from having overall income or loss when the creditor member claims a bad debt deduction on the discharge of amounts advanced to another member, and the debtor member would otherwise exclude the discharge of debt from income under an exception in I.R.C. section 108(a). Specifically, the intercompany obligation rules provide that I.R.C. section 108(a) does not apply to intercompany obligations.43 Thus, the creditor member’s bad debt deduction is effectively offset by the debtor member’s discharge of indebtedness income. Under the consolidated investment adjustment rules, the shareholder member’s basis in the debtor member would increase by the amount of the discharge of indebtedness income recognized by the debtor member.44 One might think that the shareholder member is entitled to a worthless stock deduction and, if so, effectively convert (through the operation of the investment adjustment rules) the creditor member’s bad debt deduction into a worthless stock deduction; however, as discussed next, the worthless stock deduction (or a portion thereof) may be disallowed.

On March 2, 2005, the Treasury Department and the IRS issued final regulations disallowing certain losses on the sale or other disposition of subsidiary stock of a member of a consolidated return group.45 The final regulations are similar to temporary regulations that were issued in March 2002, following the decision of the Federal Circuit in Rite Aid Corp. v. United States.46

The Treasury and the IRS also announced an intention to release proposed regulations “within the near term” to provide an alternative approach to the basis disconformity method (as described in Notice 2004-58) and, more generally, on the manner in which the repeal of the General Utilities doctrine is to be implemented in the consolidated return group context.

(i) Background

Treas. Reg. section 1.1502-2047 was issued as final in 1991 to address the repeal of the General Utilities doctrine with respect to members of a consolidated return group.48 In general, Treas. Reg. section 1.1502-20(a) disallowed all losses recognized on the sale or other disposition of stock of a consolidated subsidiary member. However, Treas. Reg. section 1.1502-20(c) provided that the amount of loss disallowed under Treas. Reg. section 1.1502-20(a) shall not exceed the sum of: (1) extraordinary gain dispositions, (2) positive investment adjustments, and (3) duplicated losses (collectively, the “loss disallowance factors”). Therefore, that portion of a loss recognized on the sale of a consolidated subsidiary member that exceeded the sum of the loss disallowance factors would generally be an allowable loss.

In general, under Treas. Reg. section 1.1502-20, an extraordinary gain disposition was the amount of income or gain recognized, net of directly related expenses including federal income taxes, by a subsidiary member on a deemed or actual disposition of its capital or trade or business assets. Gains and losses on dispositions of different assets during a tax year were not netted in arriving at the extraordinary gain disposition amount. Certain other types of income could also be characterized as extraordinary gain disposition income.49

For purposes of Treas. Reg. section 1.1502-20, a positive investment adjustment was the excess of the sum of the amounts under Treas. Reg. section 1.1502-32(b)(2)(i) through (iii) over the extraordinary gain disposition amount for such subsidiary member for such year.50 For these purposes, the positive investment adjustment represented the sum of the taxable income or loss of the subsidiary member, the tax-exempt income items of the subsidiary, and the noncapital, nondeductible expense items of the subsidiary. In calculating the positive investment adjustment amount, a loss item was taken into account in the year incurred rather than the year actually utilized by the consolidated return group. If the sum of these items was a positive amount that exceeded such subsidiary member’s extraordinary gain disposition amount, then such subsidiary was considered to have a positive investment adjustment for such year. In addition, except for a transitional netting rule not applicable here, positive investment adjustments from one year could not be offset by negative investment adjustments in a prior or subsequent year.

The duplicated loss amount under Treas. Reg. section 1.1502-20 was determined immediately after the sale or other disposition of a subsidiary member. In general, the duplicated loss amount equaled the excess of the sum of the aggregate adjusted tax basis of the subsidiary member (excluding stock and securities of another subsidiary member) and any losses or deferred deductions of the subsidiary member over the sum of the value of the subsidiary member’s stock and its liabilities.51

(ii) Rite Aid

On July 6, 2001, the Federal Circuit Court of Appeals, in Rite Aid v. United States, determined that the Treasury did not act within the authority delegated by Congress under I.R.C. Section 1502 in promulgating at least part of Treas. Reg. section 1.1502-20, the loss disallowance regulation. At a minimum, the decision held that the duplicated loss factor of the loss disallowance regulation was invalid. More broadly, the opinion’s reasoning arguably could have been read to extend to invalidate any application of the loss disallowance regulation that resulted in a consolidated tax liability greater than the tax liability that would be due by applying the separate return rules instead.

(iii) Notice 2002-11

On January 31, 2002, the IRS issued Notice 2002-11 announcing that although it believes that the court’s analysis and holding in Rite Aid were incorrect, it would not appeal the decision of the Federal Circuit Court of Appeals. In the notice, the IRS stated that it will issue new rules governing sales of stock of members of a consolidated return group at a loss. The new rules will determine loss disallowance under an amended version of Treas. Reg. section 1.337(d)-2, which provided loss disallowance rules using a tracing and appraisal regime for certain dispositions not subject to Treas. Reg. section 1.1502-20. In addition, the IRS stated that for transactions (including those for which a return has been filed) completed before the date of issuance of interim regulations, groups will be allowed certain choices in determining the amount of disallowed loss on the sale or other disposition of stock of a consolidated subsidiary member.

(iv) Treas. Reg. Sections 1.337(d)-2T and 1.1502-20T(i)

On March 7, 2002, the Treasury Department and the IRS issued temporary regulations concerning the loss disallowance rules under Treas. Reg. sections 1.337(d)-2T and 1.1502-20T(i).52 The regulations under Treas. Reg. section 1.337(d)-2T determined loss disallowance based on a tracing and appraisal regime. Under these rules, a loss on the sale or other disposition of the stock of a consolidated subsidiary member is disallowed to the extent the loss is attributable to the recognition of built-in gain on the subsidiary’s disposition of an asset. For purposes of Treas. Reg. section 1.337(d)-2T, which generally applies to dispositions after March 6, 2002, a disposition is any event in which gain or loss is recognized. For these purposes, a built-in gain is a gain that is attributable, directly or indirectly, in whole or in part, to any excess of value over basis that is reflected, before the disposition of the asset, in the basis of the share, directly or indirectly, in whole or in part.53 In other words, if the outside basis of the stock reflects the inside built-in appreciation of the asset at the time the member joins the consolidated return group (e.g., a straight stock purchase without a section 338 election), then a basis increase to such member’s stock caused by the sale and recognition of the inside gain while a member of the consolidated return group will generally be treated as a loss disallowance amount upon a subsequent sale or other disposition of the subsidiary member stock at a loss.

For dispositions occurring prior to March 7, 2002, the IRS and Treasury issued Treas. Reg. section 1.1502-20T(i), which allowed a consolidated return group to elect to recalculate the amount of disallowed loss from a prior sale or other disposition of the stock of a consolidated subsidiary member. Pursuant to Treas. Reg. section 1.1502-20T(i), a consolidated return group could elect to recalculate a disallowed loss on the sale or other disposition of the stock of a consolidated subsidiary member under either Treas. Reg. section 1.1502-20(c) (taking into account only the sum of the extraordinary gain disposition and positive investment adjustment amounts), or section 1.337(d)-2T. The election to apply either section 1.1502-20(c) or section 1.337(d)-2T was made separately for each sale or other disposition of the stock of a consolidated subsidiary member.

For a calendar-year taxpayer that recognized a loss on the sale or other disposition of subsidiary stock in 2001 or a prior year, such taxpayer could file an amended return for such prior year to apply Treas. Reg. section 1.1502-20T(i) to recalculate the amount of disallowed loss on such sale or other disposition. The amended return for such a calendar-year taxpayer was required to be filed on or before the due date of the taxpayer’s 2002 consolidated federal income tax return, including extensions (i.e., on or before September 15, 2003, assuming a valid extension was timely filed).

(v) Notice 2004-58 and Treas. Reg. Section 1.1502-20T(i)

On August 25, 2004, the IRS released an advance copy of Notice 2004-58,54 which set forth a method that the IRS will accept for determining the amount of loss that is disallowed upon the sale or other disposition of the stock of a consolidated subsidiary member. Prior to the issuance of the notice, there had been some uncertainty as to the determination of whether a loss on the sale of a consolidated subsidiary member was attributable to the recognition of built-in gain on the subsidiary’s disposition of an asset. Notice 2004-58 introduces a “basis disconformity” method to determine the extent that loss or basis is attributable to built-in gain. Under the basis disconformity method, the amount of loss disallowed under Treas. Reg. section 1.337(d)-2T is the lesser of three factors: (1) the gain amount, (2) the disconformity amount, and (3) the positive investment adjustment amount.

The gain amount is the allocable portion of the total gains (net of directly related expenses) recognized by the subsidiary on the disposition of assets during the years the subsidiary was a member of the group. The gain amount includes the subsidiary’s allocable share of items recognized by lower-tier subsidiaries.

The disconformity amount is the amount by which the stock basis in the subsidiary exceeds the share’s allocable share of the subsidiary’s net asset basis. For this purpose, the net asset basis is the excess of:

• The sum of the adjusted basis of the subsidiary’s assets (including money, but excluding any stock the subsidiary owns in another subsidiary), and any losses attributable to the subsidiary that would be carried to a separate return year, over
• The sum of the subsidiary’s liabilities that have been taken into account for tax purposes.

The disconformity amount also includes the subsidiary’s allocable share of items from lower-tier subsidiaries.

The positive investment adjustment amount is the excess, if any, of the sum of the positive adjustments made to a share under Treas. Reg. section 1.1502-32 over the sum of the negative adjustments made to a share under Treas. Reg. section 1.1502-32, excluding adjustments for distributions under Treas. Reg. section 1.1502-32(b)(2)(iv). Therefore, unlike the positive investment adjustment loss disallowance factor of Treas. Reg. section 1.1502-20, for purposes of the basis disconformity method of Notice 2004-58, positive investment adjustments from one year may be offset by negative investment adjustments from a prior or subsequent year.

Concurrent with the issuance of Notice 2004-58, the Treasury Department and the IRS issued amendments to Treas. Reg. section 1.1502-20T(i) permitting taxpayers to elect to amend their calculation of the loss disallowance with respect to prior dispositions of subsidiary stock. Pursuant to Treas. Reg. section 1.1502-20T(i), a consolidated return group can elect to recalculate a disallowed loss on the sale or other disposition of the stock of a consolidated subsidiary member under either Treas. Reg. section 1.1502-20(c) (taking into account only the sum of the extraordinary gain disposition and positive investment adjustment amounts) or Treas. Reg. section 1.337(d)-2T. The election to apply either Treas. Reg. section 1.1502-20(c) or Treas. Reg. section 1.337(d)-2T is made separately for each sale or other disposition of the stock of a consolidated subsidiary member. For a calendar-year taxpayer that recognized a loss on the sale or other disposition of subsidiary stock in 2001 or a prior year, such taxpayer can file an amended return for such prior year (if the statute of limitations for filing an amended return for such prior tax year is still open) to elect under Treas. Reg. section 1.1502-20T(i) to recalculate the amount of disallowed loss on such sale or other disposition. The amended return for such a calendar-year taxpayer is required to be filed on or before the due date of the taxpayer’s 2004 consolidated federal income tax return, including extensions (i.e., on or before September 15, 2005, assuming a valid extension is timely filed).

(vi) Treas. Reg. Section 1.337(d)-2

On March 2, 2005, the Treasury and the IRS issued Treas. Reg. section 1.337(d)-2, which adopts the rule of former Treas. Reg. section 1.337(d)-2T without substantive change. The preamble to the regulation provides that the IRS will accept the basis disconformity method of Notice 2004-58 for determining whether subsidiary stock loss is disallowed and subsidiary stock basis is reduced under the final regulation.

In addition, to permit taxpayers to make the election to apply Treas. Reg. section 1.1502-20 without regard to the duplicated loss factor of the loss disallowance rule or the rule of Treas. Reg. section 1.337(d)-2, the final regulations also adopt the rules of Treas. Reg. section 1.1502-20T as final regulations without substantive change.

The final regulations apply to dispositions and deconsolidations on or after March 3, 2005. In general, the rules of Treas. Reg. section 1.337(d)-2T (as in effect on March 2, 2005) continue to apply for dispositions and deconsolidations prior to March 3, 2005.

(h) Impact on Earnings and Profit

As noted earlier, a deduction for a worthless security is taken on the last day of the taxable year. A problem arises in regard to the date to use for earnings and profits distribution. Because earnings and profits include the excess of capital losses over capital gains,55 the timing of the deduction is important for midyear distributions. It has been suggested that, because earnings and profits are not governed by artificial recognition provisions, the date of worthlessness should be used.56

§ 9.4 DETERMINATION OF WORTHLESSNESS

(a) Introduction

Securities that fall under the loss provision of I.R.C. section 165(g) and nonbusiness bad debts (I.R.C. section 166) must be totally worthless before a deduction will be allowed.57 Business bad debts can be deducted when they become partially worthless to the extent charged off in the taxable year. This partial deduction is optional, and the taxpayer can elect to wait until the debt becomes wholly worthless, or until it is finally closed out, before deducting the loss. The taxpayer must continue as the owner of the claim for the deduction to be allowed for partial worthlessness. If the claim is sold or exchanged, a loss would be allowed on the exchange but not as a bad debt. Thus, if a creditor accepts stock from a debtor in bankruptcy in exchange for the debt, a loss on exchange would be allowed rather than a bad debt loss.58

(b) Meaning of Worthlessness

Although the term “worthless” is not defined in the code, lacking monetary value is the most commonly accepted meaning. The taxpayer has the burden of proving that the security is worthless. As proof, the taxpayer must identify those events in the current year and in prior and subsequent years establishing that the security became worthless that particular year. Because the loss is deductible only in the year in which the security became worthless, the timing of worthlessness must be established as well as the fact that the security is worthless. If the worthlessness is determined to have occurred in prior years, the taxpayer must file an amended return in order to receive the benefit of the loss. I.R.C. section 6511(d) extends the statute of limitations to seven years for these losses, to avoid placing an undue hardship on the taxpayer.59 Even with this extension, where there is doubt as to when the deduction is allowed, the best strategy under most circumstances is to take the deduction during the earliest year possible. If the IRS objects to the timing, the deduction will still be available in subsequent years.

A taxpayer’s note for $2.1 million was determined to be totally worthless by the district court in 1986. Subsequent to this date, the taxpayer received $240,000 in 1993 and 1994 and has the potential for another $65,000. The Seventh Circuit, reversing the decision of the district court, emphasized the importance of total worthlessness for nonbusiness bad debts, particularly in the intrafamily setting in which nonbusiness debts are most commonly encountered. The court noted that the deduction is unavailable if even a modest fraction of the debt can be recovered. The court held that although the debt had lost most of its value, it was not worthless.60 If the event that caused the bad debt loss is a fraudulent transfer, the deduction may be disallowed.61

(c) Burden of Proof

The burden of establishing that the stock was worthless and that the worthlessness occurred during the year reported rests with the taxpayer. The taxpayer is expected to use sound business judgment in determining the year the debt became worthless, and the courts normally apply an objective test of reasonableness in determining whether the year reported by the taxpayer is valid.62

The taxpayer is not required to be an incorrigible optimist and establish impossibility of eventual recoupment.63 However, the taxpayer must establish proof by reasonably convincing evidence64 or preponderance of evidence.65

Commentators have suggested three steps to support the claim that a tax deduction due to worthlessness is warranted:66

(d) Security as Debt

In establishing worthlessness, it is necessary to consider two factors: (1) the liquidation value of the security and (2) the future value the security may acquire through foreseeable operations. In Morton v. Commissioner,69 the court described the requirements as follows:

From an examination of these cases it is apparent that a loss by reason of the worthlessness of stock must be deducted in the year in which the stock becomes worthless and the loss is sustained, that stock may not be considered as worthless even when having no liquidating value if there is a reasonable hope and expectation that it will become valuable at some future time, and that such hope and expectation may be foreclosed by the happening of certain events such as the bankruptcy, cessation from doing business, or liquidation of the corporation, or the appointment of a receiver for it. Such events are called “identifiable” in that they are likely to be immediately known by everyone having an interest by way of stockholdings or otherwise in the affairs of the corporation; but, regardless of the adjective used to describe them, they are important for tax purposes because they limit or destroy the potential value of stock.70

Thus, to be deductible, the security must have no liquidation value and have a lack of future potential. Both of these factors are required. For non-secured-debt securities, even where the prospects for the future are nil, it must be established that the assets of the debtor are not adequate to cover any of the unsecured debt before the deduction would be allowed.

(i) Identifiable Event

Some of the events that have been identified as helpful in determining worthlessness are:

• Liquidation or reorganization of the corporation, or the decision to take such action
• Sale or foreclosure of significant assets71
• Bankruptcy or insolvency
• Operating deficit with a lack of potential for future operations
• Failure to obtain continuing financing arrangements

It often takes two or more of these events to substantiate worthlessness. The filing of a bankruptcy petition alone does not indicate that the security is worthless.

Typically, a finding of worthlessness will flow from a series of events rather than a single episode. These events often take place over a period of several years. One event affects the loss transaction prior to the year of deduction; another event closes the transaction giving rise to the deduction claim; and events occurring subsequent to the deduction year confirm that the claim was timely and appropriate. The taxpayer should, therefore, consider events occurring before, during, and after the loss, when making or seeking to prove a claim.

The test of worthlessness is objective; the taxpayer’s attitude and conduct are relevant facts. For example, if a taxpayer continues to make loans to a company that is experiencing serious difficulties, the IRS may conclude that the taxpayer thought the stock continued to have some value, and a deduction claim would fail.72

Thus, the attitude and conduct of the taxpayer toward the debt are important, and the IRS will look for properly kept records, normal business loan procedures, regular board of directors’ minutes documenting finances and business reversals, and arm’s-length dealings with the corporation and third parties.73 Conflicting decisions can be reached on similar stock, and decisions are not binding in subsequent litigation because each case is based on the number and nature of each taxpayer’s arguments for worthlessness.74

The event used to identify the loss must present facts to indicate that the loss was sustained. It is not enough just to show that the loss is imminent.75 For example, an excess of liabilities over assets that are valued properly may be used to establish worthlessness.76 However, the taxpayer will be denied a deduction for securities when no identifiable event indicates worthlessness for the tax year, or no evidence is presented that the liabilities exceed the assets.77

(e) Impact of Insolvency

The insolvency of the debtor, where the market value of total assets is less than the creditors’ claims, may, by itself, be an identifiable event. This is especially true if the prospects of recovery appear nil and discovery of this fact occurred suddenly. For example, the discovery of insolvency during an appraiser’s report on assets after the creditor had decided to foreclose was held to be an identifiable event.78 It may be sufficient evidence of insolvency that there are operating losses and the company’s finances are so precarious that bondholders can take over to the exclusion of common stockholders.79 Similarly, where there is considerable doubt as to the company’s ability to pay even preferred creditors, or where assets become depreciated due to a sudden disaster, insolvency may emerge as the identifiable event fixing the loss.80

Insolvency does not, however, necessarily indicate that the debtor’s business has no potential.81 An insolvent debtor’s attempt to reorganize under chapter 11 may indicate that the debtor has expectations of future profit.82 Also, the possibility of selling the business may indicate a potential for future profits.83 More important than the insolvency of the debtor is the type of action the debtor is taking to correct the problem that led to the insolvency. Establishing worthlessness may be more difficult in a reorganization under chapter 11 than in a liquidation under chapter 7.

(f) Impact of Liquidation Proceedings

The court in Morton v. Commissioner84 listed bankruptcy and receivership as two events that indicate the end of potential value. In 1938, when this case was decided, reference to bankruptcies most likely referred to liquidations. This case was decided prior to the Chandler Act, which modified the Bankruptcy Act to make reorganizations easier. A chapter 7 petition normally indicates a decision, voluntary or forced by creditors, to “throw in the towel.” This decision is often made because additional funds cannot be obtained, the market is weak, inventories cannot be reduced at a reasonable price, or the owners do not want to (or are unable to) invest additional funds in the business. Facts of this nature, along with the filing of a chapter 7 petition and an orderly liquidation of the business under state law, provide considerable evidence to indicate that the potential for the business to have future value has ended. Case law would support the position that insolvency plus the filing of a chapter 7 or liquidation under state law is a significant event that indicates the worthlessness of the debt and the justification for reporting the loss.85 However, the taxpayer should always consider all facts to be sure that countervailing evidence does not exist.

(g) Impact of Bankruptcy Reorganization Case or Out-of-Court Settlement

The nature of proceedings under chapters 11, 12, and 13 or of negotiations out of court suggests that the debtor has a chance of rehabilitation; this may suggest that the debt or other security is not worthless.86

However, if the status of a creditor or stockholder is such that nothing will be available after secured and priority creditors are compensated, the proceedings may suggest worthlessness of the debt or security.

Going-concern values must be determined to evaluate the potential for future profitable operations.87 In determining the worthlessness of debt or other securities, courts have looked at the going-concern value and have attempted to value the corporation as a separate, whole entity rather than looking at individual assets.88

For business bad debts, bankruptcy is an indication of at least partial worthlessness of securities. Because of the right of stay, bankruptcy reorganization proceedings often preclude the creditor from taking legal action against the debtor, at least for a period of time. This generally results in a delay in deducting any amount under I.R.C. section 165, where total worthlessness, a sale or exchange, or other evidence of a completed transaction must occur before the deduction is allowed. Thus, bankruptcy proceedings, rather than providing evidence for a deduction, often delay the reporting of the loss.

An extension of time for payment and/or a change in the interest rates does not give rise to a loss for proceedings in or out of court.89 If the extension or change in interest rate is accompanied by debt reduction, the loss is recognized.90 However, if the debt is represented by a security, creditors will lose their bad debt deduction but probably will have an amortizable bond premium.

(h) Other Factors

Events occurring subsequent to the evaluation of a debt reported as worthless are not relevant. The decision about worthlessness must be based on and judged according to conditions existing at the time the initial decision was made. For example, one court stated: “Once it appears from all the surrounding circumstances that a debt has become worthless, we cannot look to subsequent events to determine if a debt in fact becomes worthless. The possibility of collection is tested by the facts known at the time and not by hindsight.”91

Taxpayers must, however, be careful, after deducting a debt as worthless, not to take actions inconsistent with the decision to write off the debt as worthless. For example, subsequent advances to an insolvent corporation may indicate a belief that it has potential for future profits,92 and inconsistency between corporate and individual tax returns and financial statements may present problems.93

(i) Business Bad Debts (Section 166)

I.R.C. section 166 provides that, for business bad debts, a deduction can be made for debts that are worthless in whole or in part, or a deduction can be made for a reasonable addition to a reserve account. In determining whether a debt is worthless, in whole or in part, Treas. Reg. section 1.166-2(a) states that consideration will be given to all the pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. Part (b) of this regulation provides that, when the surrounding circumstances indicate that a debt is worthless and uncollectible and that in all probability legal action would not result in any collection, a presentation of these facts should constitute sufficient evidence for worthlessness of the debt under I.R.C. section 166.

I.R.C. section 166(a)(1) provides for a deduction for wholly worthless debts, and section 166(a)(2) provides for a deduction for partially worthless bad debts. The partially worthless deduction also requires that the bad debt be charged off within the taxable year. In Century Motor Coach Inc. v. Commissioner,94 the Tax Court disallowed an I.R.C. section 166(a)(1) deduction for a bad debt, on the grounds that the taxpayer had recovered a part of the debt. According to the court, the taxpayer had not relied on I.R.C. section 166(a)(2) (partial worthlessness) for the deduction and, in any event, had not charged the debt off on its books during the taxable year.

Bankruptcy is generally an indication of worthlessness of at least part of an unsecured or unpreferred debt.95 The extension of the statute of limitations to seven years under I.R.C. section 6511(d) also applies to bad-debt losses. In B.B. Rider Corp. v. Commissioner,96 the Third Circuit held that individuals who served as shareholders and officers of a refrigerator sales and service franchise could not claim business bad-debt losses for principal payments on corporate debts that they had personally guaranteed in a bankruptcy reorganization, because they did not produce evidence showing that the payments were sufficiently related to preservation of their employment with the corporation. The case also suggested that uncollected interest payments on such debt would be deductible only as nonbusiness bad debts. Following a remand and a subsequent appeal, the Third Circuit97 held that any interest payments made by the guarantors on debt of a corporation that has been discharged is deductible under I.R.C. section 163 as interest. The court noted that, because the taxpayer had a direct and fixed obligation to pay the notes and had no recourse against the corporation, the interest should be deductible.

In Lease v. Commissioner,98 the Tax Court held that Lease’s advances to Montex were contributions to capital, and, even if the advances were debt, the debt was nonbusiness bad debt. Citing Estate of Mixon v. United States,99 the Tax Court noted that, in the absence of regulations, case law controls the issue of whether advances to a corporation are debt or equity. The Tax Court concluded that the advances to Montex were clearly capital contributions rather than debt. The court noted that, when the advances were made, Montex had no capital or assets and had not even begun its operations as a mining business. The taxpayer was relying on an oral promise for capital from an investor with whom he had never previously dealt. The court concluded that no reasonable creditor would have been comfortable making a loan to a corporation without any assets, capital, or contractually committed investors.

Based on Mixon, the court concluded that an advance to Montex, even if assumed to be debt, would not qualify as a business bad debt because there was no proximate relationship between Lease’s advances and his business activities as an actual or prospective employee. The court found it inconceivable that someone would advance $295,000 to a corporation to secure employment as a corporate officer at a salary of $100,000 per year.

In Baldwin v. Commissioner,100 Jerry Baldwin and another individual formed a partnership in 1985 to manufacture and sell satellite dish antennas. The business was successful, and Baldwin acquired his partner’s interest and incorporated the business as Baldwin Enterprises Inc. (BEI). Baldwin received 150 shares, and three employees of the partnership received a total of 50 shares.

The undistributed earnings were structured as debt rather than equity in BEI. Baldwin’s basis in his partnership interest was transferred to BEI as $161,483 unsecured debt and as stock with a basis of $54,820. The unsecured debt was represented by a note that called for the payment of interest, but no payments of interest or principal were ever made. Because of financial problems, most of the employees were laid off and Baldwin claimed a $161,483 bad debt deduction on the Schedule C attached to his 1987 return. The Tax Court held that Baldwin was entitled to the bad debt deduction. The court determined that Baldwin’s advance to BEI constituted debt rather than equity. The advances were found to be reasonable under the circumstances because, as the Tax Court noted, the business had initially realized large profits and Baldwin and his advisors believed that the high level of profits would continue.

The Tax Court held that a settlement payment based on debt guarantee is not deductible as a bad debt.101 Stephen Scofield, a shareholder, officer, and director of Northeast Cellulose, Inc., signed a guarantee with Guaranty Bank & Trust Co. for a line of credit granted to Northeast. Around the same time, Scofield’s financial statements estimated that he had a $1 million interest in Northeast. Later that year, Northeast ceased doing business. The creditors filed a $3 million suit against Scofield. Scofield filed a bankruptcy petition, later settled the lawsuit, and agreed to pay $750,000 for the release of the creditors’ claims.

The Tax Court held that Scofield could not deduct as a bad debt the portion of the $750,000 that was attributable to his guarantee, because the guarantee was not proximately related to his trade or business. Rather, the court determined that Scofield wanted capital appreciation from Northeast and not income. The court allowed Scofield to deduct, under section 162, the portion of the settlement not attributable to the guarantee, because it determined that the underlying claims representing that portion originated in Scofield’s conduct as a Northeast officer or employee, not as an investor/shareholder.

Funds advanced to the wife’s son that were not formalized where no demands for repayment were made were not deductible when the son filed for bankruptcy and received his discharge.102 The IRS disallowed the loss because the couple could not prove that the amount was a bad debt arising from a debtor–creditor relationship. The Ninth Circuit, in an unpublished per curiam memorandum, affirmed the Tax Court and denied the couple’s claimed deduction for a bad debt to their son because the couple failed to prove that a valid debt existed.103

(i) Financial Institutions

Banks and other corporations regulated by federal or state authorities maintaining standards regarding the charges for bad debts are allowed to deduct for tax purposes those charge-offs required by such authorities.104

(ii) Cash-Basis Taxpayer

A cash-basis taxpayer can deduct losses from bad debts only when an actual cash loss has occurred. Thus, a taxpayer on the cash basis could not deduct the value of services rendered if the recipient is declared bankrupt and is unable to pay for such services.

(iii) Worthlessness

For nonbusiness deductions under I.R.C. section 166, it is also necessary to prove that the debt is totally worthless. Treas. Reg. section 1.166-5 states that a loss on a nonbusiness debt will be treated as sustained only if the debt has become totally worthless, and no deduction will be allowed for a nonbusiness debt that is recoverable in part during the taxable year.105

An analysis similar to that used for I.R.C. section 165(g) losses is necessary to support the deduction for a nonbusiness bad debt.

§ 9.5 SECURED DEBT

(a) Introduction

The tax consequences associated with a secured debt depend on several factors, including whether (1) the mortgagee is a conventional lender, a vendor who gave a purchase money mortgage obligation in lieu of cash as an accommodation to the buyer, or a party who purchased the mortgage obligation from the original mortgagee; (2) the mortgagor is personally liable; (3) the mortgagee holds the mortgage in connection with a trade or business; and (4) there is a foreclosure, abandonment, or voluntary conveyance.106

(b) Foreclosure

If the creditor elects to foreclose on the property, the tax consequences depend to some extent on whether the creditor purchases the property in the foreclosure sale and whether the creditor was the original owner of the property that was sold to the debtor.

(i) Third-Party Purchase

When the property is purchased by a third party, the mortgagee’s gain or loss will be the difference between the amount received on the foreclosure (less foreclosure and collection expenses) and the basis in the debt secured by the mortgaged property.107 When the mortgagee’s basis in the obligation is the same as the amount of the obligation, a gain cannot be realized, but interest may be paid.108 If the basis is less than the amount of the debt, as would be the case when the mortgage was purchased at a discount, a gain could be realized. The loss would be reported in the year of foreclosure if there is no deficiency judgment against the debtor. If there is a deficiency judgment, then the loss would be deductible in the year that the judgment became worthless.109 In order to write off the amount of the deficiency judgment, the creditor must have proof of unsuccessful attempts to collect the amount due or proof of the debtor’s insolvency.

(ii) Nonvendor Purchase: Two-Step Transaction

If a mortgagee that was not the vendor of the mortgaged property purchases the property at a foreclosure sale, the transaction must be analyzed in two steps.110 First, the mortgagee has a loss to the extent the basis of the debt exceeds the bid price. The loss will usually be a bad-debt loss and will be either an ordinary loss or a capital loss, depending on whether it is a business or nonbusiness loss. Second, a gain or loss will be recognized to the extent the fair market value of the mortgaged property differs from the mortgagee’s basis in the mortgage obligation applied to the bid.

Rev. Rul. 72-238111 contains an example illustrating the computations in the two-step transaction. An individual defaulted on an unpaid obligation of $400X and the bank purchased the property for $250X. The property’s fair market value was $300X. The two-step transaction analysis follows:

First Step
Bid price	$250X
Less basis in unpaid loan	400X
Gain (loss) realized on collection reported as bad debt deduction	($ 150X)
Second Step
Fair market value	$300X
Less basis applied to bid price	250X
Gain (or loss) realized	$ 50X

The $150X loss on the collection of the debt through foreclosure would be an ordinary business bad debt loss. Furthermore, because the bank is in the business of lending money, the $50X gain would also be ordinary income. If the mortgagee was not in the business of lending funds, the $50X gain would be reported as a capital gain and, assuming the mortgage was held for more than six months, the gain would be long-term. If the IRS could not provide convincing proof that the market value was $300X, the creditor would report a bad debt loss of $150X and no gain.

Treas. Reg. section 1.166-6(b)(2) provides that the bid price in the foreclosure sale is presumed to be its fair market value unless clear and convincing proof exists to the contrary. Rev. Rul. 72-238 states, however, that the fair market value will be found in excess of the bid price when so determined by qualified appraisers. The difference between the mortgagee’s basis and the fair market value is generally considered a capital gain or loss. The IRS also took the position, in this revenue ruling, that a mortgage held by a bank was not a capital asset and that, as a result, any gain was ordinary income. In Community Bank v. Commissioner,112 the IRS argued this position, but a decision was not reached on this point, because the court determined that the fair market value of the property acquired by Community Bank was the same as the bid price. See § 2.8(c) for a discussion of the impact of foreclosure on the debtor.

(c) Section 1038: Vendor–Mortgagee Reacquisition

In 1964, Congress passed I.R.C. section 1038, which allows a property owner who sold the property, accepted a mortgage as security, and later reacquired the property to treat the situation as if a sale did not occur. The property must have been secured and reacquired by the original seller. The seller’s estate or donee is not able to use this section. Neither a gain nor a loss will result to the mortgagee on the reacquisition of the property, except as provided in I.R.C. sections 1038(b) and (d). Under section 1038(b), the amount of the gain is the lesser of (1) money plus fair value of other property received prior to reacquisition, to the extent this exceeds the gain on the sale previously reported as income (realized gain taxed), or (2) the untaxed gain realized on the sale less costs associated with reacquisition of the property. Note that no reference is made to the fair market value of the property at the time of reacquisition.

The untaxed gain, which is described in the Treasury Regulations as a limitation on the amount of the gain,113 is the difference between the sale price and the adjusted basis at the time of sale, reduced by the amount of gain returned as income. The limitation does not apply if the selling price of the property is indefinite and cannot be determined at the time of reacquisition.

The Treasury Regulations, in defining the meaning of money and other property with respect to the sale, provide that:

• Payments made on the property at the time of reacquisition are considered received prior to the reacquisition. For example, if the purchaser gives money or property at the time of reacquisition for partial or complete satisfaction of the debt, the value of these payments will be considered received prior to reacquisition.
• Any amounts received as interest are excluded from the computation of gain on sale and are not considered as money or other property received.
• The amount received by discounting the purchaser’s indebtedness is the amount received by the seller, except that such amount shall be reduced by the amount paid or the value of property transferred to reacquire the indebtedness. For example, if S sells real property to P for $25,000 and under the contract receives $10,000 down and a note from P for $15,000, S would receive $22,000 with respect to the sale if S were to discount the note for $12,000. If, before the reacquisition of the real property, S were to reacquire the discounted note for $8,000, S would receive $14,000 with respect to the sale.

(i) Nature of Gain

The character of the gain resulting from a reacquisition is determined on the basis of whether the gain on the original sale was reported on the installment method or, if not, on the basis of whether title to the real property was transferred to the purchaser. If title was transferred to the purchaser in a deferred payment sale, the nature of the gain will depend on whether the reconveyance of the property to the seller was voluntary. For example, if the gain on the original sale of the reacquired property was returned on the installment method, the character of the gain on reacquisition by the seller must be determined in accordance with Treas. Reg. section 1.453-9(a). If the original sale was not on the installment method but was a deferred payment sale, as described in Treas. Reg. section 1.453-6(a), where title to the real property was transferred to the purchaser and the seller accepts a voluntary reconveyance of the property, the gain on the reacquisition will be ordinary income. If the obligations satisfied are securities, any gain resulting from the reacquisition will be capital gain.114

Thus, the nature of the gain, ordinary or capital, is not affected by I.R.C. section 1038.

Under I.R.C. section 1038(d), any amount previously deducted as a worthless debt, in full or in part, will be considered in the total amount received under section 1038(b), but only to the extent that the deduction resulted in a tax benefit.

(ii) Basis of Property

The basis of real property reacquired in a reacquisition is the sum of:

• The amount of the adjusted basis of the indebtedness of the purchaser that was secured by the property, and
• The amount of gain resulting from reacquiring the property, and
• The amount of money or other property paid or transferred by the seller in connection with the reacquisition.115

The basis of any indebtedness not discharged and secured by the property reacquired is zero.

The use of I.R.C. section 1038 is mandatory. This section has the effect of not allowing a loss on the reacquisition of the property even though the property may have declined in value.

The holding period for the reacquired property consists of the holding period prior to the sale plus the period after reacquisition. It does not include the period from sale to reacquisition.

(iii) Examples

Consider the next examples, presented in Treas. Reg. section 1.1038-1(h).

(d) Voluntary Conveyance and Abandonment

To avoid delay and public disclosure, the mortgagor and mortgagee may agree to an arrangement in which the mortgagor voluntarily transfers the property to the mortgagee in settlement of the debt. The amount of the gain or loss that the mortgagor will be allowed is the difference between the mortgagee’s basis in the obligation and the fair market value of the property received, adjusted for the expense of settlement and any accrued interest that was previously reported as income and not collected. The loss is reported as a bad debt deduction, and any gain would first be considered interest income to the extent that any unpaid interest is due but has not been previously reported as income. Any excess would be ordinary income.116

If the mortgage obligation is a security within the terms of I.R.C. section 165(g) or is held as a capital asset according to I.R.C. section 1232(a), a capital gain or loss will result from the conveyance.

If the mortgagor successfully abandons the property, no sale or exchange is deemed to have occurred, and any gain or loss from such action is considered ordinary income or loss. Voluntary abandonment may, however, be considered a sale. In Abrams v. Commissioner, 117 property held as a capital asset was voluntarily reconveyed to the seller to avoid foreclosure. The taxpayer called it an abandonment and reported the loss on abandonment as ordinary. The court held that a voluntary abandonment is treated as a sale. For a discussion of the impact of voluntary conveyance and abandonment on the debtor, see § 2.8(d). The same sale treatment would apply to a deed in lieu of foreclosure where the debtor voluntarily “deeds over” the property to the holder of the mortgage. This is sometimes referred to as a friendly foreclosure. In some cases, the lender might give the debtor a cash payment in exchange for the “keys” to the property and a promise not to trash or damage the property before vacating the property.

(i) Debtor Personally Liable

Even after foreclosure, voluntary conveyance, or abandonment, the mortgagee may be unable to declare the unpaid debt as totally worthless if the debtor has any right of redemption or if the mortgagor is personally liable. If it is apparent that the unpaid mortgage obligation is uncollectible, the gain or loss can be recognized.118 In instances where the mortgagor is personally liable, it may be necessary for the mortgagee to establish uncollectibility of the debt before a deduction will be allowed.

§ 9.6 REORGANIZATION

This section describes the tax consequences to the creditors of a reorganization that qualifies as a tax-free reorganization under I.R.C. section 368(a)(1). The tax-free reorganization is often in the form of a G reorganization of a debtor in bankruptcy where a corporation transfers all or part of its assets to another corporation in a plan under “title 11 or similar case” and stock or securities of the transferee corporation are distributed in a transaction that qualifies under I.R.C. sections 354, 355, or 356 or an E involving a recapitalization.

(a) Debt for Debt/Stock

The tax consequence to a creditor that exchanged its debt for another debt instrument depends on whether the debtors present a claim that constitutes a security for federal income tax purposes. The determination as to whether the debt constitutes a “security” depends on the facts and circumstances surrounding the origin and nature of the obligation. As a general rule, a debt evidenced by a written instrument with a term of 5 years or less at the time of issuance or a trade debt does not constitute a security instrument. A debt instrument with a term of 10 years or more generally does constitute a security instrument. A debt instrument with a term of more than 5 and less than 10 years may be a security depending on the nature of the instrument.

(i) Debt Not Classified as Security

If the present debt is not classified as a security, the debtor will recognize a gain or loss on the exchange of its present claim for new securities (either stock or debt or both) and other considerations. The gain or loss will be the difference between the value of the new securities and other property, including cash, and the tax basis of the present debt. Any payment that the I.R.C. may interpret as consideration for accrued interest will be taxed as ordinary income unless the interest was previously reported as accrued interest.

(ii) Debt Classified as Security

If the present debt is classified as a security, the creditor will generally not recognize any gain or loss on the exchange of present securities for new securities (stock or debt or both). A gain, but not a loss, will, however, be recognized to the extent that the principal amount of the tax securities exceeds the principal amount of the securities surrendered. A gain will also be recognized to the extent that the consideration received does not constitute a security. The gain recognized will be the difference between the lesser of the cash and other property that is not classified as a security received or the excess of the value of the total consideration (cash, other property, and new securities) over the tax basis of the debt. If a debt classified as a security is received and no debt classified as a security is exchanged for the security, a gain, but not a loss, will be recognized to the extent that the value of the security received exceeds the tax basis of the debt. The receipt of consideration for interest will be taxed as interest income unless previously reported. This interest must be reported by all reorganizations but is more likely to be a problem in a G reorganization.

The tax impact of the gain depends on the classification of the debt. For example, if the security is a capital asset, the gain will be a capital gain. If the security has been held for more than one year, it will be a long-term capital gain.

The tax basis in the securities surrendered will carry as the basis of the acquired securities and the holding period of the prior securities will be added to the holding period of the new securities.

(b) Stock for Stock

The shareholders of the debtor corporation generally will not recognize any gain or loss on the exchange of their stock for new stock of the reorganized entity. Thus, even though the basis in the stock is generally much higher than the value of the stock received, the shareholder is not able to recognize any gain or loss on the exchange. The basis and holding period of the old stock will carry over to the new stock. A gain or loss will be recolonized on disposal of the stock acquired in the reorganization.

If the shareholder does not receive any new stock or other securities as a result of the plan, as has been the case in several chapter 11 cases, a loss will be recognized as of the last day of the taxable year in which the shares became worthless as described in §§ 9.4(c)–9.4(g). It should be recognized that the loss may not necessarily be deductible in the taxable year in which the plan was confirmed without any consideration being given to the shareholder but would be deductible in any earlier taxable year if it can be shown that the facts indicate that the recovery for shareholders will be nothing.

The tax consequences to the corporation are described in Chapter 5.

The Ninth Circuit, reversing the Tax Court, held that shareholders were entitled to a worthless stock deduction for stock canceled in a chapter 11 bankruptcy proceeding in which shareholders received new shares in the reorganized corporation in exchange for contributing additional capital.119

The taxpayers acquired their rights in the new corporation not because they owned old shares but because they submitted a reorganization plan that was approved (over other options) and because they contributed new capital. The court also noted that the fact that the taxpayers participated in formulating the reorganization plan was not a factor in determining whether the old shares had potential value. Several other cases support the worthlessness of the stock.120 In these cases, new shares were issued pursuant to a plan of reorganization where the original shareholders additionally contributed to the plan or where outsiders were also offered new shares even though they did not own the original shares that were canceled. Other cases mentioned in Delk are cases that hold the contrary position that notwithstanding the cancellation of the common stock, the stock did not become worthless in that year. 121

In In re Steffen,122 even though the stock was canceled, it was placed in trust for the shareholders. Because the common shareholders had the potential for distribution under the plan confirmed by the bankruptcy court, the court held that “it cannot be said that the common stock of Bicoastal was rendered valueless simply by virtue of its cancellation, especially in light of the fact that there was a creation of a stock trust.” The court further noted that “at a minimum, the facts . . . were complicated and not a straight mom and pop organization that had the common stock canceled upon effectuation of a plan.”123 Thus the shares were not held worthless.

1 Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1934).

2 See infra note 15 and related text for a summary discussion of a taxpayer’s basis in stock for which the taxpayer claimed a worthless stock deduction.

3 Treas. Reg. § 1.166-1(g); Treas. Reg. § 1.582-1.

4 Treas. Reg. § 1.165-5(g); Treas. Reg. § 1.471-5.

5 Treas. Reg. § 1.165-1(d).

6 When a Loss Is Deductible and How Much Can Be Deducted Depends on the Nature of the Loss, 14 Tax’n for Acct. 119 (1975).

7 Natbony, Worthlessness, Debt-Equity, and Related Problems, 32 Hastings L. J. 1407, 1412 (1981).

8 See Treas. Reg. § 1.1001-1(c).

9 949 F.2d 371 (10th Cir. 1991).

10 § 165(1) provides an ordinary loss deduction for losses on deposits resulting from bankruptcy or insolvency of certain financial institutions suffered by “qualified individuals” (generally those other than owners or officers of those institutions). See Fincher v. Commissioner, 105 T.C. 126 (1995) (denying deduction under I.R.C. § 165(1) and also under I.R.C. § 166).

11 944 F.2d 747 (10th Cir. 1991).

12 Smith v. Commissioner, 65 F.3d 37 (5th Cir. 1995).

13 See Selfe v. United States, 778 F.2d 769 (11th Cir. 1985), and Sleiman v. Commissioner, 187 F.3d 1352, 1357 (11th Cir., 1999).

14 Luiz, TC Memo 2001-21, (2004)

15 But see Field Service Advice 1999-1043 199 TNT 127-71 (July 2, 1999). In a 1992 Field Service Advice, the IRS held that a creditor treats stock received from the debtor in cancellation of a debt as payment on the

16debt to the extent of the fair market value of the stock on the date of the cancellation. If the value of the stock is less than the creditor’s basis in the debt and the requirements of § 166 are met, the creditor may deduct the difference as a § 166 bad debt deduction. The IRS does not explore the possibility that the cancellation of the debt constituted a “retirement” of the debt for purposes of § 1271(a). The IRS also stated that when the creditor subsequently claimed a worthless stock deduction under § 165(g), the creditor’s basis in the stock is the fair market value of the stock on the date of the debt cancellation.

The two-pronged test is illustrated in Byers v. Commissioner, 57 T.C. 568 (1972), aff’d, 472 F.2d 590 (6th Cir. 1973), and in Cooper v. Commissioner, 61 T.C. 599 (1974).

17 See Treas. Reg. § 1.166-1(c).

18 In re Healey, 228 B.R. 332 (Bankr. N.D. Ga. 1998).

19 See I.R.C. § 385.

20 See, e.g., J.S. Biritz Constr. Co. v. Commissioner, 382 F.2d 451 (8th Cir. 1962); Estate of Miller v. Commissioner, 239 F.2d 219 (9th Cir. 1956). See also Peoplefeeders, Inc. and Subsidiaries v. Commissioner, 77 T.C.M. (CCH) 1349 (1999) (net intercompany payments from a subsidiary to a parent not treated as loans to the parent in the case in which there was no written promissory note or security agreement and a lack of repayment terms, interest, or collateral).

21 Roth Steel Tube Co. v. Commissioner, 800 F. 2d 625, 630 (6th Cir. 1986).

22 See, e.g., AutoStyle Plastics, Inc., 269 F.3d. 726 (6th Cir. 2001).

23 2003 U.S. Dist. 12564 (E.D. Ill. 2003).

24 405 U.S. 93 (1972).

25 Treas. Reg. § 1.166-5(b).

26 56 T.C.M. (CCH) 1135 (1989).

27 See Zimmerman v. United States, 318 F.2d 611 (9th Cir. 1963).

28 Klaue v. Commissioner, T.C. Memo 1999-151 (U.S. Tax Court Memos, 1999).

29 63 T.C.M. (CCH) 2778 (1992).

30 Yamamoto v. Commissioner, 958 F.2d 380 (9th Cir. 1992), reported in full, 1992 U.S. App. LEXIS 6397.

31 350 U.S. 46 (1955).

32 See Steadman v. Commissioner, 424 F.2d 1 (6th Cir. 1970), cert. denied, 400 U.S. 869 (1970).

33 See Waterman, Largen & Co. v. United States, 419 F.2d 845 (Ct. Cl. 1969), cert. denied, 400 U.S. 869 (1970); Booth Newspapers, Inc. v. United States, 303 F.2d 916 (Ct. Cl. 1962).

34 See Schlumberger Technology Corp. v. United States, 443 F.2d 1115 (5th Cir. 1971).

35 1978-1 C.B. 58, rev’g Rev. Rul. 75-13, 1975-1 C.B. 67.

36 65 T.C. 694 (1976), appeal dismissed on jurisdictional grounds, 550 F.2d 43 (1st Cir. 1977), cert. denied, 431 U.S. 966 (1977).

37 65 T.C. at 712. For a detailed analysis of Windle, see Natbony, Whither Windle, 24 St. Louis U. L. J. 67 (1969).

38 September 29, 1987.

39 Arkansas Best Corp. v. Commissioner, 800 F.2d 215 (8th Cir. 1986), aff’d, 485 U.S. 212 (1988).

40 Treas. Reg. § 1.1502-13(g).

41 The contribution of Alan Barton, CIRA, Partner, Merger & Acquisitions Tax Practice, KPMG, to this section is gratefully acknowledged. See AIRA Journal (April/May 2005), pp. 6, 14–16. Used with permission.

42 See Treas. Reg. § 1.1502-13T(g)(3)(ii)(B)(2) and § 1.1502-13(g)(5), Example 3(d). See § 2.10(a)(IV) and note 314.

43 To avoid duplication of income and losses when a subsidiary is disposed, the investment adjustment rules require the basis of stock of a subsidiary of a consolidated group to be: increased by the subsidiary’s taxable and tax-exempt income, and decreased by the subsidiary’s taxable loss (when used by the group), noncapital, nondeductible expenses, and distributions on its stock. Treas. Reg. § 1.1502-32(b)(2).

44 Supra note 39, 485 U.S. at 218.

45 T.D. 9187.

46 45 255 F.3d 1357 (Fed. Cir. 2001).

47 T.D. 8364.

48 The Tax Reform Act of 1986 repealed I.R.C. Section 311(a)(2), which was enacted in 1954 and codified what had become known as the General Utilities doctrine. The General Utilities doctrine provided that a corporation did not recognize gain or loss on a distribution of appreciated or depreciated property to its shareholders with respect to their stock. See General Utilities & Operating Co. v. Helvering, 296 US 200 (1935).

49 Treas. Reg. §§ 1.1502-20(c)(1)(i) and 1.1502-20(c)(2)(i).

50 Treas. Reg. §§ 1.1502-20(c)(1)(ii) and 1.1502-20(c)(2)(ii).

51 Treas. Reg. § 1.1502-20(c)(2)(vi).

52 T.D. 8984.

53 Treas. Reg. § 1.337(d)-2T(c)(2).

54 2004-39 I.R.B. 520.

55 Treas. Reg. § 1.312-7(b)(1).

56 Natbony, supra note 7 at 1420.

57 See Delk v. Commissioner, 113 F.3d 984 (9th Cir. 1997) (the Tax Court denied taxpayer’s worthless stock deduction even though stock was canceled and shareholders were required to invest additional funds in order to receive stock in the reorganized company. The Ninth Circuit reversed the Tax Court decision and allowed the deduction).

58 Benedum v. Granger, 180 F.2d 564 (3d Cir. 1950), cert. denied, 340 U.S. 817 (1950).

59 The Economic Recovery Tax Act of 1981 extended the loss carryover period to 15 years (I.R.C. § 172). The time period in I.R.C. § 6511(d), however, was not changed.

60 Buchanan v. United States, 87 F.3d 197 (7th Cir. 1996).

61 United States v. Chavin, 316 F.3d 666, 680 (7th Cir., 2002).

62 See Washington Institute of Technology, Inc. v. Commissioner, 10 T.C.M. (CCH) 17 (1951).

63 United States v. S.S. White Dental Mfg. Co., 274 U.S. 398 (1927).

64 Royal Packing Co. v. Commissioner, 22 F.2d 536 (9th Cir. 1927).

65 Mohr v. United States, 168 F. Supp. 734 (D. Va. 1959), rev’d and remanded on other grounds, 274 F.2d 803 (4th Cir. 1960).

66 Natbony, supra note 7 at 1428–30. See also Buchanan v. United States, 87 F.3d 197 (7th Cir. 1996) (holding taxpayers not entitled to a nonbusiness bad debt deduction and describing the worthlessness test as “no reasonable prospect of recovering a significant, though in the sense of nontrivial, fraction of [the amount owed.]”), rev’g 892 F. Supp. 1073 (N.D. Ill. 1995).

67 See Malmstedt v. Commissioner, 578 F.2d 520, 524 (4th Cir. 1978); Hunt v. Commissioner, 82 F.2d 668, 671 (5th Cir. 1936).

68 G.E. Employees’ Secur. Corp. v. Manning, 137 F.2d 637, 641 (3rd. Cir. 1943).

69 38 B.T.A. 1270 (1938), nonacq. 1939-1 C.B. 57, aff’d, 112 F.2d 320 (7th Cir. 1940).

70 38 B.T.A. at 1278.

71 See P.L.R. 199951011 (September 17, 1999) in which the IRS ruled that a parent company’s two holding companies (S1 and S2) may claim a worthless securities deduction under § 165(a) on their stock investment in S3 when S3 sold its operating assets at an arm’s-length price to a third party. After the sale, S3 was insolvent. In addition, because S3 sold all of its operating assets, there were no assets to generate income that could be distributed to S1 or S2. Thus, the S3 stock was worthless in the hands of S1 and S2. Furthermore, the loss was an ordinary loss, because S3 was affiliated with S1 and S2 within the meaning of § 165(g)(3). G. E. Employees Secur. Corp. v. Manning, 137 F.2d 637, 641 (3d Cir. 1943).

72 Singer v. Commissioner, 34 T.C.M. (CCH) 337 (1975), aff’d, 560 F.2d 196 (5th Cir. 1977).

73 Natbony, supra note 7 at 1436, discussing Scifo v. Commissioner, 68 T.C. 714 (1977), acq. 1978-2 C.B. 2, where petitioners had excellent records and the court ruled in petitioners’ favor, and Dustin v. Commissioner, 53 T.C. 491 (1959), aff’d, 467 F.2d 42 (9th Cir. 1972), where the court held against a taxpayer that had poor recordkeeping.

74 GE Employees Secur. Corp. v. Manning, 137 F.2d 637 (3d Cir. 1943), rev’g 42 F. Supp. 657 (D.N.J. 1941); Woodward v. United States, 106 F. Supp. 14 (N.D. Iowa 1952), aff’d on other grounds, 208 F.2d 893 (8th Cir. 1953).

75 Lawson v. Commissioner, 42 B.T.A. 1103 (1940); Hall Paving Co. v. United States, 338 F. Supp. 670 (D. Ga. 1971), rev’d on other grounds, 471 F.2d 261 (5th Cir. 1973).

76 Summit Drilling Corp. v. Commissioner, 5 T.C.M. (CCH) 190 (1946), aff’d, 160 F.2d 703 (10th Cir. 1947).

77 Christensen v. Commissioner, 28 T.C.M. (CCH) 594 (1969).

78 Mattes v. Commissioner, 1 T.C.M. (CCH) 220 (1942).

79 Konta v. Commissioner, 46 B.T.A. 1280 (1942) (memorandum opinion), reproduced in full, 212 Memo. B.T.A. (P-H).

80 See Ansley v. Commissioner, 217 F.2d 252 (3d Cir. 1954), rev’g 12 T.C.M. (CCH) 1110 (1953); Monmouth Plumbing Supply Co. Inc. v. United States, 4 F. Supp. 349 (D. Fla. 1933).

81 See, e.g., Cox v. Commissioner, 68 F.3d 128 (5th Cir. 1995).

82 Lehman v. Commissioner, 129 F.2d 288 (2d Cir. 1942); Sipprell v. Commissioner, 21 T.C.M. (CCH) 491 (1962). See also Barrett v. Commissioner, 71 T.C.M. (CCH) 2863 (1966), aff’d 1997, U.S. App. LEXIS 3098 (1st Cir. 1997).

83 Ainsley Corp. v. Commissioner, 22 T.C.M. (CCH) 889 (1963), rev’d, 332 F.2d 555 (9th Cir. 1964).

84 See supra note 69.

85 See Young v. Commissioner, 123 F.2d 597 (2d Cir. 1941).

86 See, e.g., Bullard v. United States, 146 F.2d 386 (2d Cir. 1944).

87 For a discussion of going-concern values, see Newton, Bankruptcy and Insolvency Accounting: Practice and Procedure (Hoboken, NJ: Wiley), Chapter 11.

88 See Ainsley Corp. v. Commissioner, 332 F.2d 555 (9th Cir. 1964).

89 See Rev. Rul. 73-160, 1973-1 C.B. 365; Rev. Rul. 73-101, 1973-1 C.B. 78.

90 See, e.g., Rev. Rul. 59-222, 1959-1 C.B. 80.

91 Minneapolis St. Paul and Sault Ste. Marie R. Co. v. United States, 164 Ct. Cl. 226, 241 (1964).

92 Rassieur v. Commissioner, 129 F.2d 820 (8th Cir. 1942); Singer v. Commissioner, 34 T.C.M. (CCH) 337 (1975), aff’d, 560 F.2d 196 (5th Cir. 1977). But see Yeager v. United States, 58-1 USTC (CCH) 9174 (W.D. Ky. 1957); George E. Warren Corp. v. United States, 141 F. Supp. 935 (Ct. Cl. 1956).

93 See Scifo v. Commissioner, 68 T.C. 714 (1977), acq. 1978-2 C.B. 2.

94 69 T.C.M. (CCH) 2959 (1995).

95 See Commissioner v. Levy, 973 F.2d 265 (4th Cir. 1992) (burden of proving worthlessness remains with the taxpayer/creditor even if the debtor is in bankruptcy proceedings).

96 725 F.2d 945 (3d Cir. 1984).

97 Stratmore v. Commissioner, 48 T.C.M. (CCH) 1369 (1984) (on remand from B. B. Rider, 725 F.2d 945), rev’d, 785 F.2d 419 (3d Cir. 1986).

98 66 T.C.M. (CCH) 1121 (1993).

99 464 F.2d 394 (5th Cir. 1972).

100 66 T.C.M. (CCH) 769 (1993).

101 Scofield v. Commissioner, T.C. Memo. 1997-547; 74 T.C.M. (CCH) 1356.

102 Kidder v. Commissioner, T.C. Memo. 1999- 345.

103 Kidder, et ux. v. Commissioner, No. 00-70444 (9th Cir. Feb. 23, 2001).

104 Treas. Reg. § 1.166-2(d).

105 See Coborn v. Commissioner, T.C. Memo 1998-377, aff’d without published opinion, 205 F.3d 1345 (8th Cir. 1999). (Tax Court denied an individual a nonbusiness bad debt deduction for funds he advanced to a corporation in which he was the controlling shareholder. The court concluded that the debt was not wholly worthless in 1988, the year in which the bad debt deduction was claimed, because the corporation continued in existence after 1988, the individual continued searching for a buyer for the stock of the corporation, a new business plan was formulated in 1989, a public offering was made in 1992, and the individual continued to transfer funds to the corporation.)

106 See Handler, Tax Consequences of Mortgage Foreclosures and Transfers of Real Property to the Mortgagee, 31 Tax L. Rev. 193 (1976) (comprehensive discussion of the tax consequences of secured debt in out-of-court situations).

107 Treas. Reg. § 1.166-6(a).

108 Id. Any accrued interest that is not paid may be reported as part of the deduction if previously reported as income.

109 Treas. Reg. § 1.166-3(b); Derby Realty Corp. v. Commissioner, 35 B.TA. 335 (1937), acq. 1937-1 C.B. 33, nonacq. 1937-2 C.B. 8, acq. 1938-1 C.B. 9.

110 Treas. Reg. § 1.166-6(a), (b); Rev. Rul. 72-238, 1972-1 C.B. 65.

111 1972-1 C.B. 65.

112 62 T.C. 503 (1974).

113 Treas. Reg. § 1.1038-1(c).

114 Treas. Reg. § 1.1038-1(d).

115 Treas. Reg. § 1.1038-1(g).

116 See Handler, supra note 106.

117 42 T.C.M. (CCH) 355 (1981).

118 Treas. Reg. § 1.166-6(a); Havemeyer v. Commissioner, 45 B.T.A. 329 (1941).

119 Delk v. Commissioner, 113 F.3d 984 (9th Cir. 1997).

120 Brooks v. United States, 32 F.Supp. 158 (M.D. Pa. 1940); DeFord v. Comm’r, 19 B.T.A. 339, 1930; and Stearns v. Kavanagh, 29 A.F.T.R. (P-H) 1487 (E.D. Mich. 1941).

121 See Coleman v. Comm’r, 31 B.T.A. 319, 1934 WL 70 (1934), aff’d, 81 F.2d 455 (10th Cir. 1936), Jones v. Comm’r, 103 F.2d 681 (9th Cir. 1939); United Gas Improvement Co. v. Comm’r, 47 B.T.A. 715 (1942), aff’d, 142 F.2d 216 (3d Cir. 1944).

122 In re Steffen, 305 B.R. 369 (Bankr. D. Fla., 2004).

123 Id., at 373–374.