“Ten, Nine, Eight . . .”
This is the final weekend of the final month of the final year of the decade. As the clock ticks away the hours, many folks are busy returning gifts, planning New Year celebrations, scheduling college bowl game parties, debating who was the best quarterback of the decade,[i] ignoring the latest political gaffes by a long list of megalomaniacs, and wondering when and where who will do what to whom and why on their favorite “reality” shows.
There are “those” folks, however, who are doing some last minute tax planning.[ii] They may be thinking about making charitable contributions or maximizing their contribution to a 401(k) plan. Some may be considering annual exclusion gifts. Others may be in the market to acquire (and place in service) a piece of equipment in order to secure a Section 179 deduction for the year.[iii] Still others may be searching through their portfolio for investment losses to realize before the year’s end so as to offset already-realized gains.[iv] And a few who are holding an investment that, in retrospect, turned out to be a bad idea may be wondering whether 2019 is the year for which they can claim a loss deduction with respect to that investment.
A recent decision of the U.S. Tax Court[v] considered whether Taxpayer[vi] was entitled to a loss deduction that it claimed with respect to a partnership interest that Taxpayer reported became worthless during 2009.[vii]
Before delving into the particulars of this case, and in order to better understand the relevance of the facts recited below, let’s review the applicable provisions of the Code and Regulations.
The Code allows a deduction for any loss actually sustained during the tax year, provided it is not compensated for by insurance or otherwise.[viii]
To be allowable as a deduction, the loss must be evidenced by a closed and completed transaction, fixed by “identifiable events,” and actually sustained during the tax year.[ix] Thus, a mere decrease in the value of a property held by a taxpayer does not constitute a loss for which the taxpayer may claim a deduction. The loss has to be realized.
What’s more, only a bona fide loss is deductible; substance and not mere form governs in determining a deductible loss.
The amount of loss allowable as a deduction may not exceed the taxpayer’s adjusted basis for the property involved;[x] i.e., the amount of the taxpayer’s unrecovered investment.
A loss is allowed as a deduction under Section 165(a) only for the taxable year in which the loss is sustained.[xi] The most challenging aspect of establishing one’s right to the deduction may be establishing the taxable year in which the loss was sustained.
In most cases, a “closed and completed transaction” will occur upon a sale or other disposition of the property, but this requirement may also be satisfied if the property becomes worthless. Thus, “worthlessness” may be a stand-alone justification for a deduction under Section 165(a), and a taxpayer may deduct a loss from an investment in a partnership if their partnership interest becomes worthless during the tax year.[xii]
Whether a loss from the worthlessness of a partnership interest is a capital or an ordinary loss depends on whether or not the loss results from the sale or exchange of a capital asset.[xiii]
In general, where there is an actual or deemed distribution by the partnership to the taxpayer-partner, the transaction will be treated as a sale or exchange of the partnership interest, and any loss resulting from the transaction will be capital.[xiv] Such a transaction is not treated for tax purposes as involving a loss from the worthlessness of a partnership interest, regardless of the amount of the consideration actually received or deemed received in the exchange.
A loss from the worthlessness of a partnership interest will be ordinary if there is neither an actual nor a deemed distribution to the partner. In addition, the loss will be ordinary only if the transaction is not otherwise, in substance, a sale or exchange.
With these basic Section 165 principles under our collective belt, let’s turn to the decision.
Subprime Mortgage Crisis
Family was engaged in the real estate development and sales business, which it operated primarily through “LLC” which, in turn, operated through various wholly-owned, as well as multi-member, ventures.
Taxpayer was organized by Family to manage LLC, and also to provide a separate vehicle through which Family could make investments in LLC. At the time of its formation, Taxpayer was owned beneficially by the same persons that owned LLC.
Loans and Capital
At that time, LLC owed $35 million to Senior Lender.[xv] The loan documents required that LLC obtain Senior Lender’s approval before LLC made material outlays of cash.
Between 2004 and 2008, Taxpayer contributed approximately $57.6 million to LLC’s capital in exchange for a partnership interest that entitled Taxpayer to receive all distributions from LLC until Taxpayer received the amount of each capital contribution plus a specified return.
In 2005, with the success of its real estate development business, LLC refinanced its Senior Lender debt with $100 million of notes payable, plus interest. The loan documents required that LLC make scheduled principal payments throughout the term of the loan, with the remaining principal and accrued interest coming due in 2013.
Also in 2005, LLC borrowed $62.5 million of subordinate debt from Funding. The subordinate debt was secured by LLC’s assets and was subordinate to the liens created under the senior debt documents.[xvi]
LLC’s subsidiary project entities also incurred acquisition, development, and construction loans to finance their respective projects. This project debt was secured by the real property held by the particular borrowing project entity. Additionally, Taxpayer and LLC’s other members (the “Select Corporate Entities;” SCEs) jointly and severally guaranteed the project debt.
The loan documents for the project debt and the senior debt included cross-default provisions.[xvii]
The “You Know What” Hits the Fan
The subprime mortgage crisis that began in 2007 hit LLC’s business in a big way because subprime mortgages were prevalent in the housing markets in which LLC operated, and the values of homes financed with subprime mortgage debt declined in those markets at unprecedented rates. During 2008, LLC attempted to secure additional financing from various investment entities but was unsuccessful.
By the end of 2008, because the real estate market continued to decline, LLC removed new projects from the forecasts it provided to its project lenders.[xviii]
Also in 2008, LLC’s project debt lenders raised concerns regarding LLC’s subordinate debt with Funding. Cash flow projections suggested LLC would be unable to pay the subordinate debt owed to Funding. LLC negotiated with Funding concerning a discounted payoff of the subordinate debt. However, because of the senior lien on LLC’s assets, as well as other covenants in the senior debt loan documents, LLC’s ability to use its cash to pay down the subordinate debt was limited.
In addition, Family and the SCEs did not want to contribute additional cash to LLC because those funds would immediately become subject to the senior lien. Instead, LLC’s management concluded that another Family-owned entity might be able to purchase the subordinate debt at a discount. LLC’s management believed that acquisition by a related entity would reduce the risk that a third-party holder of the subordinate debt would attempt to force LLC into bankruptcy.
Ultimately, Funding agreed to a discounted purchase price of $16 million for the $62.5 million subordinate debt. To facilitate the acquisition, Family formed and capitalized “Holdings LLC.”
In October 2008, Holdings paid $16 million to acquire all of the subordinate debt. Holdings intended to collect the full $62.5 million face amount of the debt, plus interest.
LLC’s financial condition deteriorated in 2007 and 2008, and it had to record impairment charges with respect to its projects, including an impairment charge of $109.8 million under GAAP,[xix] which caused LLC’s net worth to decline substantially, which in turn caused LLC to struggle to comply with its various financial covenants under the senior debt and project debt loan documents. The existence of cross-default provisions in the senior debt and project debt loan documents exacerbated default risks for LLC and thus created a risk of bankruptcy.
Toward the end of 2008, LLC fell out of compliance with several covenants in the senior debt loan documents, including the minimum-net-worth requirement and the maximum-debt-to-equity ratio. This triggered a default, and motivated LLC to negotiate with the senior lender to waive or modify the covenants on the senior debt.
During 2008, LLC’s owners and management considered bankruptcy as a possibility given LLC’s continued financial deterioration. In addition, several project debt lenders stopped funding loans, halting construction at some projects. Finally, in late 2008, Family decided that they would not make any additional contributions to LLC given its substantial debt burden.
In December 2008, Holdings contributed the subordinate debt to LLC in exchange for a preferred equity interest in LLC. This debt-to-equity conversion allowed LLC to shed debt from its balance sheet and add net worth to its GAAP financial statements. As a result, LLC reported a net worth of approximately $34.5 million on its audited financial statements as of the end of 2008, which allowed LLC to comply with its minimum net-worth covenants.
The parties to the conversion intended that Holdings’ priority of payment on the converted equity interest vis-a-vis LLC’s preexisting members “mirror” the previous subordinate debt position – meaning that Holdings would be entitled to a return of the principal of $65 million, and a cumulative preferred return, before any other members, including Taxpayer, were entitled to distributions in liquidation or otherwise.
After the debt-to-equity conversion, and consistent with the foregoing arrangement, LLC’s operating agreement was amended to provide that all distributions would be made to Holdings until such time as it received its preferred equity interest and accrued cumulative preferred return, and that Taxpayer would not be entitled to any distributions in respect of its capital contributions until such time.
LLC’s 2008 and 2009 annual reports stated that Holdings, on account of its preferred interest, “has a liquidation preference of $65.1 million plus accrued but unpaid cumulative preference return.” At the end of 2009, LLC owed $70 million of senior debt accruing interest at 9.5% per annum, and Holdings had a preferred interest and accrued but unpaid cumulative preferred return that totaled $71.2 million.
In its report for 2008, LLC’s independent auditor reported that LLC incurred operating losses in 2008, was not in compliance with certain financial covenants related to its indebtedness, and certain of its debt matured in 2009. “These matters,” the reports concluded, “raise substantial doubt about [LLC’s] ability to continue as a going concern.” The audited financial statements were included in LLC’s annual report that was shared with its lenders.
The home building and real estate market worsened considerably in early 2009. Even after LLC’s debt-to-equity conversion, the continued decline in property values prompted lenders to issue notices of default and/or demands for loan repayment to many of LLC’s project entities and the SCEs.
LLC was unsuccessful in negotiating a “friendly foreclosure” with one project lender, who initiated foreclosure in 2009, and the proceeds from the sale of property were insufficient to pay off the debt, leaving a large deficiency. Following foreclosure, the lender pursued the SCEs, as guarantors, for the deficiency. The lender did not seek to attach or otherwise recover and sell Taxpayer’s partnership interest in LLC. After an audit and extensive negotiations, LLC agreed in early 2010 to a $2 million settlement on the deficiency in exchange for the release of the SCEs from their guaranties.
Around 2008, because of the amount and status of LLC’s project-level debt, the Senior Lender became concerned about its ability to collect on the senior debt. The Senior Lender recorded impairment charges with respect to LLC’s senior debt in 2008 and 2009 that together totaled 40-percent. In May 2009, LLC and the Senior Lender amended the terms of the senior debt, changing the maturity date, interest rates, principal payment dates, and certain covenants.
LLC’s cash flow forecasts throughout 2009 reflected its continued financial deterioration.[xx] LLC also prepared a liquidation analysis in 2009, which showed that if LLC were to liquidate completely in 2009 – as an alternative to a gradual wind-down over several years – it would have only $51.6 million to pay approximately $70 million in outstanding senior debt.
On the basis of these financial projections, LLC’s executive committee and managing board concluded that LLC could not fully repay its senior debt and project debt under the terms of their respective loan documents. Moreover, they determined that Holdings would not recover the full amount of its preferred equity interest upon liquidation,[xxi] and Taxpayer would not receive anything with respect to its interest.
LLC’s continued attempts to secure additional funding during 2009 failed. Ultimately, by the end of 2009, LLC’s owners decided to wind down the entity. On the basis of its December 2009 cash flow forecast, LLC believed it could sell all of its assets in an orderly manner by the end of 2014. LLC’s owners believed that an orderly liquidation over five years would be more beneficial to its lenders than a complete sell-off of its assets over a shorter timeframe.
On its 2009 audited consolidated statements of operations, LLC reported a net loss of $39 million for the 2009 tax year. It reported assets of $331 million, liabilities of $269 million and members’ equity of $62.8 million as of December 31, 2009.[xxii]
Taxpayer’s Income Tax Returns
Taxpayer filed Form 1065, U.S. Return of Partnership Income, for the 2009 tax year. This return reported an ordinary loss of $41.5 million, which the attached Form 4797, Sales of Business Property, explained was attributable to the worthlessness of Taxpayer’s investment in LLC.
Taxpayer issued to each of its members a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., for the 2009 tax year, which its members reported on their 2009 income tax returns.
Although the IRS agreed that the character of the loss attributable to a “worthless” interest in LLC would be ordinary, the IRS disagreed that Taxpayer was entitled to a deduction with respect to such loss in 2009. Taxpayer petitioned the U.S. Tax Court for relief.
The Tax Court
The parties agreed that Taxpayer had an adjusted basis of almost $41.5 million in its LLC partnership interest as of the time of the claimed worthlessness in 2009. Therefore, the issue for the Court was whether Taxpayer could deduct the reported loss for 2009; specifically, whether the partnership interest became worthless in 2009.
The Court observed that whether a partnership interest is worthless was a question of fact. The statute’s “general requirement that losses be deducted in the year in which they are sustained calls for a practical, not a legal, test,” it stated.[xxiii]
To prove entitlement to a Section 165(a) loss deduction for worthless property, the Court explained, a taxpayer must demonstrate its “subjective determination of worthlessness in a given year, coupled with a showing that in such year the property in question is in fact essentially valueless.”
The requirement that an asset be “essentially” valueless, the Court continued, demonstrates “the de minimis rule that the taxpayer does not have to prove that a given asset is absolutely, positively without any value whatsoever.”
But, “while a taxpayer need not be ‘an incorrigible optimist in his determination of when property becomes worthless, a mere decline, diminution, or shrinkage in value is not sufficient to establish a loss.’”
In sum, the Court had to determine whether Taxpayer subjectively determined that its partnership interest in LLC was worthless in 2009 and whether objective factors confirmed that the interest became essentially valueless in that year.
The Court first considered whether Taxpayer had subjectively determined that its partnership interest in LLC was worthless in 2009. According to the Court, the subjective determination of a taxpayer, while not conclusive, is entitled to great weight.
The Court concluded that Taxpayer had subjectively determined that its partnership interest in LLC was worthless by the end of 2009. First, Taxpayer took the position on its tax return that the partnership interest was worthless in 2009.
Second, the owners and management of Taxpayer and LLCs testified credibly at trial that they believed Taxpayer’s interest became worthless in 2009. They based their belief, in part, on the dramatic and devastating impact of the financial crisis that began in 2007, LLC’s consistent operating losses in the years leading up to and including 2009, the subordinate position of Taxpayer’s partnership interest to Holdings, and the overwhelming debt burden of LLC and its project entities.
LLC’s owners and management took into account LLC’s deteriorating cash flow projections during 2009. Those projections showed that LLC would be unable to satisfy financial obligations owed to the Senior Lender, the subordinate lender, or the project debt lenders.
Ultimately, Family decided to wind down LLC in an orderly manner to maximize value for the creditors. These facts supported the conclusion that Taxpayer subjectively believed its partnership interest in LLC became worthless in 2009.
The Court next considered whether objective indicia confirmed an absence of substantial value in LLC in 2009. It set forth the principles for determining worthlessness in the context of equity interests as follows:
The ultimate value of stock, and conversely its worthlessness, will depend not only on its current liquidating value, but also on what value it may acquire in the future through the foreseeable operations of the corporation. Both factors of value must be wiped out before we can definitely fix the loss. If the assets of the corporation exceed its liabilities, the stock has a liquidating value. If its assets are less than its liabilities but there is a reasonable hope and expectation that the assets will exceed the liabilities of the corporation in the future, its stock, while having no liquidating value, has a potential value and cannot be said to be worthless. The loss of potential value, if it exists, can be established ordinarily with satisfaction only by some “identifiable event” in the corporation’s life which puts an end to such hope and expectation.
There are, however, exceptional cases where the liabilities of a corporation are so greatly in excess of its assets and the nature of its assets and business is such that there is no reasonable hope and expectation that a continuation of the business will result in any profit to its stockholders. In such cases the stock, obviously, has no liquidating value, and since the limits of the corporation’s future are fixed, the stock, likewise, can presently be said to have no potential value. Where both these factors are established, the occurrence in a later year of an “identifiable event” in the corporation’s life, such as liquidation or receivership, will not, therefore, determine the worthlessness of the stock, for already “its value had become finally extinct.”
Thus, in determining whether Taxpayer’s partnership interest in LLC was objectively worthless, the Court considered whether, in 2009, Taxpayer’s partnership interest ceased to have liquidating value and potential future value.
Taxpayer asserted that Taxpayer’s partnership interest in LLC lacked both “liquidating value” and “potential value” by the end of 2009. Pointing to the priority of the project debt, the senior debt, and Holdings’ preferred interest, Taxpayer argued that its partnership interest was “hopelessly underwater” in 2009; all evidence indicated that it was extremely unlikely it would ever recover any value; and a set of “identifiable events” occurred in 2009 that demonstrated the worthlessness of the interest.
The IRS argued that the test for worthlessness was not satisfied, stating that the evidence showed only that LLC was “struggling financially” during 2009 and was insufficient to show worthlessness. The IRS also argued that Taxpayer had failed to show that “all possibilities of eventual profit had ‘effectively been destroyed.’”
A taxpayer claiming a worthlessness loss deduction must show that its equity interest ceased to have liquidating value during the year in issue. Generally this may be shown by an authoritative balance sheet showing liabilities in excess of assets, leaving no value for equity holders. The Court noted, however, that balance sheet insolvency at the entity level is not necessarily required when preferred equity interests are involved. A subordinate equity interest may become worthless if the company cannot satisfy a senior equity interest holder’s preferential claim in liquidation.
The Court was convinced that Taxpayer would have received nothing in liquidation of its partnership interest had LLC liquidated at the end of 2009. LLC projected that it could generate only $51.6 million were it to force a disposition of all projects by the end of 2009 and immediately pay down the project debt to the extent possible. And the evidence regarding market conditions suggested that this projection may have been optimistic. As of the end of 2009, many project entities were still years away from fully developing their projects, and the real estate market in the project markets was severely depressed as a result of the subprime mortgage crisis. Because an immediate fire sale in these conditions could have been catastrophic, LLC chose to wind down over five years.
At any rate, Taxpayer presented sufficient evidence to support the conclusion that the $51.6 million in proceeds that LLC could generate in a hypothetical 2009 liquidation would fall short of satisfying the $70 million in outstanding senior debt. The Senior Lender agreed that the senior debt would not be fully repaid if there was a 2009 liquidation. And at that time, Holdings’ preferred interest and preferred return, which also were senior to Taxpayer’s partnership interest, exceeded $71 million. Thus, the evidence showed that Taxpayer’s partnership interest in LLC was “under water” by a substantial margin in 2009, sitting behind both the senior debt and Holdings’ preferred interest.
The fact that LLC’s balance sheet for the year ending December 31, 2009, indicated that LLC was solvent did not change the Court’s conclusion that Taxpayer’s now-junior partnership interest in LLC had no value on liquidation.
LLC reported assets[xxv] in excess of its liabilities at the end of 2009. But as of the end of 2009, Holdings’ preferred interest and accrued preferred return exceeded members’ equity by nearly $8.5 million. And Holdings would have been entitled to its preferred interest and preferred return before Taxpayer received any liquidating distributions on account of its junior interest.
The Court recognized and gave effect to the junior status of Taxpayer’s interest. Because LLC’s balance sheet indicated that the value of its assets were insufficient to pay off all of LLC’s liabilities and Holdings’ preferred interest and accrued preferred return as of the end of 2009, it supported the conclusion that Taxpayer’s interest had no liquidating value.
In short, none of the IRS’s arguments could overcome the fact that Taxpayer held an interest that was junior to both a $70 million senior debt obligation and a preferred interest with an accrued preferred return that exceeded $71 million. And all of the economic data available to LLC, Taxpayer, and other financial players indicated that, under various scenarios, Taxpayer would recover nothing for its interest.
Having determined that Taxpayer’s partnership interest in LLC had no liquidating value by the end of 2009, the Court next considered whether LLC also lacked potential future value at that time. An equity interest has potential future value, the Court stated, when, despite the lack of liquidating value, there is still a “reasonable hope and expectation that [the interest] will become valuable at some future time.”
The hope and expectation that an equity interest may become valuable in the future can be foreclosed when certain “identifiable events” occur in a company’s life that effectively destroy the potential value. An “identifiable event” is “an incident or occurrence that points to or indicates a loss – an evidence of a loss.”
Identifiable events include, for example, bankruptcy, the cessation of business, liquidation, or the appointment of a receiver. In some instances, a taxpayer can demonstrate that its equity interest does not have potential future value, even in the absence of an identifiable event, if the company becomes hopelessly insolvent.
Taxpayer argued that its partnership interest in LLC no longer had potential future value in 2009, citing a combination of identifiable events. Taxpayer also argued that worthlessness was established because its partnership interest became “hopelessly insolvent” in 2009.
The Court agreed that that several identifiable events confirmed that Taxpayer’s partnership interest in LLC lacked any potential future value by the end of 2009.
First, the financial crisis and resulting recession beginning in 2007 and continuing in 2009 had a devastating impact on the residential housing markets in which LLC’s projects were being developed. LLC’s revenue decreased significantly from 2005 to 2009. LLC recorded impairment losses beginning in 2007, some project lenders stopped funding loans, and LLC was unsuccessful in attracting additional equity investment. These events, the Court stated, caused LLC to struggle to comply with its various financial covenants under the senior debt and project debt loan documents. Thus, the Court concluded that the severe recession caused by the subprime mortgage crisis that adversely affected the potential future value of Companies and its projects was an identifiable event.
Second, the audited financial statements depicted LLC’s dire financial condition in 2008 and 2009. The auditors doubted LLC’s ability to function as a going concern, and its audited financial statements reflected continued large operating losses. These “red flags” for management and lenders also were illustrative of how the cumulative events affecting LLC and its project entities “fixed” the loss of Taxpayer’s investment in LLC by the end of 2009.
Third, LLC’s cash flow forecasts reflected a significant decline in expected cash flow from operations and supported a conclusion that Taxpayer’s junior partnership interest had no potential future value by the end of 2009. As the real estate market deteriorated and Companies’ financial condition worsened, cash flow projections predictably became more pessimistic. The December 2009 forecast projected that LLC would not generate sufficient cash during its wind-down to make required principal payments on the senior debt in 2012 and 2013. The Court, therefore, concluded that the December 2009 cash flow forecast was another identifiable event indicating to Taxpayer that its junior partnership interest had lost any potential future value.
Fourth, the Court found that LLC’s decision in 2009 to wind down the entity over five years was an identifiable event fixing Taxpayer’s loss. Because Taxpayer and the SCEs remained guarantors of the project debt, they had an interest in maximizing asset values for the benefit of creditors. An immediate liquidation would have meant a fire sale of unfinished real estate projects in a very unfavorable market – a disaster scenario for these guarantors.
The IRS, however, also argued that LLC’s continued operations during 2009 and the wind-down period indicated that Taxpayer’s partnership interest must have had some potential future value.
Again, the Court disagreed. The continued operation of a company beyond the year of claimed worthlessness, the Court stated, did not itself prove future value in its equity interests. In cases involving continued operation of a company beyond the year of claimed worthlessness, the Court stated that its examination centers around whether the activities pursued during and after the year of claimed worthlessness were in the nature of an attempt to salvage something for creditors, or whether such activities were so related to a continuation of general operations that they manifest reasonable expectations of future value in the equity.
In this case, the Court continued, LLC’s operations during the wind-down were aimed at maximizing value for the project debt lenders and the senior lender. In sum, the end of LLC was inevitable in 2009 when its owners decided to wind down and that decision finally destroyed any expectation that Taxpayer might recover any value on account of its junior partnership interest.
Lastly, the 2009 defaults on project debt and subsequent foreclosures supported a finding of worthlessness in 2009. Indeed, the Senior Lender could have decided to declare a default on the senior debt because of cross-default provisions at that time. And as noted above, immediate payment of the senior debt would have left nothing for Taxpayer.
The Court found that these identifiable events together confirmed that the likelihood of potential future value was minimal.[xxvi]
With that, the Court concluded that Taxpayer properly reported a Section 165(a) loss for its worthless partnership interest in LLC in 2009.[xxvii]
Apologies – I recognize that this a long post. And on the day before New Year’s Eve, whatever that may signify.
As always, the point is for the taxpayer to be attuned to the potential for a tax benefit in every business or investment situation, including one that may not be going well, as in the case described above.
Once the opportunity is identified, it is imperative that the taxpayer start to “develop their narrative” and “prepare the record” as contemporaneously[xxviii] and as completely as possible, keeping in mind not only the substantive requirements for claiming the benefit, but also the lines of attack that the IRS is likely to pursue.
[i] Aaron Rodgers.
[ii] In fact, there are some looking to close year-end transactions, of which I am especially fond. I ask you, how can one resist a “Bah Humbug” under those circumstances?
[iii] IRC Sec. 179.
[iv] IRC Sec. 1222. As always, do not dispose of an economically sound investment just to realize an ephemeral tax benefit. See also the “wash sale” rules under IRC Sec. 1091 – just in case you had that thought.
[v] MCM Investment Management, LLC v. Comm’r, T.C. Memo. 2019-158.
[vi] Which was actually an LLC, treated as a partnership for tax purposes. Reg. Sec. 301.7701-3.
[vii] Think about it. say the return for 2009 was filed on extension in late 2010. The tax Court’s decision was issued in December 2019. Query, did the taxpayer make a “deposit” (as opposed to a payment that would remove the case from the Court’s jurisdiction) to stop the accrual of deficiency interest?
[viii] IRC Sec. 165(a).
[ix] Reg. Sec. 1.165-1(b).
[x] Reg. Sec. 1.165-1(c).
[xi] Reg. Sec. 1.165-1(d).
[xii] See, e.g., Rev. Rul. 93-80.
[xiv] IRC Sec. 731, Sec. 741, Sec. 752.
[xv] The debt was secured by LLC’ assets, including pledges of an economic interest in each of LLC’s project subsidiaries.
Unless stated otherwise, all the lenders described herein were unrelated to Family and Taxpayer.
[xvi] The subordinate debt instrument required quarterly interest payments through March 2015, and would mature in March 2035.
[xvii] Thus, a default on senior debt constituted a default on project debt, and a default of at least $10 million on project debt (either on a single loan or in the aggregate) constituted a default on senior debt.
[xviii] LLC’s project-level business plans were an important input in its cash flow forecasts. They were a required attachment to operating agreements entered into with joint venture partners and were updated regularly.
[xix] Very basically, a reduction in the goodwill of the business.
[xx] The January 2009 cash flow forecast showed that LLC could achieve an ending cash balance of almost $63.7 million if it were able to wind down all projects successfully through 2016 and pay its debt. LLC lost or terminated certain projects during the year, and the wind-down period for cash flow projections was reduced to five years.
LLC updated its cash flow forecast in December 2009. That forecast projected that LLC would have an ending cash balance of $12.3 million if it could wind down by the end of 2014 and pay off the senior debt. While LLC projected that it could achieve this positive cash balance by the end of the wind-down, it also projected that it would have a cash shortfall during the wind-down period in both 2012 and 2013.
Under the terms of the senior debt loan documents, LLC was required to make $32 million of principal payments in 2012, and approximately $30 million of principal payments in 2013, when the loan matured. But the December 2009 cash flow forecast showed that LLC would not have sufficient cash in 2012 and 2013 to make these required principal payments timely and cash shortfalls of approximately $14 million in 2012 and $7.4 million in 2013 would result.
[xxi] Holdings’ preferred equity interest and accrued cumulative preferred return would have exceeded $111 million by the end of the wind-down period in 2014.
[xxii] It reported operating revenue of $255 million for 2009, down from approximately $824 million in 2005 before the financial crisis. And according to LLC’s 2010 audited consolidated statements of operations, LLC’s operating revenue in 2010 was $162 million, or approximately 35-percent lower than in 2009.
[xxiii] Now do you see why all those facts, above, were included?
[xxiv] Interestingly, there is little discussion in the opinion regarding the possibility that LLC may have become worthless before 2009. I would have expected a more treatment of this point. After all, it is implicit in the requirement that an investment became worthless during a tax year that it had value at the beginning of such year.
[xxv] As a going concern.
[xxvi] The Court noted that the test for worthlessness is a “practical, not a legal, test”, and that taxpayers should not be held to “hard and fast technical rules” in determining the precise time in which their loss occurred. And while some identifiable event must occur in the year of the loss, which may be a single event or a series of events, the presence of identifiable events in earlier years is not “decisive upon the question of the worthlessness of stock where the evidence also establishes the existence of a potential value which may be realized on liquidation or through continuation of business.”
[xxvii] The IRS also argued that Taxpayer had not shown that its partnership interest in LLC was worthless because Taxpayer did not call an expert witness. In the IRS’s view, determining whether Taxpayer’s partnership interest had liquidating value or potential future value required expert valuation. Expert testimony can be helpful, the Court conceded, and it may be an important consideration in some cases. But the Court added that expert testimony was not necessary to show worthlessness for purposes of section 165. Moreover, the IRS did not cite any authority holding that expert valuation was required to prove worthlessness under section 165. To the contrary, the Court stated that “the taxpayer need not be forced to hire valuation experts where, as here, his own testimony is credible and founded upon reasonable factual premises.”
[xxviii] Not on the final weekend of the final month of the final year of the decade.