• Tax Considerations for Investors in Light of the Current Economic Downturn: Ensuring That Where There Is An Economic Loss, There Is An Attendant Usable Tax Loss, Or At The Very Least, No Taxable Gain
  • December 1, 2008 | Author: Saba Ashraf
  • Law Firm: Troutman Sanders LLP - Atlanta Office
  • In a down economy, most investors’ primary concern is understandably their economic loss. However, after the dismay regarding the definitiveness of an economic loss has set in, investors should take care to ensure that they are able to report a tax loss when they suffer an economic loss, or at the least that they do not have to report so called “phantom income” – taxable gain where there is no economic gain. Unfortunately, just because an investor experiences an economic loss does not mean that she, he or it will be able to recognize the loss for tax purposes. This client alert provides an overview of basic tax considerations that should be kept in mind by investors in regards to losses with respect to their investments in equity or debt interests issued by corporations or partnerships. For readers with a background in tax law, this alert should serve as a refresher of relevant rules. For readers with less familiarity with tax laws, this alert should serve as a general summary and a checklist.[1]

    Topics Covered

    What If You’re an Owner or Investor That Sells Entire Investment for Cash?

    What If You Are An Owner or Investor That Does Not Cash Out, But Whose Investment Becomes Wholly Or Partially Worthless?

    What If You are An Owner of Shares of Stock in a Corporation or Interests in a Partnership, and Remain an Owner until the Liquidation of the Entity?

    What If You Hold Debt Whose Terms Are Modified, Or Exchanged for New Debt?

    What If You Own Debt and You Exchange It For Stock?

    What If You Own Preferred Stock of a Corporation and Exchange for New Common or Preferred Stock?

    What If You’re an Owner or Investor That Sells Entire Investment for Cash?

    If you own shares in a corporation, units or interests in a partnership or a limited liability company taxed as a partnership[2], notes or bonds and you are exiting out of your investment entirely in exchange for cash or cash equivalents (and are not maintaining an interest, either as a creditor or owner in the entity or a related entity), then your primary goals should be to:

    1. Recognize a tax loss to the extent that the value of the payment you receive is less than your tax basis in your shares, units, interests or notes, as applicable.

    2. Ensure that your tax loss is an ordinary loss rather than capital loss. Why?

    • Capital losses typically are not as useful as ordinary losses, and in some cases, may be useless. They may be offset only against capital gains (in general, gain from the sale of assets held for investment, but not inventory, or other assets held for sale in the ordinary course of business), and not against ordinary income.[3] Accordingly, if an investor does not have capital gains against which it can use those capital losses, they may go unused. An individual may carry forward unused capital losses in future years (in which hopefully the individual will have capital gains). A corporation may carry back capital losses to each of the 3 years preceding the loss year, and carry them forward for 5 years following the loss year. There may be other technical limits on the use of losses that are beyond the scope of this alert.[4]

    Where the owner or investor is a partnership, the capital gains and losses of the partnership flow-through to the partners, so that the partners treat their distributive share of the loss as if it were their own capital loss.

    What If You Are An Owner or Investor That Does Not Cash Out, But Whose Investment Becomes Wholly Or Partially Worthless?

    If Investment Consists of Stock of a Corporation, or a Note or Bond that Constitutes a “Security”

    • Capital Loss on Worthless Stock or Security. The general rule is that for an investor to recognize a loss on its investment in a capital asset, the loss must be evidenced by a “closed and completed transaction” such as a sale or exchange. However, in the case of stock of a corporation, or a note or bond that is considered to be a “security” for tax purposes, an investor may claim a loss for a totally worthless security without having to show a completed transaction such as a sale or exchange. Such a loss is a capital loss.
      • What Constitutes A “Security”? The term “security” has a specific meaning for purposes of the worthless security tax deduction. Shares of stock in a corporation constitute a security. Generally, debt is a “security” for this purpose if it can be transferred only on the books and records of the issuer – which would include all book entry securities, and likely all debt designed to trade in a secondary market. Generally, notes issued in private lending transactions may not be in registered form and thus will not be securities.
      • Identifiable event. There must be an “identifiable event” evidencing the worthlessness of the securities before a deduction may be allowed. Further, the deduction arguably is not allowable for a tax year following the year in which the security first becomes worthless. “Identifiable events” that indicate worthlessness include: bankruptcy where issuer is so insolvent that there is little hope that the security holder will receive a distribution, or a plan is adopted that does not provide for any distribution with respect to the security; termination of business operations where issuer is insolvent to such a degree that there are no assets available for payment on the security; a complete liquidation of the issuer at a time when the issuer is insolvent to such a degree that there are no assets available for payment on the security; and receivership in which there are no assets available for a payment on the security. Some courts have found other events satisfactory as well.
    • Partial Worthlessness? There is no deduction for a “partially worthless” security.
    • Planning to Have an Ordinary Loss Rather than a Capital Loss. “Abandoning” The Stock or Security. Is there a way to plan to have the character of the loss be ordinary rather than capital? Maybe – by “abandoning” the worthless security immediately prior to the time it becomes worthless. Although the law in the area is not settled, it is likely that an ordinary loss deduction is available where the taxpayer has “abandoned” the stock or debt securities prior to the occurrence of one or more “identifiable events” establishing the complete worthlessness of stock or debt securities.
      • How do you abandon? In order to abandon stock effectively, a taxpayer must relinquish all rights with respect to the stock or debt securities, including any “penumbral” rights and remedies (such as a right to bring a shareholder derivative suit), and must not receive anything in return, directly or indirectly.

    If Investment Consists of Debt and Does Not Constitute a “Security”

    • Ordinary Loss. In the case of worthlessness of debt where that debt is not a “security” (as defined above), the loss will be an ordinary loss.
    • Partial Worthlessness Deduction Allowed. In the case of debt that is not a “security” a tax deduction is allowed to the extent of the partial worthlessness, but not in excess of the amount “charged off” during the year. Partial worthlessness does not mean a mere difference between a debt’s face amount and its fair market value – such as one that results from a general increase in market interest rates or a slight decrease in the debtor’s creditworthiness. While the precise meaning of “charge off” is unclear, it generally is necessary for the investor to reduce the carrying value of the debt on its balance sheet.

    If the Investment Consists of an Interest in a Partnership

    The law involving the loss on the worthlessness or abandonment of an interest in a partnership is not clear.

    • Worthlessness. Courts have held that an ordinary loss is available on the worthlessness of an interest in a partnership. The IRS appears to disagree that a loss is recognizable, but at the same time seems to suggest that if a loss on worthlessness of a partnership interest were allowed, it would be capital.
    • Abandonment. There may be a loss available on the abandonment of an interest in the partnership. Pursuant to the most recent Revenue Ruling issued by the IRS on the issue, in the situation where the partner does not share in any of the liabilities of the partnership, the loss from the abandonment of the partnership interest is ordinary. By contrast, where the partner has a share of the non-recourse liabilities of the partnership, the resulting loss is a capital loss (based on the reasoning that where the partner has a share of nonrecourse liabilities of the partnership, upon abandonment there is a deemed distribution to the partner in the amount of such share of the liabilities, and the transaction is treated as a sale or exchange of the partnership interest for the share of the liabilities). Note that where a partnership has recourse debt for which a partner is responsible, it is probably not possible to abandon the partnership interests.

    What If You Are an Owner of Shares of Stock in a Corporation or Interests in a Partnership, and Remain an Owner Until the Liquidation of the Entity?

    • Owner of Shares in Corporation. You will have a capital loss to the extent of the excess of your basis in your stock over the fair market value of any property you receive upon liquidation. Your basis will generally equal the amount you paid for the shares of stock.
    • Owner of Interests in Partnership. Generally, you will have a capital loss to the extent of the excess of your basis in the partnership.[5] Note that your basis in your partnership interests may already have been reduced significantly by your share of allocable partnership losses. Your basis in the partnership interest will generally be equal to the value of the money or property you contributed, your share of partnership income, your share of partnership liabilities, and decreased by money or your basis in property distributed to you by the partnership and your share of partnership losses and expenditures of the partnership

    What If You Hold Debt Whose Terms Are Modified, Or Exchanged for New Debt?

    If you hold debt that is modified or exchanged for new debt with terms different from those of the existing debt, then you should be mindful of two important considerations: Not only is it possible that you may not be able to recognize a tax loss if you have an economic loss, but to make matters worse, it is also possible that you may have to recognize taxable gain when you in fact have not experienced an economic gain.

    Modification of Debt

    Generally, if debt is “significantly modified” an exchange of newly issued debt (incorporating the modified terms) for the old debt is deemed to take place for U.S. federal income tax purposes. Examples of significant modifications include certain changes in yield, collateral, priority of debts, accounting or financial covenants, type of debt (recourse or nonrecourse), timing of payments, addition or deletion of obligor on a recourse debt. Multiple modifications of the same term that alone may not constitute a significant modification are significant if, had they occurred at once, there would have been a significant modification.

    Tax Consequences of Exchange of Your Debt for “New” Debt with Modified Terms

    Taxable Exchanges

    Generally, exchanges (including deemed exchanges resulting from modifications) are taxable transactions, so that the holder will recognize gain or loss equal to the difference between a holder’s adjusted tax basis in the old debt and the “issue price” of the new debt. If a debt instrument has no original issue discount (“OID”) or market discount associated with it and bears qualified stated interest,[6] then the holder’s tax basis will be its original cost reduced over time by repayments of principal. The “issue price” of debt exchanged for other debt is the trading price if either the new debt or the old debt is publicly traded. If neither is publicly traded, the “issue price” will generally be the stated principal amount of the new debt so long as it bears “adequate stated interest.”[7] If neither debt is publicly traded and there is no adequately stated interest, then the issue price is the imputed principal amount of the debt.[8]

    • Thus, in the case of publicly traded debt, if the new debt is traded at a price lower than at which the “old debt” was issued, then the investor may recognize a taxable loss. In the case of non-publicly traded debt, if the new debt has a smaller principal amount than the issue price of the old debt, then the investor may also recognize a taxable loss.
    • Unexpected results may occur under certain circumstances, however. In the case of non-publicly traded debt, where the holder acquires debt at a substantial discount to principal amount shortly before the actual or deemed exchange, and such holder receives non-publicly traded debt, then such holder will have taxable gain based on the principal amount of the “new debt” even though the fair market value of such debt (as evidenced by the terms of a holder’s recent purchase) may be significantly lower. Accordingly, there would be taxable gain, even though economically, there has been no gain to the investor, and there was no greater expectation that the new debt would be repaid. Similarly, in the case of non-publicly traded debt, where the holder of the old debt (which holder did not acquire the debt at a discount) exchanges it for new debt that is also non-publicly traded, then even though the holder might expect the exchange would allow him to recognize a tax loss, this may not be so as the issue price of the new debt is its principal amount rather than its fair market value.

    Tax-Free Exchanges Where Debt Issuer is Corporation, and Debt Constitutes “Security”

    • If (i) if the issuer is a corporation, and (ii) the “old” and the “new” debt instruments each qualifies as a “security” for federal income tax purposes, then the exchange qualifies as a tax-free reorganization. While qualification of an exchange as tax-free is usually desirable when there is taxable gain involved, it is not when there is a taxable loss involved, as if an exchange qualifies as a tax-free reorganization, then taxable loss may not be recognized.
    • It is important to understand that the term “security” has a different definition than the definition discussed above under “worthlessness.” A debt instrument due more than 10 years from the date of issuance is generally thought to constitute a security whereas a short-term debt instrument is not. Debt instruments due in less than 5 years are not securities. Debts with maturity dates between 5 and 10 years may be securities if certain factors are met.[9]

    Other Critical Issues in Taxable and Tax-Free Debt Exchanges

    Imputed Interest

    • If the issue price of the new debt is less than its stated redemption price at maturity by more than a de minimis amount, the new debt will bear “original issue discount” or OID. The difference between the issue price of the new debt and its stated redemption price at maturity[10] will be includible in the holder’s income on a current constant yield basis regardless of whether there are any cash payments of principal or interest on the new debt. The issue price of a debt may quite easily exceed its stated redemption price at maturity – for example where either the old debt or new debt is publicly traded at a relatively low price, but its principal is significantly higher than its trading price, and the debt bears adequate stated interest. Thus, even if the issuer’s financial condition is such that the holder does not reasonably expect to collect the entire amount of the debt (as reflected by the low trading price), the holder may have “phantom” income. This may seem like a particularly harsh result where the holder had an economic loss on the exchange.

    Treatment of accrued interest

    • Even if a transaction is a “tax-free reorganization,” or you otherwise have a taxable loss with respect to your debt exchange, be ware that you may have income to the extent of accrued interest that you haven’t taken into taxable income yet. Generally, holders must recognize income to the extent that the value (including in the form of new debt) received for accrued interest exceeds the amount of accrued interest previously included in the holder’s income for federal income tax purposes. The proper allocation of amounts received in a debt exchange between principal and interest is unclear, although the applicable legislative history indicates that all parties should be bound by their explicit allocation of property received in an exchange between principal and accrued interest. Thus, investors should consider being explicit about the fact that none of the amount is allocable to interest.

    What If You Own Debt and You Exchange It For Stock?

    If the debt is a “security” as defined in the section above dealing with debt exchanges, and is issued by a corporation, then the exchange will generally qualify as a reorganization and the holder of the debt will generally be unable to recognize any loss realized on the exchange. If the exchange does not qualify as a reorganization, the holder will recognize any gain or loss realized based on the differences between the value of the stock received and its tax basis in the old debt. Again, even if the exchange is tax-free, the investor should be mindful that stock received that is attributable to accrued interest will result in taxable income.

    What If You Own Preferred Stock of a Corporation and Exchange for New Common or Preferred Stock?

    The exchange will generally qualify as a reorganization, and the holder of the stock will generally be unable to recognize any loss realized on the exchange. However, if the “old” preferred stock had dividends in arrears, and the “new stock” has either an issue price or fair value that exceeds the issue price of the old preferred stock, an amount equal to the accrued dividends (up to the lesser of the fair value or issue price of the new stock) is treated as a dividend for federal income tax purposes.

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    [1] Note that this alert does not discuss the tax consequences to dealers, or persons selling their shares, units, interests, notes or bonds in the ordinary course of their business. Such persons should have an ordinary loss. Further, this alert assumes that all sales or exchanges are between unrelated parties.

    [2] Limited liability companies with more than one member are taxed as partnerships for U.S. federal income tax purposes, unless they elect to be taxed otherwise. Accordingly, this memorandum refers to such limited liability companies as partnerships, and to their members as partners.

    [3] Although note that individuals are allowed to deduct up to $3,000 of capital losses per year against ordinary income.

    [4] Although this alert does not discuss many loss limitation rules in detail, we do note that Code Section 267 completely disallows losses on transfers of property between related persons. Related persons include certain closely related family members (parents, siblings, grandparents to grandchildren, but not in-laws), a trust and its grantor and beneficiaries, an estate and its beneficiaries, and a corporation and anyone owning 50% or more of the value of the corporation. This limitation only applies to losses, gains are fully recognized with the exception of transfers between spouses for which no gain or loss is recognized.

    [5] If the partner also receives certain inventory and unrealized receivables, then the partner’s loss will equal the amount by which the partner’s basis exceeds the sum of the money received plus the partner’s basis in the inventory and unrealized receivables distributed to him.

    [6] Qualified stated interest is stated interest that is unconditionally payable in cash or in property at least annually at a single fixed rate.

    [7] Debt instruments have adequate stated interest if they bear interest at least at the applicable federal rate, published monthly by the Internal Revenue Service.

    [8] The imputed principal amount is figured by using the applicable federal rate to discount all payments (principal and interest) due under the new debt.

    [9] Factors in determining whether 5 – 10 year debt instruments are securities include overall evaluation of the nature of the debt, degree of participation and continuing interest in the affairs of the business, the extent of proprietary interest compared to the similarity of the note to a cash payment, and the purpose of the advances.

    [10] The stated redemption price at maturity is the sum of all payments provided for by the debt instrument except for qualified stated interest payments.