Code Sec. 1271(a)(1) simply states that

February 2013 By Paul C. Lau, Nora Stapleton and Kurt Piwko * When Should Code Sec. 1271(a)(1) Apply to Bad Debt? Code Sec. 1271(a)(1) simply states that [a]mounts received by the holder on retirement of any debt instrument shall be considered as amounts received in exchange therefor. This means that the character of any gain or loss is determined as if the amounts were received in a sale or exchange. In contrast, Code Sec. 166(a) specifically provides an ordinary deduction for a business bad debt without any reference to sale or exchange. While both Code Secs. 1271(a)(1) and 166(a) may involve business debt that has become partially worthless, it is unclear how the two sets of rules interact when dealing with business debts that are capital assets in the hands of the debt holders where some consideration is received in satisfaction of all or a part of the debt. Partial worthlessness generally results in an ordinary deduction under Code Sec. 166(a) while a sale or exchange on nretirement eme of apartially yworthless debt under Code Sec. 1271(a)(1) generally results in capital loss. Current authorities provide seemingly conflicting viewpoints on this interaction or, at the very least, are silent as to how these two provisions interact. A recent Tax Court case, Dagres, 1 deepens this unsettled interaction. This column explores some relevant authorities on this subject. History of Code Sec. 1271(a)(1) TAXES THE TAX MAGAZINE Paul C. Lau and Nora Stapleton are Tax Partners at Plante Moran in Chicago, and Kurt Piwko is a Senior Tax Manager at Plante Moran in Macomb, Michigan. Code Sec. 1271(a)(1) was enacted in 1984 and replaced former Code Sec. 1232(a)(1), with a history dating back to Code Sec. 117(f) of the Revenue Act of 1934. In its current form, Code Sec. 1271(a)(1) covers all debts other than (1) debts issued by individuals and purchased before June 9, 1997, (2) debts issued by persons other than a corporation, a government or political subdivision before July 2, 1982, and purchased before 15

June 9, 1997, and (3) certain other debt instruments issued before January 1, 1955. In effect, this provision applies to all newly issued debts. When initially enacted, Code Sec. 117(f) covered only evidences of indebtedness issued by corporations and any government or political subdivision that were in registered form or with interest coupons. It was reenacted, with modifications, as Code Sec. 1232(a)(1) under the 1954 Internal Revenue Code. As modified, Code Sec. 1232(a)(1) applied to debts issued by corporations and any government or political subdivision that were capital assets in the hands of the debt holders. In 1984, it was reenacted as Code Sec. 1271(a)(1) and expanded to include all obligations issued by any entity including corporations, governments, or political subdivisions thereof. In addition, the capital asset requirement was also eliminated. The only exception to these rules was indebtedness issued by individuals. In 1997, the law was expanded to include debts issued by individuals. Code Sec. 166(a) Code Sec. 166(a)(1) provides a deduction for a debt that becomes completely worthless during the tax year. Code Sec. 166(a)(2) allows ade deduction for a partially worthless debt B d on th in amount not more than the charge off during Code Sec 1 the tax year. The treatment for a bad debtor r debt differs between a C corporation and other dbt ti taxpayers that are not C corporations. A C corporation can claim an ordinary deduction for either a completely worthless debt or a partially worthless debt under Code Sec. 166(a). In the case of a taxpayer other than a C corporation, however, Code Sec. 166(d) provides different rules for business debts and nonbusiness debts. 2 First, only business bad debt can qualify for an ordinary bad debt deduction under Code Sec. 166(a) when it is either partially or wholly worthless. Second, a loss from a nonbusiness debt is classified as a short-term capital loss (i.e., a loss from the sale or exchange of a capital asset held not more than one year). Lastly, no loss can be claimed for a partially worthless nonbusiness debt. 16 2013 CCH. All Rights Reserved. Both Code Secs. 165 and 166 can apply to a loss on debt. Code Sec. 165 allows a deduction for any loss sustained during the tax year. Code Sec. 166 takes precedent when both sections apply to any debt that is not a security within the meaning of Code Sec. 165(g)(2)(C). For a security, Code Sec. 165(g)(1) applies and treats the loss as a capital loss when the worthless debt is a capital asset. However, the loss is an ordinary loss if the worthless security qualifies under Code Sec. 165(g)(3) to be treated as not a capital asset. Authorities Favoring Code Sec. 1271(a)(1) Based on the explicit language of Code Sec. 1271(a)(1) and case law, it seems that any payment by the debtor results in at least a partial debt retirement with respect to the amount of payment. Code Sec. 1271(a)(1) applies when there is a retirement. Neither the statute nor regulations define the meaning of retirement. In McClain, 3 the Supreme Court held that [n]othing in the legislative history of [Code Sec. 117(f)] requires us to attribute to the term used a meaning narrower than its accepted meaning in common speech. It also stated: In common understanding and according to [sic] dictionary definition the word retirement is broader in scope than redemption, is not, as contended, synonymous with the latter, but includes it. A retirement can be a payment to the holder of the debt instrument for either a partial or a complete extinguishment of the debt. In Reg. 1.1272-1(j), Example 6, an issuer has the y right to call 50 percent of least a partial a debt instrument. nt. The example provides sthat if fthe h tt th call option is exercised, the debt is treated as two debt instruments, one that is retired on the call date and one that remains outstanding after the call date. As explained later, case law supports the notion of partial retirement. McClain and Related Authorities McClain dealt with former Code Sec. 117(f) when the provision only covered indebtedness issued by corporations or governments. In McClain, the Supreme Court held that a cash payment to a holder of a debt instrument in an amount less than its face value was a retirement when the holder surrendered the debt instrument. The Court held that capital loss treatment was appropriate for the taxpayer who received $5 for

February 2013 each $1,000 debenture surrendered for cancellation pursuant to a plan of reorganization. The taxpayer raised the unjust result argument that a creditor who received a trifling consideration in settlement of a debt would have capital loss under Code Sec. 117(f), but would have a bad debt deduction under Code Sec. 23(k), predecessor of Code Sec. 166(a), if he refused the settlement offer. The Court simply responded: The answer is that we must apply the statute as we find it, leaving to Congress the correction of asserted inconsistencies and inequalities in its operation. In E. Atlas, 4 the court held that there was a retirement under former Code Sec. 117(f) when a taxpayer surrendered a bond and contemporaneously received the deed to a real property. This case established that either cash and/or other property can be used in a debt retirement. In R. Shaw, 5 the court held that bonds were deemed to have been retired even though they were not extinguished, but remained in existence as security for a new obligation. In this case, the bond holder received cash payment equal to 49.8 percent of the bond and assigned the bond to an unrelated party to serve as security for a new loan made to the debtor corporation. The court explained that the debtor company in effect retired ed them and reissued them to effect the pledge. These e above cases are just a few examples illustrating that a debt retirement can occur with payment of cash and/or other property and that the debt instrument nt need not be fully extinguished to be considered d retired. Partial Retirements Retirement is not just limited to final payment onan obligation. Case law held that there could be a series of retirements corresponding to the series of partial payments over a period of time. In essence, a retirement occurs on the partial repayment of a debt even though the debt is not entirely extinguished. In W. Noll, 6 the bond issuer became insolvent and a receiver was appointed. The receiver made a series of payments to the bondholder taxpayer. The IRS contended that because the petitioner merely received payments on account of his obligations with the balance still remaining due and owing, the bonds being in public circulation, available for public assignment and transfer and petitioner retaining all rights thereunder, no retirement occurred. The court rejected the argument and stated that in common speech the bonds were partially retired and that the statute does not require that the bonds be wholly retired. In E. Timken, 7 a taxpayer held creditors notes that were issued by a corporation in final settlement and discharge of an unpaid balance on bank deposits in a failed bank. The IRS argued that partial payments received by the taxpayer on these creditors notes were not payments on retirement. The court dismissed the IRS s argument, since such a view that the payments here were not retirement means in effect that only the final payment on the notes, or a single payment of the full amount, can constitute retirement. Citing W. Noll, the court held that the partial payments were on account of retirement within the meaning of former Code Sec. 117(f). It stated that [e]ach payment upon the note pro tanto retired it. The payments contributed to the retirement of the notes, the amounts were received in exchange there for and the gains were taxable as capital gains. In H. Avery, 8 the IRS contended that there was no retirement of the certificates of indebtedness because the taxpayer still holds the certificates, which can be sold by him, payments on the certificates are vague, uncertain and indefinite, and no payments are due if there are no sales of cemetery lots. The court, citing both W. Noll and E. Timken, again concluded that the amounts were received by the taxpayer upon retirement of the certificates of indebtedness and in exchange therefor within the meaning of former Code Sec. 117(f). It did not matter that the obligations were not fixed in either amount or maturity. These above cases established that any payment reducing the principal balance of an obligation can be a retirement payment, even though part of the obligation remains outstanding and still held by the debt holder. Transfer in Lieu of fforeclosure Rev. Rul. 80-57 9 deals with a real estate investment trust engaged primarily in the trade or business of short-term financing. It made a construction and development loan that was subsequently in default and accepted a deed in lieu of foreclosure when the fair market value of the property exceeded the trust s basis in the mortgage note. Since the note was an ordinary asset under Code Sec. 1221(4), Code Sec. 1232(a)(1) did not apply at the time of the ruling. Nevertheless, the ruling cited McClain, stating that the Supreme Court of the United States stated that the term retirement is construed broadly and in accordance with its ordinary meaning and includes a conveyance in lieu of foreclosure. In GCM (General Counsel Memorandum) 36877 10 the IRS Chief Counsel s Office commented on a technical advice memorandum that was subsequently TAXES THE TAX MAGAZINE 17

developed into Rev. Rul. 80-57. The Chief Counsel s Office stated that a conveyance would not constitute a sale or exchange unless the mortgage note was subject to Code Sec. 1232(a)(1), the immediate predecessor of Code Sec. 1271(a). The authority cited included Fairbanks 11 and Bingham. 12 Fairbanks was decided on a bond redemption that occurred prior to the enactment of Code Sec. 117(f). The Supreme Court held that a redemption of corporate bonds before maturity was neither a sale nor exchange within the commonly accepted meaning of the words. In Bingham, the taxpayer sold real estate in exchange for cash and a note. The buyer subsequently defaulted on the note and transferred the real estate to the taxpayer in lieu of foreclosure. The court cited Fairbanks and ruled that no sale or exchange had occurred and the taxpayer was entitled to a bad debt deduction rather than a capital loss. In the GCM, the Chief Counsel s Office agreed that if the debt was a debt subject to Code Sec. 1232 (a) (1), a conveyance in lieu of foreclosure would be treated as a sale or exchange by the debt holder. Gain or loss would be treated as gain or loss on the sale or exchange of a capital asset. At the time, Code Sec. 1232(a)(1) only applied to debts issued by corporations (or governments or political subdivisions) which were capital assets in the hands of the debt holders. Other debts, such as the debt described in the GCM, were not subject to Code Sec. 1232(a)(1). In effect, Rev. Rul. 80-57 and the GCM indicate that the IRS considers a transfer in lieu of foreclosure reas a retirement. t Furthermore, they indicate that the IRS considers McClain as an appropriate authority for applying p the meaning of retirement to a debt instrument nt that would not be subject to the former Code Sec. 117(f). Consolidated Return Regulations The consolidated return rules on intercompany obligations indicate that Code Sec. 1271(a)(1) may apply when, among other transactions, a non-intercompany obligation becomes an intercompany obligation (herein referred to as an inbound intercompany obligation ). In such cases, Reg. 1.1502-13(g)(5) provides that the obligation is deemed satisfied for cash and reissued immediately after the obligation becomes an intercompany obligation for cash in an amount equal to its fair market value (FMV). An intercompany obligation is an obligation between two members, but only for the period during which both parties are members of the consolidated group. Under Reg. 1.1502-13(g)(5)(ii), the deemed satisfaction and deemed reissuance of the debt are treated as transactions separate and apart from the transaction in which the debt becomes an intercompany obligation. In Reg. 1.1502-13(g)(7)(ii), Example 10, Code Sec. 1271(a)(1) is cited as an applicable Code section for the deemed satisfaction of the inbound intercompany obligation. A summarized version of the example is as follows: Facts. On January 1, year 1, B, a member of P s consolidated group, borrowed $100 from X, an unrelated party, in exchange for B s note providing for $10 of annual interest at the end of each year, and repayment of $100 at the end of year 5. As of January 1, year 3, B fully performed its obligation, but the note s FMV is $70 due to an increase in prevailing market interest rates. On January 1, year 3, P buys all of X s stock. B is solvent within the meaning of Code Sec. 108(d)(3). Analysis. Under Reg. 1.1502-13(g)(5)(ii), B s $100 note is treated as satisfied for $70 immediately after it becomes an intercompany obligation. Both X s $30 capital loss under Code Sec. 1271(a)(1) and B s $30 of discharge of indebtedness income under Reg. 1.61-12 are taken into account in determining consolidated taxable income for year 3. Pursuant to Reg. 1.1502-13(g)(6)(i)(B), the attributes of items from the deemed satisfaction are determined on a separate entity basis. Bis also treated as reissuing suing anew note of$100 to X. The new note is an intercompany obligation and has a $70 issue price and $ 100 stated redemption price at maturity. The $30 difference is the original issue discount that will be taken into account by B and X over the remaining term. That same regulation similarly incorporates Code Sec. 1271(a)(1) in a number of other transactions in which the deemed satisfaction and reissuance model applies. 13 It seems clear, based on the examples, that the IRS considers a debt satisfaction as a retirement under Code Sec. 1271(a)(1). Otherwise, the deemed satisfaction would not be treated as a sale or exchange and would not generate a capital loss (before the application of the matching rules). As discussed above in GCM 36877, the Chief Counsel s Office concluded that a satisfaction of a note was 18 2013 CCH. All Rights Reserved.

February 2013 not a sale or exchange unless the note was subject to Code Sec. 1232(a)(1) applicable at that time. Summary Observations Based on the above authorities, it is reasonable to conclude that the IRS considers McClain applicable for the purpose of defining the meaning of retirement for current debts that would not be subject to the code provision decided in McClain. Based on McClain, it seems that a debt holder who receives payment from the debtor and surrenders the debt or otherwise relieves the debtor of further liability should apply Code Sec. 1271(a)(1) to provide capital gain or loss treatment for a debt that is a capital asset in the hands of the debt holder. It seems clear that a partial payment of a debt that remains outstanding can also be a retirement for the paid or settled portion. A transfer in lieu of foreclosure is also a retirement, at least from the IRS s view. Finally, the consolidated return regulations apply the retirement implication under Code Sec. 1271(a)(1) when a debt is deemed satisfied. While the above authorities provide considerable support that Code Sec. 1271(a)(1) applies in cases where a debt is satisfied or settled for cash or other property, there are authorities which support an ordinary ry business bad debt under Code Sec. 166(a). Authorities Favoring Business Bad Debt td Deductions We know of fthree edifferent ent instances nces where there are some authorities favoring or supporting an ordinary bad debt deduction under Code Sec. 166(a). These e three instances are: (1) foreclosures, osure,(2) subsidiary sid liquidations, and (3) individual debt obligations. Foreclosures As described above, it seems fairly clear that the IRS views a transfer in lieu of foreclosure as a retirement subject to Code Sec. 1271(a)(1). However, it is uncertain if this view equally applies to a foreclosure situation. Reg. 1.166-6(a)(1) provides that [i]f mortgaged or pledged property is lawfully sold (whether to the creditor or another purchaser) for less than the amount of the debt, and the portion of the indebtedness remaining unsatisfied after the sale is wholly or partially uncollectible, the mortgagee or pledgee may deduct such amount under Code Sec. 166(a) (to the extent that it constitutes capital or represents an item the income from which has been returned by him) as a bad debt for the taxable year in which it becomes wholly worthless or is charged off as partially worthless. This regulation has a history that dated back to a predecessor regulation in 1926, which predated Code Sec. 1271(a)(1) and its predecessors. Hence, it raised the issue whether Code Sec. 1271(a)(1) overrides this regulation. In Rev. Rul. 90-16, 14 the IRS ruled that either a transfer of property to a creditor in lieu of foreclosure or a foreclosure transaction in satisfaction of recourse debt is a sale or exchange to the debtor. This ruling does not address the treatment from the debt holder s perspective. In GCM 36877, the Chief Counsel s Office indicated that even when a transaction is a sale or exchange to a debtor, it need not be a sale or exchange to the debt holder. Without further guidance, it is unsettled whether Code Sec. 1271(a)(1) or 166(a) applies to a foreclosure transaction. At least for a recourse debt, it seems that Reg. 1.166-6(a)(1) may still be applicable to the uncollected portion of the debt if the creditor still can pursue legal claim against the debtor for the portion that remains unsatisfied. It seems Code Sec. 1271(a) (1) applies to the portion of the recourse debt that is satisfied as a partial retirement. The remaining unsatisfied portion remains outstanding and is not retired. The unsatisfied portion can be a bad debt deduction under Code Sec. 166(a) if the creditor determines later that the amount is wholly or partially worthless. In essence, the creditor should be able to claim a bad debt deduction if the sale or retirement is separate and independent from the creditor s determination of worthlessness. This analysis is consistent with the conclusion expressed in TAM 9253003 15 and Levine. 16 In TAM 9253003, the IRS held that the taxpayer ay may determine and claim an ordinary deduction duc under Code Sec. 166 if it can demonstrate that the debt was partially worthless before the debt retirement. It indicated that Code Sec. 166 applied when a creditor unilaterally determined the worthlessness of the debt while Code Sec. 165 applied when the loss was determined by the joint actions of both the debtor and the creditor. The write-off was a bad debt deduction even though the write-off was made shortly before the settlement. In Levine, 17 the court held that the sale of the taxpayer s notes for a nominal amount did not affect the taxpayer s bad debt deduction since the sale was subsequent to and independent of the debt charge off. This demonstrates that a bad debt write-off of a debt that was subsequently sold in the same tax year may be deductible under Code Sec. 166 if the charge-off was independent of the sale. TAXES THE TAX MAGAZINE 19

Subsidiary Liquidations It is fairly common that a subsidiary owes money to its parent company at the time of liquidation. In the liquidation, the parent-subsidiary debts are extinguished. When a debtor/subsidiary is insolvent, the liquidation does not qualify as a tax-free liquidation under Code Sec. 332. Instead, it is treated as if the subsidiary transferred all of its assets in satisfaction of its indebtedness owed to the creditor/ parent. 18 In Rev. Rul. 70-489, 19 P owned all of the stock of S, which was insolvent due to the fact that its indebtedness to P exceeded the FMV of its assets. S, which had no other liabilities, transferred all of its assets to P in liquidation. P continued to operate S s operations as a branch. The IRS held that although P continued to operate S s business as a branch, it does not preclude P from claiming a bad debt and worthless securities deduction. The ruling did not mention the possible deemed retirement rules that were in effect at that time under Code Sec. 1232(a)(1), the predecessor of Code Sec. 1271(a)(1). In Rev. Rul. 2003-125, 20 the IRS again stated that a bad debt deduction may be claimed by the creditor/ parent. In the ruling, the IRS stated that the parent company may be entitled to a deduction for a partially or wholly worthless debt under 166, if the parent received assets from the liquidation of a subsidiary sidia (or deemed liquidation under the checkthe-box regulations) and the FMV of the subsidiary s assets was less than the basis of the debt held by the parent. The ruling does not discuss the possibility that t a capital ll loss under Code Sec. 1271(a)(1) might result if the liquidation was viewed as a retirement of the subsidiary s debt and the debt was considered a capital asset in the hands of the parent. Without further explanation and clarification from the IRS, it is unclear why Code Sec. 1271(a) does not apply to the settlement of intercompany debt owed to the parent in the liquidation of an insolvent subsidiary while Code Sec. 1271(a)(1) does apply to an inbound intercompany obligation subject to the deemed satisfaction and reissuance model of Reg. 1.1502-13(g)(5). Individual Debt Obligations Debt obligations issued by individuals after June 8, 1997, are subject to the retirement rules under Code Sec. 1271(a)(1). One recent Tax Court case involving the debt obligation of an individual was silent on the effect of this Code section. In Dagres, an individual taxpayer made a $5 million loan to an individual business acquaintance on November 7, 2000. On December 31, 2002, the original loan was cancelled in exchange for a new note with a principal balance of $4 million. In 2003, they entered into a settlement negotiation when the borrower was unable to repay the loan. Under the settlement agreement dated December 31, 2003, the borrower transferred to the taxpayer securities with a value of approximately $365,000 as partial payment. The balance of the note was forgiven and the taxpayer claimed a bad debt deduction of approximately $3.6 million. The Tax Court addressed the issue of whether the debt was a business debt and determined that the debt was a business debt. It then held that the taxpayer suffered a business bad debt deduction under Code Sec. 166. However, the court did not mention Code Sec. 1271(a)(1), which may be applicable to the partially worthless debt. Debts incurred by individuals after June 8, 1997, are subject to Code Sec. 1271(a)(1). Since the $5 million debt was incurred in 2000 and modified in 2002, it seems that the debt settlement may result in a capital loss for the unpaid portion. There is no indication that the debt was partially charged off under Code Sec. 166(a)(2) by the taxpayer prior to the settlement. Conclusion Based on the explicit language of Code Sec. 1271(a) (1) and case law, it seems that any payment by the debtor results in at least a partial debt retirement with respect to the amount of payment. However, it is problematic to ascertain whether any unpaid balance eis also considered retired and subject to a deemed sale or exchange treatment under Code Sec. 1271(a)(1). It is unclear why Dagres disregarded Code Sec. 1271(a)(1). Based on McClain, the settlement payment could have resulted in a complete retirement and a deemed sale or exchange of the entire debt. Similarly, the IRS has not explained why Code Sec. 166, rather than Code Sec. 1271(a)(1), applies to liquidation of insolvent subsidiaries. It seems that Code Sec. 166 should be available if the debt holder independently determines that the unpaid balance becomes worthless before or after the debt retirement under Code Sec. 1271(a)(1). While it is debatable, Dagres and other authorities cited above which are silent as to the application of Code Sec. 1271(a)(1) may stand for the proposition that a Code Sec. 166 bad debt deduction may be available for the 20 2013 CCH. All Rights Reserved.

February 2013 worthless debt balance even when its worthlessness is established at approximately the same time that a retirement occurs within the meaning of Code Sec. 1271(a)(1). ENDNOTES * This column represents the views of the authors only, and does not necessarily represent the views or professional advice of Plante Moran. 1 T.A. Dagres, 136 TC 263, Dec. 58,581 (2011). 2 A nonbusiness debt is defined under Code Sec. 166(d)(2) as a debt other than (1) a debt created or acquired in connection with the taxpayer s trade or business, or (2) a debt the loss from the worthlessness of which is incurred in the taxpayer s trade or business. For a recent discussion, see Dagres, supra note 1. 3 D.S. McClain, SCt, 41-1 USTC 9168, 311 US 527, 61 SCt 373. 4 E.A. Atlas, 4 TCM 111, Dec. 14,368(M) (1945). 5 R.M. Shaw, CA-7 41-1 USTC 9228, 117 F2d 587. 6 W.H. Noll, 43 BTA 496, Dec. 11,637 (1941). 7 E.K. Timkin, 6 TC 483, Dec. 15,032 (1946). 8 H.C. Avery, 13 TC 351, Dec. 17,193 (1949). 9 Rev. Rul. 80-57, 1980-1 CB 157. 10 GCM 36877 (Sept. 20, 1976). 11 D. Fairbanks, SCt, 39-1 USTC 9410, 306 US 436, 59 SCt 607. 12 H.P. Bingham, CA-2, 39-2 USTC 9636, 105 F2d 971. 13 See, for example, Reg. 1.1502-13(g)(7)(ii), Examples 2, 3, 4 and 6. 14 Rev. Rul. 90-16, 1990-1 CB 12. 15 TAM 9253003 (Sept. 22, 1992). 16 M. Levine, 31 TC 1121, 1959 U.S. Tax Ct. LEXIS 230 (1959). 17 Id. 18 See Rev. Rul. 59-296, 1959-2 CB 87. 19 1970-2 CB 53, superceded by Rev. Rul. 2003-125. 20 Rev. Rul. 2003-125, 2003-2 CB 1243. This article is reprinted with the publisher s permission from the TAXES THE TAX MAGAZINE, a month ly journal published by CCH, a Wolters Kluwer business. Copying or dis tri bu tion without the pub lish er s per mis sion is prohibited. To subscribe to the TAXES THE TAX MAGAZINE or other CCH Journals please call 800-449-8114 or visit www.cchgroup.com. All views expressed in the articles and col umns are those of the author and not necessarily those of CCH. TAXES THE TAX MAGAZINE 21