A capital gain or loss generally requires the “sale or exchange” of a capital asset. Capital losses are generally usable only to offset capital gains (with an additional deduction for individuals of net capital loss against ordinary income, usually limited to $3,000 per year). And while favorable capital gain rates may apply to certain net capital gains of individuals but not to corporations, capital gains are still important for corporations in enabling them to deduct capital losses. So when a taxpayer turns down $20 million for a capital asset and instead transfers it for nothing, intending that the favorable tax result will more than offset the difference, there’s probably something to be learned from the transaction. In that case, the goal was to avoid sale or exchange treatment and thus achieve a fully deductible ordinary loss rather than a capital loss. At issue, however, is whether Internal Revenue Code (IRC) §1234A applies.
Congress added §1234A in 1981 to address concerns that, in certain transactions where the result of a sale was going to be a loss rather than a capital gain, taxpayers could avoid unfavorable capital loss treatment by cancelling or otherwise terminating the transaction so there would have been no sale or exchange, thus generating an ordinary loss instead. Originally focused on tax-straddle transactions, §1234A was expanded in 1997 to address all types of property. Yet despite its age, there remains much confusion and uncertainty about its application.
Ignoring some details and exceptions, §1234A generally provides that gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property “which is (or on acquisition would be) a capital asset” in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset.
The first thing that comes to mind is the obvious question: What’s supposed to be the capital asset—the property itself or the right or obligation with respect to the property? Since §1234A contemplates some kind of a termination of a right or obligation, presumably the taxpayer must already have that right or obligation—otherwise, there’s nothing to be terminated. So it appears to be the property itself “which is (or on acquisition would be) a capital asset.” But that isn’t entirely clear. Consider that proposed regulations (Prop. Reg. §1.1234A-1) would apply §1234A to derivatives that have no underlying capital asset. So it’s reasonable to wonder, for example, about the cancellation of a contract in a business context where the contract itself is a capital asset but involves services or property that isn’t a capital asset.
$20 MILLION OR NOTHING?
A major issue is whether §1234A applies to the termination of the inherent rights arising from property ownership itself. In Pilgrim’s Pride Corp. v. Commissioner (779 F.3d 311 (5th Cir, 2015), rev’g 141 T.C. No. 17 (2013)), a corporate taxpayer abandoned preferred stock by voluntarily surrendering the shares to the original seller for no consideration. It sought an ordinary loss deduction for its basis of $98.6 million. The taxpayer had received an offer to redeem those shares for $20 million but had apparently reasoned that abandonment (with no cash and a $98.6 million ordinary loss) would provide a better economic result than $20 million cash and a $78.6 million capital loss. Presumably the taxpayer didn’t expect to have enough capital gains during the taxable year and in the carryback and carryover periods to make the result from the capital loss plus $20 million cash as favorable as the fully deductible $98.6 million ordinary loss.
The Tax Court applied §1234A, resulting in the $98.6 million being a capital loss. The Court reasoned that since the surrender terminated all of the taxpayer’s rights in the securities, §1234A required that the loss be treated as a loss from the sale of a capital asset.
The Fifth Circuit reversed that decision, reasoning that §1234A applies to the termination of rights or obligations with respect to capital assets, such as derivative or contractual rights to buy or sell capital assets, but not to the termination of ownership of the capital asset itself. Since Pilgrim’s Pride abandoned the securities itself, rather than a right or obligation with respect to the securities, the Court held that §1234A did not apply.
Note that the amended regulations on worthless securities (Reg. §1.165-5(i)) effectively treat most abandoned securities under the rules for worthless securities. This would apparently turn the loss in Pilgrim’s Pride into a capital loss if the abandonment happened today. Nonetheless, this case still has important implications in determining whether §1234A applies to other kinds of capital assets.
Another issue is whether §1234A applies to §1231 property, which isn’t a capital asset even though a gain on its sale might receive capital gain treatment. The confusion may be due to an example in the 1997 Congressional committee reports explaining what property would be covered under the expanded section (S. Rep. No. 105-33, at 135). The reports cited two cases involving leased real estate that was probably §1231 property rather than a capital asset to the taxpayer-lessor.
Nevertheless, in the recent case of CRI-Leslie, LLC v. Commissioner (147 T.C. No. 8 (2016)), the Tax Court refused to apply §1234A to a gain from $9.7 million of forfeited deposits received from a cancelled sale of real estate that was §1231 property. More troubling, the seemingly contradictory example in the Congressional committee reports wasn’t addressed by the Court.
MERGER TERMINATION FEES
A particularly complex area where §1234A has been called into question involves merger termination fees. In guidance from 2008 (LTR 200823012), the IRS indicated without explanation that §1234A didn’t apply. But in 2016, the IRS issued two pieces of guidance—FAA 20163701F and CCA 201642035—explaining how §1234A would apply to merger termination fees on the facts described there.
While §1234A is deceivingly difficult to understand, much of the IRS guidance and court decisions have just added to the confusion and uncertainty. The coverage here merely scratches the surface. Practitioners need to at least be aware of the section so that they can do appropriate research when needed.
© 2017 A.P. Curatola