Tax Court Upholds Worthless Security Deduction in Year Company Began Winding Down

(Parker Tax Publishing January 2020)

The Tax Court held that a partnership was entitled a worthless security deduction under Code Sec. 165(a) for an interest it held in a company in the year that the company decided to wind down, even though the company planned to wind down over the next five years. The court found that the taxpayer subjectively determined that the interest was worthless and that objective factors supported the finding that the interest had no liquidation value and no future value. MCM Investment Management, LLC v. Comm'r, T.C. Memo. 2019-158.

Background

Macey McMillin, along with his wife and three children, owned the McMillin Companies, LLC (Companies), which operated the family's single-family homebuilding, master-planned communities, and commercial development and management businesses. Each business was operated through various project entities. The family also formed MCM Investment Management, LLC (MCMIM) to serve as an investment vehicle and the manager of Companies. MCMIM made several capital contributions to Companies in exchange for a member interest in Companies that entitled it to receive distributions equal to its contributions plus interest.

In 1998, Companies borrowed $35 million and secured the debt with Companies' assets and pledges of economic interests in the project entities. In 2005, Companies refinanced the debt with $100 million of notes (senior debt) and borrowed another $62.5 million (subordinate debt). The subordinate debt was also secured by Companies' assets. In addition, Companies' project entities took out loans to finance their respective projects (project debt). The project debt was secured by the real property held by the particular borrowing project entity and was guaranteed by MCMIM and other entities.

Companies' financial condition deteriorated in 2007 and 2008 as a result of the subprime mortgage crisis and Companies defaulted on the senior debt. In late 2008, the McMillin family decided that they would not make any additional contributions to Companies given its substantial debt burden. The home building and real estate market worsened considerably in early 2009. Companies converted some of its debt to equity but the continued decline in property values prompted additional notices of default. In December 2009, Companies produced a cashflow forecast projecting that if it wound down over five years, it would have a cash shortfall in both 2012 and 2013 and a positive cash balance by the end of 2014. Companies also prepared a liquidation analysis which showed that if Companies completely liquidated in 2009, it would have only $51.6 million to pay approximately $70 million in outstanding senior debt.

Ultimately, Companies' owners decided to wind down the entity. Based on its December 2009 cashflow forecast, Companies believed it could complete construction of, market, and sell all of its assets in an orderly manner by the end of 2014. The owners believed that an orderly liquidation over five years would be more beneficial to Companies' lenders than a complete selloff of its assets over a shorter timeframe.

On MCMIM's 2009 Form 1065, it reported an ordinary loss of $41 million for its interest in Companies. The IRS disallowed the deduction, and MCMIM took its case to the Tax Court.

Code Sec. 165(a) allows a deduction for any loss sustained during the tax year and not compensated by insurance or otherwise. Under Reg. Sec. 1.165-1(b), such a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the tax year. Only a bona fide loss is deductible, and substance prevails over mere form. To prove entitlement to a Code Sec. 165(a) loss deduction for worthless property, a taxpayer must (1) demonstrate its subjective determination of worthlessness and (2) show that the asset in question is in fact essentially worthless. An equity interest is essentially worthless if it has no liquidating value and no potential future value.

The IRS contended that MCMIM failed to show that all possibilities of Companies' eventual profit had effectively been destroyed. According to the IRS, MCMIM could have forced a dissolution of Companies in 2009 and received a liquidating distribution. The IRS also pointed out that Companies continued operating during 2009 and the wind down period indicated that MCMIM's partnership interest must have had some potential future value. The IRS further asserted that MCMIM's interest in Companies had potential future value until foreclosure occurred with respect to each property interest encumbered by a recourse mortgage held by Companies' project entities. Finally, the IRS contended that MCMIM's loss was not bona fide because the McMillins remained beneficial owners of Companies both before and after MCMIM's partnership interest became worthless, and therefore they experienced no loss at all.

Tax Court's Analysis

The Tax Court upheld MCMIM's deduction because it found that (1) MCMIM subjectively believed the interest to be worthless in 2009, and (2) objective factors confirmed that the interest became essentially valueless in 2009. The court found that the McMillin family based their belief that the partnership interest was worthless on the devastating impact of the financial crisis, Companies' consistent operating losses, the subordinate position of MCMIM's interest, and the overwhelming debt burden of Companies and its project entities. The court also found that the owners and management took into account Companies' deteriorating cashflow projections during 2009. Those projections showed that Companies would be unable to satisfy financial obligations owed to the senior lender, the subordinate lender, or the project debt lenders.

Turning to the objective factors, the court found that there was sufficient evidence of Companies' lack of liquidation value because the $51.6 million in proceeds that Companies could generate in a hypothetical 2009 liquidation would fall short of satisfying the $70 million in outstanding senior debt. The court also noted that Holdings' preferred interest and preferred return, which also were senior to MCMIM's partnership interest, exceeded $71 million. Thus, in the court's view, MCMIM's partnership interest in Companies was under water by a substantial margin in 2009, sitting behind both the senior debt and Holdings' preferred interest. The Tax Court disagreed with the IRS that MCMIM could have forced a dissolution and received a liquidating distribution because a liquidation in 2009 would not have generated enough cash to pay off the senior debt and therefore nothing would be left for equity holders.

The court also found that several identifiable events occurred that effectively destroyed Companies' potential future value. These factors included the severe recession caused by the subprime mortgage crisis, the dire financial condition of Companies in 2008 and 2009, the significant decline in Companies' expected cashflow, the decision by Companies' owners to wind down the entity, and the 2009 defaults subsequent foreclosures. The court found that MCMIM did not have to prove that every asset held by Companies was worthless and did not have to delay the deduction under Code Sec. 165(a) merely because Companies owned real estate interests encumbered by recourse debt. In addition, the court concluded that the IRS failed to show that the transactions between the McMillin entities should not be respected for tax purposes.

For a discussion of the rules for deducting a loss on worthless securities, see Parker Tax ¶98,700.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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