No Loss Allowed for Expired Contract Where Business Continued as Normal.

(Parker Tax Publishing December 16, 2015)

A business was not entitled to a Code Sec. 165 loss deduction for a towing contract that expired where it was clear that the business did not, in substance, suffer a loss during the year even if the contract expired in form. The business continued to enjoy the benefits of the towing contract even after it initially expired. Steinberg v. Comm'r, T.C. Memo. 2015-222.

Background

Randy Steinberg and Jon Nissley were partners in Kelmark Tow, LLC, a limited liability company taxed as a partnership. In 2005, Kelmark purchased a towing contract for $1.2 million. Upon the purchase of the towing contract, Kelmark obtained the sole and exclusive right to operate the Official Police Garages (OPG) for the Southeast Area of the Los Angeles Police Department (LAPD). OPGs in Los Angeles are regulated through a contract process. Los Angeles Municipal Code Sec. 80.77.4 limits the duration of OPG contracts to a five-year term. Kelmark's contract provided for a five-year term ending on June 27, 2009. At the end of the five-year term, the City of Los Angeles could, at its sole option, extend the contract for an additional five-year term.

In 2008, the Los Angeles City Council amended the city's Municipal Code to establish permanent OPG boundaries and, on February 12, 2010, adopted a recommendation that had the effect of retroactively changing the expiration date of Kelmark's towing contract from June 27, 2009, to December 27, 2009. New OPG contracts were drafted and Kelmark was notified in writing that (1) its first five-year term had expired, and (2) if Kelmark wished to be considered for a second five-year term, it needed to submit a written request for renewal no later than February 15, 2010. An amendment to the original contract was executed on June 8, 2010, which extended the original contract to June 26, 2014. Kelmark continued to operate the Southeast Area OPG during all of 2009 and was the only provider of towing services for the LAPD in that area. Kelmark submitted monthly summary reports to the Board of Police Commissioners for each month of 2009.

On its 2009 Form 1065, U.S. Return of Partnership Income, Kelmark deducted $880,000 of amortization expense. The IRS disallowed the deduction and the pass-through of the deduction to Steinberg and Nissley on their personal tax returns. The IRS also assessed an accuracy-related penalty under Code Sec. 6662.

Analysis

While the parties agreed that the towing contact was a Code Sec. 197 intangible amortizable over a 15-year period, they disagreed as to whether Steinberg and Nissley suffered passthrough losses under Code Sec. 165 in 2009 when the contract lapsed on either June 27 or December 27, 2009, and was not amended until June 8, 2010. Steinberg and Nissley argued that since the express terms of the contract stated that it must terminate on June 27, 2009, the contract became worthless in 2009 and they were therefore entitled to loss deductions under Code Sec. 165 for 2009 equal to the remaining basis in the contract. They contended that state or local law determines property rights and asked the Tax Court to take judicial notice of the Los Angeles Code provision which limits the duration of OPG contracts to a five-year term. Steinberg and Nissley argued that general rules of contract interpretation required the court to ascertain the intent of the parties from the plain language of the contract itself.

The IRS countered that the contract did not become worthless in 2009 because (1) Kelmark continued to enjoy the same benefits of towing for the Southwest Area OPG after the towing contract expired by its own terms on June 27, 2009, (2) the city delayed extending the towing contract to include details of the new OPG ordinance in all existing OPG contracts, and Kelmark was not at risk of losing its OPG contract, (3) the city was not required to exercise its option to extend the contract before the expiration of the initial term, (4) the city did in fact exercise its option to extend, first with a temporary extension and then with an amendment to the initial contract, and (5) the terms of the amendment reflected the intentions of Kelmark and the city to include the interim period as part of the towing contract. The IRS also noted that the amendment extended the terms of the contract until June 26, 2014, which was five years after the original term expired on June 27, 2009. According to the IRS, if the parties did not intend to include the interim period in the towing contract, the amendment would have provided for a five-year term beginning on the date the amendment was signed on June 8, 2010.

The Tax Court held that Steinberg and Nissley were not entitled to loss deductions based on the towing contract becoming worthless. The court disagreed that the original contract language was dispositive of whether Steinberg and Nissley sustained passthrough losses in 2009. According to the court, both the Code and case law required that the court consider all facts and circumstances surrounding Kelmark's towing contract with the City of Los Angeles. The court looked at Kelmark's conduct in conjunction with the original contract, the amendment to the contract, and the Los Angeles Municipal Code, and said it was clear that Kelmark did not, in substance, suffer a loss in 2009 even if the contract expired in form. Kelmark continued to enjoy the benefits of the towing contract, the court said, even after it initially expired on June 27, 2009, and subsequently expired after the 180-day extension on December 27, 2009. The court noted that Kelmark continued to operate the Southeast Area OPG, and no other party provided towing services for the LAPD in the Southeast Area during any part of 2009.

The court also commented on the fact that Kelmark continued to provide monthly summary reports to the LAPD for the Southeast Area OPG, thus further indicating that nothing material occurred in 2009 that changed the relationship Kelmark maintained with the LAPD in the Southeast Area or Los Angeles. This fact, the court said, favored a finding that the contract was neither subjectively worthless in Steinberg's and Nissley's eyes nor objectively worthless given the surrounding facts and circumstances.

The court also considered the original contract in conjunction with the amendment, saying that the plain language of the amendment evidenced an intent by Kelmark and the City of Los Angeles to include the interim period within the amendment's terms because, in part, it called for an additional five-year term that ended exactly five years after the expiration date of the original contract.

Finally, the court agreed with the IRS that Steinberg and Nissley were negligent and disregarded rules and regulations when they claimed the Code Sec. 165 loss deductions and thus upheld the assessment of the accuracy-related penalty under Code Sec. 6662.

For a discussion of the general requirements for deducting Code Sec. 165 losses, see Parker Tax ¶84,503. (Staff Editor Parker Tax Publishing)

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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