The issue of whether a taxpayer was justified in writing off the balance of a purchased intangible was the matter at issue in the case of Steinberg, et al v. Commissioner, TC Memo 2015-222.
The taxpayers in this case had acquired a towing contract as part of the acquisition of the assets of a business in 2005. The contract, which provided the taxpayers the sole and exclusive right to operate “Official Police Garages” in a portion of Los Angeles. The contract had an expiration date on June 27, 2009 and the city of Los Angeles had the exclusive option to extend the term for an additional five years.
As the end of the contract approached the City decided to review the process of having such contracts and how they were awarded. As the Court explained:
On February 22, 2008, the city council drafted a motion proposing that the city reexamine its system of OPGs. The original OPG model had been created in the 1940s and paired each LAPD division with one OPG. Due to growth in the city and the LAPD over the preceding decades, the divisional concept of OPGs had become outdated. In the mid-1980s non-law-enforcement traffic officers [*4] separated from the LAPD and began to operate under the Department of Transportation (DOT). The DOT and the LAPD work closely with one another, but they have separate command structures and boundaries. The February 22, 2008, motion directed the LAPD to provide recommendations as to how the city could improve the current OPG system so as to better serve the changing boundaries of the DOT and the LAPD.
The Board of Police Commissioners responded to the city council via letter on June 19, 2008. The Board of Police Commissioners recommended that the city council direct the city attorney to draft the necessary amendments to the Los Angeles Municipal Code to establish permanent OPG geographic boundaries. On August 12, 2008, the city council concurred with the recommendation of the Board of Police Commissioners.
Amending the city's Municipal Code to establish permanent OPG boundaries necessitated the drafting of new OPG contracts. The Board of Police Commissioners recommended that, rather than entering into new five-year contracts with existing contractors, the city council extend the existing OPG contracts for a period of 180 days in order to prevent an interruption of OPG services. On December 4, 2009, the Mayor of the City of Los Angeles transmitted the Board of Police Commissioner's request to the city council. The city council [*5] did not adopt the Board of Police Commissioner's recommendation until February 12, 2010. The February 12, 2010, adoption of the recommendation had the effect of retroactively changing the expiration date of Kelmark's towing contract from June 27 to December 27, 2009.2 In the meantime, on December 8, 2009, the Board of Police Commissioners notified Kelmark 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 to the Board of Police Commissioners no later than February 15, 2010.
On April 9, 2010, the city council approved an ordinance that amended the Los Angeles Municipal Code and established permanent OPG boundaries. The ordinance became effective on June 1, 2010. The city council and Kelmark executed a first amendment to Agreement No. C-106804 (Amendment to Agreement No. C-106804) on June 8, 2010, that stated, inter alia, that (1) on May 26, 2010, the city council had approved the exercise of the option to extend Kelmark's contract for an additional five-year term, (2) the term of Agreement No. C-106804 had expired on December 27, 2009, and (3) both parties agreed to [*6] extend the term of Agreement No. C-106804 to June 26, 2014. The Amendment to Agreement No. C-106804 includes a ratification clause which states: "If [Kelmark's] services were required prior to the execution of this Amendment, and services were performed in accordance with the terms and conditions of this Amendment, they are hereby ratified."
Despite the upheaval surrounding OPGs across the city, Kelmark was the only provider of towing services for the LAPD in the Southeast Area and was the only operator of the Southeast Area OPG during 2009. Kelmark continued to operate the Southeast Area OPG during the entire taxable year ending December 31, 2009. Kelmark submitted monthly summary reports to the Board of Police Commissioners for each month of tax year 2009. The monthly reports included information on the number of vehicles impounded, stored, released, or sold during each calendar month of 2009.
The taxpayers argued that, since the contract expired in mid-2009 and was not immediately renewed by the city, that the unamortized portion of the agreement should be written off in 2009.
The IRS disagreed, noting:
Respondent argues 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 reflect the intentions of Kelmark and the city to include the interim period as part of the towing contract.
Respondent notes that the amendment extended the terms of the contract until June 26, 2014, which is five years after the original term expired on June 27, 2009. Respondent argues that 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. Additionally, respondent notes the ratification clause in the amendment that explicitly ratified acts performed during the interim period to include them within the terms of the towing contract. Further, respondent argues that the Court must consider the original contract and the amendment as one agreement because the amendment incorporated the original contract into its terms. Finally, respondent notes that financial accounting and tax accounting have different objectives, and regardless of the contract's value for financial accounting purposes, petitioners are not entitled to a deduction under section 165 for tax purposes.
The Tax Court sided with the IRS. First it noted that the conduct of the parties was not consistent with the rights actually ending at the contract expiration. The Court noted:
When we consider Kelmark's conduct in conjunction with the original contract, the amendment to the contract, and the Los Angeles Municipal Code, it is 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 even after it initially expired on June 27, 2009, and subsequently expired after the 180-day extension on December 27, 2009. It 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. Kelmark also continued to provide monthly summary reports to the LAPD for the Southeast Area OPG. In short nothing material occurred in 2009 that changed the relationship Kelmark maintained with the LAPD in the Southeast Area or the City of Los Angeles. This fact favors a finding that the contract was neither subjectively worthless in petitioners' eyes nor objectively worthless given the surrounding facts and circumstances. See Echols v. Commissioner, 950 F.2d at 213.
The taxpayers had argued that financial accounting standards required the recognition of a loss—but the Court agreed with the IRS that wasn’t relevant, noting:
We also agree with respondent that a contract's value for financial accounting purposes does not determine its value for Federal income tax accounting purposes. Financial and tax accounting have vastly different objectives. Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542-543 (1979) ("The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; * * * [t]he primary goal of the income tax system, in contrast, is the equitable collection of revenue. * * * [A]ny presumptive equivalency between tax and financial accounting would be unacceptable.").
Finally, the Court noted:
Moreover, to be deductible, a loss must be evidenced by closed and completed transactions. Sec. 1.165-1(b), Income Tax Regs. There was no closed and completed transaction between petitioners and the City of Los Angeles in [*18] 2009. As previously stated, Kelmark continued to enjoy the benefits of a contractual relationship with the City of Los Angeles during the entirety of 2009. The fact that the amendment was not signed until 2010, after the debate about setting permanent OPG boundaries had been resolved, clearly shows that there was no closed and completed transaction that would support finding that Kelmark suffered a loss in 2009. See, e.g., Nicolazzi v. Commissioner, 79 T.C. 109, 131-132 (1982) (finding no closed and completed transaction in 1976 where taxpayer purchased a lottery lease in 1976 and did not exercise a put option until 1977), aff'd, 722 F.2d 324 (6th Cir. 1983). Accordingly, we find that Kelmark's contract with the City of Los Angeles did not become worthless in 2009, and petitioners are not entitled to deductions under section 165 equal to the then-remaining unamortized basis in the contract.
In fact, the Tax Court, in determining that penalties should be applied, agreed with the IRS that the taxpayers had been negligent and disregarded the rules and regulations in claiming the loss, noting:
We agree with respondent that petitioners were negligent and disregarded rules and regulations when they claimed loss deductions under section 165 on their amended 2009 Federal income tax returns. Section 165 allows deductions only for “bona fide” losses, and substance and not mere form governs in determining whether a loss is deductible. Sec. 1.165-1(b), Income Tax Regs. At the time petitioners filed the amended returns in which they claimed the loss deductions under section 165, Kelmark had already entered into the amendment with the City of Los Angeles that extended the terms of the towing contract for an additional five-year period. As previously discussed at length, Kelmark continued to enjoy the benefits of the towing contract during the interim period, and, in substance, it suffered no loss during tax year 2009. Claiming a deduction for a loss under section 165 when no loss has actually occurred would seem to be “too good to be true” to a reasonable and prudent person, and petitioners acted negligently in failing to ascertain the correctness of the deductions. Further, petitioners were careless when they did not exercise reasonable diligence to ascertain whether their claimed loss deductions were contrary to the requirement that only bona fide losses are allowed as deductions under section 165. See sec. 1.165-1(b), Income Tax Regs. Respondent has met his burden of production to show that petitioners were negligent and disregarded rules and regulations by claiming loss deductions to which they were not entitled.