Fifth Circuit Strikes Down Tax Court View that §1234A Eliminates Ordinary Loss on Abandonment of Capital Asset

In the view of the Tax Court (but not the Fifth Circuit) the taxpayer and the IRS didn’t understand the real issue, but the Tax Court sent them back to look at the issue in a different way, resulting in a potentially significant decision in the case of Pilgrim’s Pride Corporation v. Commissioner, 141 TC No. 17.  The case ended up turning on the issue of whether it is possible for a taxpayer to achieve an ordinary loss when abandoning a security under the current version of IRC §1234A.

While the decision has been overturned on appeal (Pilgrim’s Pride v. Commissioner, CA5, 115 AFTR 2d ¶ 2015-477, reversing 141 TC No. 17), it remains to be seen if the Tax Court will continue to apply this view of IRC §1234A outside the confines of the Fifth Circuit.

Similarly, the actual issue in question (abandoning stock) is no longer a real issue, as Reg. 1.165-5(i) now provides abandoned stock will be presumed worthless (and thus a capital loss under the provisions of §165(g)).  But the applicability of Revenue Procedure 93-80 to abandonments of partnership interests since 1997 is very much a matter in question based on the resolution of this case.

Original Tax Court Decision

The corporation in this case had abandoned securities which had a basis of $96.8 million rather than accept an offer to redeem them of $20 million.  The corporation believed an abandonment would generate an ordinary loss under IRC §165, and that the tax benefit from the ordinary loss would exceed the $20 million being offered for a sale of the shares.

Generally IRC §1211 governs capital gain or loss status, and it does not apply if there is not a sale or exchange.  Without a sale or exchange, a loss generally would be treated as an ordinary loss under the general rule of IRC §165.

However, IRC §1234A provides the following:

Code Sec. 1234A. Gains or losses from certain terminations

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of -

(1) a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or

(2) a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer,

shall be treated as gain or loss from the sale of a capital asset. The preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation arrangement).

Neither the IRS nor the corporation had originally argued that this provision would apply to a purported abandonment of stock—but the Tax Court believed it might be the key and asked the parties to submit arguments on the issue.

The taxpayer argued that the provision clear was meant to address not property already held, but rather rights held by the taxpayer.  The taxpayer suggested that the provision was not meant by Congress to effectively eliminate the ability to abandon a security or similar ownership interest that gave the holder certain rights with the regard to the entity in question.

The Tax Court did not agree.  The Court held:

We hold that the plain meaning of the phrase "a right or obligation * * * with respect to property" encompasses the property rights inherent in intangible property as well as ancillary or derivative contractual rights.

The taxpayer protested that if this reading of the statute were correct, the IRS should have revised Revenue Ruling 93-80.  That ruling dealt with issue of an abandonment vs. a sale of a partnership interest. 

As the Court described it, the ruling in question held:

In situation 1 there was a deemed distribution to the partner resulting from the reduction in his share of partnership liabilities. The ruling held that the loss on the abandonment was a capital loss. In situation 2, the partner was not entitled to include any portion of partnership liabilities in the basis of his partnership interest and did not receive any actual or deemed distributions when he abandoned his partnership interest. The ruling held that the loss in situation 2 was an ordinary loss. The ruling holds that a loss incurred on the abandonment or worthlessness of a partnership interest is an ordinary loss only if sale or exchange treatment does not apply. The ruling makes clear that, if a provision of the Code requires the transaction to be treated as a sale or exchange, such as when there is a deemed distribution attributable to the reduction in the partner's share of partnership liabilities pursuant to section 752(b), the partner's loss is capital.

If §1234A applies to the stock interest, it certainly would appear it would apply to the partnership interest, and therefore the loss in situation 2 would be capital in nature, just like the loss in situation 1.  The taxpayer argued that since the IRS had not revised this ruling, clearly the IRS must believe that §1234A is inapplicable to an ownership interest.

The Tax Court did not agree.  The opinion notes:

Rev. Rul. 93-80, supra, was issued four years before section 1234A was amended in 1997 to apply to all property that is (or would be if acquired) a capital asset in the hands of the taxpayer. As we previously stated, the Commissioner is not required to assert a particular position as soon as the statute authorizes such an interpretation, whether that position is taken in a regulation or in a revenue ruling.

Thus the Court concludes:

The surrender of the Securities terminated all of GK Co-op's rights with respect to the Securities which were capital assets in the hands of GK Co-op. The loss on the surrender of the Securities is attributable to the termination of those rights. Accordingly, the loss is treated as a loss from the sale of a capital asset pursuant to section 1234A.

As the taxpayer noted, this view of §1234A has broad implications, and not just for the sale of stock.  The Tax Court implicitly agreed with the view that it should be similarly impossible for a taxpayer to obtain ordinary loss treatment on the sale of a partnership interest.

Fifth Circuit Reverses

Given the dollars involved, it’s not surprising that Pilgrim’s Pride appealed this decision to the Fifth Circuit Court of Appeals.

In fact, the Fifth Circuit simply states that IRC §1234A does not apply to a termination of ownership of the asset itself, noting:

The primary question in this case is whether § 1234A(1) applies to a taxpayer’s abandonment of a capital asset.  The answer is no.  By its plain terms, § 1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g. derivative or contractual rights to buy or sell capital assets). It does not apply to the termination of ownership of the capital asset itself.  Applied to the facts of this case, Pilgrim’s Pride abandoned the Securities, not a “right or obligation . . . with respect to” the Securities.  26 U.S.C. § 1234A(1).

The panel disagrees with the view held in the Tax Court opinion that an abandonment of a capital asset necessarily equates to the termination of rights under IRC §1234A—which would, effectively, render it impossible to incur an ordinary loss under §165, the real problem of the implications of the Tax Court decision.

The Court phrases its view this way:

The Commissioner’s position is that Congress, rather than simply stating that the abandonment of a capital asset results in capital loss, chose to legislate that result by reference to the termination of rights and obligations “inherent in” capital assets.

The Court then explicitly rejects this view:

We disagree. Congress does not legislate in logic puzzles, and we do not "tag Congress with an extravagant preference for the opaque when the use of a clear adjective or noun would have worked nicely." Gutierrez v. Ada, 528 U.S. 250, 256 (2000); cf. Dep't of Homeland Sec. v. MacLean, 135 S. Ct 913, 921 (2015) ("Had Congress wanted to draw that distinction, there were far easier and clearer ways to do so."). Instead, we assume that "the ordinary meaning of [statutory] language accurately expresses the legislative purpose." Gross v. FBL Fin. Servs., Inc., 557 U.S. 167, 175 (2009) (internal quotation marks omitted).

The Court does reference, in a footnote, the issue of Revenue Procedure 93-80.  In response to the IRS’s comment that the 1997 law change superseded the ruling, the Court noted the position “is odd considering that the IRS never has formally revoked the Ruling and has relied on the Ruling since the statutory amendment.” 

The Court then goes on to note that the IRS in 2007 the IRS issued Reg. §1.165-5(i) that provided that, effective only for abandonments of stock or other securities on or after March 12, 2008 that the security shall be deemed worthless and the loss would therefore generally be capital under §165(g).  That regulation would be unnecessary if IRC §1234A came to the result suggested in this case, therefore the Court concludes that (at least until the Tax Court sent the IRS back to look at the issue in this case) the IRS position had been that IRC §1234A did not apply to abandonments of a capital asset.

Thus the Fifth Circuit reversed the Tax Court’s holding in this case.

As an aside, it should be noted that the above regulation, presuming it is valid, would change the result in this case for any abandonment of stock and securities on or after March 12, 2008, thus Pilgrim’s Pride would not obtain the ordinary loss now.  But as the rule under §165(g) does not apply to partnership interests, the determination of how IRC §1234A works is very important in a partnership context—that is, can we still rely on Revenue Procedure 93-80?

So Where Do We Stand?

While Pilgrim’s Pride now has its loss deduction restored (and likely will stay in place unless the Supreme Court is asked to take up the case by the IRS and decides to do so—neither of which appears likely), the question remains about what this means for taxpayers outside the jurisdiction of the Fifth Circuit.

Technically the original opinion stands as the official position of the Tax Court and for now advisers should warn clients that the IRS may assert this position and the Tax Court may back them up (outside the Fifth Circuit where the Golsen rule will cause the Tax Court to defer to the appellate case)—so it could take a trip to the appropriate Court of Appeals in order to (hopefully) obtain the desired result.

As well, the Fifth Circuit opinion has in it the issues that could be used by another circuit to sustain the Tax Court’s view.  The IRS did cite cases where the Supreme Court had decided that an asset includes “inherent rights” and that Congress is presumed to legislate aware of how the Supreme Court interprets terms.  But the Court concludes that the cases merely indicate the term “can be” used that way—not that it has to be.  But given that the Fifth Circuit panel presumed to rule on the “plain language” of the statute that may not be a very comforting observation (that is, the language may not be all that plain after all).

As is noted above, the major impact of this decision is in the area of abandonment of partnership interests where the partner in question is not relieved of liabilities, and thus would obtain the ordinary loss treatment in the analysis found in Revenue Procedure 93-80.  The Fifth Circuit’s decision puts that option clearly on the table again though, as noted above, not without some risk on examination.