Friday, July 03, 2015

Partnership Rules Not Applicable to Determining Recourse vs Nonrecourse Status of Debt Outside of Subchapter K

Code Section 752 and its regulations provide extensive rules as to determining whether partnership debt is recourse or nonrecourse. Such determinations are relevant for basis determination purposes under Subchapter K (the Subchapter applicable to partnership taxation) and other Subchapter K purposes.

In Chief Counsel Advice, the IRS concluded that, for purposes of determining whether a limited liability company taxed as a partnership has either cancellation of debt (COD) income under Code Sec. 61(a)(12) or gains from dealings in property under Code Sec. 61(a)(3) upon foreclosure of its property, the Code Section 752 rules do not govern whether the debt at issue was recourse or nonrecourse. Instead, the Section 752 rules apply only for Subchapter K purposes.

Why was recourse vs. nonrecourse status relevant? This is because when a taxpayer disposes of encumbered property, and the encumbrance exceeds the value of the property, different tax results apply depending on whether the debt is recourse or nonrecourse. If it is a recourse debt, the amount realized on the sale attributable to the debt is limited so as to bring the amount realized only up to the fair market value of the property. The excess of the recourse debt over the fair market value of the property is treated as COD income. The bad news is that COD income is taxed at ordinary income rates. The good news, sometimes, is that COD income may be avoidable if one of the exceptions under Section 108 apply (relating to when cancellation of indebtedness income need not be recognized).

If the debt is nonrecourse, then the entire amount of the nonrecourse debt is included in the amount realized, and there is no COD income. Here the good news and bad news is flipped – all of the income is eligible for long term capital gains rates (if otherwise applicable based on holding period and character of the asset), but no opportunity for avoidance of COD income under Section 108 applies.

Chief Counsel Advice 201525010

Sunday, June 28, 2015

No Theft Loss for Securities “Pump-and-Dump”

Pump-and-dump occurs when corporate officers or other shareholders fraudulently promote shares of a company and engage in fraudulent sales to increase the value of shares. This is injurious to other shareholders who suffer losses when the value of the stock ultimately collapses.

Such shareholders will be able to deduct their losses, but to the extent they are long-term capital losses they can only use them to offset long-term capital gains and another $3,000 in income each year. To avoid these limitations, such shareholders would prefer to be able to deduct their losses as theft losses under Code Section 165(c)(3). That section allows a theft loss if a theft occurs is determined under applicable state law

In a recent case, a victim of a pump-and-dump scheme was denied theft loss treatment. Both court decisions and IRS pronouncements establish that for a theft loss to occur in most states, there must be a direct flow of property or funds from the victim to the wrongdoer, or that the wrongdoer at least specifically targeted the victim. For example, the IRS has long taken the position that stock acquired on the open market that loses value due to corporate misconduct is not eligible for the theft-loss deduction.

Since the victim here purchased his shares on the open market and not from the perpetrators of the fraud, these limitations prevented a theft for state law purposes. This is the case even though it is possible that some of the shares of the perpetrators may have been purchased by the victim, because the sale flowed through the open market mechanism.

The state here was Ohio, and Ohio does characterize embezzlement, wrongful conversion, forgery, counterfeiting, deceit, and fraud as “theft offenses.” However, the term “theft offense” does not itself define a substantive crime in Ohio — it is merely a list of other crimes that are grouped together in the Ohio Revised Code. As such, it does not constitute a “theft” for federal theft loss deduction purposes.

Greenberger, Et Al. v. U.S., 115 AFTR 2d 2015-XXXX, (DC OH), 06/19/2015