1. TaxUpdate
August 2010
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Losses at the Forefront — Recent
Follow Us on Twitter Guidance Under Section 165
http://twitter.com/PepperTax Annette M. Ahlers | AhlersA@pepperlAw.coM
Speakers’ Corner It was inevitable that the guidance coming out of the IRS would
begin to focus on addressing the numerous tax issues raised by
• On September 23, Lance S. Jacobs will moderate
business events resulting from the declining economy. Taxpayers
“D.C. State and Local Tax Update,” a luncheon
are incurring significant losses by selling or disposing of worthless
program of the District of Columbia Bar Associa-
assets, and/or walking away from debts that they either cannot pay
tion’s Taxation Section/State & Local Tax Com-
(as the debtor),1 or are informed that the obligation will not be
mittee.
paid (as the creditor). These events generate tax losses that generally
• Joan C. Arnold will present at the ABA Section of may be considered for deduction under Section 165.2 This article
Taxation’s 2010 Joint Fall CLE Meeting being held provides a high-level overview of certain recent administrative rul-
September 23-25, in Toronto, Canada. Ms. Arnold’s ings across disparate factual situations, and is not intended to be a
panel is on “Pitfalls and Benefits of Foreign comprehensive review of all relevant guidance that has been issued.
Corporation using LLCs in the United States.” For example, the IRS has issued an LMSB Coordinated Issue
Paper that is very specific to the banking industry, which involves
a limited application of the tax treatment related to supervisory
goodwill. Supervisory goodwill is a very complex concept and is be-
yond the scope of this article. The issue paper is included, however,
to highlight certain potential issues that relate to a taxpayer’s ability
to sustain a tax position supporting a deduction under Section 165.
Section 165
In general, Section 165 allows a deduction for any loss sustained
during the taxable year and not compensated for by insurance or
otherwise. Under an abandonment or discontinued operations
situation, Treas. Reg. Section 1.165-2(a) provides that a loss is a
deductible loss under Section 165(a) if it is incurred in a business
or in a transaction entered into for profit and arising from the sud-
The material in this publication was created as of the date set forth above and is den termination of the usefulness in such business or transaction
based on laws, court decisions, administrative rulings and congressional materials
that existed at that time, and should not be construed as legal advice or legal of any non-depreciable property, when the business or transaction
opinions on specific facts. The information in this publication is not intended to
create, and the transmission and receipt of it does not constitute, a lawyer-client is discontinued or when such property is permanently discarded
relationship. Internal Revenue Service rules require that we advise you that the
tax advice, if any, contained in this publication was not intended or written to be
used by you, and cannot be used by you, for the purposes of (i) avoiding penalties
under the Internal Revenue Code or (ii) promoting, marketing or recommending to
another party any transaction or matter addressed herein. Please send address
corrections to phinfo@pepperlaw.com. © 2010 Pepper Hamilton LLP. All Rights
Reserved. This publication may contain attorney advertising.
1 Losses at the Forefront — Recent Guidance 6 Pepper Hamilton’s Tax Practice Group
Under Section 165
in this issue... 4 Florida Amends Regulation Requiring
Adjustments in Calculating Federal Taxable
Income

2. from use. A second application of Section 165(a) occurs when were merely part of the overall plan to obtain financing, and
property is sold or exchanged for a loss.3 thus, were an offset to the proceeds received from the overall
capital raised in the financing arrangement.6 Under this view, any
A recent Chief Counsel Advice Memorandum highlights some
changes or modifications to the terms of payment on the forward
of the nuances that must be considered when determining
contract were merely modifications and did not cause the overall
whether a loss incurred on a transaction will be considered an
financing arrangements to be abandoned.
abandoned transaction for tax purposes, and thus, whether costs
associated with the transaction will be deductible under Section The issue before the IRS in the CCA was whether or not the
165(a). fact that the IRS provided the taxpayer with a ruling that the
settlement of the forward contract in cash instead of stock was
CCA 2010250474
a Section 1032 transaction provided support for the taxpayer’s
In CCA 201025047, the taxpayer received a private letter rul- position that the cash settlement in lieu of the stock issuance
ing (and supplemental ruling)5 on various aspects of the terms created an abandonment transaction, and that the costs associ-
of a forward contract on the taxpayer’s stock that was part of a ated with the forward contract could be deducted. Presumably, to
financing package that included the issuance of debt and other find that the original forward contract arrangement was termi-
investment units. On its tax return for the relevant years, the nated, the IRS would need to agree to a bifurcation of the overall
taxpayer originally allocated all the costs associated with the financing arrangement into certain component pieces. Once
financing package to the debt portion of the package, which the components were identified, they would then receive their
were then amortized over the life of the debt. On exam, how- own tax characterization. Thus, when the terms of the payment
ever, the taxpayer and the IRS agreed to allocate a portion of the of the forward contract were modified, the taxpayer could then
financing arrangement costs to the forward contract portion of argue that the original “transaction” was abandoned, and a new
the overall financing transaction. After this new allocation, the one was entered into. The IRS did not, however, conclude that
taxpayer attempted to deduct the portion of the financing ar- the forward contract was severable from the original financing
rangement costs allocated to the forward contract as an aban- transaction. The IRS stated that the Section 1032 ruling did
donment loss when the taxpayer ultimately settled the forward not provide the taxpayer a basis for a Section 165 deduction,
contract for cash and incurred a loss. The IRS did not agree with and instead repeated its long-held view that the cash settlement
the taxpayer’s attempts to take the loss on the settlement of the of a forward contract is the equivalent of issuing the stock for
forward contract. the contract price and then selling the stock for cash. The tax
Upon examination the taxpayer argued that it was entitled to a consequences are the same. Therefore, in order to avoid potential
Section 165 deduction for the costs associated with the forward whipsaw to the government, the IRS treats these transactions in
contract, because the taxpayer did not, in fact, issue its stock the same way. Thus, not only was the forward contract not aban-
pursuant to the forward contract, but instead settled the for- doned, it was settled for cash pursuant to its terms, and therefore,
ward contract with cash. The taxpayer’s primary argument was no abandonment of the “transaction” occurred, even with the
that because they did not issue stock pursuant to the terms of described modification in the terms of the forward contract.
the forward contract, the stock settlement aspect of the forward Thus, the changes in the terms of the forward contract that the
contract was abandoned, and thus, the costs associated with that taxpayer pointed to in its argument were disregarded, and the
aspect of the overall financing arrangement could be properly IRS concluded that, “[c]hanges in a transaction do not constitute
deducted as abandonment costs under Section 165. The IRS abandonment.”7
exam determined, however, that the forward contract costs were In distinguishing those circumstances in which a transaction is
costs associated with raising capital and were associated with the abandoned, the IRS stated that “[a] loss deduction is allowed for
actual completion of the forward contract by its terms, which costs incurred for a transaction when the taxpayer is left without
specifically allowed the contract to be settled for cash. In fact, the any value to show for the costs incurred,” citing Rev. Rul. 79-2,
subject of the IRS PLR was that Section 1032 would apply to 1979-1 C.B. 98, where “individual taxpayers were allowed a Sec-
the cash settlement of a forward contract. Under the IRS exam’s tion 165(c) loss when they abandoned the public offering of their
view the costs associated with the completed forward contract corporation.”8
2 www.pepperlaw.com

3. TaxUpdate
As a third argument, the taxpayer cited Treas. Reg. Section
1.263(a)-5(1), Example 3, which describes four potential transac-
tions being considered by a taxpayer. When only one is pursued,
the costs associated with the remaining three may be recovered
Taxpayers need to keep good records
under Section 165 because they are costs associated with aban- that establish a tax basis in the assets
doned transactions. The CCA concludes that the Section 263
regulations are not the appropriate place to look to determine
they are in a position to abandon or
whether or not a transaction is abandoned, but that the law un- dispose of at a loss.
der Section 165 must be evaluated to make that determination.
In addition, the IRS found that the example in the Section 263
regulations was factually distinguishable from the taxpayer’s facts
in the CCA, in that the taxpayer in the CCA actually executed
the forward contract and received value according to the revised
terms of the transaction. LMSB4-0210-008—IRS Coordinated Issue Paper on Distressed
Asset Trust (DAT) Tax Shelters for All Industries
LMSB4-1109-042—IRS LMSB Revised Coordinated Issue
Paper on Supervisory Goodwill in Savings, Loan Industry On March 23, 2010 the IRS issued LMSB4-0210-008 that
addresses a version of the DAT tax shelter that uses distressed
On May 11, 2010 the IRS issued LMSB4-1109-042, which assets (including creditors interest in debt) to shift economic
answers the question, among others, of “[w]hether taxpayers are losses from a tax-indifferent party to a U.S. taxpayer with no
entitled to losses under I.R.C. § 165 with respect to supervisory other economic interest, except a desire to use the loss. While the
goodwill based upon worthlessness, abandonment or confisca- issue paper focuses on the use of debt instruments and Section
tion.” This issue paper was generated by the IRS’ concern that af- 166 losses, it states that “[a]s of the date of this paper, the field
ter the enactment of the Financial Institutions Reform, Recovery, has only seen DAT transactions involving business bad debt
and Enforcement Act of 1989 (FIRREA) taxpayers began taking deductions under I.R.C. § 166. However, if a sale or exchange
the position that a tax asset called “supervisory goodwill” was cre- triggers the loss, an analysis regarding lack of profit motive under
ated under the Section 597 definitions of property and assistance I.R.C. § 165 might apply to disallow the loss.” The issue paper
under Section 406 of the National Housing Act. Using these continues the prior theme of the IRS in the authorities discussed
definitions, which generally provided that supervisory goodwill above and focuses on when the asset became worthless and how
was an asset for certain regulatory purposes, taxpayers proceeded the taxpayer can prove its tax basis in the asset.
to claim tax losses under Section 165 because the supervisory
goodwill was abandoned, confiscated, or made worthless as a PePPer PerSPective
result of FIRREA’s enactment. As discussed above, it is understandable that significant ad-
In finding that taxpayers are not allowed a deduction with ministrative rulings under Section 165 are being issued because
respect to worthless or abandoned supervisory goodwill, the po- abandonment or loss issues arise on a very routine basis, and in
sition paper provides that supervisory goodwill is an accounting particular, in a depressed or downsizing economy. While all of
concept that does not qualify as “money or other property under these rulings address very different situations and industries, one
§ 597.” Thus, no abandonment or worthlessness deduction can common theme is apparent. A Section 165 deduction will not be
be asserted because there is no tax basis for supervisory good- allowed without significant documentation of the asset’s tax basis
will, and even if such a tax basis could be established, a taxpayer and value at the time of the proposed deduction. In particular,
would be unlikely to be able to prove that the asset has been taxpayers need to keep good records that establish a tax basis
affirmatively abandoned with no reasonable hope of recovery. The in the assets they are in a position to abandon or dispose of at a
IRS stated that the “mere diminution in the value of property is loss. In addition, they must show an actual event that establishes
not enough to establish an abandonment loss.”9 There must be the fact of worthlessness and they must document that the assets
a closed and completed transaction and an identifiable event in (or transaction) provide no other benefit to the taxpayer (or that
order to sustain a deduction under Section 165.10 the abandoned transaction is part of a larger transaction).
www.pepperlaw.com 3

4. endnoteS Florida Amends Regulation
1 This article will not address the specific tax implications of Requiring Adjustments in
the guidance on the debtor, but it will instead focus on the
tax consequences to the creditor or owner. Calculating Federal Taxable
2 References to Code Sections are to the Internal Revenue Income
Code of 1986, as amended, unless otherwise stated. lAnce s. JAcobs | JAcobsls@pepperlAw.coM
3 Numerous provisions of the Internal Revenue Code address
the timing and ability of a particular taxpayer to take a loss
Florida recently enacted some changes to Fla. Admin. Code
for federal income tax purposes. A comprehensive discussion
12C-1.013 (the Regulation), which details adjustments to federal
of allowable losses is beyond the scope of this article and no
taxable income that are used in arriving at Florida taxable in-
inference should be made by any omission or inclusion of
come. The changes principally affect the treatment of 50 percent
any facts or law or any discussion in this article as to wheth-
bonus depreciation and cancellation of indebtedness income.
er or not a loss will be allowed for a particular taxpayer in a
particular situation, other than as discussed herein. BonuS dePreciation adjuStmentS
4 (Mar. 22, 2010). As is often the case involving state adjustments, where the state
decides to diverge from a federal deduction, the Regulation
5 PLR 2004-50-016 (Dec. 10, 2004) and PLR 2005-18-8062
requires taxpayers to add back the bonus depreciation taken on
(May 6, 2005).
property under Section 168(k) of the Internal Revenue Code of
6 CCA 201025047, citing to McCrory v. U.S., 651 F.2d 828 1986, as amended (the Code). In this case, for instance, com-
(2nd Cir. 1981); Barbour Coal Co. v. Comm’r, 74 F.2d 163 (10th mencing in the year of the add-back, the taxpayer can take one-
Cir. 1934); Affiliated Capital Corp. v. Comm’r, 88 T.C. 1157 seventh of the bonus depreciation over seven consecutive years in
(1987). calculating its Florida income tax. In the event of a merger or an
acquisition, the subtractions can be transferred to the surviving
7 The IRS cited FRGC Investment, LLC v. Comm’r, T.C.
company as a result of such merger or acquisition.
Memo, 2002-276 (Oct. 31, 2002) to support its position in
this regard. The Regulation provides that the basis of the property af-
fected by these rules nonetheless remains the same for federal
8 The IRS also cited Rev. Rul. 77-254, 1977-2 C.B. 63, which
and Florida income tax purposes, and if the property is sold or
allowed a deduction for costs associated with an abandoned
otherwise disposed of, the gain is the same for both federal and
purchase of a business.
Florida income tax purposes.
9 LMSB4-1109-042 (May 11, 2010), page 3. The IRS cites
cancellation of indeBtedneSS
Kraft Inc. v. United States, 30 Fed. Cl. 739, 785-86 (1994);
Lakewood Associates v. Commissioner, 109 T.C. 450, 456 As with the bonus depreciation adjustment, taxpayers are
(1997), aff ’d without published opinion, 173 F.3d 850 (4th required to add back the cancellation of indebtedness income
Cir. 1998); and United States v. S.S. White Dental Mfg. Co., deferred under Section 108(i) of the Code, as well as any deferral
274 U.S. 398, 401 (1927). attributable to original issue discount under Section 108(i)(2) of
the Code. The offsetting subtraction does not occur in the same
10 Treas. Reg. Section 1.165-1(b).
year; as a result, the deferral is essentially denied for Florida tax
purposes and the subtraction occurs in the year that the income
is recognized for federal income tax purposes. The ultimate
subtraction cannot exceed the amount initially added to income
in calculating Florida tax. Additionally, the Regulation provides
that the income is included in the Florida tax base in the year of
4 www.pepperlaw.com

5. TaxUpdate
deferral, but it is not included in the sales factor calculation for
apportionment purposes.
PePPer PerSPective RSS on www.pepperlaw.com
Several provisions in the new Regulation essentially reduce the
benefits of new federal tax rules for Florida taxpayers. The basis
of assets sold or otherwise disposed of remains the same for
Subscribe to the latest Pepper articles
federal and Florida purposes, even though federally taxpayers via RSS feeds. Visit www.pepperlaw.com
may have gotten the full benefit of the bonus depreciation if the
asset is sold before the seven-year catch-up period provided for
today and click on the RSS button on
in the Regulation. Put differently, Florida is calculating gain for the publications page to subscribe to
Florida income tax purposes using basis in an asset that has been
depreciated to a greater extent federally than for Florida. Like-
our latest articles in your news reader.
wise, the cancellation of indebtedness addition provisions deny
the benefits from the federal law changes. These provisions re-
quire taxpayers to essentially include income, deferred for federal
income tax purposes, in income without providing taxpayers the
benefit of any sales factor dilution that they might receive (espe-
cially if they are domiciled outside of Florida). Such inclusions
of income without the apportionment effect almost always raise
issues of constitutionality, as they may distort the income due to
the state in violation of the Commerce Clause requirements that
a tax be fairly apportioned.
Peppercast: Independent Contractor Compliance
In this podcast, Pepper attorney Richard Reibstein, a partner in the New York office and a member of the firm’s Labor
and Employment Group and co-chair of the firm’s Independent Contractor Compliance Practice, discusses the new
bill in Congress dealing with misclassification of independent contractors and what companies that use freelancers,
consultants, per diems, long-term temps, and other contingent workers can do to avoid liability for an array of mis-
classification liabilities.
Listen today by visiting the Tax section of www.pepperpodcasts.com.
www.pepperlaw.com 5

6. Pepper Hamilton’s Tax Practice Group
Federal and International Tax Issues
Annette M. Ahlers 202.220.1218 ahlersa@pepperlaw.com
Joan C. Arnold 215.981.4362 arnoldj@pepperlaw.com
James W. Barson 412.454.5077 barsonj@pepperlaw.com
Steven D. Bortnick 212.808.2715 bortnicks@pepperlaw.com
609.951.4117
Gordon R. Downing 215.981.4434 downingg@pepperlaw.com
W. Roderick Gagné 215.981.4695 gagner@pepperlaw.com
Howard S. Goldberg 215.981.4955 goldbergh@pepperlaw.com
Bryan D. Keith 202.220.1220 keithb@pepperlaw.com
Timothy J. Leska 215.981.4008 leskat@pepperlaw.com
Ellen McElroy 202.220.1589 mcelroye@pepperlaw.com
Marc D. Nickel 202.220.1618 nickelm@pepperlaw.com
Michelle Parten 215.981.4894 partenm@pepperlaw.com
Paul D. Pellegrini 215.981.4474 pellegrinip@pepperlaw.com
Lisa B. Petkun 215.981.4385 petkunl@pepperlaw.com
Todd B. Reinstein 202.220.1520 reinsteint@pepperlaw.com
Joan M. Roll 215.981.4515 rollj@pepperlaw.com
Laura D. Warren 215.981.4593 warrenl@pepperlaw.com
State and Local Tax Issues
Philip E. Cook, Jr. 412.454.5075 cookp@pepperlaw.com
Lance S. Jacobs 202.220.1202 jacobsls@pepperlaw.com
Employee Benefits Issues
Jonathan A. Clark 215.981.4436 clarkja@pepperlaw.com
David M. Kaplan 215.981.4620 kapland@pepperlaw.com
Andrew J. Rudolph 215.981.4749 rudolpha@pepperlaw.com
6 www.pepperlaw.com