Category: Accounting Periods & Methods Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com On December 15, 1996, the taxpayer (R, an individual) purchased a note with a principal balance of $950,000 and accrued interest of $200,000. The maker of the note was a general partnership (S) in which R owns a 25% interest. R actually purchased the note through a partnership (W) owned entirely by R and his children. W purchased the note for $700,000 from the bank to whom the note was originally owed. The note is secured by a first mortgage on commercial real estate. The note is also guaranteed by all four partners of S, one of whom is currently in bankruptcy, one of whom is insolvent, and one of whom lives out of state and may also be insolvent. It appears that the only partner with the financial wherewithal to make good on the guarantee is R. At the time the note was purchased, S was approximately 18 months in arrears on the mortgage. In January, 1997, S paid $100,000 against the $200,000 interest accrued on the note. The issue is whether in view of the speculative nature of the note, W is required to report interest income prior to recovery of the basis in the note. You cite Liftin v. Comr., 36 TC 909 (1961), aff'd 317 F2d 234, 63-1 USTC ¶9465 (4th Cir., 1963). In this case the taxpayer purchased notes at deep discounts. The court held the notes to be "highly speculative" based on discounts from face of up to 45%, the existence of a lienholder with a superior claim to that of the taxpayer, and the small amount of equity in the properties. The court held that where there is doubt the contract will be completely carried out, the taxpayer need not recognize discount income until his cost basis in the note is completely recovered. It seems the courts are unwilling to force recognition of interest income in the case of speculative notes purchased at a discount where there is real doubt as to recovery of principal and/or interest. The difficulty is the courts cannot seem to agree on the degree to which the obligation in question must be speculative in order to warrant such treatment. The Liftin case cited above provides one standard: doubt that the contract will be completely carried out. There are other cases, however, that provide somewhat different standards. In Darby Investment Corp. v. Comr., 37 T.C. 839 (1962), aff'd, 315 F.2d 551 (6th Cir. 1963); and Inter-City Television Film Corp., 43 T.C. 270 (1964), the rule seems to be an obligation is not speculative if there is reasonable certainty the taxpayer will recover his cost. The case of Underhill v. Comr., 45 TC 489 (1966); holds that an obligation is speculative unless a taxpayer is reasonably certain of recovering his cost and a major portion of the discount. In Underhill, the tax court took into account the following factors: 1) existence of personal liability of the debtor and his credit rating; 2) marketability of the obligation; 3) whether the obligor was in substantial default at the time the obligation was acquired; 4) payment terms and the extent and nature of the security; and the size of the loan discount. As I understand it, the property and the parties involved are in New Jersey, which is in the Third Circuit. We have cases from the Tax Court, the Sixth Circuit, and the Fourth Circuit. Accordingly, it is unclear which case, if any, would be followed by a court in the Third Circuit. In addition, whether the obligation in question is speculative (and if so whether the obligation is sufficiently speculative to warrant cost recovery reporting) is inherently a question of fact. It is very difficult to imagine the IRS accepting cost recovery reporting at the examination or the administrative appeals level, and of course it is impossible to know how a court would ultimately rule on this matter. This leaves the taxpayer in a rather risky position. Based on the facts as I understand them, there seems to be a reasonable filing position to report on the cost recovery method. Just how reasonable and sustainable the taxpayer's position is depends on which court decision is followed. It seems clear that the obligation in question is speculative in view of its 40% discount from face, the extent to which the obligation was in default at the time it was acquired, and the lack of effective recourse against anything other than the property itself. But is the obligation sufficiently speculative to warrant cost recovery reporting? Under the Liftin standard, an obligation is sufficiently speculative if there is doubt that the borrower can completely fulfill his obligations under the contract. I suspect it would be rather easy under the circumstances to justify significant doubt that the borrower in this case will repay the entire amount of principal and interest on this note. Similarly, under the Underhill standard, the obligation is sufficiently speculative if there is not a reasonable certainty that the taxpayer will recover his cost plus a significant portion of the discount. It seems to me the Underhill standard is similar, but a good deal more stringent, than the Liftin standard. Liftin only requires doubt that the borrower will perform completely on his obligation. Underhill requires doubt that the taxpayer will be unable to recover his cost plus a significant amount of his discount. I suspect that a trier of fact would ultimately decide that the note in question is sufficiently speculative under the Underhill standard. Based on what I have heard, I believe there is a great deal of doubt as to borrower's ability to perform with respect to a substantial portion of the discount in this case (i.e., the difference between the $700,000 paid and the total principal of $950,000 plus $200,000 of accrued interest plus all future interest due on the note). Finally, there is Darby Investments and Inter-City Television. These cases hold that an obligation is not sufficiently speculative if the taxpayer is reasonably certain of recovering his cost. The Darby/Inter-City standard is the most stringent and thus presents the taxpayer's greatest risk. If Darby/Inter-City is chosen as the proper standard, the taxpayer might very well have difficulty making his case. The government would likely argue that the taxpayer would not have invested $700,000 without reasonable certainty that he could recover at least that amount either through payments or foreclosure. I suspect the government might press the position that the property was worth at least $700,000 at all times, with the result that the taxpayer's facts do not pass muster under Darby/Inter-City. On the other hand, the taxpayer could counter that the bank from whom the note was purchased would not have sold the note for $700,000 if the bank felt comfortable it could recover at least that much through the same means. The taxpayer could also argue that he was jointly and severally liable for the whole note under his guarantee arrangement. Given the other guarantor's lack of financial strength, the amount the taxpayer stood to lose at a $700,000 purchase price was far less than his exposure under the guaranty. Hence, the taxpayer could argue that the price demanded by the bank was far more than anyone could expect to receive from the borrower and thus represented a probable loss on the note at a $700,000 purchase price. The taxpayer's motivation was to create a much lower loss potential than otherwise would have been the case under his guaranty obligation. A court in the Third Circuit might follow any of the three standards set forth above or create its own standard. It is not possible to predict with any degree of certainty the outcome of this matter if it were litigated. I strongly suggest that you consider disclosing the position on the taxpayer's return in order to avoid application of the 20% accuracy-related penalty in the event the taxpayer's position cannot be sustained. See IRC Section 6662. |
