Category: Individual Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Facts The terms of the note called for payments to begin in 1994. Subsequently, the purchaser filed for bankruptcy, and in December, 1994 the first mortgage holder foreclosed on the real estate which provided security for the taxpayer's installment note. Presumably the taxpayer has no prospects of ever collecting on the $70,000 debt. Issue Answer Note the discussion below entitled "Disposition of Installment Obligation". An alternative way of viewing this transaction could, depending on state law, result in capital loss for the taxpayer. Also, bear in mind that the amount of the loss suffered is not the entire $70,000 face of the note but rather its tax basis which is presumably considerably lower than the face value. Discussion: Bad Debt Loss Under Section 166(d)(2), a business bad debt must meet either of the following two requirements. A) The debt must be created or acquired in connection with the taxpayer-creditor's trade or business;
Any bad debt not conforming with either of the two alternative requirements set forth above is treated as nonbusiness. Clearly, the taxpayer's bad debt does not meet the second of the two alternative tests. The loss from worthlessness of this debt was incurred at a time when the taxpayer no longer was engaged in a trade or business. On the other hand, the first alternative test seems more promising. The debt in question was created in connection with the sale of the taxpayer's business. The language of the statute simply requires that the debt be created in connection with the taxpayer's business. Absent guidance to the contrary, one must interpret the words of a statute in accordance with their ordinary meaning. It seems to me unavoidable that a debt created from the sale of a taxpayer's business is connected with that trade or business. Surprisingly, my research to this point has not uncovered any usable cases interpreting this point. Two cases seem to provide some support for conclusion, Cluett v. Commr., 8 TC 1178 (1947); and Bernstein v. Commr., TC Memo 1960-213, PH TCM ¶60,213, 19 TCM 1187 (1960). Both these cases involve a loss suffered as a result of the worthless of a debt created when a major business asset was sold. In each case, the taxpayer continued in his original business. This is similar to but not precisely congruent with the facts at hand. The commentator-author of the bad debt section of the CCH Federal Tax Service (formerly Bender's Federal Tax Service) offers an example (for which no source citation is offered) in which a worthless note resulting from the sale of a taxpayer's business gave rise to a business bad debt deduction. See CCH Federal Tax Service at ¶G15.84. Of course, commentary of this type has no authoritative weight and the commentator did not offer a supporting source for his statement; however, it is comforting that someone else interprets the material before us in a manner consistent with position desired for this taxpayer. In order to find that a bad debt is a business rather than nonbusiness, the taxpayer must show that there is a proximate relationship between the creation of the debt and the taxpayer's trade or business. The proximity test is applicable to both the alternative statutory categories of nonbusiness bad debt. In other words, the question of a proximate relationship between a bad debt and the taxpayer's business is relevant to both the tests under IRC Section 166(d)(2)(A) and 166(d)(2)(B). Aubrey F. Nash v. Commr., 31 TC 569 (1958). The Supreme Court in Generes, 405 US 93, set forth the standard by which the determination of proximity should be made. The Court ruled that one must look to the taxpayer's dominant motivation in creating the debt in question. What was the taxpayer's dominant motivation in creating this debt? It seems to me inescapable that the taxpayer's only motivation in creating this debt was to liquidate the assets created by the taxpayer's business. How could such a debt not bear a proximate relationship to the business the liquidation of which gave rise to the debt in the first instance? The regulations touch indirectly on this concept. In the context of discussing the test under Section 166(d)(2)(B), Regulation 1.166-5(d), Example 6, provides that a loss incurred in liquidating a trade or business is a proximate incident to that trade or business. In the facts of the example, A sold goods to B on credit. A later liquidated the business and suffered a loss as a result of being unable to collect the debt from B. It is unremarkable that the regulations find this a business bad debt loss; however, it is helpful that the regulations provide a general statement to the effect that a loss on liquidating a business is proximately related to that business. It seems to me that the taxpayer in this case has liquidated his business and suffered a loss in the process. The language of Example 6 supports the conclusion that the taxpayer's loss bears a proximate relationship to his business. Discussion: Disposition of Installment Obligation IRC Sec. 453B(f) provides that if an installment obligation is cancelled or otherwise becomes unenforceable, there is a deemed disposition of the note. The character of any resulting gain or loss is determined by the character of the assets the sale of which gave rise to the installment note in the first instance. Presumably, the original asset sale produced largely capital gain. Accordingly, if Section 453B(f) applies, the resulting loss would be a capital loss. As a practical matter, foreclosure by the senior lender effectively renders the taxpayer's note worthless. The issue is whether under this provision, an event which renders a debt worthless is tantamount to the debt becoming unenforceable. Presumably, Section 453B(f) was enacted to create a deemed disposition of an installment obligation in cases in which the taxpayer voluntarily cancelled the note or the note becomes unenforceable through operation of law, e.g., through running of the statute of limitations on collection of the note. There seems to be no indication one way or the other for notes rendered worthless by the foreclosure of a senior lienholder. It seems to me that if under state law the second mortgagor's claim is cancelled or rendered unenforceable by the foreclosure of a senior mortgage holder, Section 453B(f) applies; whereas, if the foreclosure merely renders the note worthless, Section 453B(f) should not apply. This question should be put to a competent attorney in the taxpayer's jurisdiction. |
