In a recent taxpayer-favorable case, the Tax Court upheld a loss deduction for a worthless investment under Code Section 165.1 At issue was an interest held by a partnership in a related family-owned real estate development business. The taxpayer, MCM Investment Management LLC (“MCM”) alleged its interest in McMillin Companies, LLC (“InvestCo”), a real estate development and sales business conducting business in California and Texas, became worthless in 2009 and therefore was entitled to a deduction in the amount of $41.4 million. InvestCo, at the time the deduction was taken, held investments in 73 different project entities, 11 management services entities, and 3 investment-holding companies.
Structure of the Family Business and the Downturn
MCM was owned by four members of the same family. MCM owned a 20% interest in InvestCo and was the managing member. The four family members were the owners of the other 80% interest in InvestCo. As a real estate investment and development business, the operations of InvestCo and its holdings were highly leveraged. From a balance sheet perspective, InvestCo held significant real estate holdings but was subject to $100 million in senior debt and another $65 million in subordinate debt, all guaranteed personally by the four family members and MCM.
At the beginning of the recession in 2007, values of homes plummeted and therefore the financial status of InvestCo deteriorated drastically. In 2008, the members of MCM formed a new entity (“HoldCo”) to purchase the subordinate debt at a discount, paying $16 million in an arm’s length transaction. Following the purchase of the debt, HoldCo contributed the debt to InvestCo in exchange for a preferred equity interest in InvestCo, receiving a liquidation preference of the original $65 million of subordinate debt, plus accrued interest before the other members, including MCM, received any distributions.
In a liquidation analysis of InvestCo in 2009, a liquidation would result in having only $54 million to pay the outstanding $71 million in outstanding senior debt. Therefore, it was concluded that InvestCo could not pay its senior debt, much less its preferred equity distributions and subsequent regular distributions. Accordingly, HoldCo, MCM, and the members holding common equity would receive nothing in a liquidation.
Loss Deduction under Section 165
Under Section 165(a), a taxpayer is allowed a deduction for losses sustained during the tax year and not compensated by insurance or otherwise. To be allowable, such a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the tax year.2
Closed and Completed; Worthlessness
“In most cases, a ‘closed and completed transaction’ will occur upon sale or other disposition of the property, but this requirement may be satisfied if the taxpayer abandons the asset or the asset becomes worthless.”3 To prove that an asset is “worthless,” a taxpayer must demonstrate its “subjective determination of worthlessness in a given year, coupled with a showing that in such year the asset in question is in fact essentially valueless.”4 Determination of worthlessness of a partnership is a question of fact.5 Accordingly, a taxpayer intending to take a deduction under Section 165(a) must be able to make a subjective showing of worthlessness coupled with objective factors indicated that the property in question is “essentially valueless” in the year the deduction is to be taken.6
In the case of MCM’s interest in InvestCo, worthlessness was not determined upon disposition, as no such final disposition or abandonment occurred. Instead, worthlessness was determined by MCM subjectively whenMCM took the position on its tax return that the partnership interest in InvestCo was worthless in 2009, showing a manifestation of MCM’s intent that the interest was indeed worthless. MCM based its belief on the 2007 crash and the significant losses suffered in the following years as well as the fact that in a liquidation, MCM would receive nothing and that debt-holders would not be able to be fully repaid. Ultimately, InvestCo was shut down. The Tax Court determined that these facts supported the conclusion that MCM subjectively determined that its interest in InvestCo was worthless.
Objective Factors (No Value Today and a Hopeless Tomorrow)
MCM was able to show evidence on a zero-liquidation value of its interest. Furthermore, MCM successfully argued that its interest lacked potential future value. The Tax Court agreed with MCM on identifiable events, including:
- The devastating impact of the 2007 financial crisis, its effect on the business of InvestCo;
- The audited financial statements of the company, which depicted a dire financial condition of InvestCo in 2008 and 2009;
- InvestCo’s significant decline in expected cashflows in its cashflow forecasts; and
- InvestCo’s members’ decision to wind down.
IRS’ Unsuccessful Arguments
The IRS argued that MCM’s objective test was not met. Its position was that potential future value would exist until a foreclosure occurred with respect to each real property interest held by InvestCo or its subsidiaries encumbered with recourse debt. The IRS was effectively arguing a foreclosure requirement. The Tax Court disagreed, holding that a taxpayer need not delay in deducting a loss under Section 165(a) merely because the partnership owns real estate interests encumbered by recourse debt.
No Expert Testimony
The IRS also argued a lack of expert valuation determining that the partnership interest held by MCM was indeed of no liquidation or potential future value. The Tax Court noted that such testimony, while helpful, is not necessary to show worthlessness for the purposes of Section 165. The Tax Court also noted that while the IRS argued for an expert valuation requirement, no authority was provided by the IRS showing that such expert valuation is indeed required to prove worthlessness under Section 165.
Loss Not Bona Fide
Lastly, the Tax Court opinion discussed the IRS’ argument that the losses were not bona fide within the regulatory meaning. Specifically, the IRS argued that MCM should not be allowed the loss as the same parties remained beneficial owners of InvestCo before and after the interests of MCM became worthless, thus experiencing in reality no loss at all. The Tax Court determined, for multiple reasons, that the IRS failed to demonstrate that the transactions, and therefore the loss, should not be respected for tax purposes.7.
For many reasons, it is great to see taxpayer-favorable cases come through the Tax Court. However, this case serves as a reminder of what goes into being able to take a deduction under Section 165(a) and what peculiarities exist when there are multiple tiers of debt and equity as well as related parties at multiple levels. In the end, MCM, subjectively realized the loss that was supported by objective factors supporting the worthlessness of the interest in question.
- MCM Investment Management LLC, v. Comm’r, T.C. Memo 2019-158.
- Treas. Reg. Sec. 1.165-1(b), (d)(1).
- See Tucker v. Comm’r, 841 F.3d 1241, 1249 (11th Cir. 2016)
- See Echols v. Comm’r (Echols I), 935 F.2d 703, 706 (5th Cir. 1991).
- See Boehm v. Comm’r, 326 U.S. 287, 293 (1945).
- See Echols v. Comm’r (Echols II), 950 F.2d 209 (5th Cir. 1991).
- The IRS made arguments surrounding the acquisition of the subordinated debt at a discount, the separateness of MCM and HoldCo, and value transfers from HoldCo to MCM.