In light of recent market volatility triggered by the COVID-19 pandemic and the potential prolonged economic slowdown, clients have been considering various tax issues that become prominent in a recessionary environment. One issue the current market volatility brings back to the forefront is when a taxpayer can claim a deduction for worthless, or partially worthless, debt that it holds as a creditor. This memorandum explores the factors clients should bear in mind when claiming a worthless debt deduction.1 In considering when a taxpayer may claim a deduction for worthless debt, clients should consider the following questions.
- Is the debt in question a “security”?
If the debt is a “security,” Section 165 of the Internal Revenue Code (the Code)2 allows a taxpayer to claim a loss if the security has become wholly worthless during the year in which the deduction is claimed. A security is defined, for these purposes, as a bond, debenture, note or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form. Accordingly, Section 165 does not apply to debt (1) issued by a partnership (including a limited liability company taxed as a partnership) or an individual or (2) not issued in registered form (unless issued with interest coupons). Section 165(g) provides that in the case of a security held as a capital asset, a loss sustained as a result of the security becoming worthless will be treated as a loss from the sale or exchange of a capital asset on the last day of the taxable year in which it becomes worthless. Therefore, if a taxpayer claims a worthless securities deduction with respect to a security it held as a capital asset, such loss will be a capital loss (and it would be long-term capital loss if the debt had been owned by the taxpayer for more than one year).
- Can a deduction be claimed for a worthless debt that is not a security?
If a taxpayer holds a worthless debt that is not a security, as defined for purposes of Section 165, it may nonetheless be entitled to claim a bad debt deduction under Section 166 in the year in which the debt became worthless. In the case of corporations and business debts of noncorporate taxpayers, Section 166 allows for an ordinary deduction in the amount of the adjusted basis in the worthless debt. In the case of nonbusiness debts of noncorporate taxpayers, the loss is treated as a loss from the sale of a capital asset.
- May a deduction be claimed for debt that is not entirely worthless?
If the debt is not a security, Section 166 provides a deduction for partial worthlessness but not in excess of the amount charged off by the taxpayer during the taxable year. Furthermore, unlike in the case of wholly worthless securities or debts, partial worthlessness need not have occurred in the taxable year in which the deduction is claimed; only the chargeoff must have occurred during that year. Section 165 does not contain an analogous provision. Thus, no deduction is available for partial worthlessness of debt that is a security within the meaning of Section 165.
- How does a taxpayer prove that the debt it holds is worthless?
The burden of proving worthlessness lies squarely on the taxpayer’s shoulders. This generally is a facts and circumstances analysis, but there may be specific markers that, if proven by the taxpayer, bolster the taxpayer’s claim of worthlessness. In many cases, a taxpayer is able to point to an “identifiable event” that fixes the worthlessness. “Identifiable event” is not defined in the Code or Treasury Regulations. Nevertheless, courts have often pointed to events such as the bankruptcy of the issuer of the debt, liquidation of the issuer, a sale of all of the issuer’s assets, and a complete cessation of the issuer’s business.
Other facts may be sufficient to prove worthlessness. The financial condition of the company is a critical factor. In numerous cases, courts have looked to whether the liabilities of the enterprise far exceed the fair market value of its assets. Additionally, courts have considered whether there has been a decline in the debtor’s business or the debtor’s earning capacity, whether the debtor has already defaulted or refused to pay and, if the debt is secured by collateral, whether such collateral has declined significantly in value, in each case without a reasonable prospect for a reversal of fortune.
- Is an identifiable event a requirement for claiming a worthless debt deduction?
Treasury Regulations under Section 165 state that a deduction for a loss is allowed when the loss is evidenced by a closed and completed transaction, fixed by identifiable events and sustained during the taxable year in which the deduction is claimed. It is not clear whether this rule applies in the case of worthlessness which, by its nature, does not require any transaction to have occurred. Furthermore, there is no such statement in Section 166 or the Treasury Regulations under that section. Case law is mixed on the question of whether an identifiable event is a necessary condition to establish worthlessness, but it seems that an identifiable event may not be required in all cases. In a number of cases, courts have held an instrument to be worthless without the taxpayer’s having apparently established an identifiable event, suggesting that an identifiable event may not be a prerequisite to sustaining worthlessness when other objective, favorable facts clearly establish worthlessness.
In the case of a partially worthless debt deduction under Section 166, case law does not indicate that an identifiable event is a prerequisite for the deduction. A few cases suggest that a partial worthless debt deduction may be allowed even though the debtor continues its operations (and is not insolvent or bankrupt). In contrast to the complete worthlessness cases, the key question the courts have asked in partial worthlessness cases is whether, in the reasonable business judgment of the taxpayer, in light of the facts and circumstances, a portion of the debt is not recoverable.
- Can market fluctuations triggered by COVID-19 support a worthless securities loss or bad debt deduction?
The determination of worthlessness under both Section 165 and Section 166 is based on the collectability of the underlying debt obligation and not on a mere decline in its market value. However, where a significant economic recession or market crash has an adverse effect on the business or creditworthiness of the issuer or reduces, or eliminates, the value of collateral securing the debt, some courts have been willing to treat the recession or crash as an identifiable event or otherwise take it into account in determining worthlessness.
1 For a discussion of certain other tax issues clients should consider, see COVID-19: Common U.S. Tax Considerations During an Economic Downturn, dated March 30, 2020, discussing debt modifications, net operating losses and bankruptcy/insolvency.
2 Except as noted otherwise, references to sections in this memo are references to the Code.
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