Insolvent Corporation May Use Cost Recovery Method

[3] Field Service Advice is not binding on Examination or Appeals and is not a final case determination. Such advice is advisory and does not resolve Service position on an issue or provide the basis for closing a case. The determination of the Service in the case is to be made through the exercise of the independent judgment of the Field office with jurisdiction over the case.

[7] The taxpayer elected under section 108(b)(5) to reduce its basis in depreciable property before reducing other tax attributes. It did have nondepreciable assets, however, that were also subject to basis reduction in the order prescribed by section 108(b). One of those assets was a note relating to a wrap-around mortgage from * * *, a limited partnership, with a face amount of * * *. This amount consisted of $* * * owed to banks and $* * * owed on a second mortgage. * * * originally acquired the mortgage in * * *. In * * *, * * * lent an additional $* * * to * * *. Before the basis reduction, * * *'s basis in the notes were $* * * for the wrap-around mortgage, * * * for the expansion mortgage, and $ * * * for the additional notes. * * * reduced its basis in those notes to $* * *, $* * *, and $* * * respectively.

[8] During the years before the court, * * * collected amounts on the notes that included payments of interest as well as partial payments of principal. The taxation of the portion of the payments allocable to interest is not at issue. With respect to the principal, however, petitioner argues that it should not have to recognize income on recovery of the principal until it recovers its entire basis as reduced by the attribute reduction described above (cost recovery method). Petitioner argues that because * * *'s sole source of income is rental payments from petitioner, and because * * * has experienced financial problems, collection of the mortgage payments is speculative. The notice of deficiency takes the position that income should be recognized on a pro rata basis and that part of each principal payment is basis and part is income. Accordingly, income should be realized each time * * * collected a payment of principal.

[10] While the legislative history to sections 108 and 1017 supports the concept that income should be recovered in the future, it is silent about exactly how that should work, particularly in this situation. Accordingly, we looked at some analogous situations relating to partial recovery of principal.

[11] As you pointed out in your Request for Field Service Advice, the overwhelming weight of authority supports the argument that taxpayers are generally allowed to report income on a cost recovery basis when they acquire obligations that are speculative in nature. In Underhill v. Commissioner, 45 T.C. 489 (1966), the taxpayer acquired mortgages at a discount and used the cost recovery method of reporting income. The Tax Court posed the question as follows:

[12] The Tax Court, relying on a line of cases starting with Burnet v. Logan, 293 U.S. 404 (1931), held that the use of the cost recovery method is appropriate if the contract is of such a speculative nature that the holder cannot be reasonably certain of ever recovering his basis. Lifton v. Commissioner, 36 T.C. 909 (1961), aff'd, 317 F.2d 234 (4th Cir. 1963); Phillips v. Frank, 295 F.2d 629 (9th Cir. 1961); Darby Investment Corp. v. Commissioner, 37 T.C. 839 (1961), aff'd, 315 F.2d 661 (6th Cir. 1963). More recently, in Estate of Ratliff v. Commissioner, 101 T.C. 276, 281 (1993), the Tax Court reaffirmed the principle in question, although in a different context. Accordingly assuming that recovery was speculative, if the principal recovery in question arose because of the taxpayer's purchase of the mortgage, rather than because of the attribute reduction required by section 108(b), the taxpayer would not have realized income until its basis was recovered. ³

[13] Analysis of the legislative history of sections 108 and 1017 does not suggest that Congress intended a different result. S. Rep. No. 1035, 95th Cong., 2d Sess. 10, 16, 1980-2 C.B. 620, 625, 629. As you pointed out, the Tax Court has held that where the taxpayer's basis was reduced for other reasons the cost recovery method should still be applied if the note is speculative. Smith v. Commissioner, 48 T.C. 872 (1967), aff'd on this issue, 424 F.2d 219 (9th Cir. 1970) (section 1366 basis reduction). Accordingly, assuming that you are satisfied that collection of the mortgage by the petitioner from * * * was indeed speculative, we would concede this issue.

[14] Your request for Field Service Advice requested our comments on the factors we consider helpful in determining whether the notes were speculative. We believe that Underhill correctly states the law in this area and lists a number of factors that should be considered. In Underhill, Judge Tannenwald noted that:

[15] You also requested assistance on the appropriate time period for determining the value of the notes, i.e., when the notes were originally acquired, increased, or after the taxpayer reduced its basis. While we can locate no direct authority for this, we believe the correct answer is to look at their value when the notes were originally acquired or, alternatively, when they were increased, but not when the taxpayer reduced its basis. We believe that this is consistent with the analysis in Underhill, where the court found as a fact that the value of the properties securing the mortgages generally increased in value from their acquisition to the years of recovery but held that they were speculative nonetheless. 45 T.C. at 491. We do not believe that this determination changes because of a change in market conditions. In other words, if the debt was speculative when acquired or issued, it should stay that way and vice versa.

[16] If you have any questions or need further assistance, please contact Warren Joseph at (202) 622-7900.

² We presume that the petitioner is on the accrual method. However, we do not believe that this affects the result.

³ We assume that recovery of the principal is in fact sufficiently speculative that it would have qualified under the Underhill test if the petitioner had bought the mortgages from a third party.