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Worthless Debt Securities and Bad Debts: Identifying Identifiable Events

Posted on Jan. 9, 2023
Laura M. Barzilai
Laura M. Barzilai

Laura M. Barzilai is a partner at Sidley Austin LLP in New York.

In this report, Barzilai examines what constitutes an identifiable event for purposes of proving the worthlessness of securities or debt, and she explores whether a recession or market crash is an identifiable event.

The views expressed here are the author’s and are not those of Sidley Austin. An earlier version of this report was presented at the New York Tax Review on February 10, 2014.

I. Introduction

The general rule of the Internal Revenue Code is that to claim a loss, the taxpayer must demonstrate that there has been a closed and completed transaction. This is most easily demonstrated with a sale or disposition resulting in the recognition of the loss under section 1001. For losses attributable to worthless securities or bad debts, however, there is no closed and completed transaction. Instead, there is a determination by the taxpayer that the security or debt that it holds has been rendered wholly — or, in some cases, partially — worthless. What has come to be known as the Great Recession, which began at the end of 2007, caused many securities and debts to be at least partially worthless, if not wholly worthless — at least in the view of the layperson. And, in the opinion of many, we are heading for another recession — great or otherwise — that may cause outstanding securities and debts to be seen as worthless. The layperson’s view of worthlessness, however, may not be sufficient to entitle a taxpayer to claim a loss or other deduction for that worthlessness under the code.

Taxpayers who see the value of the debt that they hold dwindle or evaporate during a recession may claim worthless securities deductions under section 165(g) or bad debt deductions under section 166. The tax returns reflecting those deductions may be audited, and the deductions may be challenged by the IRS, depending on the particular facts and circumstances involved. For almost 100 years, if not more, taxpayers and courts have grappled with the issue of what is required to prove worthlessness and whether a taxpayer has met its burden to prove worthlessness. Because there is the distinct possibility of a recession causing outstanding debts to diminish in value and because taxpayers are investing in distressed debt, this is an opportune time to revisit the law regarding worthlessness and partial worthlessness, and what is required to prove that worthlessness.

The burden of proving worthlessness under sections 165(g) and 166 is on the taxpayer. As discussed later, this generally will be based on an analysis of the relevant facts and circumstances. However, case law repeatedly refers to a specific requirement that the taxpayer show the occurrence of an identifiable event that fixes the worthlessness. An examination of the statutory, regulatory, and case law sheds light on the extent to which there is such a requirement. To the extent there is one, case law provides guidance on what may constitute an identifiable event, including whether a recession — including a great recession — itself could be such an event.

II. Statutory and Regulatory Background

A. Current Law

Section 165 provides the general rule allowing deductions for losses sustained during a tax year and for which the taxpayer is not otherwise compensated. Although the statute sets out various rules for specific types of losses, it does not define generally what it means to sustain a loss. Reg. section 1.165-1(b) provides that the deduction will be allowed only when the loss is “evidenced by closed and completed transactions, fixed by identifiable events, . . . and actually sustained during the taxable year.” The requisite closed and completed transaction is usually found in a sale or disposition allowing for the recognition of loss under section 1001. Section 165, however, specifies other instances in which a loss may be recognized without a section 1001 sale or disposition.1

For a security held as a capital asset, section 165(g) provides that 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 tax year in which it becomes worthless. Reg. section 1.165-5(b) provides ordinary loss treatment for securities that are not capital assets and become worthless during the tax year. In either case, the security must become “wholly” worthless in the tax year for which the loss is claimed.

Section 165(g) applies only when the obligation in question is a security, which is defined 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.”2 Therefore, it does not apply to debt issued by a partnership or an individual,3 and it does not apply to a debt that is not issued in registered form (unless it is issued with interest coupons).4

When the debt is not a security, as defined for purposes of section 165, a taxpayer may still be able to claim a deduction for worthlessness under section 166. Section 166(a)(1) allows a deduction for any debt that becomes worthless during the tax year. Section 166(a)(2), which has no counterpart in section 165, provides a deduction for partial worthlessness, stating: “When satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.” The deduction allowed under section 166 is an ordinary deduction for corporations and for business debts of noncorporate taxpayers.5

B. History

Before discussing how courts have approached establishing worthlessness, it is helpful to understand the history of these provisions because many of the cases predate the current code.

The ability to claim a deduction for a worthless debt has existed since 1894.6 The cases referred to in this report don’t go back that far. So we can begin this discussion with the Revenue Act of 1918. That act allowed both individuals and corporations to claim a deduction for debts “ascertained to be worthless and charged off within the taxable year.”7 Treasury regulations also allowed a deduction for bonds ascertained to be worthless in a tax year.8 In the Revenue Act of 1921, this was expanded so that the commissioner, in his discretion, could allow a deduction for debts recoverable only in part.9 In the 1932 code, the provisions were amended to limit the amount of a partial bad debt deduction to the amount of the debt charged off within the tax year.10 At that point, the statutory language regarding partial bad debt deductions read as it does today.

Regulations in effect during that period stated that losses generally required a closed and completed transaction.11 Although there was no reference to an “identifiable event” in the regulations until 1934,12 no loss deduction was allowed as the result of the shrinkage in value of securities “such as stocks or bonds . . . through fluctuation of market or otherwise.”13 However, if stock of a corporation became worthless, a deduction was allowed upon a showing of worthlessness “as made in the case of bad debts.”14 Regulations governing bad debt deductions provided:

Before a taxpayer may charge off and deduct a debt in part, he must ascertain and be able to demonstrate, with a reasonable degree of certainty, the amount thereof which is uncollectible. . . . In determining whether a debt is worthless in whole or in part the Commissioner will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. Partial deductions will be allowed with respect to specific debts only.

An account merely written down or a debt recognized as worthless prior to the beginning of the taxable year is not deductible. Where all the surrounding and attendant circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of these facts will be sufficient evidence of the worthlessness of the debt for the purpose of deduction. Bankruptcy may or may not be an indication of the worthlessness of a debt, and actual determination of worthlessness in such a case is sometimes possible before and at other times only when a settlement in bankruptcy shall have been had. Where a taxpayer ascertained a debt to be worthless and charged it off in one year, the mere fact that bankruptcy proceedings instituted against the debtor are terminated in a later year confirming the conclusion that the debt is worthless will not authorize shifting the deduction to such later year.15

Note that deductions for wholly worthless debt were allowed in the tax year in which debts or bonds were “ascertained” to be worthless. For stock, however, deductions were allowed in the tax year in which the stock became worthless.

It was not until the enactment of the Revenue Act of 1938 that a code section provided rules for deductions associated with worthless stock or securities in addition to the separate rules for bad debts. One section provided for recognition of a capital loss if shares of stock or rights to subscribe in those shares became worthless during the tax year and were capital assets.16 A separate provision, under the subsection for deductions associated with bad debts, provided for recognition of a capital loss for securities that were ascertained to be worthless, were charged off, and were capital assets.17 For this purpose, the term “securities” was defined in the same manner that debt securities are defined today under section 165(g)(2)(C).18 Deductions for wholly worthless bad debts and debt securities continued to be based on the taxpayer’s ascertaining the debt to be worthless, whereas the deduction for worthless stock required that the stock actually be worthless.

The Revenue Act of 1942 reflected a fundamental change by removing the word “ascertained” from the provisions regarding worthless debt securities and bad debts.19 In other words, it was no longer sufficient that the worthlessness of any security or debt be ascertained by the taxpayer during the tax year; worthlessness had to have in fact occurred during the tax year. Moreover, the statute eliminated the charge-off requirement. The legislative history described the “ascertainment” and charge-off requirements as causing “considerable difficulty,” with particular emphasis on the charge-off requirement for taxpayers that didn’t keep adequate records.20 These changes were retroactive to tax years beginning after December 31, 1938. The accompanying regulations weren’t modified in any substantive way.21

By making the two changes described above in 1942, Congress, apparently inadvertently, limited the partial bad debt deduction to an amount that became worthless in the tax year.22 One year later, Congress retroactively reinstated the charge-off requirement for a partial bad debt deduction.23 The legislative history of the Revenue Act of 1943 explained that there had been no intention to change the substantive law on the deductibility of partial bad debts to require that the amount deducted have become worthless in the year in which the deduction was claimed.24

The 1954 code modified the relevant provisions to read as they read today. Of note, one set of rules, embodied in section 165, now applies to worthless stock and securities. The rules regarding bad debts, other than securities, are embodied in section 166.

III. Proving Worthlessness

The code and the regulations provide ample guidance on the basic entitlement to a deduction for worthless securities and wholly or partially worthless debt and on the character of the deduction as a capital loss or an ordinary deduction. However, the ability to claim a deduction turns on being able to show that the security or debt is worthless or partially worthless.

Neither section 165 nor its regulations set forth a standard for proving worthlessness. The regulations under section 166 provide some, albeit limited, assistance by stating the general rule that all pertinent evidence will be considered, including the financial condition of the debtor and the value of any collateral securing the debt.25 Those regulations also state that bankruptcy generally indicates worthlessness of at least a part of an unsecured and unpreferred debt obligation.26 Finally, the regulations tell us that the creditor does not have to take legal action to enforce payment when circumstances indicate that the debt is worthless and that legal action probably wouldn’t result in collection.27

As noted, the general rule of reg. section 1.165-1(b) is that to be deductible under section 165, “a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year.”28 (Emphasis added.) Similarly, reg. section 1.165-1(d) provides that the year in which the deduction is allowed is the year in which the loss is sustained, which is “the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year.” (Emphasis added.) The phrase “identifiable events,” however, does not appear in reg. section 1.165-5 regarding worthless securities. Similarly, the phrase appears nowhere in the regulations under section 166.

The only further guidance provided by the regulations is that fluctuations in market value do not provide a basis for claiming a loss. This reflects the general realization-based approach of the code, as opposed to a general mark-to-market regime. Reg. section 1.165-4(a) provides:

No deduction shall be allowed under section 165(a) solely on account of a decline in the value of stock owned by the taxpayer when the decline is due to a fluctuation in the market price of the stock or to other similar cause. A mere shrinkage in the value of the stock owned by the taxpayer, even though extensive, does not give rise to a deduction under section 165(a) if the stock has any recognizable value on the date claimed as the date of loss.

However, reg. section 1.165-4(a) goes on to state, “No loss for a decline in the value of the stock owned by the taxpayer shall be allowed as a deduction under section 165(a) . . . except as otherwise provided in section 1.165-5 with respect to stock which becomes worthless during the taxable year.” Reg. section 1.165-5(b) and (c) allows a deduction under section 165(a) for wholly worthless securities. A similar rule appears in reg. section 1.165-5(f) for securities, with a slight variation in the language. It states: “A taxpayer possessing a security to which this section relates shall not be allowed any deduction under section 165(a) on account of mere market fluctuations in the value of such security.” (Emphasis added.) It then cross-references reg. section 1.165-4.

This statutory and regulatory framework raises several questions regarding proof of worthlessness. First, does a taxpayer, at a minimum, have to show that an identifiable event occurs in order to claim a deduction for a worthless security or bad debt? Is the answer different under section 165 for worthless stock and worthless securities? Is the answer different for losses claimed under section 165 and for deductions claimed under section 166? Is the answer different for claims of wholly worthless debt under section 166 and partially worthless debt under section 166? And to the extent that an identifiable event is required, does a significant economic recession or market crash constitute an identifiable event, as opposed to a mere market fluctuation?29

A. Identifiable Events: Wholly Worthless

1. Statutory and regulatory provisions.

Section 165(g)(1) states that if a security becomes worthless during the tax year, the resulting loss shall be treated as a loss from the sale or exchange of a capital asset. Reg. section 1.165-5(b), which allows an ordinary loss for ordinary assets, and reg. section 1.165-5(c) provide that the loss resulting from the worthlessness may be deducted under section 165(a). If any identifiable event is in fact required under the general rule set forth in reg. section 1.165-1(b) to claim a deduction under section 165(g)(1), the structure of the statute and the regulations suggests that worthlessness itself is the identifiable event. In other words, if you prove that the security you hold has become worthless during the tax year, including by demonstrating the financial condition of the debtor and the value of any collateral securing the debt, you have provided the identifiable event required to claim the loss. In fact, it may be impossible to apply the literal and complete wording of reg. section 1.165-1(b) to a worthless securities loss given that it requires a closed and completed transaction, fixed by identifiable events. Yet the apparent purpose of section 165(g) was to recognize that it may not be possible to have such a transaction when a worthless security is concerned.30

For bad debt deductions, nothing in the statute or the regulations refers to identifiable events. As noted, the only guidance provided on proving worthlessness under section 166 is the requirement under reg. section 1.166-2(a) to consider all pertinent evidence.

2. Case law.

Courts, however, generally have taken the view that an identifiable event, other than worthlessness itself, is required. When considering whether a security is in fact worthless for purposes of section 165 or its predecessors, or wholly worthless for purposes of section 166 or its predecessors, many courts have looked to whether an identifiable event has occurred that establishes worthlessness.31 The cases cited most often for the proposition that an identifiable event is required are S.S. White Dental Manufacturing,32 Boehm,33 and Morton.34 An examination of each of these cases, however, calls into question the extent to which they stand for the proposition that an identifiable event is an absolute prerequisite to claiming a worthless securities deduction or a deduction for a wholly worthless bad debt.

In White Dental Manufacturing, the taxpayer claimed both a worthless stock deduction and a bad debt deduction for stock in, and a claim against, a German subsidiary corporation that was wholly owned by the taxpayer. In 1918 the German government seized all the assets of the corporation as enemy property. In 1920 the property was returned to the corporation, but its value had diminished drastically as a result of mismanagement while owned by the German government. The taxpayer later filed a claim against the German government but had not yet realized anything on that claim. The IRS disallowed the losses on the basis that no closed and completed transaction had occurred in 1918. The Supreme Court held that the seizure in 1918 was the requisite transaction. White Dental Manufacturing appears to be the first case involving worthlessness that uses the phrase “identifiable event.” It was decided before Treasury regulations addressing deductible losses referred to identifiable events. The Court states:

The statute obviously does not contemplate and the regulations (article 144) forbid the deduction of losses resulting from the mere fluctuation in value of property owned by the taxpayer. But with equal certainty they do contemplate the deduction from gross income of losses, which are fixed by identifiable events, such as the sale of property (article 141, 144), or caused by its destruction or physical injury (article 141, 142, 143), or, in the case of debts, by the occurrence of such events as prevent their collection (article 151).35

The Court goes on to hold that the seizure of assets by the German government was a completed transaction that fixed the loss on the stock and the debt. Having characterized the seizure as a transaction, it was not necessary for the Court to discuss whether, in the absence of such a transaction, an identifiable event is required.36 Further, parsing the sentence quoted above from the opinion indicates that the Court may have been saying that identifiable events fix certain losses whereas events that prevent collection fix a loss associated with bad debts. The construction of the sentence could suggest that these latter events would not necessarily be identifiable events but a confluence of circumstances. Moreover, when referring to the applicable provisions of the Revenue Act of 1918, the Court refers only to the section that allowed a deduction for losses sustained during the tax year and for which the taxpayer was not otherwise compensated, which was relevant for the worthless stock component of the case. On the bad debt component of the case, however, the Court makes no reference to the next section of the Revenue Act of 1918, which allowed a deduction for debts ascertained to be worthless and charged off during the tax year, although it does quote the regulation addressing that section.37 There is no indication in the opinion as to why the Court didn’t address that section of the statute.

In Boehm, the taxpayer claimed a deduction for worthless stock in 1937. At that time, there was no statutory provision allowing a deduction for worthless securities. Therefore, as in White Dental Manufacturing, the taxpayer was relying on the statute allowing a deduction for a loss sustained and for which the taxpayer had not been otherwise compensated as well as the regulation under that statute allowing a deduction for stock that had become worthless during the tax year. The IRS denied the deduction, claiming that the stock had become worthless in an earlier year. The issuing corporation had been placed into receivership in a previous year, and its liabilities far exceeded its assets in that year. The taxpayer and other shareholders had initiated a derivative suit which, if successful, would have provided additional assets to the corporation. That suit wasn’t resolved until 1937, when the taxpayer claimed the deduction. The Second Circuit had concluded that the stock had become worthless in a prior year because the corporation was hopelessly insolvent and the possibility of success in the derivative suit was too speculative. The taxpayer further argued that the test for worthlessness was subjective — that is, whether the taxpayer believed that the stock continued to have value until the derivative suit was resolved. The Second Circuit held that the test for worthlessness was objective, even though a different circuit had concluded otherwise. The Supreme Court granted certiorari to address this difference of opinion. In concluding that the test is an objective one, the Court relied on the language of the regulations promulgated in 1934 regarding the general rule for claiming losses, such as references to losses “actually sustained” and losses “fixed by identifiable events.”38 Then, on the basis of the record, the Court said it was not unreasonable for the Tax Court to have concluded that the stock had become worthless before 1937.39 Therefore, the case doesn’t stand for the proposition that an identifiable event is required to prove worthlessness. It stands for the proposition that worthlessness is not a subjective test.40

In Morton, the taxpayer had acquired stock in 1929 in a corporation that invested and traded in securities. Beginning in October 1929 through the liquidation of the corporation in 1932, the value of the corporation’s assets dropped significantly. At the end of 1930, the value of the corporation’s assets was less than the sum of its liabilities and the liquidation preference of its preferred stock. The value of its assets declined further in 1931. The taxpayer claimed a loss based on worthlessness in 1932, relying on the liquidation of the corporation in that year as an identifiable event. The IRS denied the deduction, arguing that the stock became worthless in 1931, not 1932. The premise of the taxpayer’s argument was that he was not allowed a loss until an identifiable event (that is, the liquidation) occurred that fixed the amount of the loss. The premise of the IRS’s argument was not that there was an identifiable event in 1931 but that the identifiable event “can not be looked upon as the inevitable ‘yardstick’ in the decision of all . . . cases.”41 The Board of Tax Appeals and the Seventh Circuit upheld the IRS’s position. In examining whether stock held by the taxpayer had become worthless, the court explained:

It is apparent that a loss by reason of the worthlessness of stock must be deducted in the year in which the stock becomes worthless and the loss is sustained, that stock may not be considered as worthless even when having no liquidating value if there is a reasonable hope and expectation that it will become valuable at some future time, and that such hope and expectation may be foreclosed by the happening of certain events such as the bankruptcy, cessation from doing business, or liquidation of the corporation, or the appointment of a receiver for it. Such events are called “identifiable” in that they are likely to be immediately known by everyone having an interest by way of stockholdings or otherwise in the affairs of the corporation; but, regardless of the adjective used to describe them, they are important for tax purposes because they limit or destroy the potential value of stock.

The ultimate value of stock, and conversely its worthlessness, will depend not only on its current liquidating value, but also on what value it may acquire in the future through the foreseeable operations of the corporation. Both factors of value must be wiped out before we can definitely fix the loss. If the assets of the corporation exceed its liabilities, the stock has a liquidating value. If its assets are less than its liabilities but there is a reasonable hope and expectation that the assets will exceed the liabilities of the corporation in the future, its stock, while having no liquidating value, has a potential value and can not be said to be worthless. The loss of potential value, if it exists, can be established ordinarily with satisfaction only by some “identifiable event” in the corporation’s life which puts an end to such hope and expectation.42

When Morton is cited by other courts, they frequently quote one or the other of the above paragraphs. Yet, the next paragraph in the court’s opinion is equally important and flows from the last sentence quoted above which refers to value “ordinarily” being satisfied by an identifiable event:

There are, however, exceptional cases where the liabilities of a corporation are so greatly in excess of its assets and the nature of its assets and business is such that there is no reasonable hope and expectation that a continuation of the business will result in any profit to its stockholders. In such cases the stock, obviously, has no liquidating value, and since the limits of the corporation’s future are fixed, the stock, likewise, can presently be said to have no potential value. Where both these factors are established, the occurrence in a later year of an “identifiable event” in the corporation’s life, such as liquidation or receivership, will not, therefore, determine the worthlessness of the stock, for already “its value had become finally extinct.” In cases where the stock has concededly lost any liquidating value in a certain year, but an event occurs in a subsequent year which the taxpayer claims is “identifiable,” and where the Commissioner of Internal Revenue has determined that stock became worthless in the year in which it lost its liquidating value, then the taxpayer, in order to be entitled to the loss deduction in the latter year, has the burden of proving that, although the stock lost its liquidating value in the prior year, it continued to have a potential value until the occurrence of the event.43

The IRS prevailed in Morton and, therefore, it was one of those cases in which an identifiable event did not determine the worthlessness of the stock.44

It is important to note that each of the three cases referred to above involved worthless common stock.45 Common stock, unlike debt securities, generally does not have a fixed maturity date. Therefore, while it may be possible to prove that the stock has no liquidating value in a given year without an identifiable event, in many situations it is considerably harder to prove that in that year, there is no reasonable hope or expectation that the stock will recover its value in the future without such an event.46 Presumably, that is why almost all the cases addressing section 165(g)(1) involve claims of worthless stock. It seems logical that the maturity date of a debt security would affect the determination of whether it is reasonable to expect that the security will recover its value. A creditor should not be expected to look for a recovery far beyond the maturity date of the instrument it holds. This has been recognized by some courts.47

It is also important to note that since at least 1918, a worthless stock deduction was allowed only in the year in which the stock became worthless. In contrast, until the enactment of the Revenue Act of 1942, deductions for worthless debt securities or bad debts were allowed in the year in which the taxpayer ascertained that they were worthless.48 Therefore, the taxpayer’s subjective belief played a large role in analyzing entitlement to the deduction. Some courts have described the standard that existed before the Revenue Act of 1942 as entirely subjective.49 Others explained that it was still necessary for the taxpayer to prove that the debt was objectively worthless, but the taxpayer wouldn’t lose the deduction if it only ascertained the worthlessness in a later year; determining the year in which the taxpayer first ascertained the debt to be worthless was a subjective test.50 Under either interpretation, however, the precise year in which the debt actually became worthless was not at issue.51 This may have tended to push more of the deductions into later years in which the worthlessness was clearer, resulting in fewer cases debating worthlessness itself for tax years before the effective date of the 1942 amendments and, instead, debating either whether the taxpayer had ascertained the worthlessness in the year of the deduction or whether the taxpayer reasonably could have ascertained the worthlessness in an earlier year.52 After the 1942 amendments, which removed the word “ascertained” from the statute, the phrase “identifiable event” was sometimes used to distinguish the new objective test from the prior subjective one.53

Although most cases decided under section 165(g)(1) involve worthless stock, there are several cases addressing claims under section 165(g)(1) for worthless debt securities. However, even when the court refers to a requirement to show an identifiable event, the facts of the cases often reflect more fundamental deficiencies, such as a failure to prove that the debtor was insolvent.54 In other words, the issue addressed by the courts in these particular cases was not whether an identifiable event was required but whether worthlessness based on any objective standard had been proven. The focus on the financial status of the debtor suggests that the courts may have been willing to find worthlessness when the liabilities of the debtor far exceeded its assets. For example, in Jasinski,55 the court cited Morton for the requirement to prove that an identifiable event had occurred fixing worthlessness. It then went on to state that the lack of trading in the debentures at issue and the debtor’s default in making one interest payment were inconclusive in proving worthlessness. Although the court said its decision was based on the lack of an identifiable event, the remainder of the court’s opinion focused on the corporation’s balance sheet, which did not indicate worthlessness, and the fact that the debtor continued operating its business.

The same can be said of cases involving a section 166(a)(1) deduction for wholly worthless debt. In Estate of Hoffman,56 the court concluded that the taxpayer had failed to show an identifiable event demonstrating worthlessness.57 However, the discussion in the opinion makes clear that it was not the failure to show an event that caused the court to decide against the taxpayer; it was the evidence that the taxpayer, who was the majority owner of the debtor, believed that the debtor’s business was in the process of rebounding.58 In Dustin,59 the court stated: “Worthlessness must be determined by objective standards; generally this burden is met by showing that some identifiable event occurred during the course of the year which effectively demonstrates the absence of potential value, although such is not indispensable.60 (Emphasis added.) The taxpayer based his bad debt deduction on the debtor’s purported insolvency and insufficient working capital. The court said that insolvency “is not necessarily evidence of worthlessness, for a debtor’s luck may change for the better in the future.”61 The taxpayer also argued that the failure of two books published by the debtor, a textbook publisher, in the year for which the deduction was claimed, constituted the requisite identifiable event. The court rejected this argument because the debtor was working on new books during the year in question, and it had produced quality books in the past. Therefore, given the nature of the publishing business, there was still reasonable hope that the debt would have value. Moreover, the debtor hadn’t defaulted on any of its obligations. Although the opinion references the concept of an identifiable event, the holding was based on the taxpayer’s fundamental failure to prove worthlessness and not the failure to prove an identifiable event.62 Other cases decided against the taxpayer under section 166(a)(1) that mention “identifiable event” ultimately rest on this fundamental failure.63

There are also cases in which worthlessness is not proven, in which the courts have made no reference to either the lack or the presence of an identifiable event.64 Those cases have been decided under section 166; it appears that each case addressing whether a debt security is worthless for purposes of section 165(g), regardless of the outcome of the case, refers to an “identifiable event.”

In many, if not most, of the cases discussed or cited, it is the IRS asserting that worthlessness requires the showing of an identifiable event. However, this is not always the situation. In at least one case involving a wholly worthless debt deduction under section 166, the IRS successfully took a position similar to the one it took in Morton — that is, that the debt had become worthless before the year in which an identifiable event occurred. In Levin,65 the taxpayer claimed a bad debt deduction for a demand loan for the year in which he first became in need of the funds and demanded repayment of the debt. The IRS argued that the loan had become worthless before that year. The statute of limitations on collecting the debt had expired. However, the court didn’t base its decision on that fact. Instead, it concluded that the debt had become worthless earlier based on the debtor’s severe financial circumstances.

It is important to emphasize that even if an identifiable event has occurred, this alone is insufficient to support a deduction for worthlessness. Identifiable events are often pointed to as evidence of worthlessness. However, even when the courts have recognized identifiable events, worthlessness still had to be proven.66 For example, although a bankruptcy filing is recognized as an identifiable event,67 a debt instrument of a bankrupt debtor may still have value.68 In Dallmeyer,69 the debtor was determined by a court to be bankrupt in 1943; however, it was not until 1944 that the bankruptcy referee determined that the debtor lacked sufficient assets to pay the debt owed to the taxpayer. The taxpayer claimed a bad debt deduction in 1944, but the IRS disallowed the deduction, arguing that the adjudication of bankruptcy in 1943 was the identifiable event establishing worthlessness. The court determined that based on the facts presented, it was uncertain at the beginning of 1944 whether the debtor would have sufficient assets to pay the debt because insufficient evidence had been presented to the referee at that time. The court held for the taxpayer, stating that the relevant identifiable event was the later determination by the referee.70 In Mack,71 the taxpayer claimed a bad debt deduction in 1987. The debt became due in that year, and the taxpayer unsuccessfully tried to collect the amount owed from the debtor who claimed he was insolvent. In 1988 the debtor’s creditors filed an involuntary bankruptcy petition. The taxpayer did not file a claim in the bankruptcy proceeding because he had already determined his debt would not be paid. The debtor was discharged from his debts in 1989. The court disallowed the bad debt deduction in 1987 for lack of an identifiable event that established worthlessness. It went on to conclude that the debt became worthless in 1988. In reaching that conclusion, the court did not refer to the bankruptcy petition being an identifiable event but to the filings showing that the taxpayer would not collect anything from the debtor even if he had filed a claim in the bankruptcy proceeding.72

As discussed, many cases referring to an identifiable event requirement are ultimately decided against the taxpayer because of a failure to establish worthlessness. Similarly, section 166 cases that refer to the requirement and decide in favor of the taxpayer often reach that conclusion based on factors, other than an identifiable event, that establish worthlessness. For example, in American Offshore,73 after stating that a taxpayer must generally show identifiable events, the court proceeded to list factors determining worthlessness, many of which constitute facts rather than events. Included in the list are (1) a decline in the debtor’s business, (2) a decline in the value of property securing the debt, (3) the overall business climate, and (4) the insolvency of the debtor. Therefore, although the court references “identifiable events,” it acknowledges that either events or facts can support a finding of worthlessness. After concluding that the debt in question was worthless based on these factors, the court said that the collapse of the debtor’s industry, which led to a loss of value in the collateral, was “a sufficiently identifiable set of circumstances to explain the worthlessness” of the debt.74

Two recent cases address facts arising during the Great Recession. In Owens,75 the Tax Court similarly relied on all facts and circumstances, rather than a single identifiable event, to agree with the taxpayer’s position that the debt in question became worthless in 2008, the year before the debtor filed for bankruptcy. The IRS argued that the relevant identifiable event was the bankruptcy filing, which didn’t occur until 2009. The Tax Court stated, “While bankruptcy is certainly an indication that a debt is worthless, the absence of a bankruptcy filing does not mean a debt isn’t worthless.” It then went on to cite American Offshore and the same list of factors that indicate worthlessness. Ultimately, the Tax Court concluded that based on the facts and circumstances, the debt became worthless in 2008 because (1) in that year, the debtor told the taxpayer it would file for bankruptcy; (2) the taxpayer was junior to secured lenders, and in 2008 the debtor had defaulted on the secured debt;76 (3) the taxpayer believed that the debtor’s liabilities far exceeded the value of the debtor’s assets; and (4) events after 2008 supported the taxpayer’s belief.77

2590 Associates78 involved a loan made by the taxpayer to a real estate developer. In 2009 another lender to the borrower commenced foreclosure proceedings on the underlying property, and soon thereafter the borrower filed counterclaims against the second lender. The debt leading to the foreclosure was not yet due at that time, and the borrower believed that it would be able to repay the debt a few months later. After the filing of the foreclosure case, the borrower continued to operate and receive rent from its tenants. In 2011 the borrower lost the ability to finance the real estate project with Gulf Opportunity Zone government bonds. Also in 2011, the court dismissed the borrower’s defenses and counterclaims in the foreclosure proceeding. However, the judgment in the case wasn’t rendered until 2012 because of unresolved claims by the lender unrelated to the foreclosure. The taxpayer claimed a worthless debt deduction under section 166 for its 2011 tax year. The IRS didn’t contest the worthlessness of the debt but argued that it became worthless either in 2009 when the foreclosure case began or in 2012 when the final judgment was issued. The court, in three consecutive sentences, said that “a debt’s worthlessness is determined by identifiable events,” “a debt becomes worthless when the taxpayer has no reasonable expectation of repayment,” and “some objective factors considered by the Court in determining worthlessness include the value of property securing the debt, the debtor’s earning capacity, events of default, the debtor’s refusal to pay, actions to collect the debt, any subsequent dealings between the parties, and the debtor’s lack of assets.”79 The court then went on to allow the 2011 deduction based on its conclusions that (1) in 2009 there was a reasonable expectation of repayment of the debt, and the borrower was continuing to negotiate with its other lender; and (2) the judgment being delivered in 2012 was the result of unrelated issues. The court found that the debt became worthless in 2011 because in that year, the borrower no longer believed it would be able to refinance the underlying real estate project. The court said, “With these [2011] events it was reasonable to abandon hope of recovery” of the note.80 Once again, although the court referenced identifiable events, its conclusions were stated in terms of the reasonableness of expectations regarding repayment based on all the facts and circumstances.

In section 166 cases in which the facts provide strong support for worthlessness, courts have upheld deductions either with no discussion whatsoever of identifiable events or despite the fact that there was no such event (or at least one traditionally recognized as an identifiable event, such as bankruptcy or a decision to liquidate). In Lagoy,81 the taxpayer lent money on an unsecured basis to two corporations in exchange for demand notes for the purpose of acquiring a business. The acquisition didn’t occur. In 1986, when the taxpayer unsuccessfully demanded payment of one of the notes, the debtor’s negative net worth was more than 10 times the amount of the debt owed to the taxpayer, and the fair market value of the debtor’s assets was insufficient to pay its secured creditors. While that debtor continued in business, the other ceased operations and sold its assets in 1987. The taxpayer claimed that part of the first debtor’s note became worthless in 1986 and that the remainder became worthless in 1987. The court determined that the debt became wholly worthless in 1986 and, therefore, it denied the taxpayer’s 1987 partial bad debt deduction. The court said that worthlessness must be shown by objective standards and, citing American Offshore, considered four factors: (1) whether the debt is subordinated, (2) whether there has been a decline in the debtor’s business, (3) the FMV of assets available to repay the debt, and (4) the debtor’s refusal to pay. The court did not give significant weight to the fact that one of the debtors continued to operate on a limited basis.

In Riss,82 the court made no mention whatsoever of an identifiable event requirement. It said, “The proper test to be used in determining the worthlessness of a debt is the exercise of sound business judgment, and there is no black rubric standard. If collection seems hopeless to a reasonable man knowledgeable in the field of business, a deduction is justified.”83 The Eighth Circuit found that the facts presented a close case, and it ultimately concluded that it couldn’t consider the Tax Court’s decision to deny the deduction unreasonable. However, in describing the factors indicating worthlessness, the circuit court pointed to the debtor’s insolvency and factors negatively affecting the debtor’s operating ability. As in Lagoy, the court did not give significant weight to the fact that the debtor continued to operate.84

As noted, the IRS has sometimes taken the position in litigation that a debt instrument became worthless before the occurrence of an identifiable event.85 In a published ruling, the IRS appears to have taken a similar view that an identifiable event is not a prerequisite to sustaining a bad debt deduction. In Rev. Rul. 71-577, 1971-2 C.B. 129, the IRS concluded that a taxpayer could deduct the unpaid balance of a deposit with a savings and loan association upon notification from the receiver of the association in bankruptcy that it was doubtful that the taxpayer would receive anything for his deposit. The ruling, which addressed a wholly worthless nonbusiness debt, makes no reference to identifiable events and refers only to the requirement under reg. section 1.166-2(a) to consider all pertinent evidence, including the debtor’s financial condition.86 Even under section 165(g), the IRS has acknowledged that the lack of potential value can be demonstrated either by showing that liabilities exceed assets by an amount such that there is no hope for recovery or by the presence of identifiable events that demonstrate worthlessness.87 This is consistent with the IRS’s position in Morton, in which it argued that the stock in question was worthless before the year in which the identifiable event occurred, and in Levin, in which it made the same argument in a bad debt case (that is, worthlessness may precede an identifiable event).

3. Takeaways.

When there is a recognizable, identifiable event that clearly establishes the worthlessness of a debt, it is easy to say that the identifiable event was the necessary condition to finding worthlessness. However, the cases discussed ultimately stand for the proposition that the real requirement is not an event per se but objective facts that demonstrate the worthlessness. These facts may include an event that has been recognized by the courts as a so-called identifiable event.

There does seem to be a predilection to refer to an identifiable event requirement in section 165(g) cases, whereas section 166 cases seem more willing to speak in terms of an evaluation of the facts and circumstances. This is consistent with the regulatory language under the respective sections, even though the regulations under section 165 regarding worthless stock or securities do not literally require an identifiable event to prove worthlessness. It is likely that the references to an identifiable event in the section 165(g) cases stem from the fact that under that section, worthlessness allows the recognition of a loss that would not otherwise be recognizable without a closed and completed transaction, fixed by identifiable events. Without an event to point to, courts may be concerned that allowing the deduction would move in the direction of a generally applicable mark-to-market regime for securities. Further, it would be a one-way mark-to-market regime, given that there is no requirement for a taxpayer to include previously deducted amounts in income, without a realization event, if it is later determined that the security does have value.88

It could also be posited that a debt instrument that is a security as defined in section 165(g) is more likely to be something otherwise transferable or transferred in a closed and complete transaction, given the requirement that it be in registered form (or issued with interest coupons). However, this argument is not really supportable, and it would be pure speculation because there does not appear to be a strong rationale, if any, for the different rules set forth in section 165(g) for debts that are securities and those set forth in section 166 for debts that are not.89

To sustain a deduction for a wholly worthless debt under either section 165(g) or section 166, the taxpayer has the burden of proving that the debt is in fact worthless. Although insolvency may not be a sufficient factor unless it is severe, and the debtor’s continuing in business is generally an unhelpful fact, the cases discussed demonstrate that when the facts and circumstances clearly show worthlessness, the deduction will not be disallowed solely because of the failure to proffer a specific identifiable event. And if in that situation a court feels obliged to find an identifiable event, it appears that one can be found. In American Offshore, the collapse of the debtor’s industry, which caused the value of collateral to deteriorate, was found to be an “identifiable set of circumstances.” If the facts had not supported worthlessness, the court may have concluded that those same circumstances didn’t constitute an identifiable event.

An identifiable event is neither a necessary condition nor a sufficient condition for proof of worthlessness. Neither the IRS nor taxpayers should lose the forest for the trees — the ultimate question is whether the debt is in fact worthless and not whether any one of a handful of specific identifiable events — such as bankruptcy, liquidation, the sale of all the debtor’s assets, or the complete cessation of business — caused that to be so.

B. Identifiable Events: Partially Worthless

As noted, nowhere in section 166 or its regulations is there mention of an identifiable event requirement. And unlike the regulations under section 165(g), the regulations under section 166 specifically address evidence of worthlessness90 and state simply that in determining whether a debt is worthless in whole or in part, all evidence should be considered.91 Although many courts have referenced a requirement to show an identifiable event for wholly worthless debts, there appears to be no such common law requirement for partially worthless debts.92

1. Case law.

An examination of the case law applicable to deductions for partially worthless debts under section 166(a)(1) demonstrates that an identifiable event is not a prerequisite to claiming that deduction. In Findley,93 the Tax Court said, “It seems obvious that partial worthlessness of an obligation must be evidenced by some event or some change in the financial condition of the debtor, subsequent to the time when the obligation was created, which adversely affects the debtor’s ability to make repayment.”94 (Emphasis added.) In Austin,95 the court clearly stated the requirement of an identifiable event in the context of a worthless securities deduction claimed by the taxpayer for stock under section 165(g). Yet in the opinion’s very next discussion, the court allowed the taxpayer a deduction for a partially worthless bad debt without mentioning the phrase “identifiable event.” The same was true in Portland Manufacturing,96 in which the court allowed a deduction for partially worthless debt based on the taxpayer’s finding that the borrower was operating at a continual loss. Similarly, in at least five other cases involving section 166(a)(2), the court mentioned no requirement that the taxpayer demonstrate an identifiable event to claim a deduction for partially worthless debt.97

Interestingly, there are at least three cases in which the court held that the taxpayer failed to show an identifiable event proving worthlessness and then noted or suggested that a partial bad debt deduction may have been available on the same facts if the taxpayer had presented that issue to the court.98

There appears to be only one case in which a court said that an identifiable event was required for a taxpayer to claim a deduction for partially worthless debt under section 166(a)(2). In ABC Beverage,99 the Tax Court stated, “A taxpayer must generally show that identifiable events occurred to render the debt worthless during the year in which the taxpayer claimed the deduction.”100 The taxpayer in ABC Beverage seized the assets of a borrower in default, released the borrower from the loan in question, and claimed a partially worthless bad debt deduction in an amount equal to the excess of the then-outstanding principal balance of the loan over the FMV of the assets seized. Thus, ABC Beverage differs from the typical case for partially worthless debts in that the loan was not outstanding at the end of the tax year in which the deduction was claimed. In fact, it is unclear why the court didn’t address whether this was more appropriately viewed as a sale or exchange transaction; perhaps that argument was not raised by the IRS.101 The taxpayer claimed a deduction for partially worthless debt instead of wholly worthless debt because the collateral seized had value. Thus, the taxpayer was able to show identifiable events regardless of whether it was required to do so.

The court in ABC Beverage cites only one case for the proposition that a taxpayer must “generally” show that identifiable events occurred to render a debt worthless: American Offshore.102 However, American Offshore concerned a claim for total worthlessness, not partial worthlessness, and each of the cases cited by that court for the proposition that identifiable events are required were cases regarding wholly worthless debts, not partially worthless debts.103 Further, as discussed,104 after saying that a taxpayer must generally show identifiable events, the court in American Offshore proceeded to list factors determining worthlessness, many of which constitute facts rather than events, acknowledging that either events or facts can support a finding of worthlessness.

While one or more of the factors cited by American Offshore,105 when sufficiently severe, will establish total worthlessness, the same factor or factors, when less severe, may suffice to establish partial worthlessness. Moreover, some factors that have been cited as militating against total worthlessness, such as remaining earning capacity, sluggish business conditions, and availability of collateral,106 may actually indicate partial worthlessness. For example, the debtor’s reduced earning capacity and sluggish business conditions were taken into account by the court in Portland Manufacturing and Brandtjen & Kluge107 in allowing the taxpayer to claim deductions for partially worthless debt. Likewise, the availability of collateral with a value less than the outstanding debt allowed the taxpayer in ABC Beverage to claim a deduction for partially worthless debt rather than wholly worthless debt.

Further evidence that no identifiable event is required for a partial bad deduction are cases in which debt repayment depended on the future sale of the debtor’s assets or of the collateral securing the debt. Courts have allowed partial bad debt deductions before the actual sale based on the reasonable estimation of the future sales proceeds supported by appraisals, bids received, or the judgment of a creditor with experience in the relevant industry. For example, in Portland Manufacturing,108 the debt was secured by all of the debtor’s assets. The amount of the debt that would be recovered would depend on the future sale of those assets. Although that sale didn’t occur until two years after the tax year in which the deduction was claimed, the court allowed the deduction based on the taxpayer’s reasonable estimate of the assets’ salvage value. In Turbeville,109 the taxpayer had an amount on deposit with a bank that was secured by assets of the bank. The bank had become insolvent, and the taxpayer deducted half of the amount on deposit as a partial bad debt. The parties had stipulated to the value of the collateral and to the fact that the collateral was the only means for satisfying the amount owed to the taxpayer. The court concluded that the taxpayer was not required to wait until the sale of the collateral to claim the partial bad debt deduction.

In many of these cases, the debtor was about to wind up operations. It could be argued that the decision to wind up operations was the required identifiable event in these cases, even though the courts made no reference to an identifiable event. However, there are cases in which partial bad deductions have been allowed even though the debtor continued its operations. For example, the court in Flynn110 allowed a partial bad debt deduction based on the debtor’s financial condition even though the taxpayer continued to make loans to the debtor in subsequent years and the debtor continued in operation for four more years. In Imperial Furniture,111 the court upheld a partial bad debt deduction based on the taxpayer’s investigation into the debtor’s financial condition, including an audit of the debtor, even though the debtor continued in operation and the taxpayer hadn’t tried to demand payment out of concern that a forced sale of the debtor’s assets would have diminished the amount the taxpayer would ultimately recover on the debt.112

The discussion in partial bad debt cases under section 166 focuses on the reasonable business judgment of the taxpayer, in light of the facts and circumstances, in concluding that the deducted portion of the debt is not recoverable rather than on the presence of identifiable events. In a way, this harks back to the more subjective pre-1942 law, which allowed a deduction in the year in which the taxpayer ascertained a debt to be worthless. This focus results largely from the discretion the IRS is accorded by section 166(a)(2) in determining the availability of a deduction for partially worthless debt.113 The cases addressing this discretion provide further support for there being no need to show an identifiable event.

Although the IRS is given discretion in determining the availability of a deduction for a partially worthless debt, that discretion is not absolute.114 The taxpayer may overcome the IRS’s determination by showing that, considering all the facts and surrounding circumstances, a part of the debt is unrecoverable.115 The IRS “may not ignore the soundly exercised business judgment of a taxpayer’s officers in determining partial worthlessness.”116 In particular, “if management’s business judgment is supported by facts establishing partial worthlessness, [the IRS’s] exercise of discretion will be overturned.”117 Therefore, for partial bad debt deductions, considerable weight is given to the taxpayer’s belief of partial worthlessness. Unlike in the wholly worthless debt cases, the focus is on whether it was reasonable for the taxpayer to conclude that it would not recover the portion of the debt at issue.

In Austin,118 the court accepted the testimony of the president of the insolvent borrower (a wholly owned subsidiary of the taxpayer) regarding his computation of the taxpayer’s estimated recovery “based on his business judgment as an experienced tobacco operator and as a certified public accountant.”119 Moreover, the court noted that the president had “extensive background in the tobacco industry on a management level.”120 Similarly, in Portland Manufacturing, the Tax Court allowed the taxpayer to claim a deduction for partially worthless debt when the debtor corporation, a lumber mill, was operating at continual losses. The Tax Court accepted the testimony of the officers of the taxpayer regarding the salvage value of the debtor’s assets based on their “extensive backgrounds in the lumber industry on a managerial level.”121 Moreover, the officers of the taxpayer who made the decision to charge off the borrower’s debt were also officers of the borrower and thus intimately familiar with the borrower’s operations. Further, the borrower in Portland Manufacturing was still an operating business during the tax year in which the taxpayer charged off its debt, although at the very end of the year, the borrower decided to begin winding up its business. It didn’t cease operations until March of the following year, and its assets weren’t sold until the year after that. The court, in finding for the taxpayer, made no mention of an identifiable event requirement or of the decision to cease operations. It focused solely on the business judgment of the taxpayer and the facts indicating that the taxpayer would not recover the full amount of the debt.

Similar analysis appears in cases under prior versions of the code which, except for the addition and removal of the charge-off requirement, have included the same language regarding partial bad debt deductions as appears in today’s code. The court in Clark122 addressed a partial bad debt deduction claimed in 1926. The debtor corporation had been operating at a loss since 1925 and was in bad financial condition at the end of 1926. In 1927 another creditor forced the company into involuntary bankruptcy. The taxpayer, who had been an officer and director of the debtor, claimed a bad deduction in 1926 in an amount that he considered conservative. The debtor in Clark was operating at a continual loss but had been making payments on its debt. The court allowed the deduction based on the investigations made by the taxpayer and his status as an officer of the debtor, which gave the taxpayer “the necessary information as to the value of the mortgage security so that he could draw a fair and honest conclusion.”123

The court reached a similar conclusion in Brandtjen & Kluge,124 in which the taxpayer was permitted to take a deduction for partially worthless debt after its accountants inspected the books of the debtor and found that the debtor was operating at a continual loss. Thus, in Austin, Portland Manufacturing, Clark, and Brandtjen & Kluge, the court found that the reasonable business judgment of the taxpayer, supported by the taxpayer’s knowledge of the financial condition of the debtor, was sufficient to allow the taxpayer to take a deduction for partially worthless debt. None of those decisions referenced a requirement to show an identifiable event in order to claim the deduction.

2. Reflections on case law.

There are several reasons why an identifiable event has taken on importance in the context of wholly worthless debt rather than partially worthless debt. First, unlike a loss for a wholly worthless debt, which can be claimed only in the year in which the loss is “in fact” sustained, a deduction for a partially worthless debt under section 166(a)(2) may be claimed by the taxpayer in the year of its choosing, although limited to the amount of the debt charged off during that year.125 Section 166(a)(1) allows a deduction only for a debt “which becomes worthless within the taxable year.” Therefore, cases decided under section 166(a)(1) often revolve around a determination of the year in which the debt first became worthless. The existence of an identifiable event helps determine that year. In other words, in many cases, the presence of an identifiable event relates to the timing of worthlessness rather than worthlessness itself. The timing inquiry is irrelevant for partial bad debt deductions.

The second purpose often stated for the identifiable event requirement is the need to prove that there is no reasonable hope or expectation that the security or debt will recover its value in the future. This is a critical factor in determining whether a security is wholly worthless under section 165 or a debt is wholly worthless under section 166. However, the possibility that a debtor’s financial condition might one day improve has not prohibited creditors from claiming a deduction for partially worthless debt under section 166(a)(2). In none of the cases discussed in which the evidence supported partial worthlessness was the taxpayer required to forestall taking a deduction in the hope that the debtor’s business might one day improve.126

Finally, the existence of an identifiable event may be considered important in the context of a deduction for a wholly worthless debt because of the need to establish a substitute for the closed and completed transaction that would establish a loss (and perhaps a capital loss rather than an ordinary deduction) if the debt were actually sold or discharged at less than the amount owed.127 Whereas the time for claiming a wholly worthless debt deduction is generally fixed by the occurrence of an identifiable event, the time for claiming a deduction for a partially worthless debt is fixed by when the taxpayer charges off a corresponding amount of the debt on its books.128 A charge-off before the taxpayer sells or otherwise disposes of a debt — and independent of that sale, even if the sale occurs in the same tax year — generally allows the taxpayer to claim a partial bad debt deduction.129 As one court explained it (citing section 23(k), the predecessor to section 166):

That section obviously provides a measure of relief for a taxpayer who has suffered a real loss but who has not been able to realize it for tax purposes in the way losses are usually required to be realized before they are recognized i.e. by so dealing with his property that future events will not enable him to recoup in whole or in part. In the statute the usual certainty in that respect is replaced by giving the Commissioner the power to allow a deduction not in excess of the amount charged off when he is satisfied that the debt is recoverable only in part. That can mean only that the amount of the deduction is to be determined by taking into consideration as one factor the amount the taxpayer may reasonably be expected to receive in the future while he continues to be the obligee. The charge-off permitted in section 23(k) is, of course, to let the taxpayer have his gross income for the period reduced by a deduction which he could not otherwise take while the fluctuations in the value of a receivable would change the amount of his actual loss and might wipe it out entirely.130

As the court stated in Findley, “The purpose of the charge-off, in the case of a debt claimed to have become worthless in part, is to perpetuate evidence of taxpayer’s election to abandon part of the debt as an asset . . . — a procedure which is unnecessary in the case of wholly worthless debts, where total worthlessness is the sole test.”131

IV. Crash or Recession: Identifiable Events?

To the extent that either section 165 or section 166 requires the taxpayer to show an identifiable event that establishes worthlessness of a debt instrument, can a market crash or great recession, such as the one of 2007-2009, serve as that identifiable event?132 Neither section 165 nor section 166 was intended to create a mark-to-market regime. In other words, the mere decline in the instrument’s value is not sufficient grounds to claim a deduction under either section 165 or section 166. This is clearly stated in the regulations under section 165. However, events like the recession of 2007-2009 raise the question of whether something other than “mere” market fluctuations may constitute an identifiable event or otherwise help to establish worthlessness or partial worthlessness. Even the language of the section 165 regulations provides an exception for a decline in value when worthlessness is established.133

Several cases regarding worthlessness have indicated that market crashes and similar conditions may constitute identifiable events. In Rhodes,134 the taxpayer claimed a loss in 1927 for property he had acquired for resale but was unable to sell until 1928, and then for only one-twentieth of what he had paid for it. The loss was claimed under the statutory provision that allowed a deduction for losses sustained and for which the taxpayer is not otherwise compensated. The opinion states that courts “may take judicial notice of a business depression and require less specific facts to prove a loss when a depression is current. This does not mean, however, that a taxpayer can justify a loss deduction by merely offering testimony that business generally is depressed or stagnant.”135 Even though the taxpayer later was able to sell the property, the court noted the collapse of Florida property values after earlier years of high-priced speculation as one of the identifiable events that justified a taxpayer’s claim for loss. An earlier case took note of a serious financial depression in late 1920.136 Although the court made no reference to identifiable events, in analyzing whether the taxpayer had ascertained certain debts to be worthless, the court stated:

The petitioner has shown the deplorable conditions in which business found itself in the latter part of 1920 in the States in which petitioner sold its goods. In such circumstances as are shown to have existed, it may be conceded that less specific information with reference to the financial condition of each of its debtors might be required in determining worthlessness than might seem necessary under normal conditions.

As in Rhodes, Florida real estate was at issue in Hauk v. Huwe,137 a case involving a worthless stock deduction. Between 1920 (when it was acquired by the taxpayer) and 1925, the stock of a Florida real estate corporation appreciated significantly. The question before the court was whether the taxpayer was entitled to a worthless stock deduction in 1929, after the corporation’s fortunes had changed. The corporation was admittedly insolvent in 1929. However, the IRS argued that it had been so before 1929, even though, before trial, it argued that the corporation had considerable value in 1929. The court first said, “It is a matter of common knowledge that the crash on the stock market with its resulting effect on all stocks took place in the Fall of 1929.”138 The court then sustained the deduction, concluding that the corporation’s insolvency and the 1929 market crash that caused it were the requisite identifiable events supporting the taxpayer’s claim of worthlessness.139

One court took a similar view of the October 1987 stock market crash. In American Underwriters,140 the taxpayer and its affiliate were in the business of trading securities and high-risk derivatives. The affiliate acquired many of its assets with demand loans from the taxpayer. The affiliate lost $23 million when the stock market fell in October 1987, an event that the court described in some detail and defined as the “Crash” in its opinion. In 1987 the taxpayer forgave $5 million of the $18 million it was owed and demanded payment for the remainder, which the affiliate was unable to repay. The taxpayer claimed a $5 million bad debt deduction in that year. The court recited that worthlessness ordinarily requires a showing of an identifiable event. It went on to say that the determination of worthlessness cannot be based on the taxpayer’s subjective opinion but on a conclusion reached by the taxpayer applying sound business judgment to the factual information it has.141 The court concluded that at least $5 million of the debt owed to the taxpayer was worthless at the end of 1987 because the affiliate was insolvent and that “the cause of [that] insolvency was the Crash, which was sudden and unexpected.”142 One might question whether that description of the crash was intended to distinguish it from a “mere fluctuation in value.”

Other courts, however, have not treated either of these stock market crashes as identifiable events for purposes of claiming a loss under section 165 or a deduction under section 166. Raisseur143 involved a nonrecourse debt secured by stock of a privately held corporation engaged in the securities brokerage business. The corporation had been insolvent for some time, and in 1933 the corporation dissolved, and the taxpayer claimed a bad debt deduction for that year.144 The IRS argued that the worthlessness had occurred in an earlier year. The court held for the taxpayer. Although the court took judicial notice of the “drastic” and “depressive” effect that the October 1929 crash had and continued to have through 1932,145 its conclusion was based in part on the fact that by 1931, the company’s principal asset was bonds issued by International Telegram and Telegraph (IT&T). Although the value of these bonds had dropped, IT&T hadn’t defaulted on any of its payments and remained a solvent corporation. Ultimately, the court viewed this as a mere fluctuation in value. Under the facts of this case, the court viewed the decision to liquidate, rather than the 1929 crash, as the identifiable event that finally determined worthlessness.146

In Furer,147 the taxpayer had purchased stock on margin and, following the October 1987 crash, the stock was sold at a loss to satisfy his debt obligations. The taxpayer argued that his loss should be an ordinary casualty loss, the casualty being the crash. The court analyzed the decline in the stock’s value and the sale separately. Regarding the decline in value, the court referred to reg. section 1.165-4(a)’s prohibition on claiming a loss for a “mere” shrinkage in value, albeit extensive, unless the stock is sold or becomes worthless. The taxpayer claimed that the regulation refers to a “mere shrinkage” in value, that the October 1987 crash was not a “mere” shrinkage and, therefore, the regulation was not applicable. The taxpayer argued that the regulation precluded a deduction only for a gradual market decline and not for a sudden and unexpected crash. The court rejected those arguments. It also said that a casualty loss must generally result from physical damage to property. It is important to note, however, that this case addressed whether a market crash was a casualty and not whether the crash proved that the securities involved were worthless under section 165(g). The taxpayer didn’t argue that the stock was worthless (and, in fact, it was sold at a price greater than $0). Therefore, this case is distinguishable from the cases cited above in which the 1929 or 1989 market crash was held to have been the cause of worthlessness.148

None of the cases discussed above stands for the proposition that fluctuations in value as the result of a severe market crash are sufficient to establish worthlessness or partial worthlessness. However, when that market crash has an adverse impact on the underlying assets or creditworthiness of the debtor, courts have been willing to treat the market crash as an identifiable event or otherwise take it into account in determining worthlessness. In each of the cases discussed and cited (with the exception of Furer), the market crash ultimately affected the value of the assets of the entity that issued the security or debt. Therefore, none of these cases is inconsistent with the notion that a mere fluctuation in value is not a basis for claiming a deduction. In these cases, the market crash either led to the insolvency of the debtor or reduced, or eliminated, the value of collateral securing the debt. In fact, that was the situation in Morton, a case often cited for the standard of proof in worthlessness cases. In Morton, which involved worthless stock rather than debt, the stock at issue was stock of an investment company. The value of its assets was eroded by the 1929 stock market crash, and the value continued to decline as the markets declined through 1932. Although the taxpayer claimed a loss in 1932, the court concluded that the stock was without value before then because of the effects of the 1929 crash. The value of the stock was inextricably linked to the value of the securities owned by the corporation. The court stated:

The assets of the corporation consisted of securities subject to fluctuation, and the ownership of a subsidiary corporation organized to carry on the business of an investment trust of the fixed type which one of the officers of the corporation felt had great possibilities. There is nothing in the record, however, to indicate that any officer or director of the corporation had a hope or expectation that a continued operation of the corporation would result in creating an equity for the holders of its common stock, much less that such a hope and expectation was reasonable under the circumstances.149

The same was true in American Underwriters, as well as in Rhodes and Hauk in which a market depression affected the value of the debtor’s underlying real estate business. Even in Raisseur, in which the court held against the taxpayer, it was looking at the effect of the market crash on the value of the debtor’s underlying assets.

Based on this case law, a taxpayer should expect to have difficulty sustaining a worthless securities or bad debt deduction grounded solely on a market crash or another great recession affecting the value of the security or debt. However, in cases in which a market crisis causes a more fundamental problem with the collateral for the debt or with the business or assets of the issuer, events like the great recession should be taken into account in evaluating worthlessness and, if considered necessary, be treated as the identifiable event that fixes worthlessness. This is consistent with the list of factors considered in American Offshore and other cases, and it is consistent with Morton, one of the earliest and most often-cited cases addressing proof of worthlessness.

FOOTNOTES

1 In addition to the deduction for worthless securities, discussed in this report, section 165 allows a loss arising from theft, casualty, disasters, and wagering transactions (subject to some limitations).

2 Section 165(g)(2)(c).

3 One commentator has suggested that a debt instrument issued by a limited liability company shouldn’t qualify as a security regardless of whether the LLC is a disregarded entity wholly owned by a corporation. David C. Garlock, Federal Income Taxation of Debt Instruments, para. 1603.02[B] (2010).

4 “Registered form” is not defined for purposes of section 165(g). However, for other purposes, section 165(j)(2)(B) defines it with reference to section 163(f)(2). That definition is consistent with case law defining the term for purposes of section 165(g) or predecessor sections. See, e.g., Gerard v. Helvering, 120 F.2d 235 (2d Cir. 1941); Estate of Martin v. Commissioner, 7 T.C. 1081 (1946); and Funk v. Commissioner, 35 T.C. 42 (1960). The reference to debt with interest coupons is presumably a reference to bearer bonds with physically attached interest coupons, which are subject to the limitations on interest deductibility in section 163(f) and the limitations on losses in section 165(j) and, as noted in Garlock, supra note 3, have not been issued in the U.S. public market in decades.

5 Section 166(d). For a noncorporate taxpayer, section 166(d) limits bad debt deductions for nonbusiness debt to wholly worthless debt. Also, deductions for wholly worthless nonbusiness bad debts are treated as short-term capital losses. The determination of whether a particular debt is a nonbusiness bad debt is beyond the scope of this report.

6 Revenue Act of 1894, section 28.

7 Revenue Act of 1918, sections 214(a)(7) (for individuals) and 234(a)(5) (for corporations).

8 Treas. reg. art. 154.

9 Revenue Act of 1921, sections 214(7) and 234(a)(5). The act also allowed a deduction based on a reasonable addition to a bad debt reserve. Section 166 of the code no longer provides a reserve method of accounting for bad debts. Under section 585, some banks are allowed a deduction for a reasonable addition to a bad debt reserve. That method of accounting for bad debts is beyond the scope of this report.

10 Revenue Act of 1932, section 23(j). Regulations in effect before this amendment required a charge-off for partial bad debt deductions. See also Santa Monica Mountain Park Co. v. United States, 99 F.2d 450 (9th Cir. 1938) (concluding that a charge-off was required for a partial bad debt deduction before the 1932 amendment).

11 Treas. reg. 45, art. 141.

12 See Treas. reg. 86, art. 23(e)-1 (1934).

13 Treas. reg. 45, art. 144 and 561.

14 Id.

15 Treas. reg. 45, art. 151.

16 Former section 23(g)(2) and (3) (1938).

17 The legislative history indicates that it was intended to replicate the capital loss treatment upon a sale of a security in cases in which the loss arose from the worthlessness of the security, thus preventing the conversion of a capital loss into an ordinary loss. H. Rep. No. 75-1860, at 18-19 (1938).

18 Former section 23(k)(2) and (3) (1938).

19 Revenue Act of 1942, section 124 (amending section 23(k) of the 1939 IRC). Section 124 also added provisions regarding nonbusiness debt of noncorporate taxpayers.

20 H. Rep. No. 77-2333, at 44 (1942). Neither current nor prior statutes or regulations have defined what constitutes a charge-off. The only requirement is that it be a charge-off of the specific debt. Reg. section 1.166-3(a). One court stated that “anything which manifests the intent to eliminate an item from assets is sufficient.” Commissioner v. MacDonald Engineering Co., 102 F.2d 942, 945 (7th Cir. 1939) (citing Jones v. Commissioner, 38 F.2d 550 (7th Cir. 1930); Stephenson v. Commissioner, 43 F.2d 348 (8th Cir. 1930); and Shiman v. Commissioner, 60 F.2d 65 (2d Cir. 1932)). See also Randolph E. Paul, “Suggested Modifications of the Bad Debt Provision of the Federal Revenue Act,” 22 Cornell L.Q. 196, 201-202 (1936) (discussing the flexible manner in which the courts have approached the charge-off requirement).

21 See reg. section 29.23(k)-1 (1943).

22 See Estate of Fahnestock v. Commissioner, 2 T.C. 756 (1943) (denying partial bad deduction to the extent the amount deducted had become worthless in a prior year on the basis of the 1942 amendments).

23 Revenue Act of 1943, section 113.

24 S. Rep. No. 78-627 (1943) (stating congressional intent to overturn Estate of Fahnestock, 2 T.C. 756).

25 Reg. section 1.166-2(a).

26 Reg. section 1.166-2(c).

27 Reg. section 1.166-2(b).

28 Similar language appeared in Treasury regulations as early as 1934. Treas. reg. 86, art. 23(e)-1 (1934).

29 For an earlier example of a commentator raising numerous questions about the statutory and regulatory provisions regarding deductions for worthless and partially worthless debts and securities, see Paul, supra note 20.

30 See Jerred G. Blanchard Jr. and Garlock, “Worthless Stock and Debt Losses,” 83 Taxes 205, 208 (Mar. 2005) (“If a security becomes worthless . . . the taxpayer may have no opportunity to dispose of the security in a [closed and completed] transaction, for no one would purchase a truly worthless security. To spare taxpayers the unpleasant choice of holding on to declining securities in the hope of a recovery or selling them to take a tax loss, the tax law has long permitted taxpayers to claim a loss for totally worthless securities without the loss being ‘congealed’ via a ‘closed and completed transaction.’”).

31 E.g., United States v. Davenport, 412 F. Supp. 2d 1201, at 1207 (W.D. Okla. 2005); Austin Co. v. Commissioner, 71 T.C. 955, 970 (1979); Delk v. Commissioner, 113 F.3d 984 (9th Cir. 1997); Fairbanks, Morse & Co. v. Harrison, 63 F. Supp. 495, 503 (N.D. Ill. 1945); Mahler v. Commissioner, 119 F.2d 869 (2d Cir. 1941); and Bartlett v. Commissioner, 114 F.2d 634 (4th Cir. 1940) (court describes requirement to show identifiable event for worthless stock deduction as softening the harsh rule that the deduction is allowed only in the year in which worthlessness actually occurs by allowing these events to fix the time when worthlessness occurs).

32 United States v. S.S. White Dental Manufacturing Co., 274 U.S. 398 (1927).

33 Boehm v. Commissioner, 326 U.S. 287 (1945).

34 Morton v. Commissioner, 38 B.T.A. 1270 (1938), aff’d, 112 F.2d 320 (7th Cir. 1940).

35 White Dental Manufacturing, 274 U.S. at 401 (citations omitted).

36 The taxpayer’s case was very sympathetic. Given that the government was arguing that a completed transaction was required, it is not surprising that the Court characterized the seizure as a completed transaction rather than concluding that it was some other sort of event or discussing what would constitute an identifiable event.

37 For the language of that regulation, see the text accompanying note 15, supra.

38 Boehm, 326 U.S. at 292. Regulations promulgated under the 1934 code introduced the language that a loss generally “be evidenced by closed and completed transactions, fixed by identifiable events, bona fide and actually sustained during the taxable period for which allowed.” Treas. reg. 86, art. 23(e)-1.

39 When Boehm was decided, this conclusion was particularly harsh because the taxpayer would have been unable to claim a refund for the earlier year in which the IRS found the stock to have been worthless. The refund had to be filed within three years from the time the original return was filed. The Revenue Act of 1942 provided some relief by allowing a seven-year period in which to file a refund claim attributable to a bad debt or a worthless security. Revenue Act of 1942, section 169. That rule now appears in section 6511(d)(1).

40 See also Boesel v. Commissioner, 208 F.2d 817, 819 (2d Cir. 1954) (“The way of the taxpayer is hard who tries to fix the loss of a capital investment by anything except a sale. But the principles of law which govern such situations are clear and have long been settled. There must be some identifiable event which shows that a loss was actually sustained in the taxable period. The mere subjective conclusion of petitioner that the loss then took place will not suffice.”) (citing Boehm; case did not involve a worthless securities deduction).

41 Morton, 38 B.T.A. at 1277.

42 Id. at 1278-1279.

43 Id. at 1279.

44 See also Bilthouse v. United States, 553 F.3d 513 (7th Cir. 2009) (court acknowledged that there was no definitive event establishing worthlessness in a year before the year in which the worthless stock deduction was claimed, but it concluded that facts and circumstances indicated worthlessness had occurred in the earlier year); Steadman v. Commissioner, 424 F.2d 1 (6th Cir. 1970), aff’g 50 T.C. 369 (citing Morton, worthless stock deduction allowed based on insolvency and huge net operating loss, even though the corporation continued in operation); Keeney v. Commissioner, 116 F.2d 401, 403 (2d Cir. 1940) (a taxpayer cannot “postpone his claim of loss until only an ‘incorrigible optimist’ would fail to know that the stock had become worthless at an earlier date”).

45 Although White Dental Manufacturing also involved a bad debt deduction, the Court’s analysis was not based on the section of the Revenue Act of 1918 providing for a bad debt deduction but on the separate section providing for a deduction for uncompensated losses. Further, the Court based its decision on finding that a transaction took place in the year at issue (i.e., the seizure of assets by the German government).

46 Courts seem to take the view that requiring an identifiable event for worthless stock softens the harsh rule that the deduction is allowed only in the year in which worthlessness actually occurs. Perhaps the premise is that it is much more likely that taxpayers will be aware of these events. See Bartlett, 114 F.2d 634. See also Morton, 38 B.T.A. at 1278 (identifiable event “likely to be immediately known”); Mahler, 119 F.2d 869 (“In establishing the date of worthlessness of stock, the taxpayer is aided by the rule that the date is to be fixed by ‘identifiable events.’”); and Keeney, 116 F.2d at 403 (“It is true that some liberality is accorded to the taxpayer, and this has taken the form of requiring that worthlessness be established by some identifiable event.”).

47 Bonynge v. Helvering, 117 F.2d 157 (2d Cir. 1941) (“One can say with greater assurance that an apparently irretrievable financial collapse today makes worthless a note due next year, than it does a bond payable in ten years.”); see also In re Walmsley, 112 A.F.T.R. 2d 2013-6238 (Bankr. D. Or. 2013) (taxpayer’s summary judgment motion regarding a bad debt deduction was denied when the taxpayer provided no evidence of when the purported debt was due).

48 As discussed later in this report, under current law, deductions for partially worthless bad debts are not required to be claimed in the tax year in which the debt becomes partially worthless but may be claimed in a later year.

49 James A. Messer Co. v. Commissioner, 57 T.C. 848, 861 n.3 (1970) (“Prior to . . . 1942 the test of worthlessness was subjective.”); Redman v. Commissioner, 155 F.2d 319, 320 (1st Cir. 1946) (“The test of ascertainment of worthlessness under section 23(k) before the 1942 amendment was deemed to be a subjective test rather than an objective one.”); and Harris v. Commissioner, 140 F.2d 809 (2d Cir. 1944). Although Messer cites congressional reports for the premise that the 1942 amendments stressed identifiable events and circumstances, none of the reports cited by the court use the phrase “identifiable events.” See H. Rep. No. 77-2333, at 76 (1942); and S. Rep. No. 77-1631, 89-90 (1942).

50 San Joaquin Brick Co. v. Commissioner, 130 F.2d 220, 226 (9th Cir. 1942). (“The taxpayer must present evidence . . . to show: (1) That the debt actually was uncollectible during the year in which he claims the deduction and (2) that he actually ‘ascertained’ that fact for the first time during the tax year in question.”). See also Fairbanks, Morse & Co., 63 F. Supp. 495 (same); Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566, 579 (1927) (“Nor is it a question whether the taxpayer believed the debt to be worthless. To so hold would be to grant an undue advantage to the pessimist or to the taxpayer who made no investigation. In our opinion the burden upon the petitioner is to show what steps he took to collect the debt, what information came to his knowledge and what other circumstances existed which led him to his conclusion.”).

51 The court in Minneapolis, St. Paul & Sault Ste. Marie Railroad Co. v. United States, 164 Ct. Cl. 226, 239-240 (1964), concluded that the change in law from a subjective test to an objective test related to questions of timing, stating, “The test of worthlessness prior to the 1942 amendments was deemed to be a subjective rather than objective one, and the taxpayer could properly claim the deduction in the year in which there was a bona fide ascertainment by the taxpayer of the worthlessness of a debt irrespective of whether its worthlessness could have been ascertained prior to the year when it was discovered, so long as taxpayer exercised reasonable judgment.” See also Fairbanks, Morse & Co., 63 F. Supp. at 501 (“This involves a subjective test; that is, the proper year to claim the deduction is the one in which the taxpayer ascertained the debt to be worthless and charged it off.”).

52 E.g., Quinn v. Commissioner, 111 F.2d 372 (5th Cir. 1940) (taxpayer failed to show that he made an effort to ascertain a debt’s worthlessness by conducting a reasonable investigation of the facts); see also Santa Monica Mountain Park, 99 F.2d 450 (taxpayer claimed bad debt deduction in an amended return filed in a later year; case decided based on failure to charge off the debt, although court noted that the ascertainment of worthlessness occurred in the later year); James A. Messer Co., 57 T.C. 848; Redman, 155 F.2d 319; and Harris, 140 F.2d 809.

53 E.g., Watkins v. Glenn, 88 F. Supp. 70 (D. Ky. 1950); James A. Messer Co., 57 T.C. 848; and Wolfson v. Commissioner, T.C. Memo. 1982-698.

54 Dewey v. Commissioner, T.C. Memo. 1993-645 (although debtor was in bankruptcy proceedings, taxpayer failed to provide any evidence regarding the specifics of the bankruptcy proceeding); Jasinski v. Commissioner, T.C. Memo. 1978-1 (balance sheet showing insolvency was based on book values, not fair market values, and if amounts owed to and by subsidiaries were ignored, debtor was solvent); Brown v. Commissioner, T.C. Memo. 1988-174 (debtor’s bankruptcy petition indicated holders of debt in question would recover over 40 percent of the value of their claims); Favia v. Commissioner, T.C. Memo. 2002-154 (failure to prove insolvency of debtor).

55 Jasinski, T.C. Memo. 1978-1.

56 Estate of Hoffman v. Commissioner, 8 Fed. Appx. 262 (4th Cir. 2001).

57 See also Franklin v. Commissioner, T.C. Memo. 2020-127 (although the court references a failure to provide evidence pointing to specific, identifiable events causing one debt to be worthless, for a second debt at issue, the court didn’t reference that failure but rather a failure to provide any evidence explaining why the debt was worthless).

58 See also Cox v. Commissioner, 68 F.3d 128 (5th Cir. 1995) (court states requirement of identifiable event; however, notwithstanding debtor’s bankruptcy filing, other evidence indicated the debt had some value).

59 Dustin v. Commissioner, 53 T.C. 491, 501, aff’d, 467 F.2d 47 (9th Cir. 1972).

60 Id. at 501.

61 Id. at 502.

62 Also, the court referenced the fact that the loans were not memorialized by notes; they were entries in a general ledger with no specified maturity date.

63 E.g., O’Neal’s Feeder Supply Inc. v. Commissioner, No. 2:96-cv-0514 (W.D. La. 2000); Shaw v. Commissioner, T.C. Memo. 2013-170; and Rendall v. Commissioner, T.C. Memo. 2006-174.

64 E.g., Reading & Bates Corp. v. United States, 40 Fed. Cl. 737 (1998); Buchanan v. United States, 87 F.3d 197 (7th Cir. 1996); Walmsley, 112 A.F.T.R. 2d 2013-6238; Intergraph Corp. v. Commissioner, 106 T.C. 312 (1996); and Estate of Arcy v. United States, 579 F. Supp. 485 (E.D. Mich. 1983).

65 Levin v. United States, 220 Ct. Cl. 197 (1979).

66 There are sometimes references to the need to show more than one identifiable event. See, e.g., Garlock, supra note 3. Rather than requiring multiple identifiable events to sustain a deduction for a worthless debt, it seems more accurate to say that the courts will permit a variety of events and circumstances to be considered in lieu of a single, clearly identifiable event. For example, in Minneapolis, St. Paul & Ste. Marie Railroad Co., 164 Ct. Cl. 226, a case regarding total worthlessness, the court appears to have been permitting, rather than requiring, multiple identifiable events to be used when a single event was not clearly identifiable. Further, several cases show that a single identifiable event may be sufficient to establish the tax year in which total worthlessness occurs. E.g., Denman v. Brumback, 58 F.2d 128 (6th Cir. 1932); and Davenport, 412 F. Supp. 2d 1201.

67 See, e.g., Steadman, 50 T.C. at 376-377.

68 See, e.g., Estate of Mann v. Commissioner, 731 F.2d 267 (5th Cir. 1984) (debtor’s involuntary bankruptcy filing not dispositive of worthlessness of debt); FSA 200226004 (“The [identifiable] events listed in Morton are not conclusive of worthlessness in themselves. . . . Identifiable events must be analyzed in the context in which they occur to determine if they either evidence or cause the utter worthlessness.”).

69 Dallmeyer v. Commissioner, 14 T.C. 1282 (1950).

70 See also Favia, T.C. Memo. 2002-154 (section 165(g) deduction disallowed despite the debtor’s bankruptcy filing when financial statements indicated that assets exceeded liabilities).

71 Mack v. Commissioner, T.C. Memo. 1995-482.

72 See also Goldberg v. Commissioner, T.C. Memo. 1970-27 (debtor filed petition for reorganization under Bankruptcy Act, but in concluding security was worthless, court analyzed financial condition of debtor).

73 American Offshore Inc. v. Commissioner, 97 T.C. 579 (1991).

74 Id. at 596. Notably, the court didn’t discuss whether the industry might recover. See also Moore v. Commissioner, 943 F. Supp. 603 (E.D. Va. 1996) (citing frequently Cole v. Commissioner, 871 F.2d 64 (7th Cir. 1989)). In Cole, the court listed factors very similar to those listed in American Offshore but held against the taxpayer after applying those factors to the facts of the case.

75 Owens v. Commissioner, T.C. Memo. 2017-157.

76 The 2008 default could be viewed as an identifiable event. However, the court said that the IRS viewed only the 2009 bankruptcy as a “good” identifiable event, id. at 1103, and the court didn’t call out the default as an identifiable event but instead treated it as part of a facts and circumstances analysis.

77 See also Bercy v. Commissioner, T.C. Memo. 2019-118 (court stated that sale of the debtor’s assets was an identifiable event but also referred to a requirement to examine all circumstances and concluded that the taxpayer reasonably abandoned hope of recovery and exercised sound business judgment in determining the year of worthlessness).

78 2590 Associates LLC v. Commissioner, T.C. Memo. 2019-3.

79 Id. at 34. The court cited American Offshore, 97 T.C. 579, for the first and third sentences.

80 Id. at 36. Because of procedural rules concerning when the IRS raised the issue of the year of worthlessness, the IRS bore the burden of proof in this case.

81 Lagoy v. Commissioner, T.C. Memo. 1992-213.

82 Riss v. Commissioner, 478 F.2d 1160 (8th Cir. 1973).

83 Id. at 1166 (citations omitted). This standard is reminiscent of the language used by courts when a deduction was allowed for debt when ascertained by the taxpayer to be worthless.

84 See also Levin, 220 Ct. Cl. 197 (court held that debt became worthless in an earlier year, with no discussion of identifiable events).

85 See text accompanying note 65, supra.

86 Interestingly, although the IRS made no reference to identifiable events, the only case it cited in the ruling was White Dental Manufacturing, one of the cases often cited for a requirement to show an identifiable event. The case is cited for the proposition that a debt is worthless when “there is little or no chance of further payments of the debt.”

87 FSA 200242004 and FSA 200226004.

88 See reg. section 1.165-1(d)(2)(iii) (if subsequent reimbursement for loss is made, income is included in the year of reimbursement). The same rule applies in the context of section 166 under reg. section 1.166-1(f).

89 See Garlock, supra note 3 (“this system was not the product of any systematic thought but rather resulted from a series of legislative changes without anyone taking into account all of the relevant policy considerations”). When the predecessor to section 165(g) was enacted in 1938, the legislative history indicates that it was intended to replicate the capital loss treatment upon a sale of a security when the loss arises from worthlessness of the security. H. Rep. No. 75-1860, at 18-19 (1938). However, the application of section 165(g) is no longer limited to capital assets. See reg. section 1.165-5(b). The inability to reconcile the provisions governing losses and those governing bad debt deductions was noted as early as 1936 by one commentator. See Paul, supra note 20.

90 Reg. section 1.166-2.

91 Reg. section 1.166-2(a).

92 For a taxpayer that is not a corporation, a partial bad debt deduction may not be claimed for a nonbusiness bad debt. Section 166(d)(1).

93 Findley v. Commissioner, 25 T.C. 311 (1955), aff’d per curiam, 236 F.2d 959 (3d Cir. 1956) (deduction denied because the debtor’s financial condition had not changed since the debt was created).

94 Id. at 318. The IRS quoted this part of the Findley decision in FSA 1993-623 (dated July 31, 1992).

95 Austin, 71 T.C. 955.

96 Portland Manufacturing Co. v. Commissioner, 56 T.C. 58 (1971).

97 Spratt v. Commissioner, 43 B.T.A. 503 (1941) (deduction denied because of insufficient evidence on the value of the debtor’s debt and assets); Imperial Furniture Co. v. Commissioner, 9 B.T.A. 713 (1927) (deduction allowed); Thompson v. Commissioner, T.C. Memo. 1983-81 (deduction denied because of insufficient evidence); Elmira City Realty Corp. v. Commissioner, T.C. Memo. 1957-53 (deduction allowed when the debtor was unable to pay a demand note even though the individual debtor was still alive and might at some point be able to repay the note; decision was based on the debtor’s financial and professional state); Flynn v. Commissioner, B.T.A. Memo. 1942-136 (interestingly, in Flynn, the board’s decision upholding the deduction rested on the debtor’s financial condition, with no mention of a requirement to show an identifiable event, yet it stated explicitly that a taxpayer claiming a partially worthless bad debt deduction must meet the same requirements as one claiming a wholly worthless bad debt deduction).

98 O’Neal’s Feeder Supply, No. 2:96-cv-0514; James A. Messer Co., 57 T.C. at 861 (“Prior to these [identifiable] events the debt was only partially worthless, the extent of worthlessness fluctuating with the market value of the land and building.”); Cox v. Commissioner, T.C. Memo. 1994-189, aff’d, 68 F.3d 128 (5th Cir. 1995) (court cites lack of proof of an identifiable event as a basis for disallowing a deduction under section 166(a)(1) and immediately thereafter notes that petitioner failed to prove or argue that the debt had become partially worthless, suggesting a different standard may have applied).

99 ABC Beverage Corp. v. Commissioner, T.C. Memo. 2006-195.

100 Id. at 17.

101 See section 1271(a)(1). Also, there is no statement in the facts of the case as to whether the taxpayer charged off the debt and, if it did, whether the charge-off occurred before the collateral was seized and the debtor was released from its obligation.

102 American Offshore, 97 T.C. 579.

103 Specifically, American Offshore cites White Dental Manufacturing, 274 U.S. 398; Dallmeyer, 14 T.C. 1282; Riss, 478 F.2d 1160; Crown v. Commissioner, 77 T.C. 582, 598 (1981); and Hubble v. Commissioner, T.C. Memo. 1981-625.

104 See text accompanying notes 72-73.

105 Similar factors have been cited by other courts. See Cole, 871 F.2d 64.

106 Id.

107 Portland Manufacturing, 56 T.C. 58; and Brandtjen & Kluge Inc. v. Commissioner, 34 T.C. 416 (1960) (partial worthlessness established solely by reference to the steady deterioration of the debtor’s business).

108 Portland Manufacturing, 56 T.C. 58.

109 Turbeville v. Commissioner, 31 B.T.A. 283 (1934).

110 Flynn, B.T.A. Memo. 1942-136.

111 Imperial Furniture, 9 B.T.A. 713.

112 See also Brandtjen, 34 T.C. 416.

113 As set forth in Section II.A of this report, section 166(a)(2) imposes two requirements that a taxpayer must satisfy to claim a deduction for partially worthless debt: (1) the taxpayer must demonstrate that the debt is recoverable only in part in the amount claimed by the taxpayer, and (2) the taxpayer must charge off that amount from the debt in the tax year in which the taxpayer claims the deduction. Unlike deductions for wholly worthless securities or wholly worthless debts, section 166(a)(2) states that if these two requirements are satisfied, the IRS “may allow” the partial bad debt deduction.

114 E.g., Estate of Fahnestock, 2 T.C. at 759.

115 Austin, 71 T.C. 955. See also Clark v. Commissioner, 85 F.2d 622 (3d Cir. 1936).

116 Austin, 71 T.C. at 971.

117 Id. at 972.

118 Davenport, 412 F. Supp. 2d at 1207; Austin, 71 T.C. 955, 970 (1979); Delk, 113 F.3d 984; Fairbanks, Morse & Co., 63 F. Supp. at 503; Mahler, 119 F.2d 869; and Bartlett, 114 F.2d 634.

119 Austin, 71 T.C. at 970. The president’s last name was Austin and, therefore, although not stated in the opinion, was also presumably affiliated in some way with the taxpayer corporation.

120 Id.

121 Id. at 973.

122 Clark, 85 F.2d 622.

123 Id. at 625. See also Estate of Fahnestock, 2 T.C. 756 (the IRS abused its discretion by determining that no part of the debt in question was worthless; the taxpayer’s evaluation of the debtor’s financial situation supported the amount claimed to be partially worthless). Recall that Estate of Fahnestock was decided during the period between 1938 and 1942, when Congress had inadvertently limited the partial bad debt deduction to an amount that became worthless in the tax year. See text accompanying notes 22-24, supra.

124 Brandtjen & Kluge, 34 T.C. 416.

125 As one court has noted, “And nothing seems to be better settled than that partial worthlessness, as distinguished from total uncollectibility, is a ground for deduction which may be pursued or relinquished by a taxpayer entirely at his option. If he fails to take a deduction for partial worthlessness in any year, it does not have the effect of foreclosing him from a reliance upon different developments at another time.” Moock Electric Supply Co. v. Commissioner, 41 B.T.A. 1209, 1211 (1940); see also Findley, 25 T.C. 311; E. Richard Menig Co. v. Commissioner, 9 T.C. 976, 979 (1947) (“The taxpayer can wait until the later date and deduct the entire partial worthlessness at that time, even though a part of it may have occurred in a prior year.”).

126 See, e.g., Brandtjen & Kluge, 34 T.C. at 444 (“And whether by better planning and management the losing venture could ultimately become a profitable one, we are satisfied, on the evidence, that in the years in question the receivables were in fact worthless to the extent claimed.”).

127 See text accompanying note 88, supra.

128 Section 166(a)(2); reg. section 1.166-3(a)(2)(i). A leading commentator noted: “In general, a taxpayer’s partial charge-off of a debt does not establish that the debt was worthless to the extent of the charge-off. In practice, however, most corporations . . . are reluctant to charge off receivables. Perhaps for this reason, the Service historically has not challenged a taxpayer’s tax deduction for a partially charged-off debt on factual grounds.” Garlock, supra note 3 (citations omitted). The commentator also notes that the IRS’s practice may change given the significant amount of charge-offs claimed in connection with the 2008 financial crisis. If a deduction claimed in the year of charge-off is disallowed, the charge-off in the prior year will satisfy the charge-off requirement if the taxpayer claims partial worthlessness of the same debt in a later year. Reg. section 1.166-3(a)(2)(ii).

129 E.g., Levine v. Commissioner, 31 T.C. 1121 (1959). Compare Ardela Inc. v. Commissioner, T.C. Memo. 1969-83 (even if partial worthlessness had been proven, the court denied the deduction because the charge-off occurred after the taxpayer disposed of the note in question).

130 Levy v. Commissioner, 131 F.2d 544 (2d Cir. 1942). The importance of the charge-off as, effectively, the substitute for an identifiable event is also supported by the decision in Brandtjen & Kluge, 34 T.C. 416, in which the court spent considerable time discussing whether the taxpayer had properly charged off part of a debt on its books during the tax year in which a deduction for partially worthless debt was claimed but did not require the taxpayer to show that an “identifiable event” had occurred in such year.

131 Findley, 25 T.C. at 319. Cf. Wolfson, T.C. Memo. 1982-698 (referring to a charge-off as an identifiable event).

132 Similar questions were raised in Paul, supra note 20, regarding how courts might address the Great Depression in the context of claims of worthlessness.

133 Reg. sections 1.165-4(a) (last sentence) and 1.165-5(f) (cross-referencing reg. section 1.165-4(a)).

134 Rhodes v. Commissioner, 100 F.2d 966 (6th Cir. 1939).

135 Id. at 969.

136 Higginbotham-Bailey-Logan, 8 B.T.A. at 579 (allowing the deduction for some debts and disallowing it for others for which insufficient facts as to the specific debtor were shown).

137 Hauk v. Huwe, 37-2 U.S.T.C. para. 9342 (S.D. Ohio 1937).

138 Id.

139 See also Dressler v. Commissioner, B.T.A. Memo. 1935-310 (taxpayer entitled to a worthless stock deduction for corporation engaged in the business of investing in securities that became insolvent after the 1929 crash); Stoddard v. Commissioner, B.T.A. Memo. 1935-334 (1929 crash left debtors unable to sell stock of their corporation that secured the debt and the proceeds of which were intended to repay the taxpayer; facts supported bad debt deduction); American Equipment Co. v. Commissioner, B.T.A. Memo. 1933-389 (court noted the stock market crash of 1929, which left debtor substantially without any assets of value, as a factor that allowed the taxpayer to claim a deduction for a wholly worthless debt).

140 American Underwriters v. Commissioner, T.C. Memo. 1996-548.

141 The court’s opinion speaks in terms of total worthlessness, but this appears to be a partially worthless debt case.

142 American Underwriters, T.C. Memo. 1996-548, at para. 66.

143 Raisseur v. Commissioner, 129 F.2d 820 (8th Cir. 1942).

144 The taxpayer was a stockholder in the same corporation and also claimed a worthless stock deduction.

145 Raisseur, 129 F.2d at 822.

146 The court’s discussion in this regard was on the worthlessness of the stock in the corporation. It applied the same analysis to the bad debt deduction as well. However, for the year at issue, the stock loss would be allowed only when the stock was actually worthless, whereas the bad debt deduction would be allowed in the year in which the taxpayer reasonably ascertained that the debt was worthless.

147 Furer v. Commissioner, T.C. Memo. 1993-165, aff’d, 33 F.3d 58 (9th Cir. 1994).

148 Taghadoss v. Commissioner, T.C. Summ. Op. 2008-44, presented the question of whether a casualty loss could be claimed for WorldCom stock that ceased to be transferable. Citing Furer, the court disallowed the deduction. Although worthlessness had not been raised by either party, the court considered it as a basis for the deduction but concluded that the taxpayer had failed to submit evidence showing that the stock had value at the beginning of the tax year or that the stock had no value at the end of the tax year.

149 Morton, 38 B.T.A. at 1280.

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