In order to take a worthlessness deduction for an equity investment in an entity, including an equity interest in a corporation or a partnership, the taxpayer must show that the instrument is worthless (no value at all), and must support the year of worthlessness with identifiable events occurring in that year. In addition, if a worthlessness deduction is not taken in the year the instrument became worthless, the ability to take a deduction under section 165 will likely be lost. The determination of both the fact of worthlessness and the year of worthlessness requires a significant amount of factual development and analysis. This article addresses a recent Tax Court case that held that a junior security could be worthless, even if the entity that issued the junior security still had some value.

In McM Investment Management, LLC (Dec. 10, 2019),1 the Tax Court applied the worthlessness tests of section 165 to equity investments in a partnership. In this case, the taxpayer (McM) owned an interest in, and had provided debt financing to, McMillin Companies, LLC, an entity classified as a partnership for tax purposes (the LLC). The LLC was engaged in real estate development and sales in California and Texas and suffered losses in its business operations during the economic downturn of 2007-2009. McM took a worthlessness deduction on its 2009 federal income tax return in the amount of $40,962,936, with respect to the junior equity position it held in the LLC. The IRS objected to the deduction.

The Tax Court reviewed, in detail, the LLC’s capitalization and debt financing as well as its declining business operations. Before 2008, McM had invested significant cash in the LLC in exchange for units in the LLC. At times after the investment, some of the units held by McM were transferred to family members or retained by McM.

The court noted that, during 2008, the LLC breached a number of the covenants in its bank debt. As described in the opinion, in an effort to bring the company into compliance with the covenants, the LLC and a related entity formed Holdings (a Delaware LLC, taxed as a partnership) in October 2008, and contributed cash in exchange for equity interests in Holdings. Holdings used the cash to purchase, at a discount, third-party subordinated debt that the LLC owed. In December 2008, Holdings contributed this subordinated debt of the LLC to the LLC in exchange for preferred equity in the LLC, which temporarily alleviated the minimum net-worth and other covenant breaches under the senior debt. The LLC’s operating agreement provided that Holdings’ preferred interest and accrued cumulative preferred return interest was senior to any interest that McM held. Thus, at the beginning of 2009, the capitalization of the LLC was as follows:

  • senior debt in the amount of $70 million
  • preferred equity interest in the LLC held by Holdings (which was largely owned by the LLC), with a preferred interest and accrued but unpaid cumulative preferred return in the amount of $71 million
  • Class A equity owned by certain McMillin family member LLCs and McM.

The business did not improve in 2009, and the LLC sought additional and alternative forms of financings, and also considered the possibility of bankruptcy. No additional funding was available. The LLC performed a liquidation analysis and determined that, if it were to liquidate, the available assets would be sufficient to pay off only $51 million of the $70 million of the outstanding senior debt. Thus, no funds would be available to pay Holdings, which was in a senior position to McM, making it apparent that no funds would be available to pay McM in a liquidation of the LLC. Thus, on McM’s 2009 Form 1065, an ordinary loss was reported with respect to the worthless equity interests it held in the LLC.

In allowing the section 165 deduction for McM’s worthless equity interest in the LLC, the Tax Court accepted McM’s subjective belief — based on all the facts concerning the LLC’s outstanding debt, preferred interests, liquidation preferences, business operations and business prospects as of the end of the tax year of 2009 — that McM’s investment in the LLC was worthless. The Tax Court reviewed the detailed information on business prospects, prior efforts to renegotiate debt, lack of sales or ability to develop current properties and sell them at a profit, as well as the declining market for real estate during the 2007-2009 downturn. The Tax Court then evaluated whether McM’s equity interest in the LLC was worthless under the relevant objective factors, including that the fact of worthlessness is based on fixed and identifiable events evidenced by closed and completed transactions in the year in which worthlessness is claimed.2

While the IRS argued that McM, in taking a worthlessness deduction for its equity interest in the LLC, "failed to show that all possibilities of eventual profit had effectively been destroyed,"3 the Tax Court found that a subordinate interest in an entity may be worthless if there are not enough funds currently, or anticipated, to pay the senior interests. In this case, McM was successful in showing relevant factors indicating that identifiable events demonstrating worthlessness occurred in 2009, and, thus, a deduction in that year was proper.

The IRS also argued that the LLC continued in existence after 2009, and, thus, no deduction in 2009 was proper. The Tax Court found that a taxpayer taking a worthlessness deduction for its particular equity interest does not need to prove that no asset held by the entity has value, just that the taxpayer taking the deduction no longer had rights to any proceeds that would be distributed when, and if, the entity liquidated because the equity interest held by the taxpayer was subordinate to more senior interests. Thus, the Tax Court found that the events in 2009 were fixed and identifiable events demonstrating the fact of worthlessness of the equity interest held directly by McM. Note that the case did not address the worthlessness of the preferred equity held by Holdings, but it did provide that, even though McM held an interest in the preferred equity through its ownership in Holdings, that fact did not preclude McM taking the worthless security deduction for the common equity it held directly in the LLC.4

Takeaways

In order to take a worthless stock or worthless security deduction, or take a worthlessness deduction for a partnership interest, a taxpayer must take several steps: (1) document the tax basis in the interest; (2) provide facts indicating that the interest was not worthless prior to or after the year in which worthlessness is being claimed; (3) provide facts indicating an identifiable event that is a closed and completed transaction occurred during the taxable year in which the deduction is taken; (4) document that no future value is expected with respect to the interest; and (5) show that no insurance or salvage was paid as an offset to worthlessness.

Certain ancillary documents and information may be reviewed to indicate the fact and the year of worthlessness, including financial statements showing that the asset has been written off as having no value, a sale transaction, a bankruptcy or workout transaction, balance sheets demonstrating insolvency for the corporation, or a liquidation analysis. Because the fact of worthlessness and the timing of that worthlessness are facts-and-circumstances tests, taxpayers should assemble all the appropriate documents to demonstrate the relevant value and timing benchmarks necessary to take the deduction in a particular tax year. A taxpayer may consider engaging a third party to provide valuations or other documents relevant to the worthlessness determination, such as a liquidation analysis.

As a practical note, the IRS has the benefit of hindsight in evaluating the facts indicating worthlessness and may not agree with the taxpayer’s conclusions as to the fact of worthlessness and/or the timing of that worthlessness. Thus, taxpayers should prepare their tax files in anticipation of having to support their worthless deduction positions if an exam occurs with respect to the deduction.