Background. IRC Section 1234A of the Internal Revenue Code has emerged from its relative obscurity and been the subject of several important cases and rulings in 2016. Prior to the expansion of IRC Section 1234A in 1999, taxpayers were often able to choose the tax character of a transaction by using or not using a sale or exchange. IRC Section 1234A was enacted to ensure that gains and losses from an equivalent transaction receive comparable tax treatment.
IRC Section 1234A treats any gain or loss attributable to the cancellation, lapse, expiration or other termination of a right or obligation regarding property that is (or would upon acquisition by the taxpayer be) a capital asset of the taxpayer as capital gain or loss. Despite its broad purposes and compact language, after almost 20 years there are still no regulations. Some of the ways in which IRC Section 1234A has recently been interpreted include:
Merger Termination Fees. The IRS ruled that a break-up fee paid by a taxpayer or acquiring corporation to the target corporation to terminate a merger agreement is a capital loss and not an ordinary deduction. Since the stock in the target corporation to be acquired in the merger would have been a capital asset of the taxpayer, and the merger agreement gave the taxpayer rights concerning such stock, the IRS determined that IRC Section 1234A applied.
Treating the termination fee as a capital loss is a change from the IRS’s prior position and the way most taxpayers have reported such a payment. Further, it significantly increases the cost of the break up, by virtually eliminating any tax benefit from the payment. Capital losses are deductible only against capital gains, and operating corporations usually do not generate capital gains.
The IRS has applied the same analysis to treat the target’s receipt of a termination fee as capital gain. In such a case, however, the target’s capitalized expenses in the course of the transaction prior to termination reduce such capital gain, and if greater than the fee, create a capital loss. Capital gain treatment may be more favorable in the case of a non-corporate taxpayer who may benefit from lower tax rates on net long-term capital gains.
Forfeited Deposit Is Ordinary Income. In the recent case of CRI-Leslie, LLC, the Tax Court held that a taxpayer who retained a deposit upon the termination of a contract to sell real property was not covered by IRC Section 1234A and therefore the retained deposit constituted ordinary income. Since the real property constituted IRC Section 1231 property (real property used in a trade or business that was held for more than one year), the court determined it was not a capital asset (even though net gain from the sale of IRC Section 1231 property is treated as capital gain). Since the statute refers only to capital assets, IRC Section 1234A did not apply. Absent a sale or exchange, the income is ordinary income. Many commentators thought the case would be decided differently, since the legislative history contains an example of dealing with real property, which would have been IRC Section 1231 property.
Payments Under Participation Agreement Are Ordinary. The IRS ruled that an amount received by an individual under his or her purchased interest in a settlement agreement constitutes ordinary income. There was no sale or exchange of property. Moreover, IRC Section 1234A did not apply because the payments were received pursuant to the taxpayer’s interest; there was no separate cancellation, lapse, expiration or termination.
Abandonment Loss. An abandonment of a capital asset is not specifically listed in the litany of transactions to which IRC Section 1234A applies. In Pilgrim’s Pride Corp., the Tax Court held that an abandonment of preferred stock terminated the taxpayer’s rights with respect to the stock and, accordingly, came within the requirements of IRC Section 1234A. On appeal, the U. S. Court of Appeals for the Fifth Circuit reversed, holding: “By its plain terms, §1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g., derivative or contractual rights to buy or sell capital assets). It does not apply to the termination of ownership of the capital asset itself.” It remains to be seen whether the Tax Court will continue its position outside the Fifth Circuit.
The case is even more interesting because of the tax avoidance motive for the abandonment. The taxpayer, who had purchased the preferred stock for $100,000,000, turned down an offer to sell the stock for $20,000,000, in favor of the abandonment. The tax saving from the ordinary loss on abandonment exceeded the potential sale price and benefit from a capital loss.
Of course, the receipt of any consideration by the taxpayer, including the transferee taking the property subject to a liability, converts the abandonment into a sale.