Property Abandonment Results in Capital Loss: 'Pilgrim's Pride'
A loss may be recognized for tax purposes through an abandonment of property, including a "security," such as shares of stock in a corporation or a bond or debenture issued by a corporation or governmental entity, intangible property other than a security, and tangible property. In general, the amount of the loss will be the owner's adjusted basis in the property immediately before the disposition. In the case of a security, an abandonment will be considered to have occurred if the owner "permanently surrender[s] and relinquish[es] all rights in the security and receive[s] no consideration in exchange for the security."1
It has long been thought that an abandonment may in many cases give rise to an ordinary deduction, rather than a capital loss, which arises upon a "sale or exchange" of a capital asset. The difference in character may be critical in determining the extent of any tax benefit resulting from the abandonment. For example, a capital loss may be used, generally, to offset capital gains only. By contrast, the use of ordinary losses is not so limited, and further savings may result from the rate differential for individuals between long-term capital gains and other income.
In a recent decision relating to the abandonment of a security, the Tax Court held that the resulting loss must be treated as a loss from the sale or exchange of a capital asset (and hence as a capital loss) pursuant to Internal Revenue Code (IRC) §1234A, if the abandoned property had been held by the taxpayer as a capital asset.2 This surprising decision has significant implications for the tax treatment of losses arising on the abandonment of all sorts of property, whether or not constituting "securities."
Facts in 'Pilgrim's Pride'
Pilgrim's Pride was the successor to Gold Kist (Co-op).3 In connection with Co-op's sale of a division to Southern States Cooperative (Southern), Co-op obligated itself to purchase, for $98.6 million, a package of (i) preferred stock of Southern and (ii) other financial instruments issued by Southern States Capital Trust I (Trust), a Delaware statutory trust established by Southern (collectively the "securities").4 This purchase was effected in 1999.
Roughly five years later, and in connection with plans to merge Co-op into a for-profit business corporation, the stock of which would become publicly traded, Co-op sought to dispose of all of the Southern and Trust securities, and Southern offered to acquire them for $20 million. That sale would have resulted in a large, and largely unusable, capital loss, and Co-op's board of directors concluded that an abandonment of the securities for no consideration would result in an ordinary loss and a greater overall benefit to Co-op.
Accordingly, in order to realize a loss with an ordinary character, Co-op "voluntarily and irrevocably" surrendered the securities to Southern and the Trust in June 2004 for no consideration. It recorded a loss for financial statement purposes equal to $38.8 million, the then carrying value of the securities on its books, and reported a $98.6 million ordinary loss on its tax returns for the tax year that ended in June 2004. In connection with the abandonment, an opinion was obtained from a law firm regarding the allowability of the ordinary loss deduction.
In 2009, the IRS issued a statutory notice of deficiency to Pilgrim's Pride as successor in interest to Co-op. The asserted tax deficiency reflected a determination that the loss of Co-op on the abandonment of the securities was a capital loss rather that an ordinary loss; the IRS also asserted an accuracy-related penalty under IRC §6662.
Because Pilgrim's Pride was in bankruptcy proceedings at the time of issuance of the statutory notice, it could not challenge the notice of deficiency immediately. A plan of reorganization under Chapter 11 of the Bankruptcy Code became effective with respect to Pilgrim's Pride in late 2009, and Pilgrim's Pride then filed a petition for review of the deficiency with the Tax Court. The government conceded the accuracy-related penalty, and the only issue remaining before the court was the character of the abandonment loss as capital or ordinary.
It was undisputed that the abandoned securities were capital assets of Co-op. Pursuant to IRC §165(f), losses from the "sale or exchange" of capital assets are subject to the rules of IRC §§1211 and 1212; as noted above, such capital losses are generally allowed only to the extent of capital gains. However, if a capital asset is abandoned, and the taxpayer receives no consideration for the abandoned property, the disposition does not, under case law discussed in Pilgrim's Pride, constitute a sale or exchange. Therefore, the disposition will result in an ordinary loss, rather than a capital loss, absent a specific provision of the IRC that treats the disposition as though it were a sale or exchange. The crux of the case, then, was whether there was such a provision that applied in this situation.
The nature of the arguments initially made by the government in support of capital loss treatment is not made clear by the decision, but it seems likely that the government referred at least in part to IRC §165(g), under which a loss from the worthlessness—as distinguished from the abandonment—of a security that is a capital asset is treated as a loss from the sale or exchange of a capital asset in the year in which the security became worthless.5 After opening and reply briefs were filed, the court on its own initiative asked the parties to address whether IRC §1234A required the abandonment before the court to be deemed a capital loss, and the focus of the discussion in the opinion was on whether that provision was applicable.
IRC §1234A provides:
Gain or loss attributable to the cancellation, lapse, expiration, or other termination of … a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer … shall be treated as gain or loss from the sale of a capital asset.