Deducting losses on worthless or abandoned assets.

• Author: Schnee, Edward J.

During a Prolonged Recession, It's Especially Useful to Know How to Minimize Economic Loss

As a result of the prolonged economic recession in the United States, numerous businesses have been generating operating losses. However, these reported losses are only part of the problem. Many of these businesses may also own assets that have declined in value to a point where the assets have little or no value.

Businesses that own worthless assets should consider the possibility of taking a loss deduction under Sec. 165. To the extent allowed, this deduction would give rise to either current or future tax benefits. The rules for taking the loss deduction vary greatly, depending on the type of asset involved and the taxpayer's actions. This article will cover the litigation that has clarified some, but not all, areas of the law; review the requirement for claiming a loss deduction for worthless nondepreciable business assets; and discuss the characterization of the loss.

General Rule of Sec. 165

Sec. 165(a) provides that the taxpayer "shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise." The amount of the loss equals the adjusted basis of the property calculated under Sec. 1011 as if the asset had been sold or exchanged at a loss.(1) The loss must be adjusted for any salvage value or compensation received.(2) If the loss arose from a capital asset, Secs. 1211 and 1212 (relating to the capital loss limitation and carryover) restrict the deductibility.(3) A deduction is not permitted under Sec. 165 if the loss results from a sale or exchange of property.(4) In addition, if the loss was incurred by an individual, it must have been incurred in a trade or business, in a transaction entered into for profit or from an event classified as a casualty or theft.(5)

The loss is deductible in the year sustained. However, it cannot be deducted if there is a reasonable prospect of recovery.(6) The possibility of recovery is a question of fact that must be determined by the particular circumstances involved. The recovery need not be complete to delay the deduction. The fact that the possibility of any recovery exists will delay the deduction until it can be determined with reasonable certainty that the recovery will be less than the loss sustained. In those cases in which the recovery would result from an action against a third party, the taxpayer will have to demonstrate that a favorable judgment would be insufficient to provide full reimbursement. It will be hard to establish this proof if a lawsuit has been filed for all damages sustained.(7)

Business Assets

Sec. 165 applies to nondepreciable business assets and to worthless securities, but not to inventory (covered by Sec. 471) or depreciable property (Sec. 167), or losses from debts not evidenced by a security.(8)

Sec. 166(a) allows a deduction for any debt that becomes worthless during the tax year provided the debt is not evidenced by a security.(9) Since Sec. 165(g)(2) defines a security as either a share of stock or a note, Sec. 166 applies only to accounts receivable. The Sec. 166 deduction is permitted in the year the debt becomes completely worthless even if it is not deducted for financial statement purposes.(10) If the debt is a nonbusiness debt, the loss is a short-term capital loss rather than an ordinary loss.(11) The IRS may allow a deduction for partially worthless debts, but only if it is satisfied that there will be only partial recovery and only if the part claimed has been charged off.(12)

Nondepreciable Business Assets

The proper treatment of losses from nondepreciable business assets is found in the regulations to See. 165 and the case law thereunder since the Code does not provide specific guidance. In A.J. Industries,(13) the Ninth Circuit clearly noted that a loss is not deductible as the result of a decline in value of the asset. Regs. Sec. 1.165-1(b) and (d) state that the loss is deductible when "evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year." Under Regs. Sec. 1.165-2(a), the deduction of a loss is permitted for "the sudden termination of the usefulness in such business or transaction of any nondepreciable property, in a case where such business or transaction is discontinued or when such property is permanently discarded from use therein ...."

It appears clear from the regulations that a loss on a nondepreciable asset other than securities can be claimed even though it is not worthless. The criteria used to determine when a loss can be deducted in cases other than worthlessness are (1) the occurrence of a closed and completed transaction coupled with the termination of the asset's usefulness; (2) the discontinuation of the use of the asset; or (3) the discontinuation of the business. An action that appears to meet either or both of the latter two conditions qualifies as the abandonment of an asset.

For a business to abandon an asset, there must be the intent to abandon, plus an act designed to accomplish that intent.(14) Both aspects must exist; neither the intent nor the act alone is sufficient. The actual proof of the abandonment will be determined from all the facts and circumstances.

The deductibility of a loss due to an abandonment comes from the requirement in Regs. Sec. 1.165-2(a) that the taxpayer discontinue the use of the asset or the business in which the asset is used. Early cases concluded that this requirement is based on management's opinion.(15) Since the regulation requirement that gave rise to the abandonment standard is based on the...