Sec. 1271(a) - a pitfall for unwary corporate creditors.

• Author: West, Thomas

Sec. 1271(a) can be a problem for a corporate holder of a troubled obligation, converting what otherwise might qualify as a bad debt deduction into a capital loss. This item focuses on the divergent tax treatment a corporate holder may face in a separate return context; the consolidated return regulations prescribe rules for obligations between members of the same consolidated group. (The tax consequences to the debtor are beyond the scope of this item.)

Retirement of a Debt Instrument

In general, under Sec. 1271(a), "[a]mounts received by the holder on retirement of any debt instrument shall be considered as amounts received in exchange therefor." Thus, when a troubled obligation is held as a capital asset, a capital loss could arise if the corporate holder were to accept less than full value in retirement of the obligation.

For Sec. 1271 purposes, "debt instrument" generally means "any instrument or contractual arrangement that constitutes indebtedness under general principles of Federal income tax law"; see Kegs. Sec. 1.1275-1(d). This is based on the premise that a debt-equity analysis would result in properly characterizing the "debt instrument" as bona fide debt--generally, a state or common law analysis. Consequently, the universe of obligations that qualify as "debt instruments" under Regs. Sec. 1.1275-1(d) is expansive and may include obligations that bear both formal and informal indicia of debt (e.g., notes or open-account debt). However, Sec. 1271(b) excepts certain noncorporate debt instruments from Sec. 1271(a)'s application.

Neither the Code nor the regulations define the term "retirement" for Sec. 1271 purposes. The Supreme Court, in a case involving the predecessors to both Secs. 1271 and 166, defined the term broadly (McClain, 311 US 527 (1941)), so that a retirement may occur when all or a part of a debt is extinguished in exchange for property. Thus, Sec. 1271 may be implicated any time a creditor accepts less than full value for a debt or a portion thereof.

Bad Debt Deduction

Sec. 166(a) generally provides a deduction for certain debts that become worthless, in whole or in part, during the tax year. The basis for determining the deduction is the Sec. 1011 adjusted basis used to determine gain or loss from a sale or other disposition of property. To qualify for such deduction, a creditor has to prove that the obligation was a bona fide debt that became worthless in the year it claimed the deduction. A claim of total or...