Fifth Circuit Holds that Loss on Abandoned Securities is Ordinary Loss

Posted by Lee Meyercord, Mary McNulty, David Wheat and Sam Merrill                        Yesterday, the Fifth Circuit issued its decision in Pilgrim’s Pride and held that a loss on abandoned securities is ordinary.  The Fifth Circuit rejected the IRS’s argument that Section 1234A and Section 165(g) apply to treat the loss as capital.  The opinion is available here.  BackgroundGenerally, capital gain or loss treatment requires the sale or exchange of a capital asset.  But if a capital asset is abandoned, there is no sale or exchange and the abandonment results in an ordinary loss unless there is a specific provision that treats the disposition as a sale or exchange. In Pilgrim’s Pride, the taxpayer abandoned securities that had a basis of $98.6 million and reported a $98.6 million ordinary loss under Section 165(a). The IRS issued a notice of deficiency to the taxpayer asserting that the loss was capital under Section 165(g).  Section 165(g) provides that if securities that are a capital asset become “worthless” during the taxable year, the loss will be treated as arising from the sale or exchange of a capital asset.  While the securities at issue had a stipulated value of $20 million, the IRS argued that they were still “worthless” under Section 165(g) because the securities were useless to the taxpayer.  Tax Court’s Decision The Tax Court seemed to agree with the taxpayer that the securities were not worthless for purposes of Section 165(g) but asked the parties to brief whether Section 1234A(1) applied, which the parties had not raised in their opening briefs.  Section 1234A(1) treats “gain or loss attributable to the cancellation, lapse, expiration, or other termination of (1) a right or obligation… with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer” as gain or loss on the sale of a capital asset.The IRS argued that “a right or obligation… with respect to property” includes all property rights inherent in the ownership of property as well as any contractual or derivative rights in property.  Pilgrim’s Pride argued that Section 1234A(1) only applied to contractual or derivative rights, not property rights inherent in the ownership of property.   The Tax Court agreed with the IRS and found that the term “property rights” included “property rights inherent in intangible property as well as ancillary or derivative contractual rights.”  Accordingly, the loss on the abandonment of the securities was capital because Section 1234A(1) treated the loss as arising from the sale or exchange of a capital asset. Fifth Circuit’s DecisionPilgrim’s Pride appealed to the Fifth Circuit, and the Fifth Circuit reversed and rendered judgment in favor of Pilgrim’s Pride.  The Fifth Circuit held that Section 1234A, by its terms, only applies to derivative or contractual rights and not property rights inherent in the ownership of property.  The court rejected the IRS’s interpretation of the statute, with the notable quote that “Congress does not legislate in logic puzzles.” The court then held that Section 165(g) did not apply because, under the court’s decision in Echols, worthlessness has both an objective and subjective element.  Because the parties stipulated that the securities had a value of $20 million, the securities were not objectively worthless.  While Echols addressed partnership interests rather than securities, the court found no reason why the standard of worthlessness should be different for securities.The Fifth Circuit’s decision is a relief for taxpayers and practitioners who—prior to the Tax Court’s decision—thought Section 1234A only applied to the termination of contractual or derivative rights in property and not to the abandonment of a capital asset. If you have any questions about this case or related issues, please contact one of us or any of the other Tax lawyers at Thompson & Knight.