7541 / How is a shareholder taxed when stock or other securities are abandoned?

The IRS issued regulations concerning the availability and character of a loss deduction under IRC Section 165 for losses sustained from abandoned securities. The term “worthless security” includes a security that is abandoned and that otherwise satisfies the requirements for a deductible loss (under IRC Section 165). If the abandoned security is a capital asset (and not a worthless security of certain affiliated corporations), the resulting loss is treated as loss from the sale or exchange of a capital asset on the last day of the taxable year. To abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive all consideration in exchange for the security. All facts and circumstances must be considered to determine whether the transaction is properly characterized as an abandonment rather than another type of transaction, such as an actual sale or exchange, a contribution to capital, a dividend, or a gift. The regulations apply to any abandonment of stock or other securities after March 12, 2008.¹

The courts may intervene in order to recharacterize a resulting loss from the abandonment of securities as a capital loss or an ordinary loss, if the circumstances warrant. For example, in Pilgrim’s Pride v. Commissioner,² because the transaction was deemed to be a sale or exchange of capital assets under IRC Section 1234A, the Tax Court disallowed a taxpayer’s ordinary loss claimed upon its surrender of securities, finding instead that the surrender gave rise to a capital loss subject to the loss limitations of IRC Sections 1211 and 1212. The Fifth Circuit, however, disagreed and reversed the Tax Court decision.

In Pilgrim’s Pride, the taxpayer rejected an offer to purchase its securities, finding that a greater tax benefit could be obtained by abandoning the securities instead. The taxpayer abandoned the securities and claimed an ordinary loss of nearly $100 million. The Tax Court found that Section 1234A, which treats gain or loss arising from the cancellation or other termination of a right or obligation which is a capital asset as gain or loss resulting from the sale or exchange of that asset, applied.

The Fifth Circuit agreed with the taxpayer’s argument that Section 1234A applies only to a contractual or other derivative right to property, rather than to inherent property ownership rights. In so deciding, the Fifth Circuit rejected the Tax Court finding that Section 1234A applies to property rights inherent in intangible property, such as securities, as well as any derivative contractual rights. Therefore, the taxpayer was required to treat the loss as an ordinary loss because Section 1234A does not apply to the abandonment of capital assets under the Fifth Circuit’s reasoning. The Fifth Circuit also rejected the argument that IRC Section 165(g) requires the loss to be treated as a capital loss, holding instead that Section 165(g) applies only to worthless securities and that the securities at issue in this case were not worthless when they were abandoned.³