United States: IRS Rules On Bad Debt Deduction

In a private letter ruling (PLR 201450011), released on Dec. 12, the IRS said that a corporation could take a bad debt deduction under Section 166 related to payments made to a disputed ownership fund under Treas. Reg. Sec. 1.468B-9.

Under the facts of the letter ruling, a foreign corporation (Foreign 1) owned all the stock of another foreign corporation (Foreign 2), and Foreign 2 owned all the stock of a domestic U.S. corporation. Foreign 2 had outstanding debt for which the corporation had an obligation as guarantor.

The corporation filed for voluntary bankruptcy relief under Chapter 11 the U.S. Bankruptcy Code. Foreign 2 also filed for protection from creditors in its jurisdiction, which resulted in Foreign 2's default on the outstanding debt. Because Foreign 2 defaulted on the debt, the corporation's guarantor obligation was invoked, and the debt-holders asserted a claim against the corporation through the bankruptcy code.

As part of its plan of reorganization, the corporation proposed to establish a disputed ownership fund to be held for the benefit of certain creditors of the corporation, including the debt-holders. Specifically, the corporation would transfer to the fund money or property and any subrogation right from Foreign 2 related to the guarantor obligation.

A "disputed ownership fund" is treated as the owner of all assets that it holds as a C corporation, and is defined under Treas. Reg. Sec. 1.468B-9 as an escrow account, trust or fund that satisfies the following requirements: (i) the fund is established to hold money or property subject to conflicting claims of ownership; (ii) the fund is subject to the continuing jurisdiction of a court; (iii) the fund requires approval of the court to pay or distribute money or property to a claimant; and (iv) the fund is not a "qualified settlement fund" under Treas. Reg. Sec. 1.468B-1, a bankruptcy estate or a liquidating trust under Treas. Reg. Sec. 301.7701-4(d) (except under Treas. Reg. § 1.468B-9(c)(2)(ii)).

Treas. Reg. Sec. 1.166-9(a) provides rules treating any payment in discharge of part or all of a guarantor obligation as a worthless business debt. Specifically, under Treas. Reg. Sec. 1.166-9(d), a payment in discharge of part or all of a taxpayer's guarantor obligation is treated as a worthless debt only if (i) the agreement was entered into in the course of the taxpayer's trade or business or a transaction for profit; (2) there was an enforceable legal duty upon the taxpayer to make the payment; and (3) the agreement was entered into before the obligation became worthless or partially worthless.

Under Treas. Reg. Sec. 1.166-9(e)(2), if the guarantor obligation provides for a right of subrogation or similar right against the issuer, worthless debt treatment is not allowed until the taxable year in which such right becomes totally worthless or partially worthless.

The IRS ruled that the fund constituted a disputed ownership fund under Treas. Reg. Sec. 1.468B-9, and that the corporation could take a bad debt deduction under Treas. Reg. Sec. 1.166-9 for the guarantor obligation in the year of the transfer. The IRS stated that the term "payment" for purposes of Treas. Reg. Sec. 1.166-9 should be interpreted in accordance with the cash method of accounting, and the transfer was a payment in discharge of the guarantor obligation.

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