A Tax Break for Selling Toxic Assets?

Banks and other financial institutions that were eager for a tax break related to government bailout programs may be pleasantly surprised.

A new private letter ruling issued by the Internal Revenue Service uses a cascade of interconnected tax rules to illustrate that selling off some toxic assets to a government entity will produce a tax deduction. The breadcrumb trail of tax rules that lead to the final determination are fairly straightforward, but they do require a methodical look at the situation. Here is how the IRS letter lays out its conclusion.

A corporate taxpayer that we will call Alpha Inc. for illustrative purposes is the parent of Beta Cos. Beta owns interests in assets that have declined in value vis à vis the price it originally paid for the assets. The assets impair the ability of Alpha and Beta to continue normal business operations, which has “adversely affected financial markets worldwide.” So we surmise that the assets are “toxic” loans and securities, and that Alpha and Beta are financial institutions.

At this point, the U.S. Treasury Department (or an instrumentality of the U.S. government) owns “percent 1″ of Alpha’s stock, and also owns warrants to purchase Alpha shares. Meanwhile, Beta says it intends to remove the assets from its financial statements, and the government seems willing to help.

As a result, an instrumentality of the U.S. government called GovBank establishes a limited liability company for the purpose of buying the assets. The asset purchase will work like this: GovBank will lend the LLC “amount 1″ in cash. Then the LLC will use the proceeds to purchase the assets from Beta. As payments are made on the assets, GovBank will be entitled to receive from LLC the following: (1) an amount equal to the loan, (2) compounded interest on the unpaid portion of the loan at LIBOR plus a “spread,” and (3) “fraction 1″ of the remaining cash flow from the assets, after Beta has received its portion of the “deferred purchase price.”

Under the asset purchase agreement, the aggregate purchase price paid by the LLC will consist of four components: (1) cash in the amount of the loan (from GovBank to the LLC); (2) a deferred purchase price of “amount 2″ to be paid by the LLC as payments are received on the assets, which will happen when the LLC has repaid the loan plus interest; (3) interest on the unpaid portion of the amount 2 at LIBOR plus a “spread”; and (4) a “contingent purchase price” of “fraction 2″ of the remaining cash flow on the assets, after amount 2 has been paid with interest.

Bob Willens 2“At issue in the private letter ruling is whether the loss can be currently deducted, or is the loss instead subject to disallowance or deferral.” — Robert Willens

When all is said and done, Beta realizes a loss on the sale of the assets to the LLC. At issue in the private letter ruling is whether the loss can be currently deducted, or is the loss instead subject to disallowance or deferral. The IRS concluded that the loss is currently deductible.1

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