United States: IRS Concludes That Gain On Debt Sale Was Ordinary

In a Nov. 28 field attorney advice memorandum (FAA 20144801F), the IRS concluded that a taxpayer's gain from the sale of a debt instrument was characterized as ordinary because it was a recovery of a prior bad debt deduction under Section 166.

Under the facts of the FAA, the taxpayer, which was an insurance company, had claimed a partial- worthlessness bad debt deduction under Section 166(a)(2) related to certain debt instruments it held. The taxpayer accordingly adjusted its basis in that Section 166 debt. The partial bad debt deduction also decreased the taxpayer's taxable income and tax liability in certain taxable years.

Subsequently, the taxpayer sold some of the debt that was subject to the partial bad debt deduction, some of which the taxpayer recognized for a gain.

Under Treas. Reg. Sec. 1.166-1(f), any amount attributable to the recovery during the taxable year of a partial bad debt deduction is included as ordinary gross income for the taxable year of recovery, except to the extent such recovery was excluded under Treas. Reg. Sec. 1.111-1, relating to the recovery of certain items previously deducted.

The term "recovery" is not defined under either Section 166 or the regulations; however, Treas. Reg. Sec. 1.111-1(a)(2) provides that a recovery includes "the receipt of amounts in respect of the previously deducted or credited Section 111 items, such as from the collection or sale of a bad debt."

Furthermore, Treas. Reg. Sec. 1.111-1(a) provides that income that can be attributed to the recovery of a bad debt is excluded from gross income to the extent the amount deducted did not decrease the taxpayer's tax liability during the taxable year of the deduction.

The IRS concluded that amounts the taxpayer received from the sale of the debt, which constituted a recovery of a partial bad debt deduction, was ordinary income to the taxpayer to the extent of the partial bad debt deduction.

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