In an internal legal memorandum (ILM 201441014) released Oct. 20, the IRS concluded that a corporation couldn’t take a carryover basis in certain assets acquired in a transaction in which Section 597 applies.
Under the facts of the memorandum, the state’s banking department closed a chartered bank (Failed Bank), and named an “agency” (as defined in Treas. Reg. Sec. 1.597-1(b)) as the receiver. Failed Bank owned a single-member limited liability company (Bank LLC) that was treated as a disregarded entity for federal income tax purposes under Treas. Reg. Sec. 301.7701-3(b). Bank LLC held the regular and residual interests of a real estate mortgage investment conduit (REMIC) as defined in Section 860D.
Another corporation (Bank) acquired the assets and deposit liabilities of Failed Bank, including Bank LLC. In connection with this acquisition, Agency provided two types of federal financial assistance (as defined in Section 597(c) and Treas. Reg. Sec. 1.597-1(b)): (i) “new worth assistance” in cash, and (ii) “loss guarantees” on certain loans securities acquired by Bank in the acquisition, including the REMIC securities held by Bank LLC.
Bank’s consolidated group took the position that Bank LLC should be treated as a real estate investment trust (REIT), as defined in Section 856, prior to the acquisition. After the acquisition Bank LLC filed a tax return as a REIT. Bank LLC’s REIT tax return claimed a bad debt deduction related to the REMIC securities.
Section 597 and its regulations govern the inclusion of federal financial assistance related to certain taxable transfers as defined in Treas. Reg. Sec. 1.597-5(a)(1)(i). The regulations under Section 597 provide, under Treas. Reg. Sec. 1.597-5(c)(1), that a failed institution in a taxable transfer is treated as having directly received any net worth assistance immediately before the transfer of its assets and/or liabilities to the acquirer and, under Treas. Reg. Sec. 1.597-2(a), the net worth assistance can generally be included as ordinary income to the failed institution and will typically be offset by the failed institution’s net operating losses and built-in losses.
Related to Treas. Reg. Sec. 1.597-3(g), the IRS can make appropriate adjustments to income, deductions and other items if a principal purpose of structuring or engaging in a transaction is to achieve a tax result that’s inconsistent with the purpose of Section 597.
The IRS concluded that a principal purpose of Bank LLC’s REIT election was to obtain a carryover basis in the REMIC securities and that the election ran afoul of Treas. Reg. Sec. 1.597-3(g). So, Bank LLC couldn’t take a carryover basis in the REMIC securities and wasn’t entitled to a bad debt deduction related to the securities as of the date of the acquisition.