MCM Investment Management, LLC, Mark and C’ann McMillin Family Trust Dated  04/09/1990, Tax Matters Partner, 2019 T. C. Memo. 158,  filed 12/10/19, had pith o’ sense and pride o’ worth, as Scotland’s Greatest put it, because Judge Pugh finds that the interests MCMIM held in the family’s real estate business had become worthless when MCMIM said it did.

The McMillins were owners and builders in CA and TX in the early ‘00s, leveraged up the cliché when the Black ’08 hit. They had tiered debt ahead of the equity and debt-for-equity in the business, their accountants had going concern issues, and their senior lenders were threatening fire and slaughter.

The McMillins decided to wind down the business, as a bankruptcy would be catastrophic (and they were personally on some paper).

Even though they were still winding down after year at issue, Judge Pugh allows the $40 million ordinary loss in year at issue, because she finds that, subjectively and objectively, the partnership interests were worthless. Even though intrafamily.

“First, respondent objects that [family business] did not itself acquire the subordinate debt at a discount.  But that was beyond its control because the senior lender would not permit it.  Instead the McMillin children formed [affiliate] to invest new capital in [family business] by acquiring the subordinate debt from an unrelated lender.  Moreover, [family business] and its owners wanted an affiliate to purchase the debt because it ensured that a third-party owner of the debt–such as a distressed debt purchaser–would not push [family business] into bankruptcy.  [Affiliate] later converted the subordinated debt to equity for a legitimate business reason:  to revive [family business]’ balance sheet by reversing its negative net worth, thus enabling [family business] to satisfy its minimum net-worth covenant and put it in a better position in restructuring negotiations with the senior lender.  The debt-to-equity conversion had economic substance for the parties: [Family business] shed significant debt and the risk profile of [affiliate]’s investment fundamentally changed when it traded various creditor’s rights and priorities for higher upside.

“Second, respondent argues that MCMIM and [affiliate] were two pockets of the same pair of pants.  We reject that analogy.  The McMillin entities were separate legal entities.  Respondent has not challenged their separate existence; indeed, he emphasized in his brief that ‘[w]hether the McMillin family entities are recognized as separate entities is not an issue in this case.’”  2019 T. C. Memo. 158, at p. 60. There was a real transfer, for non-tax business reasons.

Worthlessness has two separate but equal parts: subjective and objective (identifiable events).

“We conclude that MCMIM subjectively determined that its partnership interest in [family business] was worthless by the end of [year at issue].  First, MCMIM took the position on its tax return that the partnership interest was worthless in [year at issue]….  Second, the owners and management of MCMIM and Companies testified credibly at trial that they believed MCMIM’s interest became worthless in [year at issue].  They based their belief, in part, on the dramatic and devastating impact of the financial crisis…, [family business]’ consistent operating losses in the years leading up to and including [year at issue], the subordinate position of MCMIM’s partnership interest to [affiliate], and the overwhelming debt burden of [family business] and its project entities.  The owners and management took into account [family business]’ deteriorating cashflow projections during [year at issue].  Those projections showed that [family business] would be unable to satisfy financial obligations owed to the senior lender, the subordinate lender, or the project debt lenders.  Ultimately, the McMillin family decided to wind down [family business] in an orderly manner to maximize value for the creditors.  These facts support our conclusion that MCMIM subjectively believed its partnership interest in Companies was worthless in [year at issue].” 2019 T. C. Memo. 158, at pp. 28-29.

There’s plenty of evidence of identifiable events underpinning MCMIM’s subjective decision that their LLC interests were worthless. They got cashflow projections from competent staff, their Big Four accounting firm was waving red flags, senior debt would have wiped them out in a liquidation, and no lender would look at them except to demand payment.

There was no appraisal here, but there doesn’t have to be, although IRS argues there should have been. Ditto foreclosure. You don’t have to ride the plane into the ground to justifiably bail out.

Having a positive capital account on a K-1 doesn’t mean the interest has residual value. And MCMIM’s operating agreement provides for liquidating preference only if computed per Section 704(b), not per GAAP, as the K-1 did. “Because section 704(b) capital accounts can differ from GAAP capital accounts, the GAAP capital account reported on the Schedule K-1 does not necessarily reflect what liquidating distributions MCMIM would have been entitled to under … the operating agreement.” 2019 T. C. Memo. 158, at p. 40 (citation omitted).

So MCMIM winds up with both pride o’ sense (they were right their interests were worthless in year at issue), and pith o’ worth (even though worthless).