Investors in Lehman Bros Holdings Inc (LBHI) bonds and stock are confused about when they can claim the capital loss from the Chapter 11 bankruptcy on their tax return.
The common and preferred stock were cancelled and shareholders received a non-transferable beneficial interest in the Lehman Brothers Holdings Inc Plan Trust, a liquidating trust taxed as a grantor trust. The cancellation of the shares by itself does not trigger recognition of a capital loss. However, guidance from the Plan administrator was issued to former common and preferred shareholders after the Chapter 11 Plan of liquidation became effective on March 16, 2012. The letters from the Plan Adminstrator (see pdf icons) include the statement:
"It is not expected that any former stockholder of LBHI will receive any distributions as a result of its beneficial interests in the LBHI Plan Trust."
This guidance would appear to meet the IRS definition for a worthless security having no value or potential value as the result of an identifiable event. It would therefore trigger recognition of a capital loss for the remainder of a taxpayer's adjusted basis in the common or preferred shares.
Despite recognition of the capital loss, former shareholders will remain subject to income tax reporting for their share of the grantor trust activity until the Plan Trust is completely dissolved. The beneficial interest is non-transferable (just like checking in to Hotel California!).
Next let's talk about the Lehman Bros Holdings Inc bonds. Bondholders and other creditors were assigned to classes by the bankruptcy court and distribution plans were developed for each class. The Lehman Bros Holdings Inc bonds are generally Class 3 Senior Unsecured Creditors and are anticipated to receive a total recovery of about 21% of par value. It is expected that the bankruptcy estate will make distributions to bondholders every six months or so for five years or more. This definitely does not meet the IRS definition of a worthless security.
The approximate distributions for Class 3 claims that have been paid thus far are as follows:
First distribution paid 4/17/2012: 6.0% of par value
Second distribution paid 10/1/2012: 3.8% of par value
Actual distributions may vary due to fees charged by the indenture trustee.
How should bondholders account for these distributions? At the Lehman Bros Holding Inc bankruptcy websiteset up by the Plan Administrator, the following guidance was posted in the Frequently Asked Questions (FAQ) section (see pdf icon for copy):
"Does the distribution received by a holder of a U.S. Class 3 Senior Note affect the principal of the bond? Does the indicated value of the escrow CUSIP take on the original cost basis of the bond?"
Answer (important part underlined):
"The distribution to the U.S. Class 3 Senior Notes held through DTC was completed through an exchange of the bonds for an escrow position at DTC. The escrow positions were established on a one-to-one basis – so if a person held 1,000 in principal amount of an old Class 3 Senior Note, they would have 1,000 in the corresponding escrow position. The escrow positions in the Class 3 Senior Notes are transferrable. In accordance with Section 8.12 of the Plan, any distribution shall be allocated first to the principal portion, and so the initial distribution represents principal only."
Therefore, based on this guidance, all cash distributions received should be recorded as return of principal until the Plan trustee notifies the bondholders that no more payments will be made. The recognition of capital loss for the remaining adjusted basis will not be triggered until the security becomes completely worthless (in about five years!) Deductions for partial worthlessness will generally not be allowed under the Internal Revenue Code.
Bondholders who wish to recognize an immediate capital loss could do so by selling their escrow position in the Plan Trust, since the bond escrow position is transferable (unlike the stock beneficial interest which is non-transferable.) That is the only way to recognize capital loss now--by giving up any and all claims or interest in any future distributions. The adjusted basis of your LBHI bond carries over to the escrow position (after applying the return of principal distributions that you received.)
This document lists all the affected Lehman Bros Holdings Inc bond cusips and the corresponding new escrow cusip. (Big file!)