The IRS concluded in an internal legal memorandum (ILM) that a taxpayer's status as a partner in a partnership that was a dealer in securities did not mean the taxpayer was a dealer in securities under Section 475(c).

In ILM 201423019 (Jan. 22, 2014), the taxpayer, a holding company, held an interest in a partnership (Partnership X). Partnership X engaged in the business of originating and purchasing mortgages on the open market and also participated in mortgage-backed securitization activities. Specifically, Partnership X contributed mortgage loans to certain trusts and retained a residual interest in the trusts. In addition to the trusts, Partnership X had established some Delaware statutory trusts as real estate mortgage investment conduits (REMICs) as defined in Section 860D. Partnership X generally used a mark-to-market method under Section 475 for its securities.

Under a subservicing agreement, a separate partnership (Partnership Z) serviced the mortgages. Specifically, Partnership Z could collect principal and interest payments related to the mortgages but could not generally modify the terms of the mortgages, extend the principal amounts, defer payments, reduce or increase the outstanding principal, or extend the final maturity date. However, if a mortgage default was imminent, Partnership Z could modify the mortgage terms to avoid default, which generally involved deferred interest payments, lowered interest rates and reduced penalties. The taxpayer was also a partner in Partnership Z.

During a taxable year, identified as Year 3 in the ILM, Partnership Z undertook significant debt modifications related to the mortgages, resulting in significant modifications to certain mortgages pursuant to Treas. Reg. Sec. 1.1001-3.

In the ILM, the taxpayer claimed that it became a dealer in securities during Year 3 as a result of Partnership Z's activities, which enabled the taxpayer to mark to market its residual interests in the trusts pursuant to Section 475(a).

Section 475(a) requires dealers in securities to mark to market securities with certain exceptions provided under Section 475(b). For Section 475(a) purposes, the term "mark to market" means that a dealer must treat a security that is held on the last day of the taxpayer's taxable year as if it had been sold on the last business day of the taxable year for an amount equal to its fair market value, and the appropriate gain or loss must be recognized for such taxable year.

Section 475(c)(1)(A) provides that a dealer in securities is a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business (emphasis added). Debt is a security under Section 475(c)(2)(C).

Under the facts of the ILM, Partnership X was a dealer in securities under Section 475(c)(1)(A). However, the IRS concluded the taxpayer was not a dealer in securities because it was a partner in Partnership X. Similarly, the IRS concluded that none of Partnership Z's activities could be attributed to the taxpayer as dealer activities.

The IRS further concluded that Partnership Z's activities in Year 3 did not rise to the level of dealer activity under Section 475.

Pursuant to Treas. Reg. Sec. 1.1001-3(b), a significant modification of the terms of a debt instrument results in the issuance of new debt in exchange for the existing unmodified debt instrument. Because Partnership Z's activities in Year 3 resulted in the significant modification of some of the mortgages, the question arose as to whether Partnership Z's activities in Year 3 constituted originating new loans to customers, which would generally be a "dealer activity" for purposes of Section 475.

The IRS concluded that Partnership Z's activities in Year 3 did not rise to the level of dealer activity for purposes of Section 475 because Partnership Z did not originate loans to customers. The debtors of the mortgages were customers of Partnership X rather than Partnership Z. The IRS also noted that there were questions regarding whether Partnership Z regularly engaged in originating loans in the ordinary course of a trade or business because it was not in the business of originating loans and could modify loans only under certain circumstances.

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