IRS memo reveals position on section 165(g)(3) and S corporations
States that ordinary worthless stock deduction is unavailable to S corporations
INSIGHT ARTICLE |
The IRS released an Internal Legal Memorandum (ILM) that addresses whether an S corporation can generate an ordinary loss for its shareholders when an affiliated company is worthless. In addressing this question, the ILM raises three issues. The tax law governing two of the three issues is relatively clear, but the law governing the third is not.
The uncertain area is whether an S corporation is allowed an ordinary tax deduction (rather than a capital loss) with respect to worthless securities of certain subsidiaries. Corporations generally are allowed ordinary deductions in these circumstances (under section 165(g)(3) of the Tax Code), but individuals are not. In ILM 201552026 (Aug. 12, 2015), the IRS concluded that for purposes of section 165(g)(3), S corporations are treated as individuals, and as such cannot claim an ordinary deduction.
The Tax Code instructs that S corporations generally compute their taxable income in the same manner as individuals; but what that means is often unclear. In the Tax Court case Rath v. Commisioner, 101 T.C. 196 (1993), an S corporation was seeking a tax benefit available to individuals but not to corporations. The tax benefit was characterizing a loss as ordinary, rather than capital (a capital loss is often less valuable). The IRS denied the benefit, arguing that the S corporation should be treated as a corporation, not an individual. The Tax Court agreed.
The Rath case may suggest that an S corporation should compute its taxable income as an individual does, but characterize its income as a corporation does. But the IRS previously reached a different conclusion in Revenue Rulings 93-36 and 2000-43. In those cases, the IRS denied S corporations certain benefits that are available to corporations, but not to individuals.
While the IRS ruled unfavorably in the ILM, it also discussed the rationale that underlies allowing ordinary losses for worthless securities of an affiliate. The ILM explains:
The legislative history of section 165(g)(3) suggests that Congress intended the ordinary loss exception to be available only to corporations that are so closely related as to effectively be operating a single business. Under those circumstances, if stock in a non-consolidated subsidiary becomes worthless, the loss is treated as part of the parent corporation's business rather than as an investment loss.
This rationale appears to apply to S corporations as strongly as it does to other corporations (i.e., C corporations).
Given these and other relevant authorities, it remains uncertain whether an S corporation is allowed an ordinary deduction when an affiliated corporation becomes worthless. The recent ILM states the IRS’ view, but is not binding on courts or taxpayers. Prior to the release of the ILM, Treasury and the IRS requested comments on this issue and have included it on their 2015-2016 priority guidance plan. It will be interesting to see whether that guidance, when and if it is ultimately released, conforms with the ILM or takes a different position instead.
In addition to this issue, the ILM raised two other objections to the taxpayer’s ordinary deduction. It appears that the taxpayer’s arguments on these two issues were not strong.
The taxpayer owned a group of assets that were subject to liabilities exceeding their fair market value. These assets were held in a qualified subchapter S subsidiary (QSub) owned by the taxpayer. By virtue of terminating its subchapter S election, the taxpayer was deemed to contribute these assets and liabilities to a newly formed subsidiary corporation. It argued that this incorporation was tax-free, leaving it with a tax basis in its subsidiary stock (which it planned to later deduct for an ordinary loss) significantly in excess of the subsidiary’s fair market value.
The ILM points out that to qualify for this tax-free treatment (under section 351 of the Tax Code), the taxpayer needed to transfer property to its subsidiary. Under case law, assets encumbered with liabilities that significantly exceed their value typically are not considered property for this purpose. Since the incorporation did not qualify for tax-free treatment, the taxpayer would treat the contribution as a sale, recognizing income on appreciated assets and deferring any loss on loss assets. Furthermore, the parent’s tax basis in the subsidiary stock would not exceed its (worthless) fair market value, and recovery of that basis via a worthless stock deduction would not give rise to the claimed ordinary loss.
The ILM also addressed an anti-abuse rule that disallows ordinary loss treatment for worthless securities where a taxpayer acquires stock of an affiliated corporation solely for the purpose of converting a capital loss to an ordinary loss (Reg. section 1.165-5(d)(2)(ii)). The ILM explains that the taxpayer’s facts suggested that obtaining an ordinary tax loss was likely the sole purpose of the incorporation transaction.
Of the three issues the IRS addressed in this ILM, the most interesting is whether an S corporation is allowed an ordinary deduction for worthless subsidiary stock. Taxpayers and tax advisers should review the ILM and other relevant authorities when considering S corporations’ tax positions on this type of issue.