Satisfying a subsidiary’s liability: Capital item or expense?
TAX ALERT |
The holding in a recent IRS field attorney advice serves as a reminder that when a parent corporation sells the stock of subsidiary, its contractual obligation to pay the former subsidiary’s liabilities generally does not, upon payment, result in ordinary deductions but rather is capital in nature. However, the legal underpinning of the determination arguably applies beyond sale transactions to any situation where a shareholder satisfies a corporation’s liabilities.
Background and discussion
Under the facts of FAA 20132801F, Old Parent sold the stock of its wholly owned subsidiary. At the time of the sale, the subsidiary was the defendant in two class-action lawsuits, and only the subsidiary could be found liable by the courts. As part of the terms of the sale agreement, Old Parent agreed to indemnify and directly pay whatever obligation was eventually due as a result of the lawsuits. Old Parent subsequently paid $50 million in settlement of the two lawsuits. Both Old Parent and the subsidiary claimed a $50 million deduction on their tax returns.
At issue in this FAA was the long-standing principle that a taxpayer may take a deduction for its cost of doing business but cannot take a deduction for another taxpayer’s cost of doing business. In this light, the IRS noted that if the settlement payment was made by the subsidiary, it would be deductible under section 162 on the subsidiary’s return. However, at the time the liability was paid, it was paid by Old Parent, which no longer owned the subsidiary but merely had a contractual obligation under the sale agreement to pay the liability.
In order for a shareholder to claim an ordinary deduction for this type of payment, it would need to establish the payment was in fact in furtherance of its business. For example, if the settlement was made in order to protect the shareholder’s business reputation, a position may exist that the expense was ordinary and necessary at the shareholder level.
The IRS’s holding in FAA 20132801F illustrates that the party that arranges for, contracts or pays the liability is not determinative of which entity receives the deduction. Rather, the party on behalf of and for the benefit of which the expenditure was incurred is entitled to the deduction. Accordingly, a shareholder’s payment of ordinary business expenses on behalf of a corporation generally represents capital contributions to the corporation, with the deduction claimed by such corporation (rather than the shareholder).
The IRS indicated that the subsidiary was entitled to an ordinary deduction because it is deemed to have received the funds and paid the settlement itself, in furtherance of its own business. However, due to the fact that both the subsidiary and Old Parent claimed the deduction and that both were under audit, the IRS ruled that in order to avoid a whipsaw situation, the deduction should not be allowed until Old Parent either concedes, or it is finally determined, that it is not entitled to that deduction.
Old Parent’s treatment
Although Old Parent was not entitled to an ordinary deduction, it was entitled to a capital loss. In relying upon Arrowsmith v. Commissioner, the IRS reiterated that if the seller of a subsidiary, in connection with the sale contract, indemnifies a contingent liability of that subsidiary by making a payment to the acquiring company, the indemnity is treated as a reduction in the sale price of the stock. Alternatively, if the seller indemnifies a contingent liability of the subsidiary by making a payment to or on behalf of the subsidiary, the payment is treated as a contribution to the subsidiary's capital by the seller, relating back to immediately before the stock sale and thereby increasing the seller's basis in the subsidiary for purposes of determining gain or loss on the sale. Thus, the consequences are the same for the selling corporation regardless of whether the indemnity payment is treated as a reduction in the sale price or as a contribution to capital. In either event, the seller should be entitled to a capital loss, rather than an ordinary deduction, at the time the indemnity is paid or becomes fixed.
In the instant case, Old Parent’s payment of the former subsidiary’s liability resulted in a contribution to capital relating back to immediately before the stock sale, resulting in an increase in Old Parent’s basis in the subsidiary for purposes of determining its gain or loss on such sale.
 See American General Insurance Co. v. United States, (USDC Mid-Dist. Tenn., 1973), Interstate Transit Lines v. Commissioner, 319 U.S. 590 (1943), Windsberg v. Commissioner, T.C. Memo. 1978-101, Coulter Electronics Inc. v. Commissioner, T.C. Memo. 1990-186.
 Arrowsmith v. Commissioner, 344 U.S. 2 (1952).
 See also Central Gas & Electric Co. v. United States, 159 F. Supp. 353 (Ct. Cl. 1958); Federal Bulk Carriers, Inc. v. Commissioner, 66 T.C. 283 (1976); Rev. Rul. 58-374, 1958-2 C.B. 396; Clay v. Commissioner, T.C. Memo. 1981-375; and Nelson v. Commissioner, T.C. Memo. 1971-327.
 See Rev. Rul. 83-73, 1983-1 C.B. 84; G.C.M. 38977 (April 8, 1982).
 Note, however that the capital loss may be disallowed under the consolidated return loss disallowance regulations, depending on the circumstances