When a corporate subsidiary becomes insolvent, section 165(g), which addresses worthless stock, provides a potential tax savings opportunity for a domestic parent upon the subsidiary’s liquidation or other disposition.1 Notably, section 165(g)(3) allows for the recognition of an ordinary rather than a capital loss on the liquidation or disposition of a worthless subsidiary. Where a domestic subsidiary has net operating losses that are either limited under section 382 or are set to expire, a worthless stock deduction can also serve to “refresh” those losses by replacing them with a current year loss. In addition, the use of disregarded entities could accelerate the loss into a tax year prior to the actual disposition of the business and, in some cases, allow a loss without actually disposing of the business. Opportunities to recognize a loss are likely to occur upon the winding down of the subsidiary’s business or where its business is of interest to a buyer, notwithstanding, that liabilities (including intercompany liabilities) exceed the value of assets.
Analysis
In order for a domestic parent corporation (P) to claim an ordinary loss under section 165(g)(3) on the disposition of a worthless corporate subsidiary (S), the disposition must meet both an ownership and gross receipts test. Under the ownership test, P must directly own control of S, defined within section 1504(a)(2) as at least 80 percent of the total voting and value of the S stock.2 Because this definition of control includes foreign corporations, ordinary losses are available on the disposition of both foreign and domestic worthless subsidiaries. With respect to the gross receipts test, more than 90 percent of the subsidiary’s aggregate gross receipts for all taxable years that it has been in existence must be from sources other than royalties, rents (except rents derived from rental of properties to employees of the subsidiary in the ordinary course of operating the business), dividends, interest (except interest received on deferred purchase price of operating assets sold), annuities, and gains from sales or exchanges of stocks and securities.3 Documenting this requirement is often no easy task if ownership of the subsidiary has changed hands numerous times or if the subsidiary has been in existence for many years. Further complications may arise when determining the treatment of subsidiary holding companies and analyzing the gross receipts history of corporations that have merged with or liquidated into the subsidiary.4
Determining worthlessness of an insolvent subsidiary
That S is insolvent does not by itself represent a disposition and allow P to claim a worthless stock deduction. Rather, P must establish worthlessness through a closed and completed transaction that is fixed by an identifiable event.5 Also, in the context of a consolidated tax group, the timing of the loss deduction is subject to additional rules.6
Perhaps the most definite and common way of identifying worthlessness is through liquidation of the subsidiary.7 Liquidation establishes that, to the extent the shareholder does not receive value upon liquidation, such shareholder will never receive value for its stock. As a result, to the extent a subsidiary is insolvent at the time of liquidation, section 165(g) rather than section 332 applies.8 Liquidation can occur in a variety of ways, including through methods that do not result in the formal dissolution or liquidation of the subsidiary for legal purposes. Methods of liquidating that trigger the worthless stock deduction include:
- Legal liquidation or dissolution of S.
- Election to treat S, a foreign corporation, as an entity disregarded from P.9
- Conversion of S into an entity disregarded from P.10
- Merger of S with and into an entity disregarded from P.11
- Sale of S with a corresponding Section 338(h)(10) transaction.12
Treatment of intercompany debt
In determining insolvency and the ability to recognize a worthless stock deduction, debt owed by S to P is taken into account.13 However, unlike with third-party debt, distinguishing intercompany debt from equity is often difficult. If the intercompany debt is not debt for tax purposes and the value of the assets exceed the sum of external liabilities, the subsidiary may be solvent, thereby eliminating the worthless stock deduction in favor of section 332 liquidation. To assist in this debt versus equity determination, the Service and courts have established a number of factors to consider.14 A careful review of the various factors is often necessary to support the treatment of intercompany liabilities as debt. Furthermore, classification of intercompany open accounts and cash sweep accounts as debt for tax purposes is often difficult.
In situations where the intercompany accounts do not withstand scrutiny as debt, all is not lost. A worthless stock deduction may still be attainable. Where the intercompany account represents equity, it is possible that the account represents a preferred class of equity. Classification as preferred equity retains the worthless stock deduction on the common stock, as section 332 only applies when the corporate parent receives payment on each class of equity.15 However, just as terms and rights must be analyzed to make the debt/equity determination, it is important that the terms and rights associated with the intercompany account establish that the account is separate and preferred to the common equity.16 For example, where an intercompany debt has a priority claim on the assets upon liquidation over common equity, the intercompany debt should at least retain status as a preferred class of equity.17
Potential disallowance of the loss on disposition of a consolidated subsidiary
The last step in qualifying for an ordinary loss on a subsidiary corporation that is part of a consolidated group is to apply the unified loss rules (ULR).18 These rules are intended to disallow non-economic losses and eliminate duplicated losses on the disposition of a consolidated subsidiary. The ULR applies a complex set of rules, beyond the scope of this communication. The takeaway for this analysis is that the ULR could apply to the disposition of any subsidiary out of a consolidated group and must be considered prior to claiming the worthless stock deduction.
Action steps
When considering options for dealing with an insolvent subsidiary’s business, section 165(g)(3) provides an opportunity to recognize an ordinary deduction on the investment in the subsidiary that could offset income generated by other profitable activities. However, when determining whether an ordinary deduction is allowable, close attention must be paid to the requirements of section 165(g)(3), the treatment of intercompany debt, and, in some cases, the consolidated return rules.
1 All section references herein refer to the Internal Revenue Code of 1986, as amended, and the regulations thereunder.
2 Section 165(g)(3)(A).
3 Section 165(g)(3)(B).
4 PLR 200710004 (Dec. 5, 2006).
5 Treas. Reg. section 1.165-1(b).
6 Treas. Reg. section 1.1502-80(c), which defers worthlessness until the member ceases to be a member of the group or the stock is worthless as defined within Treas. Reg. section 1.1502-19(c)(iii).
7 See Mahler v. Commissioner, 119 F.2d 869 (2nd Cir. 1941); Gould Securities Co. v. U.S., 96 F.2d 780 (2nd Cir. 1938); Burnet v. Imperial Elevator Co., 66 F.2d 643 (8th Cir. 1933); Dittmarr v. C.I.R., 23 T.C. 789 (1955).
8 Rev. Rul. 59-296, 1959-2 C.B. 87; Treas. Reg. section 1.332-2(b) and Prop. Reg. sections 1.332-2(b) and (e), Example 2.
9 Treas. Reg. section 301.7701-3(g)(I)(iii) and Rev. Rul. 2003-125, 2003-2 C.B. 1243.
10 Treas. Reg. section 1.332-2(d); PLR 200035031 (June 6, 2000); PLR 9701029 (Oct. 2, 1996).
11 Id.
12See Treas. Reg. section 1.338-1(a)(2) and ILM 200818005 (Jan. 29, 2008), stating general rules of tax law apply to the transactions deemed to occur as a result of the section 338 election.
13 Rev. Rul. 59-296.
14 Notice 94-47, 1994-1 C.B. 357; Mixon, Jr., Estate of v. United States, 464 F.2d 394 (5th Cir. 1972); Kraft Foods Co.. v. Commissioner, 232 F.2d 118 (2d Cir. 1956); Miele v. Commissioner, 56 T.C. 556, 564 (1971); Litton Business Systems, Inc. v. Commissioner, 61 TC 367 (1973); Gokey Properties, Inc. v. Commissioner, 34 TC 829, 835 (1960); New England Lime Co. v. Commissioner, 13 TC 799 (1949); Dixie Dairies Corp. v. Commissioner, 74 TC 476 (1980); Wachovia Bank & Trust Co. v. United States, 288 F.2d 750, 756 (4th Cir. 1961); Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1961); A.R. Lantz Co. v. United States, 283 F. Supp. 164, 168 (D. Cal. 1968); Curry v. United States, 396 F.2d 630, 633 (5th Cir. 1968); Gooding Amusement Co. v. Commissioner, 236 F.2d 159,162 (6th Cir. 1956); Washmont Corp. v. Hendricksen, 137 F.2d 306, 308 (9th Cir. 1943).
15 Prop. Reg. Sections 1.332-2(b) and (e), Example 2; Commissioner v. Spaulding Bakeries, 252 F.2d 693 (2d Cir. 1958); FAA 20040301F (Jan. 16, 2004); ILM 200818005 (Jan. 29, 2008); ILM 200706011 (Sept. 7, 2006).
16 ILM 200706011 (Sept. 7, 2006).
17 PLR 201103026 (January 21, 2011).
18 Treas. Reg. section 1.1502-36.
