Consolidated return rules often defers the deduction
In a recently issued Chief Counsel Advice, CCA 201650013, the IRS addressed the proper timing of a worthless stock loss within a consolidated group of corporations. The CCA analyzes the special rules that may defer worthless stock deductions within consolidated groups for years after the stock first becomes worthless.
Worthless stock deductions in general
The owner of stock that becomes worthless generally may deduct its tax basis in the stock as a worthless stock loss for the year in which the stock becomes worthless. The loss typically is a capital loss if the stock is a capital asset in the taxpayer’s hands. However, more favorable ordinary loss treatment applies under some circumstances to corporations who hold stock of an affiliated corporation that has become worthless.
In some situations, claiming the deduction too late can present a risk. If a taxpayer holds stock that becomes worthless in an earlier year but does not claim the deduction until a later year, there may be a possibility that the deduction would become unavailable in the event of an IRS audit. If the IRS later denies the deduction for the later year at a time when it is too late to amend the return for the earlier year, the opportunity to claim the deduction may be lost. Consequently, it is often prudent to claim the deduction for the year in which the stock first becomes worthless.
Worthless stock deductions in consolidated returns and in CCA 201650013
The timing rules for worthless stock deductions are different, however, for stock held within a group of corporations that file consolidated federal income tax returns (a consolidated group). Worthlessness of a subsidiary’s stock is not sufficient to trigger the deduction. Instead, another triggering event—such as the subsidiary disposing of all of its assets or exiting the consolidated group—must occur.
The taxpayer in the CCA was a consolidated group. It had acquired a subsidiary (Sub) by purchasing Sub’s stock, and Sub incurred debt to a foreign affiliate. The value of Sub later declined—the taxpayer considered Sub to have negative net worth by the end of Year 3. The foreign affiliate forgave portions of Sub’s debt in Year 4 and Year 5. The taxpayer treated each debt forgiveness as a capital contribution, potentially increasing the taxpayer’s tax basis in the Sub stock.
In Year 6, Sub was deemed to liquidate because taxpayer filed a check-the-box election to treat Sub as a disregarded entity rather than as a corporation for tax purposes. Taxpayer claimed a worthless stock deduction for Year 6.
In the taxpayer’s view, the stock of Sub became worthless in Year 3 and remained worthless through Year 6. The CCA did not address whether or not the Sub stock was in fact worthless at any particular time, but instead assumed that the taxpayer’s view was correct in order to address the deduction timing issue presented.
The IRS concluded that the worthless stock deduction was not available until Year 6, the year for which the taxpayer had claimed it. Although the Sub stock became worthless in Year 3, the special rules governing worthless stock deductions required an additional triggering event before the taxpayer could claim the worthless stock deduction. The first triggering event to occur was in Year 6, when Sub ceased to be a member of the consolidated group as a result of its deemed liquidation.
Sub had reduced the scope of its business in Years 2 and 3 but continued to operate its remaining business. Sub therefore did not trigger the worthless stock loss by disposing of all of its assets. In a situation where a consolidated subsidiary corporation has become worthless and has disposed of all of its assets by selling them or by transferring them to its parent corporation in a de facto liquidation (i.e., a liquidation in fact but not a liquidation in legal form or a liquidation deemed to occur under tax rules), the worthless stock deduction for the parent’s tax basis in the subsidiary stock cannot be deferred further.
In a consolidated group, the parent’s tax basis may be a negative amount—an excess loss account (ELA) created under the consolidated return basis adjustment rules. An ELA typically must be recaptured into the parent’s income if a de facto liquidation (or certain other triggering events) occur.
The CCA illustrates the value of tax planning to recover investments in struggling or failed subsidiaries. The taxpayer in the CCA apparently analyzed and reduced intercompany debt in a manner than increased potential tax deductions and later caused a triggering event permitting a worthless stock deduction under the consolidated return rules. Tax deductions often can ameliorate the losses suffered when a subsidiary’s business declines or fails, but planning in advance may be necessary to achieve the desired tax result.