United States

IRS denies S corporation an ordinary loss on worthless stock


A recent IRS internal legal memorandum dealt a potential blow to S corporations hoping to take an ordinary (rather than capital) loss when a subsidiary becomes worthless.

Under current law, taxpayers generally claim a capital loss in the year in which a security becomes worthless. An exception exists for domestic corporations, which can take an ordinary loss when an affiliated corporation becomes worthless.

Although this rule appears unambiguous, there has been uncertainty regarding its application to S corporations. Although S corporations are clearly domestic corporations, federal tax law generally requires that S corporations compute income in the same manner as individuals. As a consequence, there has been confusion as to whether, for purposes of this rule, S corporations are treated as corporations entitled to an ordinary loss or as individuals that must claim a capital loss.

In the memorandum, the IRS concluded that the taxable income of an S corporation "shall be computed in the same manner as in the case of an individual," thereby denying ordinary loss treatment to an S corporation.

The IRS indicated that this conclusion is consistent with prior guidance that denies S corporations an ordinary loss for nonbusiness bad debts and instead requires that S corporations claim a short-term capital loss (which expressly applies to "a taxpayer other than a corporation").

Many practitioners disagree with the conclusion in the IRS memorandum, and the IRS has indicated previously that it may provide formal guidance on this issue. Therefore, S corporations with struggling subsidiaries should continue to monitor developments in this area.

Chris Adler

Senior Director

Christopher specializes in tax methods and structures and effective consulting on the client impact of various tax law outcomes. Reach him at christopher.adler@rsmus.com.

Areas of focus: Federal Tax