It may be customary for a corporation (Parent) to pay an expense on behalf of its subsidiary corporation (Subsidiary) for administrative convenience. However, courts and the IRS have established that a taxpayer may deduct an expense only when such expense proximately results from its business (Kornhauser, 276 U.S. 145 (1928)). Thus, whether a corporation is entitled to a deduction under Sec. 162 is determined more by which corporation incurred the liability than by which corporation remitted payment for such liability. In addition, Parent may be obligated to pay a contingent liability of Subsidiary, which does not even become fixed and determinable until after Subsidiary has ceased existence. Which corporation should be able to deduct the expense in this instance? This item summarizes the tax law related to when Parent pays an expense on behalf of Subsidiary and recent related IRS guidance.
Parent’s Payment of Subsidiary’s Expense
The Supreme Court held in Interstate Transit Lines, 319 U.S. 590 (1943), that a corporation could not deduct expenses that it paid on behalf of its wholly owned subsidiary. In Interstate Transit, Interstate operated a bus transit operation between Illinois, California, Missouri, and Wyoming. Because of California law, Interstate had to form a California corporation (Stages) to operate its bus transit operation in California. Interstate maintained Stages’s accounts, managed its finances, and paid its bills and payroll. In a year that Stages incurred a net operating loss, Interstate wanted to deduct Stages’s loss because Interstate had paid Stages’s expenses.
The Court held that Interstate could not deduct Stages’s loss because it related to the Stages business, which was separate from Interstate. The Court also stated that it did not matter whether Interstate made such payments under a legal obligation or voluntarily. “The mere fact that the expense was incurred under contractual obligation does not, of course, make it the equivalent of a rightful deduction” (319 U.S. at 594). (See Baltimore Aircoil Co., 333 F. Supp. 705 (D. Md. 1971), for an exception to Interstate Transit; see also Regs. Sec. 1.166-9 for the treatment of Parent’s payments in the capacity of a guarantor.)
Notwithstanding the fact that the Court disallowed Parent’s deduction in Interstate Transit, the court in Eskimo Pie Corp., 4 T.C. 669 (1945), clarified that Parent increased its basis in Subsidiary stock for payments of Subsidiary’s expenses. In Eskimo Pie, the court held that a corporation could not deduct interest paid on behalf of its subsidiary: “Payments made by a stockholder of a corporation for the purpose of protecting his interest therein must be regarded as an additional cost of his stock” (4 T.C. at 676). (See also South Am. Gold & Platinum Co., 8 T.C. 1297 (1947).)
The IRS established its position in Rev. Rul. 84-68 and confirmed that Subsidiary is entitled to a deduction under Sec. 162 if payment by Subsidiary would have resulted in such deduction. In Rev. Rul. 84-68, a corporation (P) paid cash bonuses to employees of its directly wholly owned subsidiary (S), but such S employees did not perform any services for P. The IRS ruled that P may not deduct the cash bonuses under Sec. 162, and the cash bonuses were deductible by S because P’s payment of the cash bonuses constituted:
- A contribution to S’s capital by P; and
- A constructive payment by S of the cash bonuses to the S employees.
Not discussed in the aforementioned cases are the tax consequences if Parent is obligated to pay a contingent obligation of Subsidiary, and Parent does not make such payment until Subsidiary ceases to exist. However, courts and the IRS appear to believe that the application of the Arrowsmith doctrine (established in Arrowsmith, 344 U.S. 6 (1952)) is appropriate in certain instances.
In Arrowsmith, two individual shareholders liquidated their corporation and divided the proceeds equally. The shareholders reported a resulting capital gain. A judgment was rendered four years later against the corporation and one of the shareholders. Each shareholder paid one-half of the judgment in the capacity as transferees of the corporation’s assets (the post-liquidation payments). The shareholders each claimed ordinary loss related to the post-liquidation payments, but the IRS determined that such losses were capital. The court held that the shareholders’ losses were capital and considered the judgment as the last event of the liquidation because the stockholders were required to return a portion of the liquidation proceeds (i.e., the post-liquidation payments). In other words, the post-liquidation payments reduced the amount of the shareholders’ gain from the liquidation. Because the liquidation was a capital transaction, the court held that the post-liquidation payments resulted in capital loss.
The IRS applied the Arrowsmith doctrine in Rev. Rul. 83-73 to determine the tax consequences to former shareholders of a merged corporation related to such shareholders’ obligation to indemnify the acquirer. In Rev. Rul. 83-73, a corporation (Z) merged with and into a corporation not related to Z (X) in a reorganization qualifying under Sec. 368(a)(1)(A). As a condition of the merger, Z’s shareholders agreed to reimburse X for incurred after-tax expenses related to the settlement of certain contingent claims against Z by C, an employee of Z. The X stock transferred to the Z shareholders as consideration for the merger was equal to the fair market value of Z’s assets less Z’s liabilities without consideration of the contingent liability to C. Subsequent to the merger, X settled C’s claim for $700, and Z’s shareholders reimbursed X for $500, X’s after-tax cost of the settlement. The IRS ruled that:
- X was allowed a deduction for the settlement;
- X did not have to include the reimbursement as gross income; and
- The Z shareholders increased their basis in X stock for the reimbursement.
Subsequent to Rev. Rul. 83-73, the IRS issued Letter Ruling 8429014 with similar facts as Rev. Rul. 83-73. The letter ruling provided that a holding company (P) owned all the stock of another corporation (S) that P included in its consolidated tax return. While P owned S, S established a medical benefit plan for its current and retired employees, which reimbursed the employees for their medical costs (medical liabilities). P sold all its S stock to another party (N) but agreed to assume the medical liabilities (payment obligation). P and N also agreed that N would indemnify P for the medical liabilities if and when S was entitled to a tax deduction for the medical liabilities paid by P (indemnity payments). Consistent with Rev. Rul. 83-73, the IRS ruled in Letter Ruling 8429014 that:
- The amounts paid by P related to the payment obligation were treated as P’s contributions to S’s capital immediately before P’s sale of its S stock, and increased P’s basis in its S stock (resulting in capital loss);
- S was entitled to a deduction for the medical liabilities in the year that P paid such amount;
- The indemnity payments adjusted the purchase price paid by N to P for the S stock; and
- The indemnity payments adjusted the selling price received by P from N for the S stock (resulting in capital gain).
Recently the IRS revisited Letter Ruling 8429014 in Chief Counsel Advice (CCA) 200901033 (released January 2, 2009) because the facts in the letter ruling had substantially changed. The additional facts of the CCA provide that N and S had merged with and into another corporation (X) and that a subsidiary corporation of X (Y) had succeeded P to the medical liabilities prior to Y's converting into a single-member limited liability company disregarded as an entity distinct from X for U.S. federal tax purposes (resulting in a liquidation of Y into X). Therefore, under the facts of CCA 200901033, X was successor to the medical liabilities, the payment obligation, and the indemnity payments, and X contended that it may claim both ordinary loss deductions (related to the medical liabilities) and net capital losses (related to the excess of amounts paid related to the payment obligation over the indemnity payments) as described in Letter Ruling 8429014. The IRS concluded that X could not claim net capital losses as described in Letter Ruling 8429014 because the medical liabilities, the indemnity obligations, and the payment obligation no longer belong to separate taxpayers. However, the IRS concluded that X was entitled to an ordinary deduction under Sec. 162 as it paid the medical liabilities.
Parent’s Transfer of Parent Stock to Subsidiary’s Employees
If Parent transfers Parent stock, instead of cash, to an employee of Subsidiary, Regs. Sec. 1.83-6(d) provides that such Parent stock (or options to buy Parent stock) is deemed to be (1) contributed by Parent to the capital of Subsidiary and (2) transferred by Subsidiary to the employee immediately thereafter. Thus, Subsidiary may be allowed a deduction under Sec. 83(h).
To prevent Subsidiary from recognizing gain or loss related to such a deemed transfer of Parent stock, Regs. Sec. 1.1032-3(b) provides that Subsidiary is deemed to purchase the Parent stock from Parent for an amount equal to the fair market value of the Parent stock (see Regs. Sec. 1.1032-3(e), Example (4)). Regs. Sec. 1.1032-3(d) further provides that an option issued by Parent to buy or sell Parent stock is treated in the same manner as Parent stock under Regs. Sec. 1.1032-3(b) (see Regs. Sec. 1.1032-3(e), Example (5)).
In this context, the IRS applied the Arrowsmith doctrine in Rev. Rul. 2002-1 similarly to Rev. Rul. 83-73 and Letter Ruling 8429014. In Rev. Rul. 2002-1, a domestic corporation (Distributing) wholly owned another domestic corporation (Controlled), and Controlled had an individual (B) as an employee. Distributing implemented a plan to provide additional compensation to Controlled employees, which included nonstatutory options to purchase shares of Distributing stock (pre-spin options). Under the plan, Distributing issued pre-spin options to B that did not have a readily ascertainable fair market value (within the meaning of Regs. Sec. 1.83-7(b)). Three years later, Distributing ratably distributed the Controlled stock to its shareholders under Sec. 355(c) (the spin-off).
Under the spin-off, Distributing canceled the pre-spin options and replaced them with options to buy Distributing stock and options to buy Controlled stock (post-spin options). Subsequent to the spin-off, B exercised the post-spin options. The IRS ruled that Controlled was entitled to a deduction for the amounts includible in B’s income as a result of B’s exercise of the post-spin options. Citing Rev. Rul. 83-73, the IRS stated, “The characterization of the events that occur in Year 6 [the year that B exercised the post-spin options] should reflect the relationship of D [Distributing] and C [Controlled] that existed in Year 1 and continued until immediately before the spin-off.”
Recently the IRS applied the Arrowsmith doctrine in CCA 200942038 (released June 26, 2009), concluding that the cash settlement by a common parent of a consolidated group (P) of its stock options owned by employees of its former member subsidiary (S) constituted capital loss to P. In the CCA, P wholly owned S directly and granted nonqualified stock options to certain employees of S that expired 10 years after the grant of the options. Due to financial troubles, S entered into chapter 11 bankruptcy and emerged with S’s creditors receiving all of the S equity interest. P’s S stock was canceled, and P claimed a capital loss related to its canceled S stock. Subsequent to S’s bankruptcy, P settled options owned by S’s employees with cash payments and claimed that the cash payments should be ordinary losses. However, the IRS, citing Rev. Rul. 2002-1, concluded in CCA 200942038 that the cash payments should produce the same result as if P had made the cash payments before the bankruptcy. Thus, the cash payments should result in capital loss to P.
Greg Fairbanks is a tax manager with Grant Thornton LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org