Losses Related to an Insolvent Corporation

By Jeff Borghino, CPA, Washington, DC

Editor: Greg A. Fairbanks, J.D., LL.M.

Corporations & Shareholders

The IRS issued a general legal advice memorandum, AM 2011-003 (8/26/11) (the GLAM), which addressed the tax consequences when an insolvent foreign subsidiary of a domestic U.S. corporation elected to be classified as a partnership. The GLAM addressed these and other issues:

  1. Whether the shareholder of an insolvent corporation was allowed a worthless security loss under Sec. 165(g);
  2. The federal tax treatment of the subsidiary’s liabilities; and
  3. Whether a creditor of the subsidiary was entitled to a deduction for bad debt under Sec. 166.

This item summarizes and discusses the facts and the technical framework of the IRS’s conclusions.

The Facts

The GLAM’s facts provided that a domestic U.S. corporation, X, directly and wholly owned a foreign corporation, Y, and directly owned 80% of the stock of another foreign corporation, Z. Y directly owned the remaining 20% of Z’s stock.

X’s adjusted basis in its Z stock was $100, and Y’s adjusted basis in its Z stock was $30. The fair market value of Z’s assets was $100, and Z’s liabilities were $110; therefore, Z was insolvent. Z’s adjusted basis in its assets was $120. The Z liabilities did not constitute securities under Sec. 165(g)(2), meaning they could be subject to a Sec. 166 bad-debt deduction from the lenders’ perspective. Z constituted an “eligible entity” as defined in Regs. Sec. 301.7701-3(a) and elected to be classified as a partnership (Z Partnership) for federal tax purposes under Regs. Sec. 301.7701-3(c)(1)(i).

In Situation 1, the Z liabilities were owed entirely to X. In Situation 2, the Z liabilities were owed entirely to an unrelated foreign corporation, U.

Issue 1: Worthless Security Loss

On Issue 1, the GLAM cited Sec. 165; Regs. Sec. 301.7701-3 (the check-the-box regulations); and Rev. Rul. 2003-125.

Sec. 165 : Sec. 165(a) provides that a taxpayer is allowed a deduction for a loss sustained in a tax year that was not compensated by insurance or otherwise. However, under Regs. Secs. 1.165-1(b) and (d), such loss must be (1) evidenced by closed and completed transactions; (2) fixed by identifiable events; and (3) with certain exceptions, actually sustained during the tax year. Furthermore, only a bona fide loss is allowable, and substance rather than mere form determines a deductible loss.

Under Sec. 165(g)(1), if any security that is a capital asset becomes worthless during a tax year, the resulting loss is treated as a capital loss. The definition of a “security” in Sec. 165(g)(2) includes a share of stock in a corporation; a right to subscribe for, or to receive, a share of stock in a corporation; or a debt instrument issued by a corporation with interest coupons or in registered form. Sec. 165(g)(3) provides an exception for a taxpayer’s capital loss if the security is in an “affiliated” corporation, as defined in the section.

In determining whether stock became worthless, the Board of Tax Appeals in Morton, 38 B.T.A. 1270 (1938), aff’d, 112 F.2d 320 (7th Cir. 1940), provided that the liquidating value of stock is indicia that such stock is worthless, but that there must also be no potential value for such stock to be wholly worthless. The Board of Tax Appeals said that such a loss of value “can be established ordinarily with satisfaction only by some ‘identifiable event’ in the corporation’s life which puts an end to such hope and expectation” (38 B.T.A. at 1279). The board also provided that such identifiable events include bankruptcy, cessation from doing business, liquidation, or the appointment of a receiver.

Check-the-box regulations: Under Regs. Sec. 301.7701-3(a), an eligible entity may elect its classification for federal tax purposes. An eligible entity with a single owner can elect to be classified as either (1) a corporation or (2) an entity disregarded as an entity separate from its direct owner (a disregarded entity); and an eligible entity with at least two members can elect to be classified as either (1) a corporation or (2) a partnership. Furthermore, an eligible entity can elect to change its classification under Regs. Sec. 301.7701-3(c)(1)(i) (an elective change).

Under Regs. Sec. 301.7701-3(g)(1)(iii), if an eligible entity classified as a corporation makes an elective change to a disregarded entity, the corporation is deemed to distribute all of its assets and liabilities (a deemed liquidation) to its single owner in liquidation of the corporation. Under Regs. Sec. 301.7701-3(g)(1)(ii), if an eligible entity classified as a corporation makes an elective change to a partnership, the corporation is subject to a deemed liquidation to its shareholders, and, immediately thereafter, the shareholders are deemed to contribute all of the distributed assets and liabilities to a newly formed partnership (the deemed formation).

An elective change is treated as occurring at the start of the day for which the elective change is effective. Thus, any transactions that are deemed to occur as a result of an elective change are treated as occurring immediately before the close of the day before the elective change is effective. Furthermore, it has been held that an elective change should be treated as if the deemed transactions actually occurred. See Dover Corp., 122 T.C. 324 (2004) (stating that, upon a corporation’s elective change to a disregarded entity, the deemed liquidation “is characterized as an actual liquidation of [the corporation] for income tax purposes” (emphasis in the original)). Regs. Sec. 301.7701-3(g)(2)(i) states that the tax treatment of an elective change is determined under all relevant provisions of the Code and general principles of tax law, including the step-transaction doctrine.

Rev. Rul. 2003-125: Applying the rationale in Dover and Regs. Sec. 301.7701-3(g)(2)(i), the IRS ruled in Rev. Rul. 2003-125 that a shareholder of an insolvent corporation was allowed a worthless-security loss under Sec. 165(g), based on the deemed liquidation from the corporation’s elective change to a disregarded entity. In Situation 2 of the revenue ruling, a domestic U.S. corporation, P, was a calendar-year taxpayer and directly and wholly owned a foreign corporation, FS. All of FS’s indebtedness for U.S. tax purposes was recourse to FS. FS constituted an eligible entity and was classified as a corporation for federal tax purposes. On December 31, 2002, P’s FS stock was not worthless (i.e., FS was not insolvent). On July 1, 2003, P elected to change FS’s classification from a corporation to a disregarded entity. At the close of the day immediately before the elective change, FS was insolvent.

The IRS ruled that the deemed liquidation was an identifiable event that fixed P’s loss with respect to its FS stock. P therefore was allowed a worthless-security loss under Sec. 165(g) as a result of FS’s deemed liquidation because FS was insolvent and P received no payment on its FS stock upon the deemed liquidation. The IRS also said that FS’s creditors, including P, were entitled to a deduction for partially or wholly worthless bad debt, to the extent that Sec. 166 applied.

Issue 1 conclusion: As in Rev. Rul. 2003-125, the IRS concluded in both Situations 1 and 2 of the GLAM that Z’s deemed liquidation fixed X’s and Y’s losses related to their Z stock. Thus, both X and Y were entitled to a worthless-security loss under Sec. 165(g) because X and Y received no payment on their Z stock upon Z’s deemed liquidation.

Issue 2: Subsidiary’s Liabilities

On Issue 2, the GLAM contemplated whether Z’s elective change resulted in a significant modification of the Z liabilities under Regs. Sec. 1.1001-3.

Modifications of debt instruments: For purposes of Regs. Sec. 1.1001-1(a), Regs. Sec. 1.1001-3 provides whether a modification of the terms of a debt instrument results in an exchange. Under Regs. Sec. 1.1001-3(b), a “significant” modification of the terms of an existing debt instrument results in an exchange of the original debt instrument for a modified instrument that differs materially either in kind or in extent.

Under Regs. Sec. 1.1001-3(c), a modification of the terms of a debt instrument means any alteration (1) no matter whether it is evidenced by an express agreement (oral or written), the conduct of the parties, or otherwise; and (2) including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument. Regs. Sec. 1.1001-3 applies to any modification regardless of the form; for example, it applies to an exchange of a new instrument for an existing debt instrument, or to an amendment of an existing debt instrument (Regs. Sec. 1.1001-3(a)(1)). Under Regs. Sec. 1.1001-3(c)(2)(i), even if an alteration occurs by operation of the terms of the debt instrument, it constitutes a modification if it results in the substitution of a new obligor, the addition or deletion of a co-obligor, or a change (in whole or in part) in the recourse nature of the instrument (e.g., from recourse to nonrecourse, or from nonrecourse to recourse).

Whether a modification is significant is based on the facts and circumstances (Regs. Sec. 1.1001-3(e)(1)). However, Regs. Secs. 1.1001-3(e)(2) through (6) provide specific rules, including that the substitution of a new obligor on a nonrecourse debt is not a significant modification (Regs. Sec. 1.1001-3(e)(4)(ii)). However, the substitution of a new obligor on a recourse debt is a significant modification of such debt instrument, with certain exceptions (Regs. Sec. 1.1001-3(e)(4)(i)).

Under Regs. Sec. 1.1001-3(e)(4)(i)(C), the substitution of a new obligor on a recourse debt is not a significant modification if the new obligor acquires substantially all of the assets of the original obligor, the transaction does not result in a change in payment expectations, and the transaction does not result in a “significant alteration.” Regs. Sec. 1.1001-3(e)(4)(i)(E) defines a significant alteration as one that would constitute a significant modification but for the fact that it occurs by operation of the terms of the debt instrument. Under Regs. Sec. 1.1001-3(e)(4)(vi), a change in payment expectations occurs if (1) there is a “substantial enhancement” of the obligor’s capacity to meet the payment obligations under a debt instrument, and that capacity was primarily speculative prior to the modification and is adequate after the modification; or (2) there is a “substantial impairment” of the obligor’s capacity to meet the payment obligations under the debt instrument that was adequate prior to the modification and is primarily speculative after the modification. The preamble to Regs. Sec. 1.1001-3 states, “There is no change in payment expectations . . . if the obligor has at least an adequate capacity to meet its payment obligations both before and after the modification” (T.D. 8675).

Issue 2 conclusion: The IRS concluded that Z’s elective change resulted in a modification because of the substitution of a new obligor under Regs. Sec. 1.1001-3(c)(2)(i) (i.e., the Z Partnership was substituted as obligor for Z). However, the IRS concluded in Situation 1 and Situation 2 that such modification was not significant under Regs. Sec. 1.1001-3, regardless of whether the Z liabilities were nonrecourse or recourse. If the Z liabilities were nonrecourse, Regs. Sec. 1.1001-3(e)(4)(ii) provides that the substitution of a new obligor was not a significant modification. If the Z liabilities were recourse, the substitution of a new obligor would not be a significant modification under Regs. Sec. 1.1001-3(e)(4)(i)(C) because (1) the Z Partnership acquired substantially all of Z’s assets and liabilities, (2) the elective change was not likely to result in a change in payment expectations related to the Z liabilities, and (3) there was no significant alteration.

Issue 3: Bad Debt Deduction

On Issue 3, the IRS discussed the application of Sec. 166.

Sec. 166: Sec. 166(a)(1) provides that taxpayers are generally allowed a deduction for any debt that becomes wholly worthless within the tax year. Sec. 166(a)(2) provides that the IRS may allow a deduction for partially worthless debts to the extent they are charged off within the tax year. In determining whether a debt is worthless in whole or in part, all pertinent evidence must be considered, including the value of any collateral securing the debt and the financial condition of the debtor (Regs. Sec. 1.166-2(a)).

Notwithstanding that the Code and regulations do not provide a bright-line test, courts have provided indicia that a debt is worthless. While the insolvency of a debtor constitutes such indicia, courts have held that more than the mere insolvency of a debtor is required for a debt to be worthless. See Cimarron Trust Estate, 59 T.C. 195 (1972) (holding that a corporation was not allowed a bad-debt deduction because the insolvency of the debtor did not establish worthlessness of the debt), and Gorman Lumber Sales Co., 12 T.C. 1184 (1949) (holding that a debt is worthless when the debtor was insolvent and had insufficient assets to pay claims having priority over such debt).

Issue 3 conclusion: The IRS concluded that X and U were not entitled to a deduction under Sec. 166, based solely on the elective change in Situations 1 and 2, respectively, “[b]ecause the full amount of the liability is treated as surviving the liquidation and as being contributed to the newly formed partnership.”

Commentary

The IRS’s conclusions on Issue 1 appear to be consistent with Rev. Rul. 2003-125; however, its conclusions on Issues 2 and 3 provide some noteworthy positions.

First, regarding Issue 2 in Situation 1, notwithstanding that the check-the-box regulations and Dover would treat Z’s deemed liquidation as an actual distribution of Z’s assets and liabilities to X and Y, no portion of the Z liabilities were deemed to be extinguished as a result of the deemed liquidation. Upon Z’s deemed liquidation in Situation 1, Z was insolvent, and X was its sole creditor. Nevertheless, the Z liabilities were not treated as extinguished, and Y was treated as receiving a portion of Z’s assets and liabilities, contrary to what would have occurred in an actual winding up of Z. The GLAM said, “The deemed distribution of assets will not satisfy, in whole or in part, the $110 liability because under local law, Z’s $110 liability to X in Situation 1 and to U in Situation 2 survives the deemed liquidation.”

In an actual winding up of Z, if Z’s assets were insufficient to pay the Z liabilities, there would be no assets remaining for distribution to its stockholders after the payment of the Z liabilities (see Iron Fireman Manufacturing Co., 5 T.C. 452 (1945)). However, it should be noted that, under Regs. Sec. 301.7701-3(g)(1)(ii), the deemed liquidation distributes all of Z’s assets and liabilities to its shareholders—presumably, despite Z’s insolvency. Thus, perhaps there is a disparity between an actual winding up of Z and a deemed liquidation of Z. Furthermore, it may be appropriate to treat Z’s elective change to a partnership as a modification of the Z liabilities rather than an extinguishment and immediate issuance of new debt, due to the step-transaction doctrine and Regs. Sec. 301.7701-3(g)(2)(i).

Second, regarding Issue 2, the IRS concluded that there was no significant modification of the Z liabilities, which implied that the Z liabilities were still respected as debt for federal income tax purposes despite Z’s insolvency.

Under Regs. Sec. 1.1001-3(e)(5)(i), a modification of a debt instrument that results in an instrument or property that is not debt constitutes a significant modification. Under Regs. Sec. 1.1001-3(f)(7)(ii)(A), for purposes of determining whether an instrument resulting from a modification is recharacterized as debt for federal tax purposes, any deterioration in the financial condition of the obligor between the issue date of the unmodified instrument and the date of a modification is not taken into account. However, such financial deterioration of the creditor is taken into account under Regs. Sec. 1.1001-3(f)(7)(ii)(B) if there is a substitution of a new obligor or the addition or deletion of a co-obligor. Thus, notwithstanding that there was a modification of the Z liabilities, because of a new obligor (the Z Partnership), the IRS concluded there was no significant modification, despite Z’s insolvency.

Finally, in Situation 2, it is unclear why the IRS distinguished the facts of the GLAM and Rev. Rul. 2003-125 with regard to U’s deduction under Sec. 166. It would appear that U and a third-party creditor of FS could be in the same relative position. However, as stated above, the GLAM concluded that U was not entitled to a deduction under Sec. 166 based solely on the elective change, because the full amount of the Z liabilities was treated as surviving the deemed liquidation.

Nevertheless, in both Situation 2 of the GLAM and Rev. Rul. 2003-125, there could be a change of obligor for federal tax purposes upon an elective change resulting in a modification (i.e., in the GLAM, the Z Partnership was substituted as the obligor of the Z liabilities; in Rev. Rul. 2003-125, P was substituted as the obligor on FS’s third-party liabilities because FS was a disregarded entity). Only the GLAM analyzed Regs. Sec. 1.1001-3 before concluding that U was not entitled to a deduction under Sec. 166, while Rev. Rul. 2003-125, without any similar analysis, stated that a third-party creditor would be entitled to a deduction under Sec. 166.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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