IRS Letter Ruling 200710004 breaks new ground in determining the character of a worthless stock deduction in a consolidated group. Due to the lack of direct authorities on point and the absence of clear statutory support for the ruling’s favorable conclusions, taxpayers might consider seeking their own letter rulings to benefit from the Service’s interpretations in Letter Ruling 200710004, perhaps even applying some of the principles to situations outside of a consolidated group.
The proposed transaction in the ruling is deceptively simple: Holding was an insolvent U.S. corporation converted to a limited liability company (LLC), resulting in its deemed liquidation. This conversion caused Taxpayer, which owned at least 80% of Holding’s voting power and value, to recognize a loss. The interesting element was the way in which the gross-receipts test of Sec. 165(g)(3)(B) was calculated.
Although the proposed transaction is simple, certain background facts and some history are needed to understand the conclusions reached in Letter Ruling 200710004. Foreign Parent directly and indirectly owned 100% of Taxpayer, a U.S. corporation and the parent of an affiliated group filing a consolidated return. Taxpayer owned at least 80% of the voting power and value of Holding, a U.S. corporation conducting substantially all of its business operations through its subsidiaries. At the time of the LLC conversion, Holding owned 100% of Sub1 and Sub2. Sub1 is a disregarded entity (DE) for Federal tax purposes, conducting one line of business through other DEs; Sub2 is a U.S. corporation conducting a second line of business. Holding owed significant debt to related foreign parties and a relatively small amount to Taxpayer.
At some point, Taxpayer determined that it had overpaid for the Holding stock. After this realization, Holding sold a substantial portion of its operations and subsidiaries, and used the sale proceeds to pay down some of the related-party debt. Holding’s sales (collectively, the “Sec. 381 transactions”) fell into three categories:
Sec. 338 transactions: Holding sold some first-tier subsidiaries, and Holding and the buyer made joint elections under Sec. 338(h)(10) to treat the transaction as a sale of the subsidiaries’ assets, followed by a Sec. 332 liquidation.
Sec. 332 transactions: Some of Holding’s first-tier subsidiaries sold their assets, then formally dissolved in a Sec. 332 liquidation.
De facto liquidation transactions: Some of Holding’s first-tier subsidiaries sold their assets, then distributed the sale proceeds without formally liquidating (e.g., due to potential contingent liabilities or contractual obligations).
Taxpayer represented the following: (1) Holding was insolvent and its stock was worthless; (2) the Holding subsidiaries involved in the de facto liquidation transactions liquidated pursuant to Sec. 332; and (3) Taxpayer had no excess loss account in its Holding stock.
The Service ruled that Taxpayer could claim a worthless stock deduction under Sec. 165(g) on the conversion of Holding into an LLC, which is consistent with the position set forth in Rev. Rul. 2003-125 (see also CCA 200706011), but is not, in and of itself, remarkable. It is sufficient to say that Taxpayer recognized a loss, because no amount was considered to be received with respect to the Holding common stock held by Taxpayer (i.e., there was found to be no “complete liquidation”); see Regs. Sec. 1.332-2(b); H.K. Porter Co., 87 TC 689 (1986); and Spaulding Bakeries, Inc., 27 TC 684 (1957). The primary issue was whether Taxpayer would recognize a capital or an ordinary loss on its Holding stock, which depended on how Holding’s gross receipts would be determined.
Gross Receipts Are a Sec. 381(c) Attribute
For a worthless stock loss to be ordinary (rather than capital) under Sec. 165(g)(3), more than 90% of the worthless corporation’s aggregate gross receipts for all tax years must have been from sources other than royalties, certain rents, dividends, certain interest, annuities and gains from sales of stock and securities (i.e., passive gross receipts). This gross-receipts test is applied without looking through to any underlying gross receipts of lower-tier corporations owned by the corporation being tested; see TAM 8939001.
Under Sec. 381, in a Sec. 332 liquidation, the acquiring corporation succeeds to, and takes into account up to, 22 of the liquidating corporation’s tax attributes (as enumerated in Sec. 381(c)). These items include net operating loss carryovers, earnings and profits (E&P), capital loss carryovers, methods of accounting, etc. Notably absent from this list are the transferor corporation’s historical gross receipts, as defined in Sec. 165(g)(3)(B).
A common question in these fact patterns is how a holding company, which itself may never have produced its own gross receipts from operating a direct business, should determine its aggregate gross receipts. Tax practitioners have debated whether gross receipts (as well as other nonenumerated possible tax attributes) should be viewed as a tax attribute that moves to the acquiring corporation in a Sec. 381 transaction; see, e.g., Rev. Rul. 75-223, in which the Service applied this concept to permit partial-liquidation treatment. If so, Holding might benefit from (or be burdened by, if excessively passive) the gross-receipts history of each of the companies that were part of the Sec. 381 transactions.
The IRS permitted/required Holding to take into account the historical gross receipts from the transferor corporations in each of the Sec. 381 transactions, adjusted for certain intercompany distributions (discussed below), to prevent duplication of gross receipts.
Excluded Intercompany Distributions
Letter Ruling 200710004 sets forth the general consolidated rules governing intercompany transactions, which are transactions between members of a consolidated group and include intercompany dividends. Regs. Sec. 1.1502-13(c)(1)(i) provides that separate-entity attributes of a seller’s intercompany items and a buyer’s corresponding items are redetermined to the extent needed to produce the same effect on consolidated taxable income (and consolidated tax liability), as if the seller and buyer were divisions of a single corporation and the intercompany transaction were a transaction between these divisions.
With no detailed analysis in the ruling, the Service used these general rules to view the intercompany dividends received by Holding (which are excluded from Holding’s gross income under Regs. Sec. 1.1502-13(f)(2)(ii)) as Sec. 165(g)(3) gross receipts (see similar principles applied to other traits in Rev. Ruls. 72-230 and 79-60). The IRS permitted/ required Holding to include in its aggregate gross receipts all dividends received from lower-tier subsidiary members of the consolidated group; such dividends were treated as from passive sources only to the extent attributable to the respective distributing member’s gross receipts from passive sources. For this purpose, dividends were attributed pro rata to the gross receipts giving rise to the E&P from which the dividend was distributed. Despite the statutory classification of dividends as passive receipts, some or all of the intercompany dividends can be treated as active receipts, to the extent attributable to active receipts of the subsidiary.
As previously stated, if a parent earns gross receipts in the form of dividends from a subsidiary that later liquidates in a Sec. 381 transaction, the subsidiary’s underlying gross receipts should not be double-counted in the parent’s hands.
Complete Liquidation and Worthless Stock
The final issue relates back to the threshold matter of whether Taxpayer could recognize a loss on its Holding stock. The ruling highlights a special rule governing worthless stock in a consolidated group.
Regs. Sec. 1.1502-80(c) states that a member’s stock is not treated as worthless for Sec. 165 purposes before such stock is treated as being disposed of under the principles of Regs. Sec. 1.1502-19(c)(1)(iii), which provides that the holder of stock (P) is treated as disposing of a share of its stock in another group member (S) at the time that the stock is considered worthless. For this purpose, S’s stock is deemed worthless when substantially all of its assets are treated as disposed of, abandoned or destroyed for Federal income tax purposes (e.g., under Sec. 165(a) or Regs. Sec. 1.1502-80(c)). S’s assets are not deemed disposed of or abandoned to the extent that the disposition is in complete liquidation of S.
As with the qualification for Sec. 332 treatment previously discussed, the IRS reasoned that a complete liquidation refers to one in which at least a nominal distribution (i.e., greater than zero) was made by the liquidating corporation and received by the distributee corporation in its capacity as a shareholder. This overt conclusion represents a helpful clarification of the definition of “complete liquidation” in these consolidated return rules. (Query whether this definition might also apply to “complete liquidation” as used in Regs. Sec. 1.1502-13(j)(2)(B), which relates to the definition of “successor persons.”)
In summary, the key features of Letter Ruling 200710004 are:
Sec. 165(g)(3) gross receipts were viewed as a Sec. 381(c) tax attribute;
Excluded intercompany dividends were deemed to constitute Sec. 165 (g)(3) gross receipts to the recipient in proportion (passive versus non-passive) to the underlying E&P from which they were paid (but do not duplicate such gross receipts if the dividend-paying subsidiary later liquidates in a Sec. 381 transaction); and
A taxable dissolution of a subsidiary does not constitute a complete liquidation for purposes of Regs. Sec. 1.1502-19(c)(1)(iii)(A) and-80(c) (and perhaps also, by inference, Regs. Sec. 1.1502-13(j)(2)(B)).
Of course, further consideration will be required to determine the application of these principles absent receipt of a letter ruling. Also, while not mentioned in Letter Ruling 200710004, tax advisers should remember that a loss (including a worthless stock loss) on the stock of a consolidated group member is deductible only to the extent that it successfully runs the gamut of the consolidated loss disallowance rules found in Regs. Sec. 1.337(d)-2 (see safe harbors in Notice 2004-58). Even then, taxpayers must attach the Regs. Sec. 1.337(d)-2(c) statement or the entire loss will be disallowed.
Mary Van Leuven, J.D., LL.M. is a Senior Manager at Washington National Tax KPMG LLP in Washington, DC.
Unless otherwise indicated, contributors are members of or associated with KPMG LLP. The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.
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