Editor: Annette B. Smith, CPA
Gains & Losses
An ordinary loss deduction for worthless stock of an affiliated operating subsidiary generally is permitted under Sec. 165(g)(3), as long as more than 90% of the subsidiary’s gross receipts are from active operating income. Determining whether a subsidiary’s gross receipts qualify as active operating income for this purpose can be difficult under certain circumstances, such as where the subsidiary earns interest (generally passive) in an active banking business or receives dividends (passive) from a lower-tier subsidiary that generates active operating income. In some situations, courts have interpreted the statutory language to characterize receipts as active when failure to do so would produce “an unreasonable [result] ‘plainly at variance with the policy of the legislation as a whole’” (American Trucking Ass’ns, 310 U.S. 534, 543 (1940), quoting Ozawa, 260 U.S. 178, 194 (1922), establishing this principle in a nontax case). These “exceptions” to the statute generally can be separated into two categories: active nonqualifying receipts and nonqualifying receipts attributable to active receipts.
Background
The congressional intent behind Sec. 165(g)(3) was to allow an ordinary loss, rather than a capital loss, on stock of a worthless active “operating company as opposed to an investment or holding company” in circumstances when consolidated return treatment in which “losses of the [subsidiary] may be offset against the income of the [parent]” generally is available (statement of Sen. Davis, 90 Cong. Rec. S122 (daily ed. January 12, 1944); S. Rep’t No. 1631, 77th Cong., 2d Sess. 46 (1942); see S. Rep’t No. 1530, 91st Cong., 2d Sess. 2 (1970); and Letter Rulings 200003039 and 201108001). To support this intent, Congress created an objective test to determine whether a corporation conducts an active operating business.
For an ordinary loss to be available for worthless stock in a subsidiary, receipts of the worthless affiliated domestic or foreign corporation from the following six categories (nonqualifying receipts) must constitute less than 10% of the subsidiary’s gross receipts:
- Royalties;
- Rents (except rents derived from rental of properties to employees of the corporation in the ordinary course of its operating business);
- Dividends;
- Interest (except interest received on deferred purchase price of operating assets sold);
- Annuities; and
- Gains from sales or exchanges of stocks and securities.
As noted, certain rents and interest are not treated as passive receipts if generated in the company’s operating business or from the disposition of its operating assets, respectively. As discussed below, the IRS has allowed other receipts that on their face would be nonqualifying to be treated as qualifying.
Active Nonqualifying Receipts
If, under Sec. 165(g)(3), certain rents paid by employees are treated as active, should identical rents from nonemployees be treated as passive? In Rev. Rul. 88-65, the IRS ruled that rents received under certain automobile leases constituted active receipts for purposes of Sec. 165(g)(3) due to the performance of “significant services” in connection with the leases. Citing this ruling, the IRS reached the same conclusion in Letter Ruling 200003039 for short-term vehicle rental receipts. Expanding on the rationale of Rev. Rul. 88-65, the IRS concluded in Letter Rulings 9218038 and 200924040 that interest payments earned by a federal savings bank and royalties earned by a computer software development company were qualifying receipts.
In 1994, in Field Service Advice (FSA) 1159, the IRS explained that it would
no longer follow a literal interpretation test of section 165(g)(3). Instead, [it] will look to whether the income was “active” or “passive.” In Rev. Rul. 88-65, the income was clearly from rents; however, the business was being actively managed. . . . [T]he distinction between active and passive income should be applied to other types of income.
The FSA treated interest and dividends derived in an insurance business as active receipts. “Significant services” and “being actively managed” support that it is an operating company rather than an investment or holding company. In contrast, in Technical Advice Memorandum (TAM) 9817002, the IRS concluded that interest, dividends, and capital gains that an insurance business received were not qualifying receipts because a disposition of the assets that generated the income would give rise to capital gain.
Nonqualifying Receipts Attributable to Active Receipts
Congress and the IRS have required shareholders, in certain circumstances, to look through subsidiaries and payments to determine a passive or active character. Sec. 355(g)(2)(B)(iv)(II), the lookthrough rule, treats the distributing and controlled corporations as each owning its ratable share of the assets of any 20% controlled entity for purposes of determining whether it is a disqualified investment company. Similarly, Regs. Sec. 1.351-1(c)(4) describes an investment company lookthrough rule. Regs. Sec. 1.951-1(a)(3) also provides that for purposes of determining whether a U.S. shareholder that is a domestic corporation is a personal holding company, the U.S. shareholder may look through the Sec. 951 deemed dividend to the character and source of the underlying income as it was earned by the controlled foreign corporation. In Letter Rulings 200710004 and 200932018, the IRS ruled that a predecessor’s gross receipts history as well as its operating company status will carry over under Sec. 381 in a Sec. 332 liquidation and an A reorganization, respectively. The principles underlying these rules and guidance have been applied to Sec. 165(g)(3) gross receipts determinations.
In the consolidated return context, several recent private letter rulings have concluded that gross receipts from passive sources will be treated as passive only to the extent they are attributable to the respective distributing member’s gross receipts from passive sources. See Letter Rulings 200710004, 200932018, 201006003, and 201011003.
Example 1: P owns all the stock of S1, which owns all the stock of S2. The S1 stock has a basis of $10 million, and the S2 stock has a basis of $5 million. Neither P nor its subsidiaries join in the filing of a consolidated return. Ninety-five percent of S2’s gross receipts are interest payments derived from its banking and insurance businesses. Ninety-five percent of S1’s gross receipts are dividend payments from S2; the remainder derive from its active operating business. S2 becomes worthless in year 2, and S1 becomes worthless in year 3. All requirements for a Sec. 165(g)(3) ordinary loss have been satisfied in the year of worthlessness, other than the gross receipts requirement.
S1 may be entitled to an ordinary worthless securities deduction of $5 million for its S2 stock under Sec. 165(g)(3). S2’s interest receipts have been derived from its banking and insurance businesses. Under the logic of Rev. Rul. 88-65 and Letter Ruling 9218038, S2’s banking interest receipts may be considered qualifying receipts under Sec. 165(g)(3). While there is no certainty that the IRS would treat the banking interest receipts as active, absent obtaining a private letter ruling, there may be even less certainty about the insurance-related receipts. The legislative history regarding an operating business may support treating interest payments derived from an active insurance business as a qualifying receipt, but the guidance on this issue is conflicting (see TAM 9817002 and FSA 1159).
Like S2, 95% of S1’s gross receipts are passive based on a literal reading of Sec. 165(g)(3). Unlike S2, 95% of S1’s gross receipts are not derived from its business operations. Because more than 10% of S1’s gross receipts are nonqualifying, P likely would not be entitled to an ordinary loss under Sec. 165(g)(3), but it may obtain a capital loss.
Example 2: The facts are the same as in Example 1, except that P, S1, and S2 join in filing a consolidated return.
The result for S1 should be the same, except that the basis in the stock of S1 may be reduced by the deduction under Regs. Sec. 1.1502-32. P may be entitled to a $5 million ordinary loss on its S1 stock under Sec. 165(g)(3). To reach an acceptable level of comfort on this conclusion, a private letter ruling would be needed that, like Letter Ruling 200710004, incorporates lookthrough principles to the subsidiary payments.
Example 3: The facts are the same as in Example 1, except that in year 2, before it would have become worthless, S2 liquidates into S1 under Sec. 332.
S1 should inherit S2’s gross receipts history and operating company status. P may be entitled to an ordinary loss on its S1 stock under Sec. 165(g)(3) as S2’s successor.
Conclusion
It is not clear why P should not qualify under Sec. 165(g)(3) for an ordinary loss on its S1 stock in Example 1 but may qualify in Examples 2 and 3. The policy behind Sec. 165(g)(3) is to approximate consolidated return treatment. Arguably, the rationale of lookthrough principles found both inside and outside the consolidated return context should apply with respect to deductions for worthless stock in an affiliated corporation. In addition, the statutory treatment as active receipts for certain interest on operating assets sold, the legislative history supporting operating businesses generally, and some IRS guidance could be viewed as supporting treating interest payments derived from an active insurance business as qualifying. Without further guidance, however, a private letter ruling may be the only means of gaining comfort on the characterization of receipts of a subsidiary.
EditorNotes
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
