The Internal Revenue Code generally provides for capital loss treatment when a security becomes worthless. An exception to the general rule allows for an ordinary deduction when the stock of a subsidiary in an affiliated group becomes worthless. This provision generally applies to preexisting subsidiaries that are affiliated or part of a consolidated return group. However, the IRS released Chief Counsel Advice (CCA) 201552026, which reminds taxpayers that restructuring an existing qualified subchapter S subsidiary (QSub) in an attempt to qualify for an ordinary deduction is not only already prohibited but might result in an unfavorable deferral of loss.
CCA 201552026
On the facts disclosed in the CCA, the taxpayer was an S corporation holding company that owned a QSub operating a regulated business. In year 1, QSub's business operations were depressed and, accordingly, Agency 1 issued QSub a status letter. In year 2, Agency 1 appointed Agency 2 as receiver of QSub after finding that QSub was in an unsafe and unsound condition to transact business. Based on this downturn in the business, the taxpayer and its shareholders attempted to maximize and pass through QSub's losses in year 1, before Agency 1 placed QSub into receivership. Specifically, the taxpayer wanted to recognize a loss realized by QSub and have that loss flow through to its shareholders as an ordinary loss.
The General Rule: Sec. 165
Generally, under Sec. 165(a), a deduction is permitted for any loss sustained during the tax year for which a taxpayer does not receive compensation in the form of insurance proceeds or other reimbursement. If a security becomes worthless during the tax year, the loss is treated as a loss from the sale or exchange of a capital asset on the last day of the tax year (Sec. 165(g)). This produces a capital loss subject to applicable limitations.
The Exception: Sec. 165(g)(3)
The exception to the rule can be found under Sec. 165(g)(3), which provides for an ordinary deduction if the worthless stock is that of an affiliated corporation. For purposes of this Code section, a corporation shall be treated as affiliated with the taxpayer only if criteria are met under an ownership test and a gross receipts test.
The ownership test under Sec. 165(g)(3)(A) is met if the taxpayer directly owns stock in the corporation meeting the requirements of Sec. 1504(a)(2). This cross-reference refers to the 80% vote and value test seen in an affiliated group:
The ownership of stock of any corporation meets the requirements of this paragraph if it—
(A) possesses as least 80 percent of the total voting power of the stock of such corporation, and
(B) has a value equal to at least 80 percent of the total value of the stock of such corporation.
Sec. 165(g)(3)(B) describes the gross receipts test as more than 90% of the aggregate of its gross receipts for all tax years having been from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stocks and securities.
What If an Entity's QSub Status Is Terminated Because the Parent's S Corporation Status Is Terminated?
On the surface, it may appear as though a QSub meets the ownership test under Sec. 165(g)(3)(A). A QSub must be a domestic corporation that is 100% owned by an S corporation. The QSub must not be an ineligible corporation (defined in Sec. 1361(b)(2)), and the S corporation must elect to treat that corporation as a QSub. However, under Sec. 1361(b)(3)(A), a corporation that is a QSub shall not be treated as a separate corporation. Furthermore, Regs. Sec. 1.1361-4(a)(2) provides that if an S corporation makes a valid QSub election with respect to a subsidiary, the subsidiary is deemed to have liquidated into the S corporation. With the corporation having elected QSub status and liquidated, the S corporation's ownership no longer meets the definition of a security in Sec. 165(g)(2).
Taxpayer's Position
The taxpayer described in the CCA, being aware of the QSub's disregarded status, presumably terminated its S corporation status and, therefore, terminated the subsidiary's QSub status. The taxpayer based its argument on the interaction between Regs. Secs. 1.1361-5(a)(1)(ii) and 1.1361-5(b)(1)(i). If an S corporation parent's status as an S corporation terminates by revocation, any QSubs are deemed to terminate QSub status at the close of the last day of the parent's last tax year as an S corporation. Additionally, the revocation of the subsidiary's status as a QSub is treated as an incorporation transaction. Incorporation transactions are generally tax-free if certain requirements under Sec. 351 are met.
Thus, on date 2, the taxpayer's S corporation election terminated, and on date 1, immediately before the taxpayer's election terminated, the subsidiary's QSub election terminated and it became a C corporation. The taxpayer argued that on the last day of the S corporation's tax year, the QSub became a C corporation. At that moment, the newly formed C corporation's stock was worthless as identified by the status letter. Having now met the criteria under the ownership test of Sec. 165(g)(3)(A), the taxpayer took the position that it was entitled to an ordinary loss deduction under Sec. 165(g)(3). Once that ordinary deduction was recognized, the S corporation passed it through to its shareholders under Sec. 1366.
The IRS's Position
The examining agent determined that the taxpayer's position was without merit because the incorporation transaction failed the requirements of Sec. 351 and because Sec. 165(g)(3) was not intended for S corporation subsidiaries.
Failed Sec. 351 Incorporation Transaction
Under Regs. Sec. 1.1361-5(b)(1)(i), if a QSub election terminates, the former QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before the termination from the S corporation parent in exchange for stock of the new corporation. Under Sec. 351, this exchange may be tax-free if, immediately after the exchange, the contributing parties are in control of the new corporation as defined under Sec. 368(c). A failed Sec. 351 transaction results in a sale or exchange of the QSub assets for stock in the new C corporation under Sec. 1001.
However, the issuance of the status letter suggests that the liabilities exceeded the fair market value of the QSub's assets, and, as a result, the QSub was insolvent for tax purposes. A valid Sec. 351 transaction implies an exchange of value for an ownership interest in the corporation. This precedent was established in case law (see Meyer, 121 F. Supp. 898 (Ct. Cl. 1954), cert. denied, 348 U.S. 929 (1955); Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942); and Stafford, 611 F.2d 990 (5th Cir. 1980)) and has been adopted as part of the "net value requirement" under Prop. Regs. Sec. 1.351-1(a)(1)(iii). These circumstances led to the conclusion that the taxpayer did not meet the criteria under Sec. 351 for a tax-free incorporation. Therefore, under Sec. 1001, the taxpayer would recognize gain, while any resulting loss would be required to be deferred under related-party rules of Sec. 267(f)(2)(B).
Applicability of Sec. 165(g)(3) to S Corporations
The examining agent put forth another argument based on the legislative history that an ordinary deduction was not intended to be available for an S corporation. This notion stems from the general concept that an S corporation's taxable income should be computed in the same manner as in the case of an individual (Sec. 1363(b)). Because Sec. 165(g)(3) is not listed as an exception to the general rule in Sec. 1363(b), and individuals are ineligible to claim an ordinary loss under Sec. 165(g)(3), S corporations are also ineligible.
The predecessor provision to Sec. 165(g)(3) was added to the Code in 1942 and amended in 2000 to specifically link the ownership test to Sec. 1504(a)(2). The agent noted that the basis for the exception was linked to the tax treatment of consolidated groups and their ability to offset losses of one corporation with income of another. Congress concluded that it was "desirable and equitable" to permit a parent corporation that owns sufficient interest in a subsidiary to receive an ordinary loss deduction when the subsidiary's stock becomes worthless, because the parent could reach the same result by choosing to file on a consolidated basis. The subsidiary's business activities are thought to be an extension of the parent's business activity, rather than viewing the subsidiary as an investment by the parent corporation.
Congress enacted Sec. 1363(b) in 1982. Sec. 1371, although also enacted in 1982, was amended in 1996. As amended, Sec. 1371(a) says (with certain exceptions) that "subchapter C shall apply to an S corporation and its shareholders." However, Sec. 165 is not a part of subchapter C.
Pursuit of an Ordinary Deduction
If the two previous arguments were not convincing enough, the examining agent also determined the timing of the change in status of the S corporation and its QSub was intentionally chosen by the taxpayer solely for the purpose of meeting the ownership test. Without a legitimate business purpose, the deduction would likely be disallowed under Regs. Sec. 1.165-5(d)(2)(ii), which states:
None of the stock of [the subsidiary corporation may be] acquired by the taxpayer solely for the purpose of converting a capital loss sustained by reason of the worthlessness of any such stock into an ordinary loss under section 165(g)(3).
Possible Alternative
One possible alternative that the taxpayer could have considered to recognize an ordinary deduction would have been to merge the QSub into a newly formed single-member limited liability company (SMLLC) owned by the S corporation. As an SMLLC, the entity would default to disregarded status under Regs. Sec. 301.7701-3(b)(1)(ii). Following its formation, the existing QSub could then have merged into the SMLLC, with the SMLLC surviving. Since the merger of a disregarded entity into another disregarded entity is not recognized for tax purposes, the merger could have been accomplished without tax consequences. Since an SMLLC is disregarded for income tax purposes, the S corporation may have been entitled to recognize an ordinary loss on the abandonment of the underlying assets equal to the tax basis of the assets in the SMLLC.
Pursuant to Regs. Sec. 1.167(a)-8(a)(4), to qualify for the recognition of loss from the physical abandonment of assets, the taxpayer must intend to irrevocably discard the asset so that it will neither be used again by the taxpayer nor retrieved by the taxpayer for sale, exchange, or other disposition. In this situation, the transfer to Agency 2 might have qualified as an abandonment that produces an ordinary loss under Sec. 1231 or otherwise. The S corporation could then pass through the abandonment loss to its shareholders.
Ultimately, while the taxpayer planned for an ordinary loss deduction, more sophisticated tax planning might have yielded a better result.
EditorNotes
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.
