Is an S corporation entitled to an ordinary loss deduction under Sec. 165(g)(3) when its subsidiary's stock becomes worthless—the same as a C corporation? The IRS offered its opinion in Internal Legal Memorandum (ILM) 201552026, concluding that for purposes of Sec. 165(g)(3), S corporations are treated like individuals, not corporations, and accordingly, cannot claim an ordinary loss. Nonetheless, the Treasury Department included this issue in its 2016-2017 Priority Guidance Plan.
This item focuses primarily on whether S corporations should be entitled to an ordinary loss under Sec. 165(g)(3) as a matter of law. First, this item discusses the background and reasoning of the ILM in denying the S corporation an ordinary loss deduction. Second, it addresses the statutory framework providing for ordinary loss treatment for worthless securities. Third, it explores the plain language of the statute and whether the Subchapter C or Subchapter S rules should apply to S corporations in this context. Fourth, it discusses the respective comments of the Section of Taxation of the American Bar Association (ABA) and the AICPA, both of which argue in favor of ordinary loss treatment. Finally, it concludes that ordinary loss treatment appears to be most proper based on the statutory rules and the purpose behind the provision. Taxpayers should recognize, however, that the IRS currently takes a contrary view. As a consequence, it is important to consult with a tax professional before taking this position, to understand, and possibly mitigate, any risks.
The relevant facts enumerated in the ILM are as follows: (1) An S corporation owned a qualified subchapter S subsidiary (QSub); (2) the QSub was placed in receivership because of its precarious financial condition; (3) the S corporation and its shareholders wanted to pass through an ordinary deduction before the QSub was placed in receivership; and (4) the S corporation therefore terminated its S corporation status, which caused the QSub to become a C corporation immediately before the termination of its parent's Subchapter S status. At this point, the parent claimed that its wholly owned subsidiary was worthless and tried to claim an ordinary loss deduction and pass the loss through to its shareholders.
The ILM outlines three arguments against ordinary loss treatment: (1) The subsidiary's QSub termination results in a failed Sec. 351 incorporation transaction of the new C corporation; (2) under the anti-abuse rule, a corporation may not acquire stock of a subsidiary for the sole purpose of creating a Sec. 165(g)(3) deduction; and (3) S corporations are not entitled to an ordinary loss under Sec. 165(g)(3) as a matter of law because S corporations are treated as individuals for this purpose. It is this last argument that this item looks at more closely, as the other two arguments are not controversial.
In denying ordinary loss treatment, the ILM notes that Congress intended the ordinary loss exception of Sec. 165(g)(3) to be available only to corporations that are so closely related as to be operating as a single business. It would seem that this reasoning applies equally to affiliated C corporations as it does to an S corporation and its C corporation subsidiary or an S corporation and its former QSub. Indeed, the QSub was disregarded as separate from the S corporation while the QSub election was in effect for federal income tax purposes.
The relevant statutory provisions must first be consulted to determine whether capital or ordinary loss treatment is appropriate. Sec. 165(g)(1) lays out the general rule that if a security, which is a capital asset, 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. There is, however, an important exception. Sec. 165(g)(3) provides that the security of an affiliated corporation owned by a domestic corporation is not treated as a capital asset.
Sec. 165(g)(2) defines the term security to include a share of stock in a corporation. Affiliation is defined in Sec. 165(g)(3)(A), which looks to the Sec. 1504(a)(2) rules, i.e., ownership of at least 80% of the voting power and at least 80% of the total value of the stock (the so-called 80%-vote-and-value test). In determining whether ordinary loss treatment applies, Sec. 165(g)(3)(B) also imposes a gross-receipts test. More than 90% of the gross receipts of the subsidiary for all tax years must have been from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stocks and securities (with certain exceptions). The effect of this rule is that domestic corporations owning at least 80% of the vote and value of the stock of another corporation that itself operates a trade or business are entitled to an ordinary loss if the affiliated company's stock becomes worthless. Accordingly, the worthlessness of the stock of an affiliated corporation should be treated as an ordinary loss under the plain language of the statute.
Subchapter C v. Subchapter S: Which rules apply to S corps.?
In the ILM, the IRS's conclusion that an S corporation cannot qualify for Sec. 165(g)(3) treatment is based heavily on the general rule of Sec. 1363(b) that an S corporation computes taxable income "in the same manner as in the case of an individual," with four enumerated exceptions, which do not include Sec. 165(g)(3). The IRS also discusses the legislative histories of Sec. 165(g)(3), its predecessor Sec. 23(g)(4), and Secs. 1363(b) and 1371(a), as well as prior guidance and case law, before concluding:
Considering the plain meaning of Sec. 1363(b), the other authorities discussed above, and Congress's failure to expressly extend the application of Sec. 165(g)(3) to S corporations, an ordinary loss under Sec. 165(g)(3) should not be available to S corporations and their shareholders.
The IRS does not, however, address in any detail another relevant provision of the Code. Sec. 1371(a), which states that except as otherwise provided in the Code, and except to the extent inconsistent with Subchapter S, Subchapter C shall apply to an S corporation and its shareholders. Instead, the ILM merely states that Sec. 1371(a) provides that, with certain exceptions, Subchapter C applies to an S corporation and its shareholders, and notes rather obliquely that Sec. 165 does not fall within Subchapter C. The IRS does not even make passing reference in the ILM to its prior guidance regarding other Subchapter C provisions that it found applicable to S corporations, such as Secs. 332 and 338 (see Technical Advice Memorandum 9245004). The IRS's cursory analysis of Sec. 1371(a) in the ILM ignores the broader principle that Sec. 1371(a) stands for, to wit, that an S corporation is to be treated as a corporation unless to do so would conflict with Subchapter S.
Plain language of the statute
There is nothing in the language of Sec. 165(g)(3) or its legislative history to indicate that Congress's use of the word "corporation" was meant to apply only to C corporations. Indeed, the Code defines an S corporation as a corporation for which an election under Sec. 1362 has been made and defines a C corporation as a corporation that is not an S corporation.
Moreover, several courts have found that S corporations were "corporations" for purposes of the Code. In Rath, 101 T.C. 196 (1993), the Tax Court held that an S corporation was not entitled to characterize a loss as ordinary, as opposed to capital, finding that the S corporation should be treated as a corporation, not an individual, for purposes of Sec. 1244. In Trugman, 138 T.C. 390 (2012), the Tax Court held that an S corporation was not an individual for purposes of the first-time homebuyer credit of Sec. 36, finding that "[a]n S election does not alter the corporation's corporate status; it merely alters the corporation's Federal tax implications." In BDO Seidman, 492 F.3d 806 (7th Cir. 2007), the Seventh Circuit, in deciding whether an S corporation was a corporation for purposes of the predecessor to Sec. 7525(b), stated that "when a particular section of the IRC is intended to apply only to C corporations, Congress will use that term, rather than the generic 'corporation.' "
In light of the plain language of Sec. 165(g)(3) and the courts' ability to construe narrowly statutory language to deprive S corporations of certain benefits under the Code, it would seem logical to treat S corporations as corporations unless to do so would contravene Subchapter S (see Sec. 1371(a)).
ABA and AICPA comments
The Treasury Department invited public comments on the 2015-2016 version of its priority guidance plan, and both the AICPA and the ABA Section of Taxation provided written comments on this subject. After laying out their respective analyses, both professional organizations reached the conclusion that Sec. 165(g)(3) should afford an ordinary loss deduction to S corporations as well as C corporations and recommended that Treasury and the IRS issue guidance to this effect. The ABA comments made the additional point that if there are serious policy concerns in issuing such guidance, Congress should change the statute.
If Congress had intended the ordinary loss deduction under Sec. 165(g)(3) to apply only to C corporations, it could have so stated in the statute. However, Congress merely stated that it applies to "domestic corporations," which would on its face apply to S corporations since S corporations are required by Sec. 1361(b)(1) to be domestic corporations. The IRS should not be allowed to usurp Congress's legislative authority by interpreting the unambiguous language of Sec. 165(g)(3) to mean that it only applies to C corporations. If Congress had intended Sec. 165(g)(3) to apply only to C corporations, it could have drafted the statute in that way, and it still could by amending the statute to add a "C" before "corporations" to make this clear.
Mindy Tyson Weber is a senior director, Washington National Tax for RSM US LLP. Trina Pinneau is a manager, Washington National Tax for RSM US LLP.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.