Determining gross receipts under Sec. 165(g)(3)

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

The IRS ruled in Letter Ruling 202140002 (released Oct. 8, 2021) that a corporation included the historic gross receipts of its liquidated subsidiary for purposes of the gross-receipts test under Sec. 165(g)(3). The letter ruling has a fact pattern similar to that of Rev. Rul. 2003-125, involving a corporation that becomes insolvent and elects a change in entity classification under Regs. Sec. 301. 7701-3 (an elective change).

While the letter ruling applies only to the requesting taxpayer, it is consistent with prior rulings in which the IRS ruled that a corporation takes into account the gross receipts of a transferor corporation after a transaction under Sec. 381(a). Therefore, in the absence of definitive guidance, the letter ruling may further confirm the IRS’s view. The letter ruling is also noteworthy for containing some planning considerations for taxpayers in similar circumstances.

This item first summarizes some of the relevant authorities and then covers the facts and conclusion in Letter Ruling 202140002.

Sec. 165(g) and worthless security losses

Under Sec. 165(g)(1), a loss related to a security that is a capital asset and becomes worthless during a tax year is treated as from a sale or exchange of a capital asset on the last day of that tax year. Thus, a loss on such a worthless security is a capital loss.

However, Sec. 165(g)(3) provides an exception for taxpayers that are domestic corporations. Specifically, a security in a corporation affiliated with a taxpayer that is a domestic corporation is not treated as a capital asset for purposes of Sec. 165(g)(1). Therefore, a loss on a worthless security under those circumstances is an ordinary loss. The definition of “security” for this purpose includes a share of stock in a corporation.

The test to determine whether a corporation is affiliated with the taxpayer requires that (1) the taxpayer directly owns stock in the corporation meeting the requirements of Sec. 1504(a)(2) (possessing at least 80% of the stock’s total voting power and value); and (2) the corporation meets a “gross receipts test” that more than 90% of the corporation’s aggregate gross receipts for all tax years were from sources other than certain specified passive sources. The gross-receipts test is applied to the gross receipts for all tax years combined (see Rev. Rul. 75-186).

Specifically, the gross-receipts test requires more than 90% of the corporation’s aggregate gross receipts for all tax years to be from sources other than (1) royalties; (2) rents (except rents derived from rental of properties to employees of the corporation in the ordinary course of its operating business); (3) dividends; (4) interest (except interest received on the deferred purchase price of operating assets sold); (5) annuities; and (6) gains from sales or exchanges of stocks and securities.

The legislative history of Sec. 165(g)(3) indicates that Congress intended that an ordinary loss deduction for a worthless security was allowable only when the subsidiary was an operating company and not when the subsidiary was an investment or holding company (see Rev. Rul. 88-65, citing S. Rep’t No. 91-1530, 91st Cong., 2d Sess. 2 (1970), and S. Rep’t No. 77-1631, 77th Cong., 2d Sess. 46 (1942)).

The IRS has ruled that, for purposes of computing the gross-receipts test, a corporation takes into account the historic gross receipts of a transferor corporation in a transaction to which Sec. 381(a) applied (e.g., a liquidating distribution under Sec. 332); however, gross receipts from intercompany transactions under Regs. Sec. 1.1502-13 are eliminated to prevent duplication (see IRS Letter Rulings 201011003, 201524016, 201548003, and 201704003).

An elective change with a single owner

An eligible entity with a single owner that is classified as a corporation can request an elective change to be disregarded as an entity separate from its direct owner (a disregarded entity), with some limitations. Pursuant to Regs. Sec. 301. 7701-3(g)(1)(iii), if such an eligible entity makes an elective change to a disregarded entity, the corporation is deemed to distribute all of its assets and liabilities to its owner in liquidation of the corporation (a deemed liquidation). The effective date of an elective change generally cannot be more than 75 days prior to the date on which the election is filed. However, taxpayers may request an elective change that is effective within three years and 75 days, under circumstances described in Rev. Proc. 2009-41.

The Tax Court has 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”). 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 steptransaction doctrine.

Applying the rationale in Dover and Regs. Sec. 301.7701-3(g)(2)(i), the IRS ruled in Rev. Rul. 2003-125 whether Sec. 332 applied to a deemed liquidation in two situations involving an elective change of an eligible entity from a corporation to a disregarded entity. The pivotal issue was the requirement under Regs. Sec. 1.332-2(b) that the recipient corporation receive at least partial payment for the stock that it owned in the liquidating corporation.

In Situation 1 of Rev. Rul. 2003-125, the corporation was solvent immediately before the effective date of the elective change (i.e., the fair market value (FMV) of its assets exceeded its liabilities), and the IRS ruled that Sec. 332 applied because the shareholder would have received at least partial payment on its stock in the deemed liquidation.

In Situation 2 of Rev. Rul. 2003-125, the corporation was insolvent immediately before the effective date of the elective change (i.e., the FMV of its assets did not exceed its liabilities). The IRS ruled that Sec. 332 did not apply because the shareholder did not receive any payment on its stock in the deemed liquidation, and the shareholder was allowed a worthless security loss under Sec. 165(g).

Letter Ruling 202140002

In Letter Ruling 202140002, the taxpayer was a corporation that was the common parent of a consolidated group. The taxpayer directly wholly owned a corporation, US Sub. US Sub directly wholly owned a corporation, Holding Co., which met the requirements under Sec. 1504(a)(2). Holding Co. Directly wholly owned two corporations, Foreign Sub 1 and Foreign Sub 2.

Foreign Sub 1 was formed in year 1 to focus on developing a product. Foreign Sub 2 was formed in year 2 to be the European operating corporation to facilitate the development and ultimate exploitation of the product. Holding Co. Was formed in year 3 and subsequently acquired the stock of Foreign Sub 1 and Foreign Sub 2 through separate transactions under Secs. 351 and 368(a)(1)(B) on date 1 and date 2, respectively.

On date 3, US Sub concluded that the product was not effective but continued to investigate monetizing related intellectual property. Subsequently, it became clear that monetization was impossible, and US Sub began to wind down its operations related to the product by eliminating Foreign Sub 2’s workforce and disposing of substantially all of Foreign Sub 2’s assets. Foreign Sub 2 was insolvent on date 5.

On date 6, Holding Co. Filed an elective change to treat Foreign Sub 2 as a disregarded entity that was effective on date 4. The taxpayer represented in the letter ruling that Foreign Sub 2 was solvent on date 4 and that the deemed liquidation of Foreign Sub 2 qualified under Sec. 332.

The equity interests of Holding Co., Foreign Sub 1, and Foreign Sub 2 were determined to be worthless on date 7.

US Sub filed an elective change to treat Holding Co. As a disregarded entity that was effective on date 8, which allowed US Sub a worthless security loss under Sec. 165(g) on the stock of Holding Co., similar to Situation 2 of Rev. Rul. 2003-125.

Holding Co. Had no gross receipts since its incorporation.

The IRS ruled that Holding Co. Would take into account the historic gross receipts of Foreign Sub 2 for computing the gross-receipts test. The gross-receipts test would have been necessary to determine whether Holding Co. Was affiliated with US Sub for purposes of Sec. 165(g)(3).

Commentary

The facts and ruling in Letter Ruling 202140002 are noteworthy and contain some planning considerations for taxpayers related to Sec. 165(g). First, the ruling confirms that the IRS may require an acquiring corporation in a Sec. 381 transaction to take into account the gross receipts of a transferor corporation for purposes of the gross-receipts test, notwithstanding that “gross receipts” are not listed in Sec. 381(c). There has been no guidance for this principle other than letter rulings.

Second, the IRS applied this rationale notwithstanding that Holding Co. Was historically a holding company with no gross receipts. Presumably, there was no potential that Holding Co. Would have met the gross-receipts test without taking into account the gross receipts of Foreign Sub 2.

Finally, the availability of an elective change may present tax planning considerations in this area when a subsidiary becomes insolvent. As noted above, taxpayers may be able to make a retroactive election. In the letter ruling, Foreign Sub 2 was insolvent by date 5, but the election was filed on date 6 and effective on date 4. Assuming the dates were sequenced chronologically, Foreign Sub 2 was insolvent when the election was filed. Therefore, the taxpayer may have designated an effective date when Foreign Sub 2 was solvent to get a result similar to Situation 1 of Rev. Rul. 2003-125, as opposed to designating an effective date when Foreign Sub 2 was insolvent, which would get a result similar to Situation 2 of the same revenue ruling. As shown in Rev. Rul. 2003-125, those differences in facts could significantly affect the tax consequences.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. Contributors are members of or associated with Grant Thornton LLP. For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.