S corporations generally are taxed differently from C corporations because their income and losses are passed through to their shareholders, rather than taxed at the corporate level. But there are a number of situations where both types of corporations are treated similarly. For example, an S corporation, like a C corporation, can make a Sec. 338(d) election when it makes a qualified stock purchase and can liquidate a subsidiary tax-free under Sec. 332 (Letter Ruling 9245004).
The question of whether an S corporation should be treated the same as a C corporation when its subsidiary corporation is insolvent has not been definitively answered, however. Does Sec. 165(g)(1), which treats any security that is a capital asset and becomes worthless during the tax year as a capital loss, apply? Or does Sec. 165(g)(3), which treats losses on securities in affiliated corporations as ordinary losses, apply? An affiliated corporation for purposes of Sec. 165(g)(3) is defined under Sec. 1504(a)(2) as a corporation that owns at least 80% of both the vote and value of the stock in another corporation. (There is also a gross receipts test that is not relevant here.)
When do C corporation rules apply to S corporations?
Sec. 1371(a) provides that, except as otherwise provided in the Code or to the extent it is inconsistent with Subchapter S, Subchapter C applies to an S corporation and its shareholders. Sec. 1363(b), on the other hand, provides that, except for enumerated exceptions, the “taxable income of an S corporation shall be computed in the same manner as in the case of an individual . . .” So, is Sec. 1363(b) or Sec. 1371(a) more relevant when determining whether an S corporation can take an ordinary loss deduction for losses on a subsidiary’s stock?
In Rev. Rul. 93-36, the IRS dealt with the treatment under Sec. 166 of a nonbusiness bad debt incurred by an S corporation. The IRS ruled that under Sec. 1363(b) an S corporation is treated as a “taxpayer other than a corporation” and thus is subject to the less favorable tax treatment that applies to individual taxpayers. However, arguably this ruling should not be determinative of the proper treatment of an S corporation for purposes of Sec. 165(g)(3) because it does not address business bad debts and does not involve securities.
Sec. 165(g)(3) applies to losses when a corporation owns stock in a subsidiary corporation that is wholly owned or almost wholly owned (80/80 rule under Sec. 1504(a)(2)). When an S corporation owns a subsidiary in these circumstances, is there any reason to treat the corporation as an individual taxpayer? Under the original S corporation rules, this was not an issue because S corporations were prohibited from owning sufficient stock in a corporation to satisfy the 80/80 rule, so the provisions of Sec. 165(g)(3) were not applicable.
However, changes enacted in the Small Business Job Protection Act of 1996, P.L. 104-188, revised the S corporation rules in ways intended, at least in part, to treat C and S corporations more similarly. This included allowing S corporations to own subsidiaries that met the 80/80 rule of Sec. 1504(a)(2). In this changed environment, it would seem consistent to allow S corporations to take advantage of Sec. 165(g)(3)—but the IRS has never provided definitive guidance on this issue, and Sec. 1363(b) and Rev. Rul. 93-36 are still good law and still regard S corporations as individuals.
The alternative to Sec. 165(g)(3) for a parent corporation that wants to liquidate a subsidiary is to use Sec. 332, which permits tax-free liquidations of subsidiaries, even when owned by S corporations. But Sec. 332 cannot be used with insolvent subsidiaries because Regs. Sec. 1.332-2(b) requires the parent corporation to obtain some payment for the stock it is liquidating and the parent receives no payment for the subsidiary’s stock in a liquidation if, at the time of the liquidation, the fair market value of the subsidiary’s assets is less than the subsidiary’s liabilities. Thus, the alternative to a Sec. 332 liquidation, taking an ordinary loss under Sec. 165(g)(3), it is reasonable to conclude, should be equally available to both S and C corporations.
AICPA position
On Sept. 18, 2015, Troy Lewis, chair of the AICPA Tax Executive Committee, submitted a comment letter addressing this issue. The AICPA recommends the position that these losses should be ordinary, not capital, losses, and the letter encourages the IRS and Treasury to provide guidance that S corporations are entitled to the benefits of Sec. 165(g)(3) to the same extent as C corporations.
—Sally P. Schreiber (sschreiber@aicpa.org) is a Tax Insider senior editor.
