The IRS recently concluded in a Chief Counsel Advice memorandum
(CCA
201552026) that an S corporation (the taxpayer) couldn’t
claim and pass through to its shareholders a worthless stock
deduction under Section 165(g)(3).
In general, Section 165(g)(1) provides for the recognition of a
capital loss for any security that is a capital asset that becomes
worthless. In certain instances, however, taxpayers can claim an
ordinary loss under Section 165(g)(3) on worthless securities.
Section 165(g)(3) allows an ordinary loss for a worthless security
to be recognized by a domestic corporation if the security is from
a corporation that is affiliated within the meaning of Section
1504(a)(2), with the domestic corporation claiming the loss.
The taxpayer’s subsidiary, a qualified subchapter S
subsidiary (the subsidiary or the QSub), was in financial despair
after a period of depressed operations. The subsidiary was found to
be in an unsound condition to transact business and placed into
receivership. Before that, though, the taxpayer and its
shareholders claimed a worthless stock deduction under Section
165(g)(3) in an attempt to maximize losses in the tax year prior to
the subsidiary’s being placed in receivership.
To effect the worthless stock deduction, the taxpayer and its
shareholders affirmatively terminated the taxpayer’s S
corporation status. As a result, the subsidiary’s QSub status
also terminated. Under Treas. Reg. Sec. 1.1361-5(b)(1)(i), a Qsub
whose S corporation election terminates as a result of its
parent’s termination is treated as if the Qsub’s
election terminated at the end of the last day its parent was an S
corporation. When the subsidiary’s Qsub election terminates,
a new C corporation is deemed to acquire all of the assets of the
terminated subsidiary Qsub from the parent in exchange for deemed
newly issued stock in the new C corporation. Any tax consequences
that arise during this time frame are included on the
parent’s final S corporation tax return and pass through to
its shareholders.
The taxpayer argued that when it terminated its S election, the
subsidiary stock (now a C corporation as of the last instant of the
S corporation’s final subchapter S tax year) immediately
became worthless. So the taxpayer argued it was entitled to
recognize an ordinary worthless stock deduction in accordance with
Section 165(g)(3) on its final S corporation tax return with
respect to the subsidiary.
The IRS disagreed with the taxpayer’s position for three
reasons. First, the IRS concluded that the Qsub’s termination
and the subsequent contribution of assets by the taxpayer to the
new C corporation didn’t qualify under Section 351 and thus
was a taxable exchange under Section 1001. In general, Section
351(a) provides that “[n]o gain or loss will be recognized if
property is transferred to a corporation by one or more persons
solely in exchange for stock of such corporation and immediately
after the exchange, such person is in control of the
corporation.”
Because the subsidiary was insolvent immediately before the
termination of its Qsub election (in other words, its liabilities
exceeded the fair value of its assets), the IRS concluded that the
transferred property was significantly encumbered and
couldn’t qualify as property under Section 351. In addition,
the IRS concluded that the transaction failed Section 351 because
the requirement regarding “in exchange for stock”
cannot be met when the transferor receives stock having no value in
an insolvent corporation.
Second, the IRS concluded that Treas. Reg. Sec. 1.165-5(d)(2)(ii)
limits the application of Section 165(g)(3) when any stock of a
corporation was acquired solely to convert a capital loss sustained
by the worthlessness of any of the stock into an ordinary loss
under Section 165(g)(3). The taxpayer had many options to create a
deduction from the worthlessness of the subsidiary’s stock
that would have resulted in a capital loss, the IRS said. For
example, the taxpayer’s shareholders could have recognized a
capital loss when the taxpayer’s stock was sold, recognized a
capital loss on the subsidiary’s stock under Section
165(g)(1) or sold the subsidiary’s assets under a deemed or
an actual asset sale (recognizing capital and ordinary gain or loss
depending on the types of assets sold). Because the taxpayer chose
the only option that resulted in an ordinary loss —
terminating the S election, resulting in acquiring C corporation
stock and immediately claiming a Section 165(g)(3) deduction
— the IRS concluded that was evidence that the sole purpose
of converting the disregarding entity to a C corporation was to
qualify for an ordinary deduction, in violation of Treas. Reg. Sec.
1.165-5(d)(2)(ii).
Third, the IRS concluded that an S corporation can’t take a
Section 165(g)(3) deduction. The IRS relied in part on Section
1363(b), which provides that the taxable income of an S corporation
“shall be computed in the same manner as in the case of an
individual,” but for certain enumerated exceptions. Section
165(g)(3) isn’t listed as an exception to the general rule in
Section 1363(b).
In rejecting the taxpayer’s position, the IRS discounted
various arguments and case law. The agency buttressed this
conclusion by primarily looking to the legislative history of
Section 165(g)(3). The legislative history, the IRS said,
“suggests that Congress intended the ordinary loss exception
to be available only to corporations that are so closely related as
to effectively be operating a single business.” Congress
concluded that it was “desirable and equitable” to
allow a parent corporation to claim a Section 165(g)(3) deduction
for the worthless stock of a subsidiary corporation that is
affiliated with the parent within the meaning of Section
1504(a)(2), because the parent could otherwise claim the ordinary
deduction simply by electing to file a consolidated return. The
prohibition on the consolidation of an S corporation and a C
corporation appears to support the notion that Congress
didn’t intend to allow an S corporation to recognize an
ordinary deduction under Section 165(g)(3).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.