Taxpayer-favorable letter ruling on consolidated worthless stock deduction.

• Author: Hering, David

IRS Letter Ruling 200710004 breaks new ground in determining the character of a worthless stock deduction in a consolidated group. Due to the lack of direct authorities on point and the absence of clear statutory support for the ruling's favorable conclusions, taxpayers might consider seeking their own letter rulings to benefit from the Service's interpretations in Letter Ruling 200710004, perhaps even applying some of the principles to situations outside of a consolidated group.

The proposed transaction in the ruling is deceptively simple: Holding was an insolvent U.S. corporation converted to a limited liability company (LLC), resulting in its deemed liquidation. This conversion caused Taxpayer, which owned at least 80% of Holding's voting power and value, to recognize a loss. The interesting element was the way in which the gross-receipts test of Sec. 165(g)(3)(B) was calculated.

Facts

Although the proposed transaction is simple, certain background facts and some history are needed to understand the conclusions reached in Letter Ruling 200710004. Foreign Parent directly and indirectly owned 100% of Taxpayer, a U.S. corporation and the parent of an affiliated group filing a consolidated return.Taxpayer owned at least 80% of the voting power and value of Holding, a U.S. corporation conducting substantially all of its business operations through its subsidiaries. At the time of the LLC conversion, Holding owned 100% of Sub1 and Sub2. Sub1 is a disregarded entity (DE) for Federal tax purposes, conducting one line of business through other DEs; Sub2 is a U.S. corporation conducting a second line of business. Holding owed significant debt to related foreign parties and a relatively small amount to Taxpayer.

At some point, Taxpayer determined that it had overpaid for the Holding stock. After this realization, Holding sold a substantial portion of its operations and subsidiaries, and used the sale proceeds to pay down some of the related-party debt. Holding's sales (collectively, the "Sec. 381 transactions") fell into three categories:

1. Sec. 338 transactions: Holding sold some first-tier subsidiaries, and Holding and the buyer made joint elections under Sec. 338(h)(10) to treat the transaction as a sale of the subsidiaries' assets, followed by a Sec. 332 liquidation.

2. Sec. 332 transactions: Some of Holding's first-tier subsidiaries sold their assets, then formally dissolved in a Sec. 332 liquidation.

3. De facto liquidation transactions: Some...