Losses related to an insolvent corporation.

• Author: Borghino, Jeff

The IRS issued a general legal advice memorandum, AM 2011-003 (8/26/11) (the GLAM), which addressed the tax consequences when an insolvent foreign subsidiary of a domestic U.S. corporation elected to be classified as a partnership. The GLAM addressed these and other issues:

1. Whether the shareholder of an insolvent corporation was allowed a worthless security loss under Sec. 165(g);

2. The federal tax treatment of the subsidiary's liabilities; and

3. Whether a creditor of the subsidiary was entitled to a deduction for bad debt under Sec. 166.

This item summarizes and discusses the facts and the technical framework of the IRS's conclusions.

The Facts

The GLAM's facts provided that a domestic U.S. corporation, X, directly and wholly owned a foreign corporation, Y, and directly owned 80% of the stock of another foreign corporation, Z. Y directly owned the remaining 20% of Z's stock.

X's adjusted basis in its Z stock was $100, and Y's adjusted basis in its Z stock was $30. The fair market value of Z's assets was $100, and Z's liabilities were $110; therefore, Z was insolvent. Z's adjusted basis in its assets was $120. The Z liabilities did not constitute securities under Sec. 165(g)(2), meaning they could be subject to a Sec. 166 bad-debt deduction from the lenders' perspective. Z constituted an "eligible entity" as defined in Regs. Sec. 301.7701-3(a) and elected to be classified as a partnership (Z Partnership) for federal tax purposes under Regs. Sec. 301.7701-3(c)(l)(i).

In Situation 1, the Z liabilities were owed entirely to X. In Situation 2, the Z liabilities were owed entirely to an unrelated foreign corporation, U.

Issue 1: Worthless Security Loss

On Issue 1, the GLAM cited Sec. 165; Regs. Sec. 301.7701-3 (the check-the-box regulations); and Rev. Rul. 2003-125.

Sec. 165: Sec. 165(a) provides that a taxpayer is allowed a deduction for a loss sustained in a tax year that was not compensated by insurance or otherwise. However, under Regs. Sees. 1.1654(b) and (d), such loss must be (1) evidenced by closed and completed transactions; (2) fixed by identifiable events; and (3) with certain exceptions, actually sustained during the tax year. Furthermore, only a bona fide loss is allowable, and substance rather than mere form determines a deductible loss.

Under Sec. 165(g)(1), if any security that is a capital asset becomes worthless during a tax year, the resulting loss is treated as a capital loss. The definition of a "security" in Sec. 165(g)(2) includes a share of stock in a corporation; a right to subscribe for, or to receive, a share of stock in a corporation; or a debt instrument issued by a corporation with interest coupons or in registered form. Sec. 165(g) (3) provides an exception for a taxpayer's capital loss if the security is in an "affiliated" corporation, as defined in the section.

In determining whether stock became worthless, the Board of Tax Appeals in Morton, 38 B.T.A. 1270 (1938), aff'd, 112 F.2d 320 (7th Cir. 1940), provided that the liquidating value of stock is indicia that such stock is worthless, but that there must also be no potential value for such stock to be wholly worthless. The Board of Tax Appeals said that such a loss of value "can be established ordinarily with satisfaction only by some 'identifiable event' in the corporation's life which puts an end to such hope and expectation" (38 B.T.A. at 1279). The board also provided that such identifiable events include bankruptcy, cessation from doing business, liquidation, or the appointment of a receiver.

Cbeck-the-box regulations: Under Regs. Sec. 301.7701-3(a), an eligible entity may elect its classification for federal tax purposes. An eligible entity with a single owner can elect to be classified as either (1) a...