Ordinary deduction for worthless QSub stock.

• Author: Mauner, Eric
• Position: Subchapter S subsidiary

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The Internal Revenue Code generally provides for capital loss treatment when a security becomes worthless. An exception to the general rule allows for an ordinary deduction when the stock of a subsidiary in an affiliated group becomes worthless. This provision generally applies to preexisting subsidiaries that are affiliated or part of a consolidated return group. However, the IRS released Chief Counsel Advice (CCA) 201552026, which reminds taxpayers that restructuring an existing qualified subchapter S subsidiary (QSub) in an attempt to qualify for an ordinary deduction is not only already prohibited but might result in an unfavorable deferral of loss.

CCA 201552026

On the facts disclosed in the CCA, the taxpayer was an S corporation holding company that owned a QSub operating a regulated business. In year 1, QSub's business operations were depressed and, accordingly, Agency 1 issued QSub a status letter. In year 2, Agency 1 appointed Agency 2 as receiver of QSub after finding that QSub was in an unsafe and unsound condition to transact business. Based on this downturn in the business, the taxpayer and its shareholders attempted to maximize and pass through QSub's losses in year 1, before Agency 1 placed QSub into receivership. Specifically, the taxpayer wanted to recognize a loss realized by QSub and have that loss flow through to its shareholders as an ordinary loss.

The General Rule: Sec. 165

Generally, under Sec. 165(a), a deduction is permitted for any loss sustained during the tax year for which a taxpayer does not receive compensation in the form of insurance proceeds or other reimbursement. If a security becomes worthless during the tax year, the loss is treated as a loss from the sale or exchange of a capital asset on the last day of the tax year (Sec. 165(g)). This produces a capital loss subject to applicable limitations.

The Exception: Sec. 165(g)(3)

The exception to the rule can be found under Sec. 165(g)(3), which provides for an ordinary deduction if the worthless stock is that of an affiliated corporation. For purposes of this Code section, a corporation shall be treated as affiliated with the taxpayer only if criteria are met under an ownership test and a gross receipts test.

The ownership test under Sec. 165(g) (3)(A) is met if the taxpayer directly owns stock in the corporation meeting the requirements of Sec. 1504(a)(2). This cross-reference refers to the 80% vote and value test seen in an...