Ordinary loss deductions under sec. 165(g) (3) in the S corp. context.

• Author: D'Avico, T. Christopher

Is an S corporation entitled to an ordinary loss deduction under Sec. 165(g)(3) when its subsidiary's stock becomes worthless--the same as a C corporation? The IRS offered its opinion in Internal Legal Memorandum (ILM) 201552026, concluding that for purposes of Sec. 165(g)(3), S corporations are treated like individuals, not corporations, and accordingly, cannot claim an ordinary loss. Nonetheless, the Treasury Department included this issue in its 2016-2017 Priority Guidance Plan.

This item focuses primarily on whether S corporations should be entitled to an ordinary loss under Sec. 165(g)(3) as a matter of law. First, this item discusses the background and reasoning of the ILM in denying the S corporation an ordinary loss deduction. Second, it addresses the statutory framework providing for ordinary loss treatment for worthless securities. Third, it explores the plain language of the statute and whether the Subchapter C or Subchapter S rules should apply to S corporations in this context. Fourth, it discusses the respective comments of the Section of Taxation of the American Bar Association (ABA) and the AICPA, both of which argue in favor of ordinary loss treatment. Finally, it concludes that ordinary loss treatment appears to be most proper based on the statutory rules and the purpose behind the provision. Taxpayers should recognize, however, that the IRS currently takes a contrary view. As a consequence, it is important to consult with a tax professional before taking this position, to understand, and possibly mitigate, any risks.

ILM 201552026

The relevant facts enumerated in the ILM are as follows: (1) An S corporation owned a qualified subchapter S subsidiary (QSub); (2) the QSub was placed in receivership because of its precarious financial condition; (3) the S corporation and its shareholders wanted to pass through an ordinary deduction before the QSub was placed in receivership; and (4) the S corporation therefore terminated its S corporation status, which caused the QSub to become a C corporation immediately before the termination of its parent's Subchapter S status. At this point, the parent claimed that its wholly owned subsidiary was worthless and tried to claim an ordinary loss deduction and pass the loss through to its shareholders.

The ILM outlines three arguments against ordinary loss treatment: (1) The subsidiary's QSub termination results in a failed Sec. 351 incorporation transaction of the new C corporation; (2) under...