Ordinary worthless stock deductions: characterizing subsidiary receipts.

• Author: Smith, Annette B.

An ordinary loss deduction for worthless stock of an affiliated operating subsidiary generally is permitted under Sec. 165(g) (3), as long as more than 90% of the subsidiary's gross receipts are from active operating income. Determining whether a subsidiary's gross receipts qualify as active operating income for this purpose can be difficult under certain circumstances, such as where the subsidiary earns interest (generally passive) in an active banking business or receives dividends (passive) from a lower-tier subsidiary that generates active operating income. In some situations, courts have interpreted the statutory language to characterize receipts as active when failure to do so would produce "an unreasonable [result] 'plainly at variance with the policy of the legislation as a whole'" (American Trucking Ass'ns, 310 U.S. 534, 543 (1940), quoting Ozawa, 260 U.S. 178,194 (1922), establishing this principle in a nontax case). These "exceptions" to the statute generally can be separated into two categories: active nonqualifying receipts and nonqualifying receipts attributable to active receipts.

Background

The congressional intent behind Sec. 165(g)(3) was to allow an ordinary loss, rather than a capital loss, on stock of a worthless active "operating company as opposed to an investment or holding company" in circumstances when consolidated return treatment in which "losses of the [subsidiary] may be offset against the income of the [parent]" generally is available (statement of Sen. Davis, 90 Cong. Rec. S122 (daily ed. January 12, 1944); S. Rep't No. 1631, 77th Cong., 2d Sess. 46 (1942); see S. Rep't No. 1530, 91st Cong., 2d Sess. 2 (1970); and Letter Rulings 200003039 and 201108001). To support this intent, Congress created an objective test to determine whether a corporation conducts an active operating business.

For an ordinary loss to be available for worthless stock in a subsidiary, receipts of the worthless affiliated domestic or foreign corporation from the following six categories (nonqualifying receipts) must constitute less than 10% of the subsidiary's gross receipts:

* Royalties;

* Rents (except rents derived from rental of properties to employees of the corporation in the ordinary course of its operating business);

* Dividends;

* Interest (except interest received on deferred purchase price of operating assets sold);

* Annuities; and

* Gains from sales or exchanges of stocks and securities.

As noted, certain rents and interest...