Parent's payment on behalf of subsidiary.

• Author: Fairbanks, Greg A.

It may be customary for a corporation (Parent) to pay an expense on behalf of its subsidiary corporation (Subsidiary) for administrative convenience. However, courts and the IRS have established that a taxpayer may deduct an expense only when such expense proximately results from its business (Kornhauser, 276 U.S. 145 (1928)). Thus, whether a corporation is entitled to a deduction under Sec. 162 is determined more by which corporation incurred the liability than by which corporation remitted payment for such liability. In addition, Parent may be obligated to pay a contingent liability of Subsidiary, which does not even become fixed and determinable until after Subsidiary has ceased existence. Which corporation should be able to deduct the expense in this instance? This item summarizes the tax law related to when Parent pays an expense on behalf of Subsidiary and recent related IRS guidance.

Parent's Payment of Subsidiary's Expense

The Supreme Court held in Interstate Transit Lines, 319 U.S. 590 (1943), that a corporation could not deduct expenses that it paid on behalf of its wholly owned subsidiary. In Interstate Transit, Interstate operated a bus transit operation between Illinois, California, Missouri, and Wyoming. Because of California law, Interstate had to form a California corporation (Stages) to operate its bus transit operation in California. Interstate maintained Stages's accounts, managed its finances, and paid its bills and payroll. In a year that Stages incurred a net operating loss, Interstate wanted to deduct Stages's loss because Interstate had paid Stages's expenses.

The Court held that Interstate could not deduct Stages's loss because it related to the Stages business, which was separate from Interstate. The Court also stated that it did not matter whether Interstate made such payments under a legal obligation or voluntarily. "The mere fact that the expense was incurred under contractual obligation does not, of course, make it the equivalent of a rightful deduction" (319 U.S. at 594). (See Baltimore Aircoil Co., 333 F. Supp. 705 (D. Md. 1971), for an exception to Interstate Transit; see also Regs. Sec. 1.166-9 for the treatment of Parent's payments in the capacity of a guarantor.)

Notwithstanding the fact that the Court disallowed Parent's deduction in Interstate Transit, the court in Eskimo Pie Corp., 4 T.C. 669 (1945), clarified that Parent increased its basis in Subsidiary stock for payments of Subsidiary's expenses. In Eskimo Pie, the court held that a corporation could not deduct interest paid on behalf of its subsidiary: "Payments made by a stockholder of a corporation for the...