Effect of debt recharacterization on worthless securities deductions.

• Author: Willis, Benjamin

The Sec. 165(g) worthless securities deduction has attracted increased attention in light of the current bleak economic conditions. The IRS recently addressed concerns that the recharacterization of intercompany debt as common equity might prevent a worthless securities deduction (Field Attorney Advice (FAA) 20040301F; Chief Counsel Advice (CCA) 200706011).

This guidance concluded that debt treated as equity for tax purposes will be recharacterized as preferred, rather than common, equity. Consequently, equity owners who are also creditors may still access their common equity basis even if they continue to loan money as a lender of last resort, thereby subjecting their debt to potential recharacterization.

Background

FAA 20040301F provided that recharacterized debt is treated as preferred equity, so a worthless securities deduction could be claimed on common equity. The taxpayer owned two controlled foreign corporations (CFCs) and began lending foreign currencies to them. When the CFCs failed to make timely payment, the loans were rolled into new loans issued by the taxpayer. An independent valuation determined that the CFCs' equity had no positive value. The taxpayer made check-the-box (CTB) elections to treat the CFCs as disregarded entities, triggering worthless securities and bad debt losses under Rev. Ruls. 70-489 and 2003-125.

Following a debt-equity analysis of the intercompany loans, an audit team reviewing the transaction determined that a significant portion of the loans should be reclassified as equity. As a result of the reclassification, the CFCs were solvent at the time of the deemed liquidation.

Where equity owners, owning at least 80% of the vote and value, receive property in exchange for all their interests in complete liquidation, Sec. 332 governs. H. K. Porter Co., 87 T.C. 689 (1986), held that a liquidating corporation is deemed to distribute its property in the following order: (1) to creditors, (2) to preferred equity holders, and (3) to common equity holders. Therefore, if common equity holders receive no property in exchange for their interests upon liquidation, Sec. 332 will not apply. In FAA 20040301F, the IRS concluded that the terms of the notes should be respected for tax purposes. Because the notes provided for a preference to the companies' earnings in the form of interest payments, they were recharacterized as preferred equity.

In CCA 200706011, the Service determined that a foreign subsidiary had negative...