Worthless stock losses from liquidations and related issues in consolidation.

AuthorWhite, Matthew K.

The recent economic downturn has left many otherwise profitable affiliated groups of corporations with one or more failing subsidiaries. From a federal income tax perspective, insolvent subsidiaries often present a significant planning opportunity. If feasible from a business standpoint, the liquidation of an insolvent subsidiary could result in the recognition of an immediate stock loss. In many states, a deemed liquidation for tax purposes can be accomplished easily, through the conversion of the corporate entity into a limited liability company (LLC). In the simplest case, a parent corporation (P) that owns all of the outstanding stock and debt of an insolvent subsidiary (S) converts S into an LLC that is treated thereafter as a disregarded entity. (1) P will frequently be able to obtain immediate losses--and sometimes ordinary deductions--from the resulting deemed liquidation, without the bother of dissolving S, selling the entity or its assets to a third party, or otherwise altering S's ongoing business operations. (2)

It sounds simple and, indeed, the actual transaction could not be more straightforward. Unfortunately, the tax analysis can be surprisingly complex and uncertain, and where P and S file a consolidated return, the interaction of the consolidated return rules with generally applicable tax principles creates additional opportunities and pitfalls. But with proper fortitude, planning, and a peculiar sense of humor, you may find some enjoyment and profit in the liquidation of an insolvent subsidiary. This article reviews the key concepts and issues that are implicated by these situations.

Generally Applicable Tax Principles

Assume that parent P forms subsidiary S in Year 1 by transferring $300 to S in exchange for all of S's common stock and transferring $900 to S in exchange for an instrument that is denominated as a recourse loan. Assume that S loses a combined $1,000 in Years 1 and 2, generating $1,000 of unused net operating losses carryovers (NOLs), and that, at the end of Year 3, S's remaining assets are worth $200. At this point, P decides to liquidate S, either actually or constructively (through an LLC conversion). The S common stock is cancelled (or is deemed cancelled) in exchange for no consideration, and P receives (or is deemed to receive) the $200 of S's assets in exchange for the cancellation of the $900 S loan.

The threshold matter for determining the tax treatment of the liquidation is the proper classification of the $900 loan. If the loan documents contain arm's-length terms and S has been paying the stated interest rate, the loan likely will be respected as debt. In many circumstance, however, related parties make cash advances without observing the formalities or considering whether the advance is intended to be a more in the nature of a loan or an equity contribution. In such cases, it may be unclear whether the advance should be characterized as debt or equity. (3)

If the intercompany loan is recharacterized as equity, it must be further classified as either preferred or common stock. In general, if the loan states a "sum-certain" principal amount, then classification as preferred stock is more likely (on the theory that the principal amount would have a preference over the common stock under local law). (4) In other cases, the cash advance might not be documented or might be documented so informally that it might have no preference over the common stock. If so, the advance could be treated as common stock. (5)

Before considering the overlay of the consolidated return rules, this article reviews the consequences that flow from these three potential characterizations of the loan in the separate return context.

  1. If the Loan Is Debt

    1. Treatment of S Stock

      Where P owns an amount of stock in S meeting the requirements of section 1504(a)(2) (i.e., 80 percent of the vote and value of the S stock), section 332(a) provides that P will recognize no gain or loss on the receipt of S's property in a complete liquidation of S. Because P owns all of the stock of S in our example, P's realized loss from the liquidation might arguably be disallowed under section 332. The regulations under section 332, however, require that P "receives at least partial payment for the stock of which it owns in the liquidating corporation." (6) Thus, because P receives the $200 of S's assets in partial repayment of the loan, but receives nothing for its S stock, section 332 cannot apply. (7)

      Instead, P generally will be entitled to a loss or deduction for its worthless S stock under section 165. This section allows a deduction for "any loss sustained during the taxable year and not compensated by insurance or otherwise." (8) Section 165 permits a deduction only if the loss on stock is evidenced by a closed and completed transaction, fixed by identifiable events, and actually sustained. (9)

      Thus, at least two initial requirements must be satisfied to ensure that P is entitled to a deduction under section 165 with respect to the S stock: (i) the S stock must have first become worthless in Year 3, rather than a prior year; and (ii) P's loss must be fixed by an identifiable event. In practice, establishing the exact year in which S becomes worthless can be a challenging, fact-intensive endeavor. (10) Assuming that S did not become worthless until Year 3, the other requirement--that P's loss must be fixed by an identifiable event--would be satisfied by the actual or deemed dissolution of S in connection with the complete liquidation. (11)

      The next question is whether P's $300 loss on the S stock is capital or ordinary. Under the general rule in section 165(g)(1), if a security is a capital asset, as would typically be the case for the S stock in P's hands, P's worthless stock deduction will be treated as a capital loss. (12) Section 163(g)(3), however, provides an important exception to the general rule and permits ordinary loss treatment for worthless securities of an "affiliated corporation," defined by a two-prong test.

      First, to be an affiliated corporation, P must hold 80 percent of the S stock by vote and value. (13) In our example, P owns 100 percent of the S stock. (14) Second, the subsidiary must meet a gross receipts test. Under this test, more than 90 percent of the aggregate gross receipts of the subsidiary for all taxable years must have been from non-passive sources. (15) The list of passive sources includes royalties, rents, dividends, interest, annuities, and gains from the sales or exchanges of stock and securities. (16) In calculating gross receipts, the passive income from the sales or exchanges of stock and securities is measured by only the gain, and not the entire consideration received. (17)

      The legislative history of section 165(g)(3) provides that P should be permitted an ordinary loss in cases where S's operations would have generated predominately ordinary deductions if P had conducted them directly through a division. (18) The gross receipts test is a proxy for P's deemed operation of the S business. The gross receipts test can impose significant substantiation burdens on subsidiaries with long histories, since it aggregates all taxable years in which the subsidiary has existed. In addition, the IRS has issued several private letter rulings holding that S's gross receipts history includes the history of any predecessor corporations that merged or liquidated into S in tax-free transactions. (19) Therefore, a taxpayer may need to substantiate the gross receipts history of all predecessor corporations of S.

      On the other hand, the ability to selectively merge or liquidate target corporations into S and obtain the gross receipts history of the target presents a planning opportunity. For instance, if S is a holding company with passive income that would not satisfy the 90-percent gross receipts test, P may be able to arrange to merge or liquidate an active subsidiary elsewhere in the P group into S before S liquidates in order to qualify for a later worthless stock deduction. (20)

      Another planning opportunity arises from the ability to engage in intercompany transactions within a consolidated group to generate active receipts for S. In several private letter rulings, the IRS has held that intercompany payments received by S, including payments such as dividends that would normally be considered passive under the rules applicable to nonconsolidated taxpayers (separate entity rules), can be recharacterized as active gross receipts under principles that specifically apply to transactions between consolidated group members. (21) The letter rulings analyze payments from other group members by looking to the gross receipts history of the payor member, and treating S as receiving active or passive receipts essentially in proportion to the payor's active and passive gross receipts. (22) Apparently, if S has too many passive receipts, the IRS will permit a consolidated group to make dividend payments selectively from active subsidiaries before S liquidates in order to satisfy the 90-percent test. The IRS will not, however, permit look-through relief for dividend payments from subsidiaries that are not included in the P consolidated group. (23)

      There are a number of areas of uncertainty that arise under the gross receipts test. For example, it is unclear how capital contributions to S, or cash loans to S that are later forgiven in whole or in part, should be taken into account under the gross receipts test. (24) It is also unclear how to apply the test in situations where a subsidiary has no gross receipts. (25)

      The upshot is that if the S loan is respected as debt and S can satisfy the 90-percent gross receipts test (either based on its historic activities or through the previously described planning technique), P will generally be able to obtain an ordinary stock loss from the liquidation of S.

    2. Treatment ors Loan

      In the foregoing example, P's $700 loss realized on the receipt of...

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