Five-year carryback increases the benefit of accelerating losses
Under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), many corporate taxpayers will benefit from the five-year net operating loss (NOL) carryback provision. This provision allows for the carryback of losses arising in a taxable year beginning after Dec. 31, 2017 and before Jan. 1, 2021, to each of the prior five taxable years. This includes to prior taxable years where the corporate tax rate was higher (i.e., 35%). For further detail, see our article, CARES Act delivers five-year NOL carryback to aid corporations. Given the economic and financial downturn resulting from the current global crisis, taxpayers may have the opportunity to increase NOL carrybacks by accelerating losses on insolvent subsidiaries (foreign or domestic) without disposing of or shutting down the business.
Worthless stock deductions
When a corporate subsidiary becomes insolvent, section 165(g), which addresses worthless stock, provides a potential tax savings opportunity for a domestic parent corporation upon the subsidiary’s liquidation or other disposition.1 Notably, section 165(g)(3) allows for the recognition of an ordinary rather than a capital loss on the liquidation or disposition of a worthless subsidiary. Notably, through either an election or simple entity conversion, a loss is possible without disposing of the subsidiary or its business.
In order for a domestic parent corporation (P) to claim an ordinary loss under section 165(g)(3) on the disposition of a worthless corporate subsidiary (S), the disposition must meet both an ownership and gross receipts test. Under the ownership test, P must directly own control of S, defined within section 1504(a)(2) as at least 80% of the total voting and value of the S stock.2 Because this definition of control includes foreign corporations, ordinary losses are available on the disposition of both foreign and domestic worthless subsidiaries. With respect to the gross receipts test, more than 90% of the subsidiary’s aggregate gross receipts for all taxable years that it has been in existence must be from sources other than royalties, rents (except rents derived from rental of properties to employees of the subsidiary in the ordinary course of operating the 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.3 Documenting this requirement is often not an easy task if ownership of the subsidiary has changed hands numerous times or if the subsidiary has been in existence for many years. Additional complications may arise when determining the treatment of subsidiary holding companies and analyzing the gross receipts history of corporations that have merged with or liquidated into the subsidiary.4
Determining worthlessness of an insolvent subsidiary
That S is insolvent does not by itself represent a disposition and allow P to claim a worthless stock deduction. Rather, P must establish worthlessness through a closed and completed transaction that is fixed by an identifiable event.5 In the context of a consolidated tax group, the timing of the loss deduction is subject to additional rules.6
Perhaps the most definite and common way of identifying worthlessness is through liquidation of the subsidiary.7 To the extent the shareholder does not receive value upon liquidation; the liquidation establishes that such shareholder will never receive value for its stock. As a result, to the extent a subsidiary is insolvent at the time of liquidation, section 165(g) rather than section 332 applies.8 Liquidations can occur in a variety of ways, including through methods that do not result in the formal dissolution or liquidation of the subsidiary for legal purposes. Methods of liquidating that trigger the worthless stock deduction include:
- Legal liquidation or dissolution of S.
- ‘Check-the-box’ election to treat S, a foreign corporation, as an entity disregarded from P.9
- Conversion (under state law) of S, a domestic corporation, into an entity disregarded from P.10
- Merger of S with and into an entity disregarded from P.11
- Sale of S with a corresponding section 338(h)(10) transaction.12
Treatment of intercompany debt
In determining insolvency and the ability to recognize a worthless stock deduction, debt owed by S to P is taken into account.13 However, unlike with third-party debt, distinguishing intercompany debt from equity is often difficult. If the intercompany debt is not debt for tax purposes and the value of the assets exceed the sum of external liabilities, the subsidiary may be solvent, thereby eliminating the worthless stock deduction in favor of section 332 liquidation. To assist in this debt versus equity determination, the Service and courts have established a number of factors to consider.14 A careful review of the various factors is often necessary to support the treatment of intercompany liabilities as debt. Furthermore, classification of intercompany open accounts and cash sweep accounts as debt for tax purposes is often difficult. For example, where an intercompany debt has a priority claim on the assets upon liquidation over common equity, the intercompany debt would likely retain status as a preferred class of equity.15
Potential disallowance of the loss on disposition of a consolidated subsidiary
The last step in qualifying for an ordinary loss on a subsidiary corporation that is part of a consolidated group is to apply the unified loss rules (ULR).16 These rules are intended to disallow non-economic losses and eliminate duplicated losses on the disposition of a consolidated subsidiary. The ULR applies a complex set of rules, beyond the scope of this communication. The takeaway for this analysis is that the ULR could apply to the disposition of any subsidiary out of a consolidated group and must be considered prior to claiming the worthless stock deduction.
When considering options for dealing with an insolvent subsidiary’s business, section 165(g)(3) provides an opportunity to recognize an ordinary deduction on the investment in the subsidiary that could offset income generated by other profitable activities. However, when determining whether an ordinary deduction is allowable, close attention must be paid to the requirements of section 165(g)(3), the treatment of intercompany debt, and, in some cases, the consolidated return rules.
The unfortunate effects of the COVID-19 crisis may result in an opportunity for corporate taxpayers to accelerate losses on subsidiaries in the current year, and increase NOLs available for the five-year carryback. Most carryback years taxed corporate income at 35%, so the carryback opportunity is significant. Taxpayers should consult their tax advisors when analyzing potential losses for worthless stock deductions and the additional considerations under the CARES Act regarding the use of such losses.
1All section references herein refer to the Internal Revenue Code of 1986, as amended, and the regulations thereunder.
4PLR 200710004 (March 9, 2007).
5Reg. section 1.165-1(b).
6Reg. section 1.1502-80(c), which defers worthlessness until the member ceases to be a member of the group or the stock is worthless as defined within Reg. section 1.1502-19(c)(1)(iii).
7See Mahler v. Commissioner, 119 F.2d 869 (2nd Cir. 1941); Gould Securities Co. v. United States, 96 F.2d 780 (2nd Cir. 1938); Burnet v. Imperial Elevator Co., 66 F.2d 643 (8th Cir. 1933); Dittmar v. Commissioner, 23 T.C. 789 (1955).
8Reg. section 1.332-2(b); Prop. Reg. sections 1.332-2(b) and (e), Example 2; Rev. Rul. 2003-125, 2003-2 C.B. 1243.
9Reg. section 301.7701-3(g)(1)(iii); Rev. Rul. 2003-125.
10Reg. section 1.332-2(d); PLR 200035031 (Sept. 5, 2000); PLR 9701029 (Jan. 3, 1997).
12See Reg. section 1.338-1(a)(2); CCA 200818005 (May 2, 2008), stating general rules of tax law apply to the transactions deemed to occur as a result of the section 338 election.
13Rev. Rul. 59-296, 1959-2 C.B. 87.
14Notice 94-47, 1994-1 C.B. 357; Estate of Mixon, Jr. v. United States, 464 F.2d 394 (5th Cir. 1972); Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956); Miele v. Commissioner, 56 T.C. 556, 564 (1971); Litton Business Systems, Inc. v. Commissioner, 61 TC 367 (1973); Gokey Properties, Inc. v. Commissioner, 34 TC 829, 835 (1960); New England Lime Co. v. Commissioner, 13 TC 799 (1949); Dixie Dairies Corp. v. Commissioner, 74 TC 476 (1980); Wachovia Bank & Trust Co. v. United States, 288 F.2d 750, 756 (4th Cir. 1961); Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969); A.R. Lantz Co. v. United States, 283 F. Supp. 164, 168 (D. Cal. 1968); Curry v. United States, 396 F.2d 630, 633 (5th Cir. 1968); Gooding Amusement Co. v. Commissioner, 236 F.2d 159,162 (6th Cir. 1956); Washmont Corp. v. Hendricksen, 137 F.2d 306, 308 (9th Cir. 1943).
15PLR 201103026 (Jan. 21, 2011).
16Reg. section 1.1502-36.