National Office Concludes No Ordinary Loss Allowed to S Corporation for Worthless Subsidiary

An S corporation had a problem—its subsidiary which had elected to be treated as a Qualified Subchapter S Subsidiary (QSUB) was about to be placed in receivership by a government agency, being in a condition “unsafe to conduct business.”  This would effectively result in the S corporation losing the entire subsidiary and receiving nothing in return.

The shareholders wanted to make the best of a bad situation and at least get an ordinary loss from the worthlessness of the subsidiary.  They came up with a theory about how to trigger an ordinary loss, a theory the the National Office gave its comments on in Chief Counsel Advice 201552026.  Unfortunately for the shareholders, the National Office did not concur with their view of the proper treatment.

As the memo notes, creating an ordinary loss in this situation is not easy, since the tax law naturally prefers capital losses in these cases.  As the memo notes:

As an S corporation holding company owning a QSub, Taxpayer has several obstacles to overcome in order to pass-through an ordinary deduction to its shareholders. A QSub is a disregarded entity, that is, it is not treated as a separate corporation for federal income tax purposes, even though it remains a separate legal entity under state law. Instead, all of a QSub's assets, liabilities, items of income, deduction and credit are treated as items of the parent S corporation. With Taxpayer's initial structure the shareholders primarily had three ways to recognize a loss, none of which resulted in a $A ordinary loss:

(1) have the shareholders take a worthless stock deduction on their S corporation shares, resulting in a capital loss (assuming qualification under § 165(g)(1));

(2) have the shareholders sell their shares to a third-party for a nominal arm's length price, resulting in a capital loss (assuming someone would buy a "worthless" S corporation); or

(3) have the S corporation sell the Subsidiary stock (treated as a deemed asset sale) or assets to a third-party for an arm's length price which could result in a mix of ordinary and capital loss (depending on the character of the assets held by Subsidiary).

Casting about for a possible way to get an ordinary loss, the S corporation ran across IRC §165(g)(3).  Generally if a taxpayer abandons an asset there is no sale and, as such, there is an ordinary loss even if the asset is capital.  A sale is generally a necessary prerequisite for capital gain/loss treatment.

But a special rule generally applies to worthless securities under IRC 165(g)(1) that creates a capital loss if a security that is a capital asset in the hands of the taxpayer becomes worthless.  Like much of the tax law, this exception is subject to an exception of its own, found at IRC §165(g)(3) which offers an option to not have security in a corporation associated with the taxpayer treated as a capital asset.

All well and good except that a QSUB is disregarded as an entity while the QSUB election is in place.  So the fact that it became worthless would normally not be helpful.  But the taxpayers and their adviser came up with a method they thought would enable them to get the ordinary loss treatment by using IRC §165(g)(3).   And they did so by terminating the S election, as the memo notes:

In an attempt to qualify its shareholders for ordinary loss treatment for the full amount of their investment, Taxpayer affirmatively terminated its S corporation status effective Date 2. As a result, Subsidiary's QSub status also terminated. Under Reg. § 1.1361-5(a)(1)(ii), if an S corporation parent's status as an S corporation terminates by revocation, the QSub's status of its QSubs terminate at the close of the last day of the parent's last taxable year as an S corporation. Regulation § 1.1361-5(b)(1)(i) details the effect of such a QSub termination: "If a QSub election terminates . . ., the former QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before the termination from the S corporation parent in exchange for stock of the new corporation." Thus, on Date 2 Taxpayer's S election terminated, and on Date 1, immediately before Taxpayer's election terminated, Subsidiary's QSub election terminated and it became a C corporation.

…In the present case, Taxpayer argues that on Date 1 when it was still an S corporation, but after Subsidiary became a C corporation, was the moment at which worthlessness occurred. Based upon this analysis, Taxpayer concluded it was entitled to the ordinary deduction under § 165(g)(3) provided its subsidiary C corporation was affiliated and worthless. Once that deduction was recognized, Taxpayer passed through the ordinary deduction to its shareholders pursuant to § 1366.

However, the National Office believes that the transaction doesn’t work out that way for a number of reasons, any one of which the memo holds would be sufficient to deny ordinary loss treatment.

The major problem the National Office locked onto was the fact that when a QSUB election is terminated, the entity is treated as transferring its assets and liabilities to a new corporation in a Section 351 corporate formation transaction.  The IRS focuses on the fact that there must be an exchange for Section 351 to apply—an if the liabilities of the QSUB exceed the value of its assets, there is nothing “exchanged” for the stock in the “new” corporation, and thus no security for which a loss could be claimed.

The IRS bases this position on the following analysis:

In Meyer v. United States, 121 F. Supp. 898 (Ct. Cl. 1954), cert. denied, 348 U.S. 929 (1955), shareholders transferred worthless stock to a newly formed corporation in what a taxpayer treated as a § 351 exchange. The court concluded that the "term ‘exchange,’ in this context, connotes the transfer of stock in consideration of stock, and not the transfer of valuable stock for absolute worthless stock, as was the case here." According to the court, the “insolvency of the old corporation in the bankruptcy sense [i.e., the transferred liabilities exceeded the fair market value of the asset transferred], gave the creditors an effective command in fact and in law over the assets of the corporation” (citing Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942)). The Fifth Circuit in Stafford v. United States, examined Meyer's holding and interpreted it as meaning “‘property’ . . . [does] not include the worthless stock of a corporation which has an excess of liabilities over assets, because the requirement, in the predecessor of § 351, of an ‘exchange’ connotes the transfer of something of value for the interest received.”

Taxpayers arguing that there is no net value requirement ignore the holdings of Meyer, Alabama Asphaltic Limestone Co. and Stafford. Specifically, “property” must have value and § 351's exchange requirement means something of value must be exchanged between the shareholder and corporation. Because worthless stock does not have value, those taxpayer incorporating liabilities in excess of the value of the transferred assets do not satisfy the § 351 requirements. Thus, such transactions are taxable under § 1001.

But even if that doesn’t work, the IRS notes that the regulations under §165 prohibit a loss deduction if the taxpayer acquires stock with the sole purpose of generating an ordinary loss deduction under IRC §165(g)(3).

The memo notes:

Regulation § 1.165-5(d)(2)(ii) limits the application of § 165(g)(3) by providing that a corporation is treated as affiliated only if none of the stock of the corporation was acquired by the taxpayer solely for the purpose of converting a capital loss sustained by reason of the worthlessness of any such stock into an ordinary loss under § 165(g)(3). Assuming arguendo Subsidiary's QSub-to-C corporation conversion qualifies for tax-free treatment under § 351 (see I. above) and that § 165(g)(3) applies to an S corporation (see III. below), Taxpayer must explain why it acquired the C corporation stock for reasons other than to obtain a $A ordinary deduction.

The memo then notes that, given the fact the corporation needs an immediately worthless subsidiary to get the loss, any claim there was an additional reason would not be plausible.  Remember, the QSUB election terminates on the last day the entity was an S corporation and thus the taxpayer needs an instantaneous worthlessness of the stock at this point.  Otherwise this loss would drift into the parent corporation’s C return year, rendering any ordinary loss unavailable to the shareholders.

Finally, the memo notes that S corporations compute taxable income “in the same manner as an individual”.  The memo notes there are only four exceptions provided, none of which relate to §165(g)(3).  Since §165(g)(3) would not be available to an individual, the memo concludes that the ordinary loss cannot be claimed by an S corporation in computing taxable income passing out to its shareholders.