Entity conversion fixes year of worthless stock loss

Plain-English summary

Chief Counsel assumed that a subsidiary's stock became worthless several years before the taxpayer claimed the loss. Because the subsidiary remained in the taxpayer's consolidated group, the consolidated return regulations deferred the deduction until a specified triggering event. Earlier debt contributions did not trigger the loss because they produced no cancellation-of-debt income, and the other regulatory events had not occurred. The taxpayer could recognize the loss in the year it elected to treat the subsidiary as a disregarded entity, because that classification change caused the subsidiary to leave the consolidated group.

Ruling snapshot

• Question: In which year may the consolidated parent deduct its loss on worthless subsidiary stock?
• Outcome: advice given
• Key authorities: IRC §§ 165, 165(g), 108(e)(6); Treas. Reg. §§ 1.1502-19(c), 1.1502-80(c); Rev. Rul. 2003-125

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201650013
       Release Date: 12/9/2016
       CC:CORP:2:WWBurhop                                    Third Party Communication: None
       POSTN-115587-16                                       Date of Communication: Not Applicable

UILC: 1502.80-00, 165.06-00

date: August 23, 2016

 to:   Thomas D. Yang
       General Attorney, (Chicago)
       (Large Business & International)

from: Gerald B. Fleming
Acting Branch Chief, Branch 5
(Corporate)

subject: Proper Year of Deduction for a Worthless Stock Loss

       This Chief Counsel Advice responds to your request for assistance dated May 10, 2016.
       This advice may not be used or cited as precedent.

                                                           LEGEND

       Foreign Parent              =        ----------------------------------
       ------------------------------------------------------------------------------
       -------------------------------------------------------------------------

       Historic Parent            =         ------------------
       --------------------------------------------------------------------------

       Taxpayer                   =         --------------------------------------------------------------------------------
       ---------------------------------------------------------------------
       ------------------------------------------------------------

       FSub                      =         -------------------------
       --------------------------------------------------------------------------

       Sub                        =         ----------------------------------------------------------
       -------------------------------------------------------------------------

POSTN-115587-16 2

Country A = ----------

Date 1 = -----------

Date 2 = -------------------

Date 3 = -------------------

Date 4 = -------------------

Date 5 = -------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Year 4 = -------

Year 5 = -------

Year 6 = -------

a = --

b = --------------

c = --------------

d = --------------

e = --------------

f = --------------

g = ----------------

h = ----------------

i = ----------------

j = --------------------
POSTN-115587-16 3

                                                ISSUE

This memorandum responds to your request for advice relating to the interrelation
between section 1651 and Treas. Reg. §1.1502-80(c)2 in order to determine the
appropriate year of deduction by Taxpayer for a loss under section 165(g) for the
worthlessness of the stock of Sub.

                                           CONCLUSION

Provided that the Taxpayer meets the general requirements under section 165 to
deduct its loss on the worthlessness of the stock of Sub during all of the years at issue,
Treas. Reg. §1.1502-80(c)(1) defers the Taxpayer’s deduction of the loss on the Sub
stock until the earliest of one of four identifiable events occur.3 The only identifiable
event that occurred during the years at issue occurred when the Taxpayer elected in
Year 6 to change the classification of Sub from a corporation to an entity disregarded as
separate from the Taxpayer. The change in classification in Year 6 caused Sub to
cease to be a member of the Taxpayer’s consolidated group and, as such, permits the
Taxpayer to recognize its loss on the Sub stock in Year 6. Treas. Reg. §1.1502-
80(c)(1)(ii).

                                      SUMMARY OF FACTS

The Taxpayer is the common parent of a consolidated group of corporations that join in
the filing of a consolidated federal income tax return. The Taxpayer is wholly owned,
directly and indirectly, by Foreign Parent, a Country A corporation. Foreign Parent
historically was part of the Historic Parent group and was separated from the Historic
Parent group as part of a restructuring in Year 2. Foreign Parent directly and indirectly
owns all of the stock of FSub, a Country A Corporation. Prior to Date 4, Year 4, the

1
Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended,
that was in effect during the years at issue or the regulations issued thereunder that were in effect during
the years at issue.
2
During the years at issue, Treas. Reg. §1.1502-80(c) provided “[f]or consolidated return years beginning
on or after January 1, 1995, stock of a member is not treated as worthless under section 165 before the
stock is treated as disposed of under the principles of § 1.1502-19(c)(1)(iii).” However, current Treas.
Reg. §1.1502-80(c)(3) provides that “this paragraph (c) applies to taxable years for which the original
Federal income tax return is due without extensions) after July 18, 2007. However, taxpayers may apply
this paragraph (c) to taxable years beginning on or after January 1, 1995.” The Taxpayer appears to
have applied current Treas. Reg. §1.1502-80(c) to the transaction at issue and as such, this
memorandum applies current Treas. Reg. §1.1502-80(c).
3
We understand that there is controversy over the valuation of Sub, specifically whether Sub was in fact
worthless for purposes of section 165 during the years at issue and at the time the Taxpayer elected to
change Sub’s classification. However, in order to examine the operation of Treas. Reg. §1.1502-80(c),
we assume for purposes of this memorandum that the Sub stock was worthless for section 165 purposes
as of the end of Year 3 and at all times during the years at issue.
POSTN-115587-16 4

Taxpayer owned all of the stock of Sub. On Date 4, Year 4, the Taxpayer sold a% of
the common stock of Sub to FSub for nominal consideration. On Date 2, Year 6, FSub
sold the a% interest in Sub back to the Taxpayer for nominal consideration.

Prior to its acquisition, Sub was publicly traded. Historic Parent purchased Sub from its
public shareholders on Date 1, Year 1. As part of the acquisition transaction, Sub
became liable on approximately $b of intercompany loans used to finance the
acquisition transaction.4 After various assignments of debt, most of Sub’s intercompany
debt was owed to FSub.

Between Year 2 and Year 3, Sub sold various non-core assets to third parties for a total
of approximately $c. Of this amount, Sub used approximately $d to repay
intercompany debt. After the various restructurings of Sub’s operations and the
repayment of debt, as of the end of Year 3 Sub owed approximately $e to FSub and a
very small amount to the Taxpayer.

According to documentation provided by the Taxpayer, the Taxpayer determined that
the value of Sub’s assets had declined by approximately $f by the end of Year 3.
Because of the decline in the value of Sub’s assets and the sales of operating assets to
pay intercompany debt, the Taxpayer determined that at the end of Year 3 Sub had a
negative net worth of approximately $g. Additional documentation provided by the
Taxpayer indicates that the Taxpayer determined that Sub had a negative net worth at
the end of both Year 4 and Year 5.

Because of Sub’s reduced scope of operations, and because Sub’s continued
insolvency could trigger a springing guarantee made by FSub to one of the third-party
purchasers of Sub’s assets, Foreign Parent determined that part of the remaining debt
Sub owed to FSub should be forgiven. Thus, on Date 5, Year 4, FSub forgave
approximately $h of the Sub debt. Then, on Date 5, Year 5, FSub forgave an additional
$i of the Sub debt. The taxpayer treated the cancellation of debt as a contribution to
the capital of Sub under section 108(e)(6).

On Date 3, Year 6, the Taxpayer filed a Form 8832 to elect to treat Sub as an entity
disregarded as separate from the Taxpayer. On its federal income tax return for Year 6,
the Taxpayer claimed a loss on the stock of Sub of $j under section 165(g)(3) and Rev.
Rul. 2003-125, 2003-2 C.B. 1243.

                                               LAW

Section 165(a) provides that there shall be allowed as a deduction any loss sustained
during the taxable year and not compensated by insurance or otherwise.

4
For purposes of this memorandum, we assume that all of the intercompany debt is valid debt for federal
income tax purposes.
POSTN-115587-16 5

Treas. Reg. §§1.165-1(b) and -1(d) provide that to be allowable as a deduction under
section 165(a), a loss must be evidenced by closed and completed transactions, fixed
by identifiable events and actually sustained during the taxable year. Only a bona fide
loss is allowable. Substance and not mere form shall govern in determining a
deductible loss.

Section 165(g)(1) provides that if any security which is a capital asset becomes
worthless during the taxable year, the loss resulting therefrom shall be treated as a loss
from the sale or exchange, on the last day of the taxable year, of a capital asset.
Section 165(g)(2)(A) provides that the term “security” includes a share of stock in a
corporation.

Section 165(g)(3) provides that for the purposes of section 165(g)(1), any security in a
corporation affiliated with a taxpayer which is a domestic corporation shall not be
treated as a capital asset. A corporation shall be treated as affiliated with the taxpayer
only if the taxpayer owns directly stock in such corporation meeting the requirements of
section 1504(a)(2), and more than 90 percent of the aggregate of its gross receipts for
all taxable years have been from sources other than royalties, certain rents, dividends,
interest annuities, and gains from sales or exchanges of stocks and securities.

Whether a loss due to worthlessness actually is sustained during the taxable year is a
factual determination. Boehm v. Commissioner, 326 U.S. 287, 293 (1945), reh’g
denied, 326 U.S. 811 (1946). A taxpayer must prove with objective evidence that the
stock in question became worthless during the taxable year. Id. at 292.

In Morton v. Commissioner, 38 B.T.A. 1270, 1279 (1938), aff’d, 112 F.2d 320 (7th Cir.
1940), a shareholder claimed a deduction for worthless stock for the year in which the
corporation liquidated; the Commissioner denied the deduction on the grounds that the
stock had become worthless in a prior year. The court concluded that stock is worthless
when it has neither liquidating value nor potential future value. Thus, the court
concluded that the stock became worthless in a prior year and denied the taxpayer’s
deduction for the year in which the deduction was claimed. In the event of a corporate
liquidation, the stock of the corporation is worthless if the shareholders do not receive
payment for their stock. See H.K. Porter Co. v. Commissioner, 87 T.C. 689 (1986).

If a shareholder receives no payment for its stock in a liquidation of the corporation,
neither section 331 nor section 332 applies to the liquidation. The fact that a
shareholder receives no payment for its stock in a liquidation of the corporation
demonstrates that such shareholder’s stock is worthless. Additionally, the liquidation is
an identifiable event that fixes the loss with respect to the stock.

In Rev. Rul. 2003-125, an eligible entity treated as a corporation for U.S. federal income
tax purposes elected to change its classification from a corporation to a disregarded
entity. Rev. Rul. 2003-125 held that the shareholders of such entity are allowed a
worthless security deduction under section 165(g) if the fair market value of the assets
POSTN-115587-16 6

of the entity, including intangibles, does not exceed the entity’s liabilities such that on
the deemed liquidation of the entity, the shareholder receives no payment on its stock.

Treas. Reg. §1.1502-80(a) provides that the Internal Revenue Code or other law shall
be applicable to the group to the extent that the regulations do not exclude its
application. To the extent not excluded, other rules operate in addition, and may be
modified by, these regulations.

Treas. Reg. §1.1502-80(c)(1) provides that subsidiary stock is not treated as worthless
under section 165 until immediately before the earlier of the time (i) the stock is
worthless within the meaning of Treas. Reg. §1.1502-19(c)(1)(iii), or (ii) the subsidiary
for any reason ceases to be a member of the group.

In general, Treas. Reg. §1.1502-19(c) provides rules to determine when a member of a
group is treated as disposing of a share of subsidiary stock. Treas. Reg. §1.1502-
19(c)(1)(iii) treats a member of disposing of a share of subsidiary stock when the stock
of the subsidiary is worthless, and provides three different measures to determine
worthlessness:

(A) Substantially all of S’s assets are treated as disposed of, abandoned, or
destroyed for Federal income tax purposes (e.g., under section 165(a) or Treas.
Reg. §1.1502-80(c), or, if S’s asset is stock of a lower-tier member, the stock is
treated of as disposed of under [Treas. Reg. §1.1502-19(c)]). An asset of S is
not considered to be disposed of or abandoned to the extent the disposition is in
complete liquidation of S or is in exchange for consideration (other than relief
from indebtedness).

(B) An indebtedness of S is discharged, if any part of the amount discharged is not
included in gross income and is not treated as tax-exempt income under Treas.
Reg. §1.1502-32(b)(3)(ii)(C).

(C) A member takes into account a deduction or loss for the uncollectability of an
indebtedness of S, and the deduction or loss is not matched in the same tax year
by S’s taking into account a corresponding amount of income or gain from the
indebtedness in determining consolidated taxable income.

Treas. Reg. §1.1502-32(b)(3)(ii)(C) provides that excluded cancellation of indebtedness
income is treated as tax-exempt income only to the extent the discharge is applied to
reduce tax attributes attributable to any member of the group under section 108, section
1017, or Treas. Reg. §1.1502-28. However, if S is treated as realizing excluded
cancellation of indebtedness income pursuant to Treas. Reg. §1.1502-28(a)(3) [relating
to certain look-through rules], S shall not be treated as realizing excluded cancellation of
indebtedness income for purposes of the preceding sentence.
POSTN-115587-16 7

Section 108(e)(6) provides that, except as provided in regulations, for purposes of
determining the income of the debtor from discharge of indebtedness, if a debtor
corporation acquires its indebtedness from a shareholder as a contribution to capital,
(A) section 118 shall not apply, but (B) such corporation shall be treated as having
satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted
basis in the indebtedness.

Treas. Reg. § 1.61-12(c)(2)(ii) provides that an issuer realizes income from the
cancellation of indebtedness upon the repurchase of a debt instrument for an amount
less than its adjusted issue price (within the meaning of Treas. Reg. §1.1275-1(b)). The
amount of the discharge of indebtedness income is equal to the excess of the adjusted
issue price over the repurchase price. For purposes of Treas. Reg. §1.61-12(c)(2), the
term “repurchase” includes the retirement of a debt instrument, the conversion of a debt
instrument into the stock of the issuer, and the exchange of a newly-issued debt
instrument for an existing debt instrument. Treas. Reg. §1.61-12(c)(2)(i).

                                      ANALYSIS

As noted above, we assume for purposes of this memorandum that the Sub stock was
worthless for section 165 purposes as of the end of Year 3 and at all times during the
years at issue. However, because Sub is a member of the Taxpayer’s consolidated
group, Treas. Reg. §1.1502-80(c)(1) defers the deduction of Taxpayer’s loss on the
worthlessness of the Sub stock until one of four identifiable events occurs. Treas. Reg.
§1.1502-80(c)(1)(i) and (ii). The four identifiable events are the three events identified in
Treas. Reg. §1.1502-19(c)(1)(iii) or Sub’s ceasing to be a member of the Taxpayer’s
group for any reason.

In this case, none of the identifiable events in Treas. Reg. §1.1502-19(c)(1)(iii) are
applicable. While Sub disposed of subsidiaries and non-core lines of business,
substantially all of Sub’s assets were not treated as disposed of, abandoned or
destroyed for federal income tax purposes. Thus Treas. Reg. §1.1502-19(c)(1)(iii)(A) is
inapplicable. Similarly, Treas. Reg. §1.1502-19(c)(1)(iii)(C) is inapplicable because no
member of the Taxpayer’s group has taken a deduction or loss on the uncollectability of
the debt of Sub.

Treas. Reg. §1.1502-19(c)(1)(iii)(B) is inapplicable because FSub’s contribution of the
Sub indebtedness to capital under section 108(e)(6) did not produce cancellation of
indebtedness income. Under section 108(e)(6), Sub is treated as satisfying the debt
with cash in the amount of FSub’s basis in the debt. From the information provided,
there is no indication that any event occurred that would cause FSub’s basis in the Sub
debt to be different from the adjusted issue price of the debt. Because the adjusted
issue price of the debt and FSub’s basis in the debt are equal, Sub will not recognize
POSTN-115587-16 8

any cancellation of indebtedness income upon the contribution of the debt.5 Treas.
Reg. §1.61-12(c)(2)(ii).

As a result, the only identifiable event that could trigger the Taxpayer’s loss on its Sub
stock is the change in classification of Sub in Year 6. As noted above, we assume that
the Taxpayer’s loss on its Sub stock was realized prior to the end of Year 3 when the
Sub stock became worthless and that Treas. Reg. §1.1502-80(c)(1) deferred such loss.
The change in classification of Sub from a corporation to an entity disregarded as
separate from the Taxpayer in Year 6 caused Sub to cease to be a member of the
Taxpayer’s consolidated group, and as such, Treas. Reg. §1.1502-80(c)(1)(ii) permits
the Taxpayer to recognize its loss on the Sub stock in Year 6. See also Rev. Rul. 2003-
125.

In conclusion, we assume that the Sub stock held by the Taxpayer is worthless as of the
end of Year 3 and at all times during the years at issue. However, Treas. Reg.
§1.1502-80(c)(1) deferred the Taxpayer’s deduction of the loss on the Sub stock until
the earliest of one of four identifiable triggering events occur. The only triggering event
to occur was the Taxpayer’s election to change the classification of Sub from a
corporation to an entity disregarded as separate from the Taxpayer. The change in
classification in Year 6 caused Sub to cease to be a member of the Taxpayer’s
consolidated group and as such permits the Taxpayer to recognize its loss on the Sub
stock in Year 6. Treas. Reg. §1.1502-80(c)(1)(ii).

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-6975 if you have any further questions.

                                            ___________________________
                                            Gerald B. Fleming
                                            Acting Branch Chief, Branch 5
                                            Office of Associate Chief Counsel
                                            (Corporate)

5
We note that because Sub has tax attributes, were the contribution of debt to capital to have produced
cancellation of indebtedness income: (i) such income would have been excluded from Sub’s income
under section 108(a)(1)(B) (insolvency); (ii) because the income would have been excluded from Sub’s
income, Sub would have been required to reduce attributes under section 108(b); and (iii) because the
excluded cancellation of indebtedness income would have reduced Sub’s attributes, such income would
have been treated as tax-exempt income under Treas. Reg. §1.1502-32(b)(3)(ii)(C).