Parent may claim a worthless-stock deduction using a look-through gross-receipts method

Plain-English summary

A corporate parent converted an insolvent subsidiary into a disregarded entity and represented that the subsidiary's stock was worthless. The IRS ruled that the parent could claim a worthless-stock deduction under Section 165(g)(3), subject to the consolidated return unified loss rule and the other requirements for the deduction. For the active-gross-receipts test, the subsidiary must look through intercompany transactions to the underlying character of its counterparties' receipts, continuing through successive counterparties when necessary. Intercompany dividends are traced proportionately to the receipts that produced the distributing corporation's earnings and profits, while other intercompany payments generally follow the counterparty's receipts for the relevant year. Historic receipts from corporations acquired in Section 381 transactions are included, with eliminations to prevent duplication. The IRS did not decide whether the stock was actually worthless or whether the subsidiary ultimately passed the gross-receipts test.

Ruling snapshot

• Question: Could the parent claim a Section 165(g)(3) worthless-stock deduction, and how should intercompany receipts be tested for passive-source character?
• Outcome: Approved, subject to the stated consolidated-return limitations and factual caveats.
• Key authorities: IRC §§ 165(g)(3), 301(c)(1), 381(a); Treas. Reg. §§ 1.1502-13, 1.1502-36, 1.1502-80

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201830005 Third Party Communication: None
Release Date: 7/27/2018 Date of Communication: Not Applicable
Index Number: 165.00-00, 165.06-00,
381.00-00, 1502.13-00 Person To Contact:
-----------------------, ID No. -------------------
---------------------------------------------- ---------------------------------------------------
---------------------------------------------------- Telephone Number:
------------------------------------ ----------------------
Refer Reply To:
------------------------------------------------------------ CC:ITA:B01
---------- PLR-116945-17
Date:
EIN: ----------------- April 24, 2018

Legend

Taxpayer = --------------------------------------------------------------------------------------------
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LLC 1 = --------------------------------------------------------------------------------------------
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Sub 1 = --------------------------------------------------------------------------------------------
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Borrower = --------------------------------------------------------------------------------------------
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Sub 2 = --------------------------------------------------------------------------------------------
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Sub 3 = --------------------------------------------------------------------------------------------
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Year 1 = -------
Year 2 = -------
Date 1 = --------------------
Date 2 = --------------------
Date 3 = --------------------
A = -----------------
B = -----------------

PLR-116945-17 2

Dear ---------------------:

   This responds to your letter dated May 23, 2017, and supplemental letters dated

July 20, 2017, October 12, 2017, October 16, 2017, December 4, 2017, and April 5,
2018, submitted on behalf of Taxpayer requesting a letter ruling under § 165 of the
Internal Revenue Code (the Code). The information submitted for consideration is
summarized below.

                                    FACTS

     Taxpayer is the domestic common parent of an affiliated group of corporations

that file a consolidated federal income tax return. At the time of the Sub 1 Conversion
(defined below), LLC 1 wholly owned Taxpayer, which wholly owned Sub 1, which
wholly owned Borrower, which wholly owned Sub 2, which wholly owned Sub 3, which
owned various domestic and foreign subsidiaries.

   From Year 1 to Year 2, Borrower borrowed various amounts of cash from third

party creditors (Borrowed Funds). Moreover, during such time, cash distributions were
made or were deemed to be made from Sub 3 up the chain.

    On Date 1, Sub 1 converted to an LLC under state law and was classified as an

entity disregarded as separate from Taxpayer for federal income tax purposes (Sub 1
Conversion).

   On Date 2, Borrower converted to an LLC under state law and was classified as

an entity disregarded as separate from Taxpayer for federal income tax purposes
(Borrower Conversion).

   On Date 3, pursuant to a Restructuring Agreement, the third party creditors

agreed to reduce the amount payable from A to B in exchange for all of the new shares
of Taxpayer, the cancellation of all the old shares of Taxpayer held by LLC 1, and
releases to LLC 1, its members, and its subsidiaries down the chain (Releases).
Taxpayer states that these Releases were granted by all of the third party creditors of
the Borrowed Funds and were mutual, such that they were granted by and to all parties
of the Restructuring Agreement, including the third party creditors, LLC 1, Taxpayer,
Sub 1, Borrower, Sub 2, and Sub 3.

                             REPRESENTATIONS

1. At the time of the Sub 1 Conversion, Sub 1 had a single class of stock
   outstanding and Taxpayer directly owned 100 percent of this single class of
   stock.

PLR-116945-17 3

2. At the time of the Sub 1 Conversion, Borrower had a single class of stock
   outstanding and Sub 1 directly owned 100 percent of this single class of stock.
   Following the Sub 1 Conversion and prior to the Borrower Conversion, Taxpayer
   directly owned 100 percent of this single class of stock through its ownership of
   Sub 1, a single member LLC disregarded as separate from Taxpayer for U.S.
   federal income tax purposes.

3. Sub 1 had no assets other than the stock of Borrower as of the date of the Sub 1
   Conversion.

4. Borrower was insolvent (i.e., its liabilities exceeded the aggregate fair market
   value of its assets) as of the date of the Sub 1 Conversion and the date of the
   Borrower Conversion.

5. On the date of the Sub 1 Conversion, Sub 1’s stock was worthless within the
   meaning of §§ 165(g)(1), 1.1502-80(c), and 1.1502-19(c)(1)(iii).

6. Taxpayer had no excess loss account in its Sub 1 stock, Sub 1 had no excess
   loss account in its Borrower stock, and Borrower had no excess loss account in
   its Sub 2 stock as of the dates of the Sub 1 Conversion and the Borrower
   Conversion.

7. Taxpayer will claim a worthless stock deduction with respect to the stock of Sub
   1 only to the extent permitted by the unified loss rule in § 1.1502-36.

8. All distributions by Borrower will be treated as emanating from Sub 3’s gross
   receipts, and no distributions will be treated as emanating from Borrower’s
   Borrowed Funds.

                                  RULINGS
   

Based on the information submitted and representations made by Taxpayer, we rule as
follows:

1. Provided the requirements of § 165(g) (taking into account the provisions of
   § 1.1502-80(c)) are otherwise satisfied, Taxpayer may claim a worthless stock
   deduction under § 165(g)(3), subject to the application of § 1.1502-36.

2. For purposes of the § 165(g)(3)(B) gross receipts test, Sub 1 will include in its
   aggregate gross receipts all amounts of gross receipts received in intercompany
   transactions that are described in § 1.1502-13 (as effective/applicable on or after
   July 12, 1995) (Intercompany Transactions), and such amounts from
   Intercompany Transactions will be treated as “gross receipts from passive
   sources” only to the extent they are attributable to the Intercompany

PLR-116945-17 4

 Transactions’ counterparty’s “gross receipts from passive sources” (Look-
 Through Approach). For purposes of these rulings, “gross receipts from passive
 sources” is defined as royalties, certain rents, dividends, certain interests,
 annuities, and gains from sales of stock and securities as defined in § 165(g)(3)
 and the regulations thereunder.

3. For purposes of computing Sub 1’s “gross receipts” under § 165(g)(3)(B), Sub 1
   (and any relevant counterparty in an Intercompany Transaction) will take into
   account the historic receipts of any transferor corporation in a transaction to
   which § 381(a) applied, provided however, that Sub 1 (and any relevant
   counterparty in an Intercompany Transaction) will eliminate gross receipts from
   Intercompany Transactions with any such transferor corporation, as appropriate,
   to prevent duplication.

4. In applying the Look-Through Approach, for purposes of computing the “gross
   receipts from passive sources” of Sub 1’s counterparty in an Intercompany
   Transaction or any other counterparties in Intercompany Transactions, the
   counterparty will include in its aggregate gross receipts all amounts of gross
   receipts it received in Intercompany Transactions, and such amounts from
   Intercompany Transactions will be treated as “gross receipts from passive
   sources” to the extent they are attributable to its counterparty’s “gross receipts
   from passive sources.” In other words, Sub 1’s “gross receipts from passive
   sources” is determined by looking at all of Sub 1’s gross receipts from
   Intercompany Transactions (even if on its face the Intercompany Transaction
   appears not to be “gross receipts from passive sources”) and sourcing the gross
   receipts based on Sub 1’s counterparty’s “gross receipts from passive sources.”
   Furthermore, Sub 1’s counterparty in Intercompany Transactions (and Sub 1’s
   counterparty’s counterparty, and so on until it reaches an ultimate counterparty)
   will apply a similar rule.

5. In applying the Look-Through Approach with respect to gross receipts from
   intercompany dividends (that is, intercompany distributions to which § 301(c)(1)
   applies), the amounts will be attributed pro rata to the gross receipts that gave
   rise to the E&P from which the dividend was distributed.

6. In applying the Look-Through Approach with respect to gross receipts from
   Intercompany Transactions other than § 301(c)(1) distributions, provided the
   Intercompany Transaction counterparty’s gross receipts for the tax period are
   greater than the counterparty’s Intercompany Transaction payments, the
   amounts will be attributed pro rata to the gross receipts of the Intercompany
   Transaction counterparty for the taxable year during which the Intercompany
   Transaction occurs (adjusted as appropriate for other Intercompany Transactions
   during such period to prevent any duplication).

PLR-116945-17 5

                                     CAVEATS

   The rulings contained in this letter are based on facts and representations

submitted by Taxpayer and accompanied by a penalty of perjury statement executed by
an appropriate party. This office has not verified any of the materials submitted in
support of the request for rulings. Verification of the information, representations, and
other data may be required as part of the examination process.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

  We express no opinion with respect to Sub 1’s worthlessness or whether any of

the Releases constitute value received for stock of Sub 1. If any such Release is
determined to constitute value received for such stock, this letter ruling is null and void.

  We express no opinion as to whether Sub 1 satisfies the Gross Receipts Test of

§ 165(g)(3)(B).

   We express no opinion on the treatment of § 301(c)(2) distributions with respect

to the Gross Receipts Test of § 165(g)(3)(B).

                          PROCEDURAL STATEMENTS

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

PLR-116945-17 6

   A copy of this letter must be attached to any income tax return to which it is

relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.

                                                   Sincerely,



                                                   Brinton T. Warren
                                                   Branch Chief, Branch 3
                                                   (Income Tax & Accounting)