S corporation cannot take an ordinary worthless stock deduction

The IRS recently concluded in a Chief Counsel Advice memorandum (CCA 201552026) that an S corporation (the taxpayer) couldn’t claim and pass through to its shareholders a worthless stock deduction under Section 165(g)(3).  

In general, Section 165(g)(1) provides for the recognition of a capital loss for any security that is a capital asset that becomes worthless. In certain instances, however, taxpayers can claim an ordinary loss under Section 165(g)(3) on worthless securities. Section 165(g)(3) allows an ordinary loss for a worthless security to be recognized by a domestic corporation if the security is from a corporation that is affiliated within the meaning of Section 1504(a)(2), with the domestic corporation claiming the loss.

The taxpayer’s subsidiary, a qualified subchapter S subsidiary (the subsidiary or the QSub), was in financial despair after a period of depressed operations. The subsidiary was found to be in an unsound condition to transact business and placed into receivership. Before that, though, the taxpayer and its shareholders claimed a worthless stock deduction under Section 165(g)(3) in an attempt to maximize losses in the tax year prior to the subsidiary’s being placed in receivership.

To effect the worthless stock deduction, the taxpayer and its shareholders affirmatively terminated the taxpayer’s S corporation status. As a result, the subsidiary’s QSub status also terminated. Under Treas. Reg. Sec. 1.1361-5(b)(1)(i), a Qsub whose S corporation election terminates as a result of its parent’s termination is treated as if the Qsub’s election terminated at the end of the last day its parent was an S corporation. When the subsidiary’s Qsub election terminates, a new C corporation is deemed to acquire all of the assets of the terminated subsidiary Qsub from the parent in exchange for deemed newly issued stock in the new C corporation. Any tax consequences that arise during this time frame are included on the parent’s final S corporation tax return and pass through to its shareholders.

The taxpayer argued that when it terminated its S election, the subsidiary stock (now a C corporation as of the last instant of the S corporation’s final subchapter S tax year) immediately became worthless. So the taxpayer argued it was entitled to recognize an ordinary worthless stock deduction in accordance with Section 165(g)(3) on its final S corporation tax return with respect to the subsidiary.  

The IRS disagreed with the taxpayer’s position for three reasons. First, the IRS concluded that the Qsub’s termination and the subsequent contribution of assets by the taxpayer to the new C corporation didn’t qualify under Section 351 and thus was a taxable exchange under Section 1001. In general, Section 351(a) provides that “[n]o gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock of such corporation and immediately after the exchange, such person is in control of the corporation.”

Because the subsidiary was insolvent immediately before the termination of its Qsub election (in other words, its liabilities exceeded the fair value of its assets), the IRS concluded that the transferred property was significantly encumbered and couldn’t qualify as property under Section 351. In addition, the IRS concluded that the transaction failed Section 351 because the requirement regarding “in exchange for stock” cannot be met when the transferor receives stock having no value in an insolvent corporation.

Second, the IRS concluded that Treas. Reg. Sec. 1.165-5(d)(2)(ii) limits the application of Section 165(g)(3) when any stock of a corporation was acquired solely to convert a capital loss sustained by the worthlessness of any of the stock into an ordinary loss under Section 165(g)(3). The taxpayer had many options to create a deduction from the worthlessness of the subsidiary’s stock that would have resulted in a capital loss, the IRS said. For example, the taxpayer’s shareholders could have recognized a capital loss when the taxpayer’s stock was sold, recognized a capital loss on the subsidiary’s stock under Section 165(g)(1) or sold the subsidiary’s assets under a deemed or an actual asset sale (recognizing capital and ordinary gain or loss depending on the types of assets sold). Because the taxpayer chose the only option that resulted in an ordinary loss — terminating the S election, resulting in acquiring C corporation stock and immediately claiming a Section 165(g)(3) deduction — the IRS concluded that was evidence that the sole purpose of converting the disregarding entity to a C corporation was to qualify for an ordinary deduction, in violation of Treas. Reg. Sec. 1.165-5(d)(2)(ii).

Third, the IRS concluded that an S corporation can’t take a Section 165(g)(3) deduction. The IRS relied in part on Section 1363(b), which provides that the taxable income of an S corporation “shall be computed in the same manner as in the case of an individual,” but for certain enumerated exceptions. Section 165(g)(3) isn’t listed as an exception to the general rule in Section 1363(b).

In rejecting the taxpayer’s position, the IRS discounted various arguments and case law. The agency buttressed this conclusion by primarily looking to the legislative history of Section 165(g)(3). The legislative history, the IRS said, “suggests that Congress intended the ordinary loss exception to be available only to corporations that are so closely related as to effectively be operating a single business.” Congress concluded that it was “desirable and equitable” to allow a parent corporation to claim a Section 165(g)(3) deduction for the worthless stock of a subsidiary corporation that is affiliated with the parent within the meaning of Section 1504(a)(2), because the parent could otherwise claim the ordinary deduction simply by electing to file a consolidated return. The prohibition on the consolidation of an S corporation and a C corporation appears to support the notion that Congress didn’t intend to allow an S corporation to recognize an ordinary deduction under Section 165(g)(3).
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