• Claiming a Worthless Stock Deduction May Have Become a Little Easier
  • April 3, 2008 | Author: Todd B. Reinstein
  • Law Firm: Pepper Hamilton LLP - Washington Office
  • As uncertainty in the current economy continues to grow, corporations may have some opportunities to take worthless stock deductions in subsidiaries whose business have become worthless. The ability to claim the deduction as an ordinary loss on affiliates has been a challenge because of the requirement that the worthless company meet certain requirements. Recent guidance, however, may give some relief and present some interesting planning opportunities for corporate taxpayers.

    Worthless Stock Deduction Generally

    A taxpayer is permitted to report a loss in a security equal to its tax basis when the security becomes completely worthless during a tax year under Section 165.1 Treas. Reg. Section 1.165-1(b) provides that in order to take a deduction, the loss must be (a) evidenced by a closed and completed transaction, (b) fixed by identifiable events, and (c) actually sustained during the taxable year. The Code, however, does not define “worthlessness.” Judicial decisions have generally focused on a taxpayer’s facts and circumstances to determine whether the security has become worthless. Because this is a difficult hurdle, a single event will not generally satisfy the worthlessness test in the absence of other factors that indicate that no value remains in the stock at issue.2

    Even if a taxpayer can determine worthlessness, it must also prove that the recognition of the loss in a particular taxable year is also appropriate. The Treasury recently finalized regulations that require a taxpayer to permanently surrender and relinquish all rights in a security and receive no consideration in exchange for the security for the security to be considered abandoned.3 This is a facts and circumstance test and taxpayers need to ensure the security is properly characterized. The year of worthlessness and the character of the loss are often the cause of controversy between taxpayers and the IRS.

    Capital Versus Ordinary

    If a taxpayer can establish that a security has become worthless and the timing is correct, the next question is what is the character of the loss.4 The general rule is that that a worthless stock loss be characterized as capital. A capital loss can only be utilized against capital gain income, making it difficult for some taxpayers without current capital gain income to utilize the loss unless capital gain income exists in an applicable carryback or carryforward periods. Section 165(g)(3) provides some relief and allows a taxpayer to change the character of the loss to ordinary if the security owned was stock in an affiliate. For the worthless company to qualify as an affiliate, the taxpayer must meet two requirements. First, it must own directly stock meeting the requirements of Section 1504(a)(2), which is generally 80 percent or more of the voting power and 80 percent of the value of the corporation’s stock. The second requirement, subject to some exceptions, is that 90 percent or more of the affiliate’s aggregate gross receipts for all taxable years be from sources other than royalties, rents, dividends, interest, annuities and gains from sales or exchanges of stocks and securities.

    Look Through Approach

    An issue that many taxpayers have had in the past in taking the ordinary deduction, is passing the gross receipts test in order to convert the loss to ordinary where the subsidiary had either dividend income from lower tier subsidiaries (possibly non-qualifying gross receipts) or no gross receipts at all.

    In PLR 200710004,5 the IRS permitted a parent corporation to claim an ordinary worthless stock deduction with respect to a domestic subsidiary holding company under Section 165(g)(3). In the PLR, the holding company operated businesses through subsidiaries it owned that were eventually liquidated into the holding company in what were termed Section 381 (carryover basis) transactions. The holding company also received dividends from its operating subsidiaries in the past.

    The IRS ruled that the holding company could take into account the historic gross receipts of the transferor corporations in Section 381 transactions when analyzing the gross receipts test.6 Additionally, the IRS ruled that the holding company will include in its gross receipts all dividends received from lower-tier subsidiary members of its consolidated group, and such dividends will be treated as “gross receipts from passive sources” to the extent they are attributable to the respective distributing member’s “gross receipts from passive sources.” Only dividends that were attributable to gross receipts from passive sources were thus counted as dividends for the gross receipts test under Section 165 in the ruling.7 Importantly, the IRS appears to have adopted a look through method in the ruling in determining which gross receipts qualified under
    Section 165(g)(3).

    In somewhat of a contrast, TAM 200727016 denies a corporate taxpayer’s ordinary loss deduction of a worthless foreign subsidiary where all of the worthless foreign subsidiaries’ income was from dividends received from its subsidiaries that operated active businesses.8 The IRS basically didn’t apply the look through approach as it did in PLR 200710004 in determining the origin of the dividend income. Thus, it is unclear if the dividends were included because the worthless corporation was a foreign holding company. Also, there was no mention of
    Section 381 transactions in the TAM.

    Pepper Perspective

    By aggregating historic gross receipts received in liquidations and looking to the underlying character of the dividend, the IRS may have presented taxpayers holding worthless subsidiaries with some potential planning opportunities in the PLR. Taxpayers holding worthless subsidiaries, for example, may explore liquidating or merging other subsidiaries into the worthless affiliate to transfer active gross receipts history to a worthless holding company.

    Since the TAM did not mention Section 381 transactions, one question that has arisen is whether a foreign holding company could inherit the gross receipts of its foreign subsidiaries through a check the box election that would trigger the look through rules and thus, qualify the entity for an ordinary worthless loss.9 In contrasting the PLR 200710004 and the TAM 200727016, it is not certain how the IRS would view this type of transaction. Taxpayer’s who may be eligible for an ordinary worthless stock deduction in an affiliate might want to take a hard look at this opportunity since it could create a large permanent difference.

    One key to claiming this type of loss is making sure the taxpayer has contemporaneously documented the key components of the deduction. For example, corporate taxpayers need to document their tax basis in the worthless subsidiary, which typically requires a study under Treas. Reg. Section 1.1502-32 to determine the amount of the deduction. Second, they need to document the worthlessness of the subsidiary. Third, they need to document the gross receipts history of the subsidiary to qualify under Section 165(g)(3) to claim the deduction as ordinary. Finally, a ruling from the IRS might be required to obtain certainty if any type of planning or structuring is involved or if an ambiguity exists as to whether or not each component of the worthlessness test have been met.


    1. Unless otherwise stated, all references to “Section” is to the Internal Revenue Code of 1986, and all references to “Treas. Reg. Section” are to the Treasury Regulations promulgated thereunder.
    2. The consolidated return rules also provide a test for the worthlessness subsidiary as when substantially all of the subsidiary’s assets are treated as disposed of, abandoned, or destroyed for federal income tax purposes. See Treas. Reg. 1.1502-19(c)(1)(iii)(A).
    3. See Treas. Reg. Section 1.165-5(i)(2) (effective for abandonment of stock or securities after March 12, 2008).
    4. Of note, a corporate taxpayer claiming a worthless stock deduction on consolidated member may lose the ability to utilize tax attributes that the worthless member may have. See Section 382(g)(4)(D) requiring that the holder of 50 percent or more of a loss corporation’s stock that treats the stock as worthless but retains ownership at the end of the year of worthlessness will treat the shareholder as not owning the stock during that period. The shareholder is treated as acquiring the stock on the first day of the year following the worthlessness. Some commentators have argued that Section 382(g)(4)(D) does not apply in certain consolidated group situations since the parent of the consolidated group is not worthless and a Section 382 ownership change for a consolidated attributes are generally determined by reference to the common parent’s stock under Treas. Reg. Section 1.1502-92. This view has been largely untested.
    5. PLR 200710004 (March 9, 2007). A private letter ruling or technical advice memorandum may not be cited as authority by a taxpayer who did not receive the ruling, but it does evidence the IRS’s position on the matter.
    6. An additional question that has arisen is whether all Section 381 transactions qualify for this test and not just the ones mentioned in the PLR.
    7. The ruling was silent as to how the dividends are traced back to active sources of income. One issue is whether a distribution will follow a LIFO type of approach used in the earnings and profits context for determining qualifying gross receipts.
    8. TAM 2007270016 (July 6, 2007).
    9. Of note, taxpayers attempting this are advised to review all the tax consequences of the transaction as this might not be appropriate for all taxpayers. See CCA 200706011 (February 9, 2007) (Section 332 liquidation does not apply to a deemed liquidation of a foreign subsidiary because the subsidiary was insolvent at the time of the deemed liquidation. Taxpayer was allowed a worthless stock deduction under 165(g)(3)).