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IRS rules on gross receipts test for treatment of affiliated subsidiary’s worthless stock

 

PLR 201548003

In a private letter ruling (PLR), IRS has ruled that the common parent of an affiliated group of corporations can claim a worthless stock deduction on its wholly-owned subsidiary’s liquidation or conversion to a disregarded entity for federal income tax purposes. For purposes of the Code Sec. 165(g)(3)(B) gross receipts test, the subsidiary will include in its aggregate gross receipts all amounts of gross receipts received in intercompany transactions, and under the “look-through approach,” such amounts will be treated as “gross receipts from passive sources” only to the extent they are attributable to the intercompany transactions counterparty’s “gross receipts from passive sources.”

Background. A taxpayer may deduct losses sustained during the year and not compensated for by insurance or otherwise. (Code Sec. 165(a))

If any security which is a capital asset becomes worthless during the tax year, the resulting loss is treated as a loss from the sale or exchange, on the last day of the tax year, of a capital asset. (Code Sec. 165(g)(1)) For this purpose, “security” includes a share of stock in a corporation. (Code Sec. 165(g)(2)(A))

Code Sec. 165(g)(3) provides an exception to the general capital loss rule and allows a parent that is a domestic corporation to claim an ordinary loss for worthless securities of an affiliated corporation. A corporation is treated as affiliated with the taxpayer only if: (i) the taxpayer directly owns stock of the corporation that meets the Code Sec. 1504(a)(2) requirements (Code Sec. 165(g)(3)(A)), and (ii) more than 90% of the corporation’s gross receipts for all tax years are from sources other than royalties, certain rents, dividends, certain interest, annuities, and gains from sales of stocks and securities (i.e., “gross receipts from passive sources”). (Code Sec. 165(g)(3)(B)) The gross receipts test was designed to determine whether a subsidiary is an operating company (for which an ordinary loss may be allowed) or a holding or investment company (for which an ordinary loss is not allowed). In computing gross receipts, gross receipts from the sales or exchanges of stocks and securities are taken into account only to the extent of the gains derived from these transactions. (Code Sec. 165(g)(3))

In PLR 201149015, IRS ruled that a corporation could claim a worthless stock deduction upon its wholly-owned subsidiary’s dissolution. In the ruling, a worthless corporation (H) liquidated by taxpayer had engaged in four types of intercompany transactions with consolidated group members: it received dividends from subs including a distribution of property and workforce; it received distributions in excess of a sub’s earnings and profits (E&P); it provided management services to subs for a fee; and it bought furniture and fixtures from a sub. H had served primarily as a holding company for subs engaged in business. H and its subs became members of taxpayer’s consolidated group via a reverse subsidiary cash merger treated as a taxable stock purchase. IRS ruled that H’s gross receipts included those received in intercompany transactions and were passive to the extent they were attributable to the counterparty’s passive gross receipts (the “look-through” approach). In applying this approach for H as to a counterparty, H’s counterparty also would apply the same approach to its receipts from intercompany transactions. In applying the look-through approach for gross receipts from intercompany dividends, the amounts will be attributed pro rata to the gross receipts that generated the E&P from which the dividend was distributed. H’s gross receipts also took into account the historic gross receipts of any transferor corporation in a Code Sec. 381(a) transaction (one dealing with the carryover of tax items in a liquidation or reorganization) with adjustments made to prevent duplication.

Facts. Foreign Parent owns Parent, a domestic holding company. Parent is the common parent of an affiliated group of corporations that file a consolidated federal income tax return. Parent owns all of the outstanding common stock of Subs 1, 3, and 4. Sub 1 owns all of the outstanding stock of Sub 2. Subs 1, 2, 3 and 4 are members of the Parent consolidated group.

In Year 4, Sub 2 held receivables due from Subs 3 and 4. Sub 1 had a payable owed to Sub 3 that arose from certain debt financing used to purchase the stock of Sub 2 in Year 1. Sub 1 acquired Sub 2 from a third party.

Sub 1 does not directly engage in an active business and its primary asset is its ownership of Sub 2 stock. Sub 2 is engaged in Business and its value has deteriorated. As part of the proposed transaction, Sub 2 will distribute receivables to Sub 1. Thereafter, Sub 1 will sell all of the Sub 2 stock to an unrelated third party, resulting in a loss on the sale of the Sub 2 stock.

Sub 1 will use the cash received from the sale of the Sub 2 stock along with the amounts received in the Sub 2 distribution to partially repay the payable Sub 1 owes to Sub 3. Sub 3 will cancel the remaining balance due from Sub 1. And, Sub 1 will then liquidate under state law or convert to a limited liability company with a classification as an entity disregarded from Parent for federal income tax purposes.

Representations. Among other representations, Parent represents that:

  • In treating the dividends from Sub 2 as passive gross receipts only to the extent of Sub 2’s passive gross receipts, more than 90% of the aggregate gross receipts of Sub 1 for all tax years have been from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stocks and securities;
  • The distribution of the Sub 2 receivables to Sub 1 will be respected as a distribution and not as an addition to the purchase price paid by the buyer for Sub 2’s stock;
  • No Sub 1 stock has been acquired by Parent for the purpose of converting a capital loss into an ordinary loss;
  • The loss Parent sustains on the worthlessness of the Sub 1 stock will not be compensated for by insurance or otherwise;
  • The Sub 1 stock will become worthless during 2015 and not before;
  • Sub 1 will be insolvent for federal income tax purposes at the time of its liquidation;
  • Parent hasn’t owned, and will not own, any of the shares of Sub 1 stock with an excess loss account;
  • Sub 1 hasn’t owned, and will not own, any of the shares of Sub 2 with an excess loss account (including after taking into account the distribution of Sub 2 receivables).
  • At all times, all instruments referred to as debt have been treated as debt for U.S. federal tax purposes, and all instruments referred to as equity have been treated as equity for U.S. federal tax purposes;
  • Parent will claim a worthless stock loss with respect to the stock of Sub 1 only to the extent permitted by Reg. § 1.1502-36 (dealing with the unified loss rule);
  • The Sub 1 stock will be worthless as of the date of liquidation within the meaning of Code Sec. 165(g)(1) and Reg. § 1.1502-80(c) (under which a subsidiary’s stock isn’t treated as worthless stock before the earlier of a triggering event under the excess loss accounts rules or the subsidiary ceases to be a member of the group). Parent owns directly Sub 1 stock possessing 100% of the total voting power and 100% of the total value of the Sub 1 stock, and meets the requirements of Code Sec. 1504(a)(2);
  • The Sub 1 shares owned by Parent will be cancelled for no consideration as a result of the liquidation of Sub 1; and
  • Parent will take into account in income any excess loss account in its Sub 1 stock.

Favorable ruling. In the PLR, IRS ruled that if the requirements of Reg. § 165(g) (taking into account Reg. § 1.1502-80(c)) are satisfied, Parent may claim a worthless stock deduction under Code Sec. 165(g)(3), subject to the application of Reg. § 1.1502-36.

IRS determined that, for purposes of the Code Sec. 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 Reg. § 1.1502-13 (as effective/applicable on or after July 12, ’95) (“Intercompany Transactions”). Under the look-through approach, such amounts from Intercompany Transactions will be treated as “gross receipts from passive sources” only to the extent they are attributable to the Intercompany Transactions’ counterparty’s “gross receipts from passive sources.” (Reg. § 1.1502-13(a), Reg. § 1.1502-13(b), Reg. § 1.1502-13(c), as effective/applicable on or after July 12, ‘5) In computing Sub 1’s “gross receipts” under Code Sec. 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 Code Sec. 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.

For purposes of the Code Sec. 165(g)(3)(B) gross receipts test, the proceeds from the sale of all the outstanding shares of Sub 2 stock at a loss to an unrelated buyer will not be included in gross receipts.

In applying the look-through approach, Sub 1’s “gross receipts from passive sources” are 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.” And, 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. For gross receipts from intercompany dividends (i.e., intercompany distributions to which Code Sec. 301(c)(1) applies), the amount will be attributed pro rata to the gross receipts that gave rise to the E&P from which the dividend was distributed. For gross receipts from Intercompany Transactions other than Code Sec. 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 tax year during which the intercompany transaction occurs (adjusted as appropriate for other intercompany transactions during such period to prevent any duplication).

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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