Applying tax-loss rules to situations involving worthless subsidiaries can be tricky. Assessing whether the rules apply to banks also can be complicated. However, a breakdown of the law into manageable pieces illustrates the logic of including banks in the same categories as operating companies.
Consider the case in which a domestic corporation — a taxpayer called Alpha Corp. — owns all of the stock of a foreign subsidiary, an overseas corporation named GammaSub Inc. As of December 31, 2008, the balance sheet of GammaSub showed liabilities exceeding its total assets. Moreover, the company’s financial statements showed no gross receipts during its existence.
Alpha’s investment in GammaSub became worthless in 2008, thus entitling Alpha to a worthless stock deduction in that taxable year. Alpha claimed an ordinary deduction for its basis in the worthless stock under the tax code, specifically Section 165(g)(3), and the claim was upheld by the national office of the Internal Revenue Service. (See LTR 200914021, December 8, 2008.)
Indeed, Section 165(g)(1) provides that if any security that is a capital asset becomes worthless during the taxable year, the loss is treated as a loss from the sale or exchange of a capital asset. Therefore, the loss is treated as a capital loss. Further, Section 165(g)(2) provides that the term “security” includes stock in a corporation.
However, Section 165(g)(3) allows a taxpayer that is a domestic corporation to claim an ordinary loss for worthless securities of an affiliated corporation. For this purpose, a corporation is treated as affiliated if:
— the taxpayer directly owns stock that meets the requirements of Section 1504(a)(2) — at least 80% of the voting power and value of the corporation’s stock;
— more than 90% of the aggregate of the gross receipts for all taxable years has been from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stock and securities.
In the instant case, the “ownership test” is clearly satisfied. The question, however, is how to apply Section 165 (g)(3)(B)’s gross receipts test to GammaSub, an operating company that received no gross receipts during its existence.
One branch of the IRS, the Large and Mid-Size Business Division, argued that the specific, numerical gross receipts test of Section165(g)(3)(B) requires some amount of gross receipts and precludes Section 165(g)(3)(B) classification when a corporation has none. Both the taxpayer — Alpha Corp. in the example — and another branch of the IRS, the Appeals Division, argued that when a subsidiary becomes worthless without ever receiving any gross receipts, the gross receipts test is inapplicable. In that case, the “appropriate approach” is to look to the purpose of the statute. The purpose, the argument goes, is to permit ordinary loss treatment for subsidiaries that are operating companies rather than investment or holding companies.
“In We are somewhat surprised by the national office’s willingness to ignore the absence of gross receipts. However, we are encouraged that this flexibility suggests that the IRS is willing to apply an ‘analytical’ approach to the question of whether the gross receipts test is satisfied.” — Robert Willens