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
The IRS national office agreed with the taxpayer and the Appeals Division, concluding that Section 165(g)(3)(B) should not be read narrowly to impose an exclusive minimum gross receipts requirement. That is, when a corporation has gross receipts, the numerical gross receipts formula should control.
However, according to the national office, when a corporation has no gross receipts, the categorical denial of Section 165(g)(3)(B) classification of operating company status can produce anomalous results that are clearly contrary to the statutory purpose. The legislative history supports the corporate taxpayer’s assertion that Congress intended to permit ordinary loss treatment when the subsidiary (whose securities have become worthless) is an operating company rather than an investment or holding company.
The numerical gross receipts test was meant to implement that statutory intent and applies when a corporation has gross receipts. However, the numerical gross receipts test should not be applied to deny operating company classification to a “truly operating company” (with no passive income) that happens to have no gross receipts. Here, because GammaSub functioned as an operating subsidiary and not as an investment or holding company, Alpha may take an ordinary loss deduction measured by the amount of its basis in GammaSub’s stock.
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.
But it is still unclear whether a bank with worthless securities would qualify as an affiliate of the domestic corporation that owns the bank’s stock. The bank will have generated gross receipts, and more than 10% thereof will, no doubt, consist of interest. This ruling, while beneficial to operating companies that lack gross receipts, does state that “the numerical gross receipts test applies when a corporation has gross receipts.” That said, we firmly believe that a bank should be seen as meeting the gross receipts test.
To be sure, in the case of a bank, the sale or exchange by the bank of the debt instruments that produce the interest income — and that cause the bank to facially violate the gross receipts test — is not considered the sale or exchange of a capital asset under Section 582(c). Moreover, it is clear that a bank is an operating company rather than an investment or holding company.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.