With respect to a “security” that is a capital asset, a taxpayer is permitted to take a worthless security deduction if the security becomes worthless during the taxable year.15 This deduction is a capital loss. Where the taxpayer, however, is a domestic corporation and the security is issued by a corporation which is “affiliated” with the taxpayer, such loss may be treated as an ordinary loss.16 For this exception to apply, the issuing affiliated corporation must satisfy a “gross receipts” test, which essentially requires that more than 90 percent of the corporation’s aggregate gross receipts for all taxable years to be “active income” (i.e., cannot be passive receipts). In a private letter ruling17 released in early December 2011, the IRS issued guidance on a look-through approach for purposes of applying the gross receipts test for a parent corporation seeking an ordinary loss deduction for the worthless stock of an affiliated corporation.
The facts in the private letter ruling were as follows: the taxpayer, the common parent of an affiliated group of corporations (“Taxpayer”), owned 100 percent of HoldCo1, which owned 100 percent of HoldCo2, which owned 100 percent of Subsidiary. HoldCo2 previously entered into intercompany transactions with other members of consolidated groups to which it was a member, including the receipt of cash dividends, providing management services in exchange for a management fee, and the purchase of furniture and fixtures. After Subsidiary’s last significant asset was rendered worthless, both HoldCo2 and Subsidiary were legally dissolved, at which point the stock of HoldCo2 and Subsidiary was rendered worthless for purposes of Section 165(g)(1).18 Taxpayer wanted to claim a worthless stock deduction with respect to the stock of HoldCo2.
The IRS ruled that HoldCo1 could claim a worthless stock deduction under Section 165(g)(3) upon the dissolution of HoldCo2. Taxpayer represented that the stock of HoldCo2 and Subsidiary was worthless within the meaning of Section 165(g)(1) as of the date of dissolution. For purposes of the gross receipts test, the IRS ruled that HoldCo2 must include in its aggregate gross receipts all amounts of gross receipts received in intercompany transactions and must employ a “look-through approach” in determining the portion of the gross receipts that were from passive sources. The gross receipts from intercompany transactions were treated as gross receipts from passive sources to the extent they were attributable to the intercompany transactions’ counterparty’s gross receipts from passive sources.19 In addition, in determining its gross receipts, HoldCo2 must take into account the historic gross receipts of any corporation if HoldCo2 succeeded to such corporation’s tax attributes. In applying the look-through approach to gross receipts from intercompany dividends, the amounts were attributed pro rata to the gross receipts that gave rise to the earnings and profits from which the dividend was distributed. Finally, in applying the look-through approach with respect to gross receipts from intercompany transactions other than intercompany dividends, provided the intercompany transaction’s counterparty’s gross receipts are greater than its own intercompany transaction payments, the IRS noted that the amounts will be attributed pro rata to the gross receipts of the counterparty for the taxable year during which the intercompany transaction occurred.