A newly released IRS letter ruling (PLR 201006003, Oct. 28, 2009) provides guidance on how a consolidated return group may obtain an ordinary loss deduction in liquidating an insolvent subsidiary. Although a write-off of worthless stock generally produces a capital loss deduction, Code Section 165(g)(3) converts these losses to ordinary deductions when they arise from a write-off of stock of an affiliated corporation. The taxpayer described in the ruling was able to utilize this provision to claim the tax benefits of ordinary deductions in a transaction that involved not a write-off but a liquidation of a wholly owned subsidiary. In view of the current economic climate, it is likely that many corporations will similarly seek to claim these tax benefits.
Worthless Stock Deductions for Subsidiary Liquidations: Background
Although a liquidation of a subsidiary is typically a nontaxable event by reason of Code Section 332, Treas. Reg. Sec. 1.332-2(b) holds that Section 332 does not apply if the parent corporation does not receive at least partial payment for its stock. Rev. Rul. 59-296, 1959-2 C.B. 87, amplified by Rev. Rul. 2003-125, 2003-2 CB 1243, holds that a liquidated subsidiary’s stock is demonstrably worthless because its parent corporation receives no payment for its equity investment on account of the subsidiary’s insolvency. Consequently, a liquidation of an insolvent subsidiary does not qualify under Section 332 and instead produces a worthless stock loss eligible for treatment under Section 165(g)(3).
However, to obtain an ordinary loss, Section 165(g)(3)(B) further requires that more than 90 percent of the aggregate gross receipts of the liquidated subsidiary for all taxable years must have been derived from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stocks and securities (passive receipts). In the case of a subsidiary that has served as a divisional holding company within a consolidated return group, the inclusion of dividends among the disqualifying category of passive receipts has been considered a possible impediment. A sub-holding company of this type is typically in receipt of dividends from lower-tier subsidiaries within its operating division. Although Treas. Reg. Sec. 1.1502-13(f)(2)(ii) excludes intercompany dividends from consolidated taxable income, at least two prior private letter rulings (PLR 200710004, Dec. 5, 2006; PLR 200932018, Apr. 14, 2009) had held that intercompany dividends would have to be taken into account for purposes of Section 165(g)(3)(B) to the extent that they were “attributable” to passive receipts of a lower-tier subsidiary. Neither ruling, however, had set forth the mechanics of the “attribution” calculation.
The New Ruling
PLR 201006003 does not expressly disagree with the conclusions reached by these prior rulings but suggests an alternative exit strategy. Specifically, the new ruling holds that an insolvent liquidating subsidiary may exclude from its passive receipts all intercompany dividends that it previously received to the extent such dividends had been paid by lower-tier subsidiaries that were “rolled up” through mergers or liquidations prior to the top-tier subsidiary’s own liquidation into its parent corporation. Instead, the insolvent liquidating subsidiary is required to treat the historic gross receipts of the rolled-up subsidiaries (likely to be active receipts from business operations) as its own receipts. Because conversion of a corporation to a disregarded entity is also treated as a liquidation for tax purposes, a divisional holding company may apparently cleanse itself of the taint of previously received intercompany dividends by converting its lower-tier subsidiaries to disregarded entities under applicable state law before engaging in its own deduction-generating liquidation into its parent corporation.
At the same time, PLR 201006003 sounded one sour planning note for taxpayers?intercompany dividends paid by lower-tier subsidiaries in taxable years in which the former, pre-1995 intercompany transaction regulations were in effect would have to be taken into account as passive receipts in the case of lower-tier subsidiaries that had been sold prior to 1995. With respect to such dividends, the ruling did not attempt to determine whether such dividends had been attributable to active or passive receipts of the sold subsidiaries. Former Treas. Reg. Sec. 1.1502-14(a)(1) had eliminated (rather than excluded) intercompany dividends from consolidated taxable income, and the new ruling may have concluded that this slight difference in wording required a different legal analysis. It is also possible the lapse of time made it impossible for the taxpayer requesting the ruling to make any representations concerning the source of dividends paid by subsidiaries that it had sold over a decade earlier.
Although revealing a planning opportunity in structuring roll-up transactions to produce ordinary loss deductions, PLR 201006003 renders less certain the scope of the “dividend attribution” analysis of the prior rulings. Taxpayers seeking to claim worthless stock deductions with respect to long-established divisional businesses may be wise to obtain their own private letter rulings.