Section 165 Worthless stock deduction
By: Mansoor Ansari Attorney at Law
A taxpayer is permitted to report a loss in a security equal to its tax basis when the security becomes completely worthless during a tax year under Section 165.1 Treas. Reg. Section 1.165-1(b) provides that in order to take a deduction, the loss must be (a) evidenced by a closed and completed transaction, (b) fixed by identifiable events, and (c) actually sustained during the taxable year. The Code, however, does not define “worthlessness.” Judicial decisions have generally focused on a taxpayer’s facts and circumstances to determine whether the security has become worthless. Because this is a difficult hurdle, a single event will not generally satisfy the worthlessness test in the absence of other factors that indicate that no value remains in the stock at issue.2
If a taxpayer can claim worthlessness, it must also prove that the recognition of the loss in a particular taxable year is also appropriate. The Treasury recently finalized regulations that require a taxpayer to permanently surrender and relinquish all rights in a security and receive no consideration in exchange for the security for the security to be considered abandoned.3 This is a facts and circumstance test and taxpayers need to ensure the security is properly characterized. The year of worthlessness and the character of the loss are often the cause of controversy between taxpayers and the IRS.
Capital loss or Ordinary loss
If a taxpayer can establish that a security has become worthless and the timing is correct, then what is the character of the loss? The rule is that that a worthless stock loss be characterized as capital. A capital loss can only be utilized against capital gain income, making it difficult for some taxpayers without current capital gain income to utilize the loss unless capital gain income exists in an applicable carryback or carryforward periods. Section 165(g)(3) provides some relief and allows a taxpayer to change the character of the loss to ordinary if the security owned was stock in an affiliate. For the worthless company to qualify as an affiliate, the taxpayer must meet two requirements. First, it must own directly stock meeting the requirements of Section 1504(a)(2), which is generally 80 percent or more of the voting power and 80 percent of the value of the corporation’s stock. The second requirement, subject to some exceptions, is that 90 percent or more of the affiliate’s aggregate gross receipts for all taxable years be from sources other than royalties, rents, dividends, interest, annuities and gains from sales or exchanges of stocks and securities.
Look Through Approach
An issue that many taxpayers have had in the past in taking the ordinary deduction, is passing the gross receipts test in order to convert the loss to ordinary where the subsidiary had either dividend income from lower tier subsidiaries (possibly non-qualifying gross receipts) or no gross receipts at all.
In PLR 200710004,5 the IRS permitted a parent corporation to claim an ordinary worthless stock deduction with respect to a domestic subsidiary holding company under Section 165(g)(3). In the PLR, the holding company operated businesses through subsidiaries it owned that were eventually liquidated into the holding company in what were termed Section 381 (carryover basis) transactions. The holding company also received dividends from its operating subsidiaries in the past.
The IRS ruled that the holding company could take into account the historic gross receipts of the transferor corporations in Section 381 transactions when analyzing the gross receipts test.6 Additionally, the IRS ruled that the holding company will include in its gross receipts all dividends received from lower-tier subsidiary members of its consolidated group, and such dividends will be treated as “gross receipts from passive sources” to the extent they are attributable to the respective distributing member’s “gross receipts from passive sources.” Only dividends that were attributable to gross receipts from passive sources were thus counted as dividends for the gross receipts test under Section 165 in the ruling.7 Importantly, the IRS appears to have adopted a look through method in the ruling in determining which gross receipts qualified under Section 165(g)(3).
In somewhat of a contrast, TAM 200727016 denies a corporate taxpayer’s ordinary loss deduction of a worthless foreign subsidiary where all of the worthless foreign subsidiaries’ income was from dividends received from its subsidiaries that operated active businesses.8 The IRS basically didn’t apply the look through approach as it did in PLR 200710004 in determining the origin of the dividend income. Thus, it is unclear if the dividends were included because the worthless corporation was a foreign holding company. Also, there was no mention of Section 381 transactions in the TAM.
MANSOOR ANSARI J.D., LL.M. (TAX)
Section 165 worthless stock deduction