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Determining worthless stock, insolvency and the IRS rules on them

Q: I own all of the stock of a C corporation with three subsidiaries. One has lost money since its acquisition and the parent corporation has kept it alive with loans. The subsidiary is insolvent and I want to claim a worthless stock deduction. There are some elements of the business I would probably continue and I need to know if there is a way to claim a worthless stock deduction if I continue to operate a part of the business. My thought now is to sell or transfer assets to the parent and then liquidate the subsidiary and claim the deduction.Jim Hamill

A: I am going to answer your question but also advise you to discuss the issue in more detail with a tax adviser. You can use my guidance as a way to initiate a discussion but someone needs to take a more in-depth look at the business of this subsidiary before a definitive conclusion can be reached.

First, because you have a subsidiary corporation a worthless stock loss can be an ordinary loss. Stock losses are generally capital losses, and corporations can only use capital losses to offset capital gains. So a worthless stock deduction within a consolidated group is very valued because it is ordinary rather than capital.

Second, to claim a worthless stock loss two things have to occur. The corporation must be insolvent, and there has to be some identifiable event that supports the worthlessness.

Accepting that your corporation is insolvent isn’t enough to support worthlessness. There must also be some event that can support no hope of recovery for this corporation.

Now, returning to the insolvency issue, the IRS has said that in examining insolvency the potential future value of intangibles must be considered. In Revenue Ruling 2003-125 the IRS warned that if there is a reasonable hope that an intangible may have future value that potential value must be considered in the insolvency test.

The potential future value argument was restated by the IRS as a litigation position in guidance issued in 2013. The existence of significant intangible value in many businesses will make this a fertile ground for disputes in future worthlessness cases.

A liquidation of the corporation is commonly accepted by courts as an identifiable event that supports worthlessness. If an insolvent subsidiary is liquidated into its parent all of the tax features of the subsidiary disappear. This can help prove no future value exists.

The Internal Revenue Service building in Washington. (Susan Walsh/Associated Press)

If the subsidiary is solvent then a liquidation would allow property to be transferred to the parent. If property is transferred then the stock was not worthless. Thus a solvent entity liquidation does not lead to a worthless stock deduction.

So at this point let’s say that you can prove the subsidiary is insolvent, even considering any potential future value of intangibles. Then we’ll liquidate the subsidiary to create a loss triggering event.

But you want to continue to operate some of the business. There are two ways to do this (again assuming the business is insolvent). One would be to liquidate the subsidiary and to continue to operate some part of the business.

That is OK, even with the worthless stock deduction, again because the overall business is insolvent, and therefore worthless (net of the liabilities), and there is an event (the liquidation) to support that.

My last suggestion is that if you intend to carry on any part of the subsidiary’s business, it may be advisable to isolate that business is a separate legal entity, just as you now have. So the issue becomes, how do you keep some of the business in a separate entity and still liquidate the current entity?

The best way to do this would be to establish a new LLC owned by the parent corporation and then merge the existing subsidiary into this LLC. An LLC owned by one party (the parent corporation) is ignored (the technical term is disregarded) for tax purposes.

This means that the merger of the existing subsidiary into the new LLC will be treated as if the subsidiary liquidated (it did not, but the tax law pretends it did). This approach is a commonly used way to create an identifiable event for a worthless stock deduction.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at