When A Business Fails
It goes without saying that no one goes into business in order to realize a loss. Unfortunately, not all businesses succeed, and many owners suffer significant losses. The challenge presented for the tax adviser to the business is how to best utilize those losses for income tax purposes and, thereby, to ease the resulting economic blow to the owners of the business.
Although the solution to this problem will necessarily depend upon the facts and circumstances of the particular business and its owners, it is probably safe to say that most taxpayers would prefer to treat the loss as an ordinary, as opposed to a capital, loss. In trying to accommodate this preference, advisers must tread carefully.
A Loss Subsidiary
Consider the case of an S corporation that owns a qualified subchapter S subsidiary (or “Qsub”) that has become worthless. The S corporation parent has several obstacles to overcome in order to pass an ordinary deduction through to its shareholders. A Qsub is a disregarded entity; that is, it is not treated as a separate corporation for federal income tax purposes, even though it remains a separate legal entity under state law. Instead, all of a Qsub’s assets, liabilities, items of income, deduction and credit are treated as items of the parent S corporation.
The shareholders of the S corporation parent primarily have three ways to recognize a loss, none of which results in an ordinary loss:
Take a worthless stock deduction on their S corporation shares, resulting in a capital loss (assuming qualification under the Code);
- Sell their shares to a third-party for a nominal arm’s length price, resulting in a capital loss (assuming someone would buy a “worthless” S corporation); or
- Have the S corporation sell the subsidiary stock (treated as a deemed asset sale) or assets to a third-party for an arm’s length price which could result in a mix of ordinary and capital loss (depending on the character of the assets held by subsidiary).
Revoke the “S” Election?
Taxpayer was an S corporation that owned Subsidiary, a Qsub that operated a regulated Business. In Year 1, Subsidiary’s Business operations were depressed and, based on this downturn, Taxpayer and its shareholders sought to maximize and pass through Subsidiary’s losses in Year 1, before Agency placed Subsidiary in receivership. Specifically, Taxpayer wanted to recognize a loss realized by Subsidiary and have that loss flow through to its shareholders as an ordinary loss.
In an attempt to qualify its shareholders for ordinary loss treatment for the full amount of their investment, Taxpayer affirmatively terminated its S corporation status. As a result, Subsidiary’s Qsub status also terminated and, under IRS regulations, Subsidiary (the former Qsub) was treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) from Taxpayer (its S corporation parent) in exchange for stock of the new corporation.
Thus, immediately before Taxpayer’s “S” election terminated, Subsidiary’s Qsub election terminated and it became a C corporation.
Ordinary Loss – On Subsidiary Stock?
A taxpayer may realize an ordinary loss from the worthlessness of the stock of a subsidiary corporation, notwithstanding that the stock otherwise is a capital asset, if certain “affiliation” and “gross receipts” tests are satisfied. A corporation is treated as affiliated with a taxpayer if: (1) the taxpayer owns stock in that corporation representing at least 80% of both the total voting power and total value of the stock of such corporation; and (2) generally, more than 90 percent of the aggregate of its gross receipts for all tax years has been from sources other than passive investments (e.g., rents, dividends, interest, and gains from sales of securities).
Taxpayer argued that when it was still an S corporation, but after Subsidiary became a C corporation, Subsidiary became worthless – i.e., at the moment that Subsidiary was deemed to have acquired its assets from the Taxpayer.
Based upon this analysis, Taxpayer asserted that it was entitled to an ordinary deduction, provided that its “new” subsidiary C corporation was affiliated and worthless. Once that deduction was recognized, Taxpayer passed through the ordinary deduction to its shareholders.
The IRS Disagrees
The IRS rejected the Taxpayer’s position on several grounds.
According to the IRS, when a Qsub election terminates, the former QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities), immediately before the termination, from the S corporation parent in exchange for stock of the new corporation.
In such a case, the deemed creation of a new corporation may qualify as a tax-free transaction. Alternatively, the transaction may be taxable and, if any of the transferred assets has a basis in excess of its fair market value, the recognition of the loss may be deferred under the “related party” rules.
In order to qualify as a tax-free transaction, a contribution of property to a corporation must be made solely in exchange for stock of such corporation and, immediately after the exchange, the contributor must be in control of the corporation.
An Insolvent QSub
However, insolvency can destroy an otherwise tax-free contribution to a corporation in two ways. First, significantly encumbered property may not be considered “property”; thus, there can be no contribution of property. Second, the “in exchange for stock” requirement is not met when the transferor receives stock in an insolvent corporation. (A similar “net value” rule applies to corporate reorganizations).
Specifically, “property” must have value, and something of value must be exchanged between the contributing shareholder and corporation. The IRS stated that because worthless subsidiary stock does not have value, the deemed contribution transaction incorporating liabilities in excess of the value of the transferred assets were taxable, and would be deferred under the related party rules.
A taxpayer may realize an ordinary loss from the worthlessness of the stock of a subsidiary corporation if certain “affiliation” and “gross receipts” tests are satisfied.
A corporation is treated as affiliated only if none of the stock of the corporation was acquired by the taxpayer solely for the purpose of converting a capital loss sustained by reason of the worthlessness of any such stock into an ordinary loss.
Thus, according to the IRS, Taxpayer had to explain why it “acquired” the C corporation stock for reasons other than to obtain an ordinary deduction.
In determining whether this anti-abuse rule applies, the IRS noted that Taxpayer had many options to create a deduction from Subsidiary’s alleged worthlessness. Of the options available to Taxpayer, terminating the QSub election, resulting in acquiring C corporation stock, was the only option that arguably generated an ordinary loss. This stock acquisition coupled with an immediate claim of an ordinary loss deduction was evidence, the IRS said, that the sole purpose of converting the Qsub into a C corporation was to attempt to qualify for an ordinary deduction.
Indeed, though there are a few benefits bestowed on taxpayers that terminate their QSub election, none of these benefits are relevant in the context of an S corporation running a defunct business. Some of the usual reasons a taxpayer may convert from QSub-to-C status are:
- Federal income tax rates are sometimes lower for C corporations than individuals;
- Employee-owners of C corporations do not have to include certain fringe benefits as income;
- C corporations may carryback capital losses two years; and
- C corporations have greater flexibility to choose when their fiscal year ends.
An S corporation in the process of receivership would not be engaged in tax planning about future tax brackets, shareholder-employee fringe benefits, carrying back of losses, or changing to a fiscal year. With an ordinary loss at stake, Taxpayer’s purpose was clear. This is exactly the type of acquisition of stock with the intent to convert a capital loss into an ordinary loss that the anti-abuse rule was designed to prevent.
Thus, the newly created C corporation was not treated as affiliated with Taxpayer and the ordinary deduction was disallowed.
Sometimes, You Have to Settle
Although tax advisers like to believe that no tax challenge is too daunting, or incapable of being addressed, the truth is that, quite often, there is no entirely satisfactory solution to every tax problem.
The sooner the adviser realizes this, the better he or she will manage the client-taxpayer’s expectations, and the more likely the adviser will stay clear of aggressive or “too good to be true” fixes that, in the end, will only harm the taxpayer and the adviser’s reputation.