PLR 1314005: IRS allows an ordinary worthless-stock deduction after a foreign subsidiary changes classification

Plain-English summary

A domestic parent planned to change an insolvent foreign subsidiary's federal tax classification from a corporation to a disregarded entity. The subsidiary owned an interest in a foreign partnership, and the taxpayer needed to count the subsidiary's distributive share of the partnership's gross receipts to satisfy the affiliated-corporation gross-receipts test. The IRS ruled that the partnership's receipts could be included for that test. It also ruled that the parent was entitled to an ordinary worthless-stock deduction for the subsidiary's stock after the deemed liquidation, and that specified related classification elections and a transfer would not prevent the deduction. The ruling was limited to the requested consequences and the submitted facts.

Ruling snapshot

• Question: Can the subsidiary include its partnership share of gross receipts and claim an ordinary worthless-stock deduction after changing to a disregarded entity?
• Outcome: Approved for the three requested rulings, subject to the stated facts and representations.
• Key authorities: IRC §§ 165(g)(3), 301.7701-3, 332, 702, 1222, and 6110; Treas. Reg. §§ 1.165-1, 1.332-2, and 1.702-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201314005 Third Party Communication: n/a
Release Date: 4/5/2013
Index Number: 165.06-02
Person To Contact:
------------------------------------- ----------------------, ID No. --------------------
------------------ ----------------------------------------------------
---------------------------------------- Telephone Number:
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Refer Reply To:
CC:ITA:B03
PLR-128218-12
Date:
December 21, 2012

In re: A ruling request regarding § 165(g)(3)(B) of the Internal Revenue Code.

Legend

X = -------------------------------------------------------------

Y = --------------------------------------------------------

Z = -------------------------------------------------------

FP = ------------------------

FC1 = -----------------------------------

FC2 = -----------------------------------------------------

FP2 = -------------------------------------------------

Year 1 = -------

Year 4 = -------

State A = --------------

a% = --------

b% = ------

c% = ------

d% = ------

PLR-128218-12 2

e% = ------

$a = ----------------

$b = -----------------

Dear ----------------:

This is in response to your representative’s June 27, 2012, letter and December 17,
2012, supplemental submission requesting a ruling on the application of § 165(g)(3)(B)
to an insolvent subsidiary that will elect to be treated as a disregarded entity for federal
tax purposes.

                                      FACTS

X is a publicly traded corporation organized under the laws of State A. X operates in
the United States and in numerous foreign countries, principally through foreign
subsidiaries.

X is the parent of a consolidated group of corporations. Among other subsidiaries, X
owns a% of both Y and Z. Y and Z are both State A corporations and join X in filing a
consolidated return. X and its subsidiaries derive most of their combined receipts from
the sale of products.

Y owns b% of FP, a foreign entity classified as a partnership for U.S. federal tax
purposes. X owns the remainder of FP. Y also owns c% of FC1, a foreign entity
classified as a corporation for U.S. federal tax purposes. FP owns the remainder of
FC1.

Z owns a% of FC2, a foreign entity classified as a corporation for U.S. federal tax
purposes. FC2 owns d% of FP2, a foreign entity classified as a partnership for U.S.
federal tax purposes. FC1 owns the remainder of FP2.

FC2 acquired its d% interest in FP2 in Year 1 by issuing a note payable with a principal
amount of approximately $a as consideration in the exchange. Additionally, FC2
currently holds FP2 debt with a principal amount of $b. A third party valuation report
determined FC2 to be insolvent as of Year 4. FC2 derives much of its revenue from its
investment in FP2, but FP2 has substantial active business operations conducted
through disregarded entities. FC2 can only satisfy the gross receipts test in
§ 165(g)(3)(B) if its distributive share of FP2’s gross receipts are counted. No gross
receipts arising from the operating companies following their elections to be taxed as
corporations will be counted.

PLR-128218-12 3

X intends to restructure certain foreign operations in order to (1) consolidate operations
under its foreign holding company structure; (2) achieve entity simplification and cost
reduction; and (3) achieve local tax efficiency in the foreign jurisdiction.

As part of a single integrated plan, the following steps will be taken as part of the
restructuring:

1. X has transferred its interest in FP to Z.

2. X and Y will merge, with X surviving.

3. The disregarded operating companies owned by FC2 will make check-the-box
   elections to change their classification from disregarded entities to corporations
   for U.S. federal income tax purposes.

4. FC2 will make a check-the-box election to change its classification from a
   corporation to a disregarded entity for U.S. federal income tax purposes (FC2
   Election).

5. Z will transfer all of FC2 to FP for no consideration.

X represents the following:

1. At all times, all instruments referred to as debt herein have been treated as debt
   for U.S. federal tax purposes. Also, at all times, all instruments referred to as
   equity herein have been treated as equity for U.S. federal tax purposes.

2. At all times relevant to the FC2 Election, FC2 will be an eligible entity as defined
   in § 301.7701-3(a) of the Procedure and Administration Regulations.

3. FC2 will not have made a check-the-box election to change its entity classification
   within the 60-month period preceding the FC2 Election.

4. A timely and valid check-the-box election will be made and the result will be to
   treat FC2 as a disregarded entity for U.S. federal tax purposes.

5. At all times relevant to the proposed restructuring, FC2 will have one class of
   issued and outstanding stock, all of which will be owned by Z on the effective
   date of the FC2 Election.

6. In each year prior to the effective date of the FC2 Election, FC2 did not cease
   business, file for bankruptcy, or have any other identifiable event.

PLR-128218-12 4

7. In each year prior to the effective date of the FC2 Election, FC2’s current
   liabilities (not taking into account any contingent liabilities) will exceed the fair
   market value of FC2’s assets (including tangible and intangible assets such as
   goodwill and going concern value).

8. None of the FC2 stock was acquired for the purpose of converting a capital loss
   sustained by reason of the worthlessness of any such stock into an ordinary loss
   under § 165(g)(3).

9. At all times relevant to the proposed restructuring, FP2 will be properly classified
   as a partnership for U.S. federal tax purposes.

10. Taking into account FC2’s distributive share of FP2’s gross receipts, more than -
    ----% of the aggregate gross receipts of FC2 for all taxable years will be from
    sources other than royalties, rents, dividends, interest, annuities, and gains from
    sales or exchanges of stocks and securities, within the meaning of
    § 165(g)(3)(B). For purposes of this representation, FC2 will take into account
    the gross receipts arising from its check-the-box election.

                             RULINGS REQUESTED
    

11. FC2 should include its distributive share of FP2’s gross receipts for purposes of
    computing the gross receipts test under § 165(g)(3)(B).

12. Z is entitled to an ordinary worthless stock deduction under § 165(g)(3) for FC2’s
    stock.

13. Neither the operating companies’ elections to be treated as corporations nor Z’s
    transfer of FC2 to FP will affect Z’s ability to claim a worthless stock deduction
    with respect to the stock of FC2 under § 165(g)(3).

                                LAW & ANALYSIS
    

X represents that FC2 is an eligible entity that may check-the-box to change its entity
classification under § 301.7701-3(c)(1)(i), and proposes to do so and change its
classification from corporation to disregarded entity. This will result in FC2 being
deemed to distribute all of its assets and liabilities to Z in liquidation. Section 301.7701-
3(g)(1)(iii).

Section 332(a) provides that no gain or loss shall be recognized on the receipt by a
corporation of property distributed in complete liquidation of another corporation.

PLR-128218-12 5

Section 1.332-2(b) provides that § 332 (non-recognition) applies only if the recipient
corporation receives at least partial payment for its stock in the liquidating corporation,
and references § 165(g) for the consequences of worthless securities if § 332 does not
apply.

Section 165(a) allows a deduction for losses sustained during the taxable year and not
compensated for by insurance or otherwise, including capital losses. Section 165(f). A
loss deduction is permitted under § 165 only for the taxable year in which the loss is
sustained, as evidenced by closed and completed transactions and as fixed by
identifiable events. Section § 1.165-1(b). A capital loss results from the sale or
exchange of a capital asset. Section 1222. Stock in a corporation is generally a capital
asset. Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988). For most capital
assets, a loss due to worthlessness or abandonment is ordinary for lack of a sale or
exchange. See, Echols v. Commissioner, 950 F.2d 209 (5th Cir. 1991).

However, for securities, § 165(g)(1), provides the missing sale or exchange, deemed to
occur on the last day of the taxable year, and the resulting loss is generally capital.
Section 165(g)(2)(A) provides that the term security includes a share of stock in a
corporation. Under § 165(g)(3), any security in a corporation “affiliated” with a taxpayer
that is a domestic corporation is not treated as a capital asset, and the loss is ordinary.
For purposes of § 165(g)(3), a corporation is treated as "affiliated" with the taxpayer (a
domestic corporation) only if the taxpayer directly owns stock of the corporation that
meets the requirements of § 1504(a)(2), and more than 90 percent of the aggregate of
the corporation's gross receipts ("gross receipts") for all taxable years has been from
sources other than royalties, certain rents, dividends, certain interest, annuities, and
gains from sales of stocks and securities.

Rev. Rul. 70-489, 1970-2 C.B. 53, amplifying Rev. Rul. 59-296, 1959-2 C.B. 87, holds
that where a wholly owned subsidiary had bona fide indebtedness to its parent
corporation that exceeded the fair market value of its assets and the subsidiary
transferred all of its assets to its parent in partial satisfaction of its indebtedness, the
parent could claim both a bad debt deduction and a worthless security deduction, even
though the parent continued the business formerly conducted by the subsidiary.

Rev. Rul. 2003-125, 2003-2 C.B. 1243, holds that when an entity classification election
is made to change an entity from a corporation to a disregarded entity, the former
shareholder of such corporation is allowed a worthless security deduction under
§ 165(g)(3) if the fair market value of the assets of the corporation does not exceed the
total amount of the corporation's liabilities, such that on the deemed liquidation of the
corporation, the former corporate shareholder receives no payment on its stock in the
liquidated corporation.

Section 702(a) provides that in determining his income tax, each partner shall take into
account separately his distributive share of the partnership’s items enumerated therein.

PLR-128218-12 6

Section 1.702-1(a) provides, in part, that each partner is required to take into account
separately in his return his distributive share, whether or not distributed, of each class or
item of partnership income, gain, loss, deduction or credit described in subparagraphs
(1) through (9) of that paragraph. Section 1.701-1(a)(8)(ii) states, in part, that each
partner must also take into account separately his distributive share of any partnership
item which, if separately taken into account by any partner, would result in an income
tax liability for that partner different from that which would result if that partner did not
take the item into account separately.

Section 702(b) provides that the character of any item of income, gain, loss, deduction,
or credit included in a partner’s distributive share under paragraphs (1) through (7) of
subsection (a) shall be determined as if such item were realized directly from the source
from which realized by the partnership, or incurred in the same manner as incurred by
the partnership.

Rev. Rul. 71-455, 1972-1 C.B. 318, held that an S corporation’s distributive share of
gross receipts from a partnership should be included for purposes of applying the
passive investment income test under § 1372(e)(5). The ruling relied on § 1.702-1(a)(8)
in finding that the partner’s distributive share of gross receipts should flow through to the
partner under § 702.

FC2, an eligible entity currently classified as a corporation, will elect to be treated as a
disregarded entity as part of the proposed restructuring. As a result, FC2 will be
deemed to distribute all of its assets and liabilities to Z, its sole shareholder. X
represents that, as of the effective date of the election, FC2’s liabilities will exceed the
fair market value of FC2’s assets, taking into account goodwill and going concern value.
Consequently, Z will not receive payment in exchange for its FC2 stock and
§ 165(g) will apply to the transaction. Since Z is the sole shareholder of FC2 the
ownership test in § 165(g)(3)(A) is satisfied. However, FC2’s principal asset is its
interest in FP2, and FC2 can only meet the gross receipts test under § 165(g)(3)(B) if it
can look through its FP2 partnership interest and include its distributive share of FP2’s
gross receipts for purposes of testing the 90% gross receipt threshold.

A partnership should be treated as an aggregate for purposes of the 90% gross receipts
test as the income tax liability at the partner level would differ if the partner did not take
its distributive share of partnership income into account. Therefore, in calculating FC2’s
gross receipts, the character of each item in the hands of FP2 passes through to FC2
as if earned directly.

                                     RULINGS

Based solely on the information submitted and the representations set forth above, we
rule as follows:

PLR-128218-12 7

1. FC2 should include its distributive share of FP2’s gross receipts for purposes of
   computing the gross receipts test under § 165(g)(3)(B).

2. Z is entitled to an ordinary worthless stock deduction under § 165(g)(3).

3. Neither the operating companies’ elections to be treated as corporations nor Z’s
   transfer of FC2 to FP will affect Z’s ability to claim a worthless stock deduction
   with respect to the stock of FC2 under § 165(g)(3).

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. This letter does not address the tax consequences of steps 1, 2, 3 and 5 of
the restructuring, other than how steps 3 and 5 relate to the consequences of step 4,
the FC2 Election, as requested in ruling 3. We have assumed, based on the taxpayer’s
representation that no identifiable event had occurred before the check-the-box election,
that the stock of FC2 was not worthless in an earlier year. We have also assumed that
X’s representation that FC2’s liabilities will exceed the fair market value of FC2’s assets
taking into account goodwill and going concern value, fully values FP2 by taking into
account the operating companies’ goodwill and going concern value.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

PLR-128218-12 8

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                 Sincerely,



                                 Christopher F. Kane
                                 Branch Chief, Branch 3
                                 (Income Tax & Accounting)

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