The disruptions caused by the COVID-19 pandemic have driven significant losses for many businesses, causing some to permanently close. Owners of these and other distressed businesses should consider whether they are eligible for a deduction attributable to an investment in worthless stock.
Generally, if the stock is a capital asset and becomes wholly worthless during the taxable year, the investor may recognize a capital loss. The amount of the capital loss is the adjusted basis of the stock at the time of worthlessness.
However, a special rule applies to the worthlessness of stock in qualifying subsidiary corporations. Under this exception, it may be possible for the parent company to claim an ordinary loss on the worthlessness of a subsidiary company if certain requirements are met.
Deduction for worthless subsidiary stock
The complete worthlessness of stock in a subsidiary may generate an ordinary loss deduction equal to the basis of the stock of the subsidiary in the hands of its immediate corporate parent, as determined under the consolidated return basis adjustment rules. It should be noted that in certain cases, the otherwise allowable loss may be reduced or eliminated pursuant to other consolidated return rules.
The amount of deduction attributable to stock in a worthless foreign subsidiary is generally the investment made to acquire and fund the foreign subsidiary (with certain adjustments) and is unaffected by the consolidated return adjustment rules.
In addition to establishing worthlessness (see below), the subsidiary must meet the following tests as well as certain other requirements to qualify for the ordinary loss deduction:
- Affiliation test: The taxpayer must directly own stock constituting 80% of the voting power and 80% of the value of non-voting stock but excluding certain limited preferred stock.
- Gross receipts test: More than 90% of the aggregate gross receipts of the affiliated subsidiary corporation for all taxable years during which it has been in existence must be from sources other than royalties, rent (except rent from property rented to employees of the corporation in the ordinary course of its operating business), dividends, interest (except interest from the deferred purchase price of operating assets sold by the corporation), annuities and gains from the sale of stock or securities.
In addition to meeting the affiliation and gross receipts tests, the taxpayer must establish that the subsidiary stock is wholly worthless (meaning the stock has no liquidating or potential future value). Stock has no liquidating value when the fair market value of the business’ assets is less than its liabilities, which for this purpose includes intercompany liabilities owed to the immediate parent. All assets— including tangible assets such as machinery and equipment, as well as intangibles such as goodwill, going concern value, workforce in place, supplier-based intangibles, customer-based intangibles, trademarks, tradenames, etc.—must be considered in determining the value of the gross assets.
Once stock is deemed worthless, there must be an “identifiable event” to trigger the loss deduction for income tax purposes. Examples of an identifiable event include:
- A legal dissolution of the subsidiary.
- A formal or informal subsidiary liquidation.
- A “check-the-box” election, or entity classification election, to treat a foreign subsidiary as a disregarded entity.
- A state law formless conversion of the subsidiary from a corporation to an entity classified as a disregarded entity (i.e., a single-member LLC).
The continuance of a subsidiary’s business following a worthless stock deduction for any purpose other than winding down the business operations must be done in a manner that separates the circumstances supporting the deduction from subsequent events that allow the business to continue.
Coordination with NOL and disaster loss rules
A worthless stock deduction that is treated as an ordinary loss in the current year could create or increase a net operating loss (NOL) that can be carried forward or, in limited cases, carried back. The CARES Act temporarily reinstated the NOL carryback provisions by extending the carryback period to five taxable years for losses originating in 2018, 2019, or 2020. By carrying a loss back to taxable years prior to 2018, taxpayers may have the opportunity to receive a refund for taxes paid at tax rates as high as 35%, creating a permanent benefit as compared to otherwise carrying the loss forward to reduce taxes paid at a 21% rate. In some cases, a carryback can generate a refund sooner than would otherwise be available with the use of an NOL carryforward.
While most 2020 returns have already been prepared, certain losses attributable to COVID-19 in 2021 may be eligible for an election under Section 165(i) to be claimed on the preceding taxable year’s return. The determination of whether a taxpayer is eligible to make this election for a worthless stock loss should be made on a case-by-case basis.
Statute of limitations
Determining the timing as to when a corporation’s stock becomes worthless can be a very difficult task. In recognition of this challenge, the tax law provides a seven-year statute of limitations for deductions with respect to the worthlessness of a security.
How we can help
Worthless stock deductions can provide significant tax benefits and should be carefully considered given the economic harm caused to many businesses by the COVID-19 pandemic. Please contact our professionals to discuss further.
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