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Section 165 permits deductions for losses. A loss must usually be triggered by a sale, exchange, or other disposition prior to a taxpayer claiming the deduction and recognizing the loss. An exception to the general rule exists where the loss relates to a failed investment in subsidiary stock. In that scenario, Section 165(g)(1) allows the taxpayer to claim the loss deduction absent a typical realization event.1 This worthless stock deduction ("WSD") enables taxpayers to recover investments in failed corporations by claiming a loss equal to their adjusted basis in the subsidiary's stock.
Taxpayers engaging in worthless stock deduction planning are likely to focus on three questions:
1. When can I claim the deduction?
2. How much is the deduction?
3. Is the deduction ordinary or capital in character?
"When" and "how much" usually have straightforward answers (the tax year during which the stock became worthless2 and the amount of the taxpayer's basis in the newly worthless stock,3 respectively).
The third question, the answer to which is less straightforward, is of heightened importance vis-a-vis the first two. This is because most taxpayers prefer to shield ordinary income, not capital gains, with loss deductions. The statute's plain language does not yield the desired result. Under Section 165(g)(1), if stock4 becomes worthless during the tax year, the resulting loss is usually treated as a loss from the sale or exchange, on the last day of the tax year, of a capital asset.
For consolidated groups with intermediate holding company structures, the character question is trickier. There, ordinary or capital treatment turns on the worthless subsidiary's erstwhile business activities. If greater than 90% of the subsidiary's gross receipts were derived from active sources,5 its parent can claim an ordinary deduction. Simple enough for basic parent-subsidiary structures. Unfortunately, the (authoritative) rules do not tell affiliated taxpayers filing consolidated returns whether a holding company ("HoldCo") with no business activities of its own can rely on subsidiary gross receipts for purposes of the GRT.
As has been previously discussed,6 the IRS has issued a series of private letter rulings that provide consolidated taxpayers with a general (albeit non-precedential) rule of thumb: a domestic parent can probably claim an ordinary WSD with respect to its shares in a HoldCo, so long as the...