Attorney Suggests Amending Consolidated Return Regs to Incorporate Worthless Stock Deduction

[1] This letter analyzes the effect of various consolidated return regulations, including Prop. Reg. § 1.1502-35, on the ability of a consolidated group member to claim a worthless stock deduction with respect to a subsidiary's stock. Under Prop. Reg. § 1.1502-35(f), a worthless stock deduction may be denied and the group may never get a deduction for its economic loss. The letter concludes that when Prop. Reg. § 1.1502-35 is issued as a final or temporary regulation, paragraph (f), as well as other regulations, should be modified so that the consolidated tax liability of the group is clearly reflected.¹

[2] In general, a worthless stock deduction under section 165(g)(3) may be claimed in three situations:

[5] If this suggestion is adopted, the only case in which a special consolidated return provision will be required to implement the purposes of Prop. Reg. § 1.1502-35 will be the case in which a worthless subsidiary remains in existence as a member of the group following the claim of the worthless stock deduction (situation 3 above). In such a case, the subsidiary's tax attributes should be subject to a zero limitation under section 382(g)(4)(D).⁶ Following the claim of the stock loss, the subsidiary, however, may continue to hold high basis/low value assets. Recognition of the loss with respect to those assets would create an excess loss account ("ELA"), the recognition of which could be deferred indefinitely. Accordingly, the group would have claimed two deductions with respect to a single economic loss. The problem can be solved by allowing the owning member to claim the worthless stock deduction, but requiring the subsidiary to recognize gain or loss on its assets as if the assets were sold immediately before the claim. Thus, the group would achieve the same results as if the subsidiary were, in fact, dissolved. A double deduction would not be available.

[6] Another positive consequence of such a rule would be the elimination of any lingering need for Reg. § 1.1502-80(c). That provision is largely deadwood today, but retains minimal utility only in light of Prop. Reg. § 1.1502-35. Regulation 1.1502-80(c) was initially promulgated as a relief rule for a group with a worthless subsidiary, when the subsidiary held high basis/low value assets. Under the duplicated loss rule,⁷ prior to its invalidation in Rite Aid, an owning member would have been disallowed the worthless stock deduction to the extent the subsidiary held high basis/low value assets. Regulation § 1.1502-80(c) allowed taxpayers to claim a worthless stock deduction by requiring a delay in eligibility for the claim until the subsidiary had disposed of substantially all of its assets, and thus would no longer have the deduction disallowed by the duplicated loss rule. After Rite Aid and the government's abandonment of Reg. § 1.1502-20, the principal purpose for the promulgation of Reg. § 1.1502-80(c) ceased. Its only remaining raison d'etre is to prevent a double deduction by the group upon a taxable disposition of those assets following claims for worthlessness of stock if the subsidiary remains a member. A special rule requiring the subsidiary to recognize gain or loss on its assets immediately prior to the worthless stock claim would completely eliminate the need for Reg. § 1.1502-80(c) and eliminate any opportunity for a group to claim a double deduction.

[7] In conjunction with these changes, Reg. § 1.1502- 19(c)(1)(iii) needs revision. Clause (A), in particular, has created uncertainty ever since its promulgation. First, the definition of "substantially all" for purposes of that provision has never been articulated. Second, it is unclear whether a dissolution of an insolvent subsidiary constitutes a "complete liquidation." (The same issue arises under Reg. § 1.1502-13(j)(2).) Most commentators believe it does not. The purpose of the rule is to require a trigger of an ELA once the subsidiary is devoid of substantially all of its assets. It would seem prudent, however, to return to the pre-1994 incarnation of the rule and require recapture when the subsidiary is considered worthless within the meaning of section 165(g)(3). In the case of a subsidiary that is insolvent and has ceased operations, there is no compelling reason to defer recapture of the ELA or a worthless stock deduction until creditor claims are settled or until the time (if ever) substantially all of the subsidiary's assets are disposed of.

[8] The elimination of Reg. § 1.1502-80(c), as well as other changes to the regulations, should generally be prospective. To avoid denial of a single deduction, however, taxpayers should be provided an election to apply the current rules or the modified rules for transactions after March 6, 2002, and before new regulations are issued in final or temporary form. A special rule needs to be provided to prevent a taxpayer from falling between the cracks. For example, if actual worthlessness occurred in 2002, before substantially all of a subsidiary's assets were disposed of, and a modified rule allows a deduction at the time of worthlessness under section 165(g)(3), care must be taken to ensure that a taxpayer who followed Reg. § 1.1502-80(c) for a prior year is not disallowed the deduction in a future year.

[9] Thank you for your consideration.

²Reg. § 1.332-2(b).

³292 US 62 (1934).

⁴255 F.3d 1357 (Fed. Cir. 2001).

⁵532 U.S. 822 (2001).

⁶One commentator has suggested that a double deduction can be achieved by a statutory merger of an insolvent subsidiary into its owning member, before the end of the consolidated return year notwithstanding Rev. Rul. 59-296, 1959-2 CB 87. See Norman Scott, Inc., 48 TC 598 (1967), relating to merger of insolvent brother into sister corporation. Under section 382(g)(4)(D), the zero limitation applies only if 50% of the subsidiary's stock is held by the shareholder at the close of the shareholder's taxable year. See, Blanchard, Bennett and Spear, "Deductibility of Investments in Financially Troubled Subsidiaries and Related Federal Tax Considerations," 80 TAXES 90, (March 2002). A regulation provision reaffirming the Service's position in Rev. Rul. 59-296 would protect the government's interest.

⁷Reg. § 1.102-20(c)(2)(vi).