Consolidated groups with members that have worthless common stock but some value on their preferred stock should consider opportunities to merge the member into other group members in order to accelerate a worthless stock deduction.
The Internal Revenue Service (IRS) publicly acknowledged that worthless stock deductions can be accelerated in a consolidated group through tax-free intercompany mergers.
At a recent bar association panel, senior IRS attorney Theresa Abell stated that an example in the consolidated return regulations on subsidiary stock losses is erroneous because it conflicts with an operative provision in the regulations that would allow a worthless stock deduction to be claimed through a tax-free intercompany merger. Accordingly, consolidated groups with loss corporations having common and preferred stock outstanding should consider intercompany mergers in order to accelerate a worthless stock deduction.
Failing companies will often have a capital structure consisting of common stock that is worthless and preferred stock that retains some residual value. In these situations, if a tax-free merger of the company is feasible (i.e., a valid business reason for the transaction exists and other technical requirements are met), the merger can result in both preservation of the inside attributes of the company, such as net operating losses (NOLs) or built-in asset losses, and an immediate worthless stock deduction for the holders of the common stock (which may be an ordinary loss if the requirements of section 165(g)(3) are satisfied). Thus, if the merger takes place between affiliated corporations, the affiliated group may enjoy the double benefit of both the NOLs and the worthless stock deduction.
For affiliated corporations that file a consolidated return, special rules apply to dispositions of subsidiary stock at a loss (Unified Loss Rules, or ULRs). The ULRs limit the ability of consolidated groups to claim losses with respect to the stock of member subsidiaries and, in effect, duplicate those losses through deductions deriving from inside attributes such as NOLs. For example, the ULRs can disallow all or part of a loss realized from the sale of a subsidiary. Moreover, when a stock loss is allowed under the ULRs, the inside attributes of the subsidiary may be partially reduced or in some cases eliminated in order to prevent the duplication of losses.
There are also special rules that may defer or eliminate the ability of a consolidated group to claim a worthless stock deduction under section 165. See §1.1502-80(c) (the 165 deferral rule). Thus, when a subsidiary in a consolidated group has worthless stock, both the ULRs and the 165 deferral rule can apply. Finally, losses with respect to member stock are generally deferred (and sometimes permanently disallowed) when they arise from transactions within the consolidated group.
In view of the numerous consolidated return limitations on stock losses, one might assume that a tax-free merger within a group could never result in the acceleration of a worthless stock deduction. The drafters of the ULRs apparently made this assumption.
In Example (iii) of §1.1502-36(d)(7)(iii), a consolidated group member (S) has one outstanding share of worthless common stock held by member M and one outstanding share of preferred stock with positive value held by member M1. S merges into another member (M2) in a tax-free reorganization, with M1 receiving M2 stock in exchange for its preferred share while M’s share of common stock is cancelled without consideration. The example concludes that M1’s worthless stock deduction must be deferred and that the inside attributes of S inherited by M2 in the merger must nonetheless be reduced by the amount of M’s potential worthless stock deduction.
Example (iii) is noteworthy for two reasons. First, it is the only published authority in a final regulation confirming that a worthless stock deduction can coexist with a tax-free merger when all parties are related. Second, the example illustrates that the government incorrectly assumed that the worthless stock deduction would be deferred upon the merger.
The consolidated return rules described above almost always provide for continued loss deferral in tax-free transactions within the group, and adopt very broad notions of “successor” and “predecessor” entities so that tax items can be deferred until the group, as a single entity, recognizes an economic gain or loss through dealings with third parties. A tax-free merger is the paradigm case where successor treatment normally would apply.
However, because of what is arguably a technical glitch, the 165 deferral rule does not contain a “successor” provision. Accordingly, although the example asserts that deferral is required under §1.1502-80(c), there is no operative regulatory language that would cause M’s deduction to be deferred following the intercompany merger.
Theresa Abell, a special counsel in the Corporate division of the IRS, acknowledged at a recent bar association panel that Example (iii) is inconsistent with the operative rules, which would permit M’s worthless stock deduction to be claimed upon the merger of S. Abell also indicated that any change to regulations (which would presumably add a successor rule to §1.1502-80(c)) will be prospective.
The ability to accelerate a worthless stock deduction from an intercompany merger is a surprising result that affords significant planning opportunities. These opportunities will exist until the IRS closes the loophole with a prospective regulation. Although a reduction of the target member’s attributes will be required, the present value of an immediate worthless stock deduction often exceeds the future costs of the attribute reduction. The loophole is likely to exist for at least the entire 2009 tax year (but the IRS can be expected to close it eventually).
Consolidated groups with members that have worthless common stock but some value on their preferred stock should consider opportunities to merge the member into other group members in order to accelerate a worthless stock deduction. In addition, consolidated groups with subsidiaries that conduct speculative businesses should consider, in appropriate cases, recapitalizing such subsidiaries with preferred stock in order to position themselves for an accelerated worthless stock deduction on the common equity if the business does not succeed.