October 31, 2011
Worthless Stock Deductions - A look into Section 165(g)(3)
By Michael Pytka, Supervisor, Tax & Business
In March 2011, the IRS issued a private letter ruling (PLR 201108001), specifically related to savings & loan companies and their wholly-owned banking subsidiaries, wherein it is specified that interest income on consumer loans and gains or losses from the sale of the subsidiary's real estate assets are treated as active income. Before the letter ruling was issued, these activities were treated as portfolio income and the capital losses were subject to annual limitations. This is a favorable update to the Internal Revenue Code interpretation, because active income and losses produced by an activity will yield ordinary gains or losses. A deduction taken for an ordinary loss is more beneficial to a corporate taxpayer as capital losses can only be utilized to the extent there are capital gains; ordinary losses do not have such limitations. If a parent corporation were to sell or abandon the worthless securities they own in their banking subsidiary, the new private letter ruling delineates that the subsidiary and its activities are treated as active, and thus an ordinary loss deduction shall be allowed for the parent.
In order for savings & loan companies to take advantage of the ordinary loss deduction, the parent company must prove their affiliation to their banking subsidiary through two separate tests. The first is the “ownership test,” which requires that the parent corporation must own directly stock in the subsidiary, possessing at least 80% of the parent’s voting and value of the corporation’s stock. The second test is the “gross receipts test,” which essentially states that more than 90% of the subsidiary’s gross receipts must be derived from active income. Additionally, the loss must be evidenced by a closed and completed transaction, fixed by identifiable events, and sustained during the tax year.
This private letter ruling is most likely a result of the economic crisis, due to the large number of subsidiaries entering bankruptcy or becoming insolvent. Many banking subsidiary income is generated through real estate sales and interest on notes receivable, which, under the old rule, would be classified as portfolio income, thus making it more difficult to pass the "gross receipts test." Now that this type of income is classified as active, allowing a broader measure to be included in gross receipts, the test is more easily met by parent companies.