As the economic effects arising from the worldwide spread of the novel Coronavirus (COVID-19) continue to develop, it is clear that forced closures, travel and trade restrictions, steep declines in demand, and other pressures will cause many businesses throughout the world to struggle. In these uncertain times, taxpayers may obtain a significant benefit by evaluating their businesses held through subsidiaries (both domestic and international) to assess the potential to take a worthless stock deduction with respect to one or more of those subsidiaries.
Worthless Stock Rules Generally
A stockholder is generally entitled to deduct the amount of its tax basis in the stock of a corporation in the taxable year in which such stock becomes worthless. For stock of a corporation to be considered worthless for tax purposes, that corporation must not only be insolvent (which generally means that it does not have sufficient assets to make at least some payment upon each class of its stock) but also must not have any potential future value (note that there are additional special rules to determine worthlessness of stock of a corporation that is a member of a consolidated group). This generally requires an “identifiable event” to fix the worthlessness of the stock. A common “identifiable event” is the liquidation of the corporation; however, a legal liquidation or dissolution is not required and the deemed liquidation that occurs through a “check-the-box” entity classification election (CTB Election) or an entity-type conversion (e.g., to a limited liability company, which would generally be treated as a flow-through for U.S. federal tax purposes) is generally sufficient to satisfy the identifiable event standard. Although the timing of a legal liquidation can be uncertain and potentially last more than a single tax year, a CTB Election or entity-type conversion can be a powerful tool to obtain certainty of the timing of a worthless stock deduction without significantly disrupting the continuing business. Notably, a taxpayer can also continue to own and operate the struggling business (including, for example, through a flow-through subsidiary that made a CTB Election or a limited liability company) without jeopardizing the worthless stock deduction.
Ordinary Instead of Capital Loss
A domestic corporation can offset only capital gains with capital losses, whereas ordinary losses can offset ordinary income (such as operating income) or capital gain. If a domestic corporation is a stockholder that owns at least 80% of the voting power and value of stock in a worthless corporation, and the worthless corporation satisfies a “gross receipts test,” then the domestic corporate stockholder is generally entitled to a more valuable ordinary loss (rather than a capital loss) with respect to the worthless subsidiary stock. The “gross receipts test” generally requires that more than 90% of the gross receipts of the worthless corporation were derived from non-passive sources (e.g., income other than from interest, rents, royalties, etc.). If a worthless corporation does not otherwise satisfy the gross receipts test, but owns operating subsidiaries, it may be possible to engage in certain transactions (such as mergers or liquidations) to cause the worthless corporation to succeed to the gross receipts history of its operating subsidiaries and thereby satisfy the “gross receipts test.”
A worthless stock deduction may be beneficial wherever found in a taxpayer’s domestic or international structure. For example, a worthless stock deduction with respect to the stock of a domestic consolidated subsidiary might yield a significant benefit to the domestic consolidated group by reducing the group’s tax liability (note, however, that special rules apply in the domestic consolidated context that might enhance, defer, reduce or eliminate the potential tax benefit associated with the stock of a worthless domestic consolidated subsidiary). Additionally, in certain circumstances, a worthless stock loss stemming from a CTB Election or entity-type conversion of a directly owned foreign subsidiary may qualify for ordinary deduction treatment. Moreover, if the CTB Election or entity-style conversion is followed by a legal liquidation of the foreign subsidiary, that might also, in the future, allow the domestic corporation stockholder to qualify for “foreign derived intangible income” (so-called FDII) deductions for certain ongoing activities. Similarly, a worthless stock loss with respect to a lower-tier foreign subsidiary may reduce a taxpayer’s “global low tax intangible income” (so-called “GILTI”) tax liability in certain cases (although this benefit may be limited by certain GILTI basis adjustment rules).
Furthermore, claiming a worthless stock loss deduction in 2020 may be even more impactful for taxpayers because of the recently enacted Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Specifically, because the CARES Act allows a net operating loss (NOL) generated in 2020 to be carried back up to 5 years and eliminate up to 100% of the taxable income (excluding any mandatory repatriation income) in those prior years, a worthless stock loss in 2020 may give taxpayers an ability to more completely reduce tax in prior years. Importantly, this includes taxable years in which the corporate income tax rate was 35% instead of 21% or NOL usage was previously limited to 80% of taxable income.
Finally, while the benefits of a worthless stock loss in 2020 may be significant, taxpayers should be mindful that the relevant tax rules are complex (particularly in the GILTI and consolidated group context) and special care should be taken to understand both the benefits and collateral consequences that can arise from engaging in transactions that potentially give rise to a worthless stock loss. The Weil Tax Department has experience in these matters, and if you have any questions about how or whether you may benefit from evaluating if a worthless stock loss is available to you, please contact Devon Bodoh, Greg Featherman, Graham Magill or Joseph M. Pari.