CONVERSION OF INSOLVENT SUBSIDIARY INTO SINGLE-MEMBER LLC: DOES 332 NON-RECOGNITION PRECLUDE A WORTHLESS STOCK DEDUCTION?
As a general rule, where a parent corporation elects to change a subsidiary's tax classification from corporation status to disregarded entity status (e.g., conversion of a corporate subsidiary into a single-member LLC), the election is treated as a constructive liquidation. This means that I.R.C. § 332 will generally preclude the parent corporation from recognizing gain or loss as a result of the liquidation.
But what if the subsidiary which is deemed to liquidate into the parent corporation is insolvent at the time of this deemed liquidation? Does Section 332's non-recognition rule preclude the parent corporation from claiming a worthless stock deduction under I.R.C. § 165(g) insofar as such a deduction is essentially in the nature of a loss?
It shouldn't, and here's why:
The non-recognition rules contained in Section 332 are only implicated if the transaction satisfies the three-prong test set forth in I.R.C. § 332(b). Under the first prong of Section 332(b), the recipient corporation must own at least eighty percent of the total vote and value of the liquidating corporation's stock, on the date of adoption of the plan of liquidation, and at all times until receipt of the liquidating corporation's property.
Under the second prong of Section 332(b) the distribution must be either: (1) in complete cancellation of all of the stock of the liquidating corporation, and within the taxable year ; or (2) one of a series of distributions in complete cancellation of the stock of the subsidiary in accordance with a plan under which all the liquidating distributions will be completed within three years from the close of the taxable year during which the first of the series of distributions occurred under the plan.
Under the third prong of Section 332(b), the distribution must be pursuant to a plan of liquidation that has been adopted by each of the corporate parties to the transaction. To be clear, the statute does not explicitly state that a plan of liquidation is a necessary prerequisite to non-recognition treatment under Section 332. However, the requirement is explicit in the definition of "complete liquidation" as defined in the treasury regulations. Specifically, the regulations state: "[t]o constitute a distribution in complete liquidation within the meaning of Section 332, the distribution must be (1) made by the liquidating corporation in complete cancellation or redemption of all of its stock in accordance with a plan of liquidation; or (2) one of a series of distributions in complete cancellation or redemption of all its stock in accordance with a plan of liquidation." See Treas. Reg. § 1.332-2(a) & § 1.332-2(c). It should be noted, however, that a formal plan of liquidation is not required. See e.g., Fowler Hosiery Co. v. Commissioner, 301 F.2d 394 (7th Cir. 1962) (holding that there was no need for liquidating subsidiary to adopt a formal plan of liquidation; it was sufficient that the distribution was in fact part of a plan of complete liquidation); McCarthey v. Conley, 229 F. Supp 517 (D.C. Conn. 1964) (stating that the Court must consider whether or not any informal plan did exist as a matter of fact, notwithstanding the absence of a formal plan).
In addition to the three-prong analysis set forth in the statute, Treasury Regulation § 1.332-2(b) provides that Section 332 only applies to cases in which the recipient corporation receives at least partial payment for the stock which it owns in the liquidating corporation. A transfer of assets is first applicable to discharge any indebtedness to the transferee. Houston Natural Gas Corp. v. Commissioner, 9 TC 570, 574 (U.S. Tax Ct. 1947). Consequently, when the fair market value of a subsidiary's assets, (including intangible assets such as goodwill and going concern value) is less than the sum of its liabilities, no part of the transfer is attributable to the parent's stock ownership, and the payment -for-stock requirement is not satisfied. See Rev.Rul. 2003-125, 2003-2 CB 1243. And of course, if the payment-for-stock requirement is not satisfied, the Section 332 non-recognition rules are inapplicable.
As a result, if the subsidiary is insolvent in the sense that the fair market value of its assets (including goodwill and going concern value) do not exceed the sum of its liabilities, Section 332 will not apply to preclude recognition of a loss by the parent corporation. And in that case, Section 332 would not disallow a Section 165(g) worthless stock deduction. This is true even though the liquidation resulting from a check-the-box election to be disregarded is constructive rather than actual. See Private Letter Ruling 201115001.
As a final note, it should be emphasized that the parent corporation would receive an ordinary loss deduction instead of a capital loss deduction under the affiliation exception. See I.R.C. §165(g)(3). This is significant for two reasons. First, the loss deduction is not subject to the capital loss limitations. Moreover, the loss is first applied as an offset to ordinary income. Thus, the corporation may currently deduct the entire loss notwithstanding whether it has any capital gains for the year.