rr-03-125.pdf

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Part I

Section 165.BLosses

26 CFR 1.165-1: Losses.
(Also § 332; § 1.332-2)

Rev. Rul. 2003-125

ISSUE

Under the circumstances described below, when an election is made to change
the federal tax classification of an entity from a corporation to a disregarded entity under
§ 301.7701-3 of the Procedure and Administration Regulations, is the shareholder
allowed a worthless security deduction under § 165(g)(3) of the Internal Revenue
Code?

FACTS

Situation 1

P is a domestic corporation that is a calendar year taxpayer. FS is an entity that
is organized under the laws of Country X. FS has only one class of equity interests
outstanding, all of which is owned by P. Since the date of its organization, FS has
derived all of its gross receipts from manufacturing operations. FS is indebted to P and
to trade creditors. All of FS’s indebtedness constitutes valid indebtedness for federal
tax purposes and is recourse to FS. FS is an eligible entity within the meaning of
' 301.7701-3(a) and, prior to July 1, 2003, FS is treated as a corporation within the
meaning of ' 7701(a)(3) for federal tax purposes.

On December 31, 2002, P’s FS stock was not worthless. On July 1, 2003, P files
a valid Form 8832, Entity Classification Election, changing the classification of FS from
a corporation to a disregarded entity for federal tax purposes effective as of that date.
The election has no effect on the treatment of FS under Country X law. After the
election is effective, FS continues its manufacturing operations. At the close of the day
immediately before the effective date of the election, the fair market value of FS’s
assets, including intangible assets such as goodwill and going concern value, exceeds
the sum of its liabilities. However, at that time, the fair market value of FS’s assets,
excluding intangible assets such as goodwill and going concern value, does not exceed
the sum of its liabilities.

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Situation 2

The facts are the same as in Situation 1, except that at the close of the day
immediately before the effective date of the election, the fair market value of FS’s
assets, including intangible assets such as goodwill and going concern value, does not
exceed the sum of its liabilities.

LAW AND ANALYSIS

Section 301.7701-3(g)(1)(iii) provides that if an eligible entity classified as an
association properly elects under ' 301.7701-3(c)(1)(i) to be classified as a disregarded
entity, the association is deemed to distribute all of its assets and liabilities to its single
owner in liquidation of the association.

Under § 301.7701-3(g)(2), the tax treatment of a change in the classification of
an entity for federal income tax purposes by an election under § 301.7701-3(c)(1)(i) is
determined under all relevant provisions of the Internal Revenue Code and general
principles of tax law, including the step transaction doctrine.

Section 301.7701-3(g)(3) provides that any transaction deemed to occur as a
result of a change in classification is treated as occurring immediately before the close
of the day before the election is effective.

Under § 332(a), no gain or loss shall be recognized on the receipt by a
corporation of property distributed in complete liquidation of another corporation.
Section 332(b) provides, in part, that a distribution shall be considered to be in complete
liquidation only if the corporation receiving such property was, on the date of the
adoption of the plan of liquidation and at all times thereafter until the receipt of the
property, the owner of stock that meets the requirements of § 1504(a)(2) and the
distribution is made in complete cancellation or redemption of all of the stock of the
liquidating corporation.

Section 1.332-2(b) of the Income Tax Regulations provides that ' 332 applies
only to those cases in which the recipient corporation receives at least partial payment
for stock which it owns in the liquidating corporation. If ' 332 is not applicable, see
' 165(g) relative to allowance of losses on worthless securities.

In determining the amount of gain recognized by shareholders upon a taxable
corporate liquidation, courts have recognized that goodwill and other intangible assets
that are distributed in the liquidation must be taken into account. See, e.g., Carty v.
Commissioner, 38 T.C. 46 (1962).

Section 165(a) allows as a deduction any loss sustained during the year and not
compensated for by insurance or otherwise. Under § 1.165-1(b) and (d), to be
allowable as a deduction under ' 165(a), a loss must be evidenced by closed and

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completed transactions, fixed by identifiable events, and, with certain exceptions,
actually sustained during the taxable year. Only a bona fide loss is allowable.
Substance and not mere form governs in determining a deductible loss.

Under ' 165(g)(1), if any security which is a capital asset becomes worthless
during the taxable year, the resulting loss is treated as a loss from the sale or exchange,
on the last day of the taxable year, of a capital asset. Section 165(g)(2)(A) provides that
for purposes of a worthless security deduction, the term “security” includes a share of
stock in a corporation.

Under § 165(g)(3), any security in a corporation affiliated with a taxpayer that is a
domestic corporation is not treated as a capital asset. A corporation is treated as
affiliated with the taxpayer only if the taxpayer directly owns stock of the corporation that
meets the requirements of §1504(a)(2), and more than 90 percent of the aggregate of
the corporation=s gross receipts for all taxable years are from sources other than
royalties, certain rents, dividends, certain interest, annuities, and gains from sales of
stocks and securities.

Section 166(a)(1) allows as a deduction any debt which becomes worthless
within the taxable year.

Section 166(a)(2) provides that the Secretary, when satisfied that a debt is
recoverable only in part, may allow such debt, in an amount not in excess of the part
charged off within the taxable year, as a deduction.

Whether a loss due to worthlessness is actually sustained during the taxable
year is a factual determination. Boehm v. Commissioner, 326 U.S. 287, 293 (1945),
reh
=g denied, 326 U.S. 811 (1946). A taxpayer must prove with objective evidence that
the stock in question becomes worthless during the taxable year. Id. at 292.

In Morton v. Commissioner, 38 B.T.A. 1270, 1279 (1938), aff’d, 112 F.2d 320
(7th Cir. 1940), a shareholder claimed a worthless stock deduction for the year in which
the corporation liquidated and the Commissioner denied the deduction on the grounds
that the stock became worthless in a prior year. The court concluded that stock is
worthless when it has neither liquidating value nor potential future value. Applying this
standard, the court concluded that the stock became worthless in a prior year and, thus,
denied the worthless stock deduction in the year claimed by the taxpayer. Where a
worthless stock deduction is claimed upon the liquidation of a corporation and the stock
did not become worthless in a prior tax year, the standard for determining
worthlessness is whether the shareholders receive payment for their stock. See H.K.
Porter Co. v. Commissioner, 87 T.C. 689 (1986).

Rev. Rul. 70-489, 1970-2 C.B. 53, amplifying Rev. Rul. 59-296, 1959-2 C.B. 87,
holds that where a wholly owned subsidiary had bona fide indebtedness to its parent
corporation that exceeded the fair market value of its assets and the subsidiary

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transferred all of its assets to its parent in partial satisfaction of its indebtedness, the
parent could claim both a bad debt deduction and a worthless security deduction, even
though the parent continued the business formerly conducted by the subsidiary. The
ruling states as a fact that the stock of the subsidiary became worthless in the year at
issue.

If a shareholder receives no payment for its stock in a liquidation of the
corporation, neither § 331 nor § 332 applies to the liquidation. The fact that a
shareholder receives no payment for its stock in a liquidation of the corporation
demonstrates that such shareholder’s stock is worthless. In addition, the liquidation is
an identifiable event that fixes the loss with respect to the stock.

A shareholder receives no payment for its stock in a liquidation if, at the time of
the liquidation, the fair market value of the corporation’s assets is less than the
corporation’s liabilities. In determining the fair market value of a corporation’s assets, all
of the corporation’s assets, including tangible and intangible assets (such as goodwill
and going concern value) and assets that may not appear on the corporation’s balance
sheet, must be taken into account. In addition, the fair market value of an asset may be
different than the value that appears on the corporation’s balance sheet. The estate tax
regulations provide that the fair market value of property is the price at which the
property would change hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or sell and both having reasonable knowledge of relevant
facts. See ' 20.2031-1(b) of the Estate Tax Regulations. The Service and the courts
regularly apply the valuation standards in the estate tax regulations for purposes of
determining the value of property for income tax purposes. See, e.g., Krapf v. United
States, 977 F.2d 1454, 1457 (Fed. Cir. 1992); Martin Ice Cream Co. v. Commissioner,
110 T.C. 189, 220 (1998).

The fair market value of a corporation’s intangible assets is determined by
reference to all of the facts and circumstances, which may include, but are not limited
to, the corporation’s prospects for future profit as evidenced by such things as the
corporation’s economic outlook, the demand for the corporation’s products, the
efficiency of the corporation’s operations, and the size of the corporation’s customer
base. Other factors used in making this determination may include, but are not limited
to, whether a substantial capital infusion will be necessary in order to continue
operations, whether any significant operational changes are anticipated, and whether an
impairment loss is or will be reported for financial statement purposes or whether the
operations are or will be reported as discontinued operations for financial statement
purposes. Where a corporation’s business continues after a liquidation of the
corporation without a substantial infusion of capital and the revenues of that business
following the liquidation exceed the amount required to service debt that existed
immediately prior to the liquidation, such facts may suggest that at the time of liquidation
the fair market value of the liquidating entity’s assets, including goodwill and going
concern value, exceeded the sum of its liabilities and that the deemed distribution of
assets was with respect to stock within the meaning of § 1.332-2(b).

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In Situation 1, at the close of the day immediately before the effective date of the
election, the stock of FS is not worthless because the fair market value of FS’s assets,
including intangible assets such as goodwill and going concern value, exceeds the sum
of FS’s liabilities. Accordingly, P receives at least partial payment on its FS stock in the
deemed liquidation of FS. Hence, § 332 applies to the deemed liquidation and no loss
is allowable to P.

In Situation 2, at the close of the day immediately before the effective date of the
election, the stock of FS is worthless because the fair market value of FS’s assets,
including intangible assets such as goodwill and going concern value, does not exceed
the sum of FS’s liabilities. Accordingly, P does not receive any payment on its FS stock
in the deemed liquidation of FS and § 332 does not apply to the deemed liquidation.
The deemed liquidation is an identifiable event that fixes P’s loss with respect to the FS
stock. Therefore, P is allowed a worthless security deduction under § 165(g)(3) on its
tax return for the 2003 taxable year. FS’s creditors, including P, may be entitled to a
deduction for a partially or wholly worthless debt under § 166.

HOLDING

When an election is made to change the classification of an entity from a
corporation to a disregarded entity, the shareholder of such entity is allowed a worthless
security deduction under § 165(g)(3) if the fair market value of the assets of the entity,
including intangible assets such as goodwill and going concern value, does not exceed
the entity’s liabilities such that on the deemed liquidation of the entity the shareholder
receives no payment on its stock.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 70-489 is superseded and Rev. Rul. 59-296 is amplified.

DRAFTING INFORMATION

For further information regarding this revenue ruling, contact Glenn Bogdonoff of
the Office of Associate Chief Counsel (Income Tax and Accounting) on (202) 622-4950
(not a toll-free call) or Sean McKeever of the Office of Associate Chief Counsel
(Corporate) on (202) 622-7750 (not a toll-free call).