A worthless stock deduction can be triggered by filing a form to treat a subsidiary as a “disregarded entity,” the IRS said in December.

Corporations with subsidiaries have an investment in the stock of each subsidiary. If the subsidiary becomes insolvent, then the corporation can deduct its investment — or “tax basis” — in what is now considered worthless stock. However, there must be some action to trigger the loss.

The IRS ruled in December the action might be as simple as filing a form with the agency to treat the subsidiary as a “disregarded entity.” Such forms can only be filed for certain kinds of subsidiaries. For example, such a form could not be filed for a Delaware corporation. However, it could be filed for a subsidiary that is organized as a limited liability company, or LLC.

The filing of such a form causes the subsidiary to be considered liquidated for tax purposes. Ordinarily a loss cannot be claimed in a liquidation of a subsidiary into a parent corporation that owns 80% or more of the shares if the parent company receives something of value in exchange for canceling its shares. However, the IRS said in this case, since the subsidiary is insolvent, the parent company gets nothing of value by definition.

In testing whether a subsidiary is insolvent, be careful to take into account possible value in intangibles like goodwill and “going concern value.” A subsidiary is insolvent if its assets are worth less than its debts.

The parent company can claim a worthless stock deduction even though the subsidiary keeps operating as before after the IRS form is filed. The IRS ruling is Revenue Ruling 2003-125.

Keith Martin