The current declining global economy has caused concern and substantial losses related to many domestic and foreign investments. And, while suffering a loss is never a pleasant experience, getting the most benefit from a loss should be of paramount importance.
The tax deductibility of such investment losses depends on the nature of the investment, whether it is a capital asset and whether the investment is totally worthless.
How the Worthless Stock Deduction Works
Generally, under Section 165(g)(1), if a U.S. taxpayer owns a security that is a capital asset and that security becomes worthless during the taxable year, the resulting loss will be treated as a sale or exchange of a capital asset as of the last day of the taxable year, resulting in a capital loss equal to the taxpayer's basis in that asset. For the purposes of Section 165(g)(1), a security is defined as a share of stock in a corporation, a right to subscribe or receive a share of corporate stock, or a bond, debenture, note, certificate or other evidence of debt issued by a corporation, domestic or foreign, or government.
However, Section 165(g)(3) overrides Section 165(g)(1) and provides that such worthless security loss will be treated as an ordinary loss, rather than a capital loss, capable of offsetting ordinary income, provided the taxpayer owner is a U.S. domestic corporation and the investment security creating the loss is in an "affiliated corporation" of the taxpayer. The "affiliated corporation" combined qualification test requires that the taxpayer own at least 80 percent of the total voting power and overall value of the loss-affiliated corporation (subsidiary), and more than 90 percent of the subsidiary's gross receipts, for all taxable years of existence, are from sources other than royalties, rents, interest, dividends, annuities and gains from sales or exchanges of stocks and securities. And, it should be noted, that none of the stock of the subsidiary can be acquired by the taxpayer solely for the purpose of converting a capital loss to ordinary loss status.
Qualifying for a Worthless Stock Deduction
A worthless stock deduction (either as a capital or ordinary loss) requires taxpayers to show that their stock became worthless during the taxable year of deduction. In order to establish that the stock became worthless, the taxpayer must demonstrate both of the following:
Determination of when a subsidiary becomes worthless is subjective and based on an analysis of all the facts and circumstances. If the subsidiary continues in existence and has operations, future value must be considered. However, the IRS has ruled that even the deemed liquidation of a foreign subsidiary, via a check-the-box election to treat the foreign subsidiary as disregarded for U.S. tax purposes, can provide an identifiable event establishing worthlessness.
Determining Your Options
The realization of a worthless stock deduction for a failed foreign subsidiary in a given taxable year is not automatic and requires careful analysis and planning. Further analysis is also required to show that the worthless stock deduction may be taken as an ordinary loss, rather than a capital loss. Contact your Eide Bailly professional or a member of our National Tax Office International Tax team to discuss relevant planning options for failed foreign subsidiaries.