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Sept 1989

Avoiding income on bad-debt write-off of subsidiary's loan.

by Yu, Angela

    Abstract- The Internal Revenue Service has ruled that the bad debt reduction of a loan from a corporate parent to a second-tier subsidiary does not automatically cancel the subsidiary's debt. The IRS decision is based on the fact that the overall tax deduction of the affiliated group should correspond to its economic loss. The Revenue Act of 1987 states that the basis for determining gain or loss of affiliated group stock will not be increased by an amount excluded from gross income and that the basis of any property is not reduced. This situation offers tax planning opportunities for an affiliated group with a net operating loss carryover which has a subsidiary unable to repay corporate debt. The deduction by the corporate parent of the loans and equity in a second-tier subsidiary correspond with the losses suffered by the group and allows a bad debt reduction with no concurrent income to the debtor, thereby reducing the affiliated group's income and tax burden.

A situation common to an affiliated group involves a member of the group who has become insolvent or is unable to repay intercorporate debt. The question that arises is whether a corporate parent can deduct as a bad debt a loan made to its subsidiary without automatically triggering income to the debtor subsidiary. In Private Letter Ruling 8337010 the IRS ruled that a parent corporation's bad debt deduction, taken with respect to a loan to a second-tier subsidiary, did not automatically trigger the cancellation of the subsidiary's debt.

The pertinent facts of the ruling are as follows: P, the common parent of an affiliated group (the "P Group") filing a consolidated tax return, loaned $4.5 million to a second-tier subsidiary, Sub. 2. P's first-tier subsidiary, Sub 1, had a $500,000 basis in Sub 2's stock. Sub 2 had $2 million in losses which were absorbed by the P Group in its consolidated returns, creating an excess loss account ("ELA") of $1.5 million ($2 million less $500,000) with respect to its stock.

Under a plan of complete liquidation, Sub 2 transferred all of its assets ($2.5 million) to P in partial satisfaction of its $4.5 million debt. P claimed the $2 million outstanding balance as a bad debt deduction under Sec. 166. P forgave the balance of the debt but Sub 2 did not recognize income on this cancellation of indebtedness because it was insolvent.

The Taxpayer's Position

The taxpayer argued that P's bad debt deduction triggered cancellation of indebtedness treatment to Sub 2. As a result, Sub 2's earnings and profits would be increased by the amount of the debt forgiven, even though it did not have to recognize income on the forgiveness of debt due to its insolvency. Thus, the debt forgiveness would cause Sub 2 to increase its E&P by $2 million, which in turn caused Sub 1 to make a positive adjustment to its basis in Sub 2. This latter adjustment restored the basis of the Sub 2 stock to $500,000. The Sub 2 stock was worthless, so Sub 1 claimed a $500,000 deduction under Sec. 165(g)(3). Thus, the total deductions claimed were $4.5 million ($2.0 million NOL, $2.0 million bad debt, and $5 million worthless stock).

The IRS's Position

The IRS ruled that P's bad debt deduction did not automatically trigger the cancellation of the subsidiary's debt. The ruling pointed out that it is "the forgiveness and not the bad debt deduction" that causes an increase in the basis of the subsidiary's stock. In addition, the Service argued that "Section 111 of the Code, for example, would not deal with recovery of bad debts if all the bad debts that were written off were also forgiven (assuming most debtors do not pay forgiven debts)." The Service based its analysis on the fact that the group's overall tax deduction should correspond with its economic loss.

If the forgiveness upon Sub 2's liquidation were disregarded so that the basis adjustments relating to Sub 2's operating losses were not reversed, P's $2 million bad debt deduction would be offset by the inclusion in income of Sub 1's $1.5 million ELA in Sub 2. Since Sub 1's basis in Sub 2 would then be zero, the net tax deduction would be $2.5 million, consisting of $2 million of Sub 2's NOLs, P's $2 million bad debt deduction, and $1.5 million income from inclusion of Sub 2's ELA. This net tax deduction corresponds exactly with the economic loss, which equals Sub 1's $500,000 investment in Sub 2 plus P's $2 million net investment in Sub 2 ($4.5 million of loan less $2.5 million in returned assets).

Potential Tax Planning Under the Ruling

Sec. 1503(e)(1)(B), added by the Revenue Act of 1987, provides that in determining gain or loss on a disposition of intragroup stock, basis will not be increased for earnings and profits purposes by an amount which is excluded from gross income under Sec. 108, to the extent that neither an attribute nor the basis of any property is reduced.

Therefore, subsequent to the enactment of the new provisions, the taxpayer would not have submitted a similar ruling request because the possibility of a double deduction would have been foreclosed.(1) However, the analysis of the above ruling can provide tax planning opportunity with respect to an affiliated group which has an NOL carryover where a member of the group cannot repay corporate debt. Following the analysis of PLR 8337010, assuming the same corporate structure as the ruling, P and Sub 1's writeoff of their loans and investments in Sub 2 would not automatically constitute a forgiveness of the subsidiary's debt in the current year. In addition, Sub 2 would not have any income from such discharge and its E&P would not be increased. Hence, the parent's E&P likewise would not be increased. This is important for several reasons. For instance, the availability of earnings and profits may impact the timing of distributions to shareholders and create withholding tax obligations if foreign shareholders are present.

Moreover, where Sub 2's losses were not previously absorbed due to the availability of NOL carryovers, there would be no ELA with respect to the Sub 2 stock. As a result, P and Sub 1's current deduction of the loans and the equity invested in Sub 2 will correspond exactly with the economic loss suffered by the group. This position, directly in line with the IRS's analysis in PLR 8337010, produces a current bad debt deduction without triggering income to the debtor, thus reducing the overall taxable income of the affiliated group.

Although it may be argued that the debtor subsidiary should have income or positive basis adjustment, Sec. 108(e)(6) provides that if a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, the debtor corporation is treated as having satisfied the indebtedness for an amount equal to the shareholder's adjusted basis in indebtedness. This should also preclude debt forgiveness income. The corporate existence of Sub 2 should be maintained to avoid the potential argument that the transaction results in a de facto liquidation of Sub 2 into Sub 1. Such a liquidation could result in a cancellation of Sub 2's debt owed to Sub 1.

As an alternative argument, if the IRS insists that P's writeoff of Sub 2's debt did result in cancellation of indebtedness income to Sub 2, whose E&P must be increased under Sec. 312(1), Sub 1's basis in the Sub 2 stock would also increase accordingly. When Sub 1 took the worthless security deduction on the Sub 2 stock, its basis would reflect such increase from the cancellation. Therefore, the net result would be the same.

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