Worthless Stock Losses from Liquidations and Related Issues in Consolidation

The recent economic downturn has left many otherwise profitable affiliated groups of corporations with one or more failing subsidiaries. From a federal income tax perspective, insolvent subsidiaries often present a significant planning opportunity. If feasible from a business standpoint, the liquidation of an insolvent subsidiary could result in the recognition of an immediate stock loss. In many states, a deemed liquidation for tax purposes can be accomplished easily, through the conversion of the corporate entity into a limited liability company (LLC). In the simplest case, a parent corporation (P) that owns all of the outstanding stock and debt of an insolvent subsidiary (S) converts S into an LLC that is treated thereafter as a disregarded entity. (1) P will frequently be able to obtain immediate losses--and sometimes ordinary deductions--from the resulting deemed liquidation, without the bother of dissolving S, selling the entity or its assets to a third party, or otherwise altering S's ongoing business operations. (2) It sounds simple and, indeed, the actual transaction could not be more straightforward. Unfortunately, the tax analysis can be surprisingly complex and uncertain, and where P and S file a consolidated return, the interaction of the consolidated return rules with generally applicable tax principles creates additional opportunities and pitfalls. But with proper fortitude, planning, and a peculiar sense of humor, you may find some enjoyment and profit in the liquidation of an insolvent subsidiary. This article reviews the key concepts and issues that are implicated by these situations.