During the COVID-19 federally declared disaster, companies scrambled to come up with tax strategies that could help to curb economic losses resulting from the COVID-19 pandemic. The section 165(i) acceleration provision for “disaster losses” seemed to fit the bill. While many losses resulting from the COVID-19 pandemic likely satisfied the disaster loss criteria, the IRS recently released ILM 202325007, noting its view that certain CFC worthless stock losses fail to satisfy the requirement that disaster losses “occur within” the disaster area. Specifically, the IRS does not view worthless stock losses as having occurred within the COVID-19 disaster area if less than “substantially all” of the liquidated entity’s business metrics occurred outside of the United States. This alert discusses the IRS’s analysis in ILM 202325007 and what it might mean for taxpayers that took this position on filed returns.
Background
Section 165(a) generally allows a deduction for any loss sustained during the taxable year that is not compensated for by insurance or otherwise. Losses under section 165(a) include stock that becomes worthless in the hands of a taxpayer. Such a 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(i) permits taxpayers to elect to take “disaster losses” into account in the tax year immediately preceding the tax year in which the disaster occurred. A disaster loss includes any loss which (1) occurs in a disaster area, and (2) is attributable to a federally declared disaster. A “federally declared disaster” means any disaster subsequently determined by the President of the United States to warrant assistance by the federal government pursuant to the Stafford Act. The “disaster area” is the area determined by the President of the United States to warrant assistance by the federal government.
President Trump declared the COVID-19 pandemic a “nationwide” disaster warranting federal government assistance within the meaning of the Stafford Act on March 13, 2020. Additionally, President Trump approved requests for major disaster declarations under the Stafford Act with respect to all fifty states, the District of Columbia, the US Virgin Islands, the Commonwealth of Puerto Rico, American Samoa, the Northern Mariana Islands, Guam, and a number of tribes, beginning from January 20, 2020.
ILM 202325007
On June 23, 2023, the IRS released ILM 202325007, a memorandum responding to an IRS field officer’s request for advice regarding the application of section 165(i) to losses sustained with respect to stock of three CFCs. The taxpayer (Taxpayer) at issue in the memorandum is the common parent of an affiliated group that files a consolidated return. During the COVID-19 disaster, Taxpayer undertook a restructuring plan whereby each of three CFCs the sole shareholder of which was a subsidiary (Sub) of Taxpayer filed a Form 8832 to change entity classification, resulting in a deemed liquidation of each CFC. Sub claimed a worthless securities deduction under section 165(a) and (g) in respect of its shares of stock in the CFCs immediately before the deemed liquidations and made a section 165(i) election with respect to the losses. The election permitted Taxpayer to carry back losses to prior years, triggering tax benefits. The highly-redacted facts provide that no operations of the CFCs at issue derived material revenue from customers in the United States.
The IRS concluded that the worthless stock losses did not occur in the disaster area for the federally declared COVID-19 disaster, and, therefore, the worthless stock losses do not qualify as disaster losses under section 165(i). Because there is no authority on point under section 165(i) that clarifies where a loss sustained with respect to stock in a CFC occurs, the IRS looked to other areas of the Code that might inform where a worthless securities loss “occurs.” For example, the IRS considered rules for determining source of stock losses under section 865, but determined that these were not applicable in the section 165(i) context because they were motivated by different concerns. The section 865 rules are focused on the disposition as the recognition event, whereas section 165(i) is concerned with the decline in market value having nexus to the location of the disaster. The IRS also considered tests based on shareholders’ residence, place of sale/disposition, and the location of the foreign corporation’s headquarters. However, each of these was dismissed as inappropriate because they were not consistent with Congress’s intent to provide relief “by alleviating the financial impact of damages resulting from a physical disaster that is geographically confined.” 1
The IRS suggested a business metrics approach, considering the location of “substantially all” income-producing assets, customers, employees, and revenue streams, would be an appropriate test for determining where a worthless stock loss occurs for purposes of section 165(i). If “substantially all” of these metrics were located within the disaster area, then the worthless stock loss would have occurred within the disaster area. Because none of the CFCs derived substantially all revenue from US customers, and the other metrics were located or occurred outside of the United States, the CFC worthless stock losses at issue did not occur within the COVID-19 disaster area.
The memorandum clarifies that the only issue within its scope is the question of where the CFC worthless stock losses occurred (i.e., whether the CFC worthless stock losses occurred within the disaster area for purposes of section 165(i)). Among other issues not within the scope of the memorandum, the IRS did not opine on whether the worthless stock losses were attributable to the COVID-19 pandemic.
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1See 108 Cong. Rec. 4146 (Mar. 14, 1962).
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