Excess Loss Account Avoided

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LPCiminelli Interests Inc. v. United States (W.D.N.Y. Nov. 13, 2012) ruled for the taxpayer on an IRS assertion of excess loss account liability. The facts involve a common situation of delay in writing off a worthless consolidated subsidiary that might produce discharge of indebtedness liability and/or recognition of an excess loss account.

Facts: The taxpayer owned a subsidiary that was formed to do construction in a particular area. The subsidiary ran up a lot of debts, ceased operations and in 2004, was reported on the consolidated return as abandoned and removed from the consolidated group. For 2000-2003, the return reported it as inactive.

The IRS first asserted discharge of indebtedness income for 2004, but then agreed that section 108 protected the taxpayer from income inclusion. Then the IRS asserted that the subsidiary had an excess loss account that should have been taken into income of the group in 2004.

The taxpayer argued that the subsidiary was worthless under Reg. section 1.1502-19(c) before 2004, in a year that was now closed. Therefore, the ELA would have been triggered in a closed year.

Ruling: The court agreed with taxpayer. It applied the earlier version of the regulation (currently the regulation requires disposition of “all” of the assets) to find that substantially all of the assets had been disposed of before 2004. It reasoned that between 1997 and 2003, the sub had lost $8,197,123, or 99.64 percent of its assets.

Then the court considered whether the taxpayer had violated the anti-abuse rule. It said no because the taxpayer’s consolidated return reported the subsidiary as inactive for prior years and showed its accurate balance sheet.

Take-away: When a subsidiary is insolvent, the parent may want to accelerate the finding of insolvency if it means claiming a deduction earlier. But when the subsidiary has no stock basis, but rather, has an excess loss account, the parent may be in no hurry to recognize that income. By that point it is too late to liquidate the subsidiary under section 332 and eliminate the ELA because the subsidiary is usually insolvent and ineligible for section 332. So the tendency is to sit with the subsidiary, particularly when there may be discharge of indebtedness income to be recognized.

This taxpayer sat with the subsidiary, but was found to have done nothing improper. It reflected the status of the subsidiary on its returns. The IRS did not assert worthlessness early enough. The year closed.

Unfortunately, because the IRS missed the right basis for the audit adjustment and then missed the right year, the IRS became very resistant to settling the case; mediation was tried. The dollar amount at stake was not huge, but the taxpayer had to go to a bench trial to get relief. This taxpayer seems to have conducted itself properly, even once agreeing to an extension of the statute of limitations for assessments.

Other taxpayers should be planning for all of (1) discharge of indebtedness income and (2) excess loss account relief, and (3) worthlessness deduction from the first solid indication that a consolidated subsidiary is going out of business or becoming insolvent.