Incurring economic losses is rarely a good thing. On the other hand, harvesting a capital loss in the same tax period an unrelated capital gain is recognized has its advantages – the loss may be utilized as a deduction to reduce tax liability arising from the capital gain.1 While this statement is generally true for all types of losses, this article will focus on capital losses incurred by a corporation from the divestiture of subsidiary stock.

In general, a corporation can deduct losses recognized on the sale or exchange of capital assets.2 Those losses may be used only to reduce capital gains such as those recognized from the sale of subsidiary stock.3 Consequently, a corporation that suffers a book loss due to a drop in the value of subsidiary stock may recognize the loss by selling the shares of the subsidiary. Where the sale of the subsidiary is not possible because of the absence of a buyer, the shareholder may realize the loss pursuant to the complete liquidation of the subsidiary where the tax consequences of the liquidation are governed by Code §331.

Regrettably, not every liquidation has its tax consequences governed by Code §331. Where 80% or more of the stock of the liquidating corporation is owned by a single corporate shareholder, the tax consequences of a complete liquidation are governed by Code §332. Under Code §332, no gain or loss is recognized in connection with the complete liquidation of the subsidiary. However, corporate shareholders have been taking the position that certain steps may be taken to intentionally shut down Code §332 and bring back Code §331 into play.

Over the years, courts have allowed intentional avoidance of Code §332, rejecting counter arguments by the I.R.S. However, legislation proposed in late 2021 suggests that Congress may now look to put an end to this planning opportunity in order to raise revenue.


Code §331 Liquidation or Code §332 Liquidation?

From a corporate law standpoint, a complete liquidation of a corporation usually involves winding down of the business of the liquidating corporation, making payments to creditors, and distributing remaining assets to shareholders. From a tax perspective, however, the last step of a complete liquidation – the distribution of remaining assets – is not treated as an ordinary dividend distribution. Instead, Code §331 generally provides that the amounts received by a shareholder as part of a distribution that is part of a complete liquidation of a corporation is treated as full payment in exchange for the relinquishment of stock. In other words, Code §331 creates a fiction, under which the liquidation is treated as the transfer of the shares of the liquidating corporation by its shareholders to the liquidating corporation in exchange for the liquidating corporation's assets. An exchange of property (including shares) generally results in a recognition of gain or loss under Code §1001(c). Therefore, under Code §§331 and 1001, the deemed exchange of shares of the liquidating corporation triggers recognition of gain or loss.4

In contrast to Code §331, Code §332 provides that no gain or loss is recognized by a corporation that is a shareholder upon complete liquidation of a subsidiary, provided that certain conditions are met.5 While this is a desirable outcome when a built-in gain exists in the shares, nonrecognition treatment produces an unfavorable result when a built-in loss exists in the shares. If no loss is recognized for tax purposes, no loss may be utilized to offset taxable capital gains.

Code §332 is not drafted as an elective provision. Therefore, a simple read of the section would suggest that a taxpayer is not entitled to choose whether the section applies. However, Code §332 applies to a liquidation only if several conditions are met. If any of the conditions are not met, Code §331 governs the tax treatment of the liquidation.

The first condition requires that 80% or more of the voting power and value of all shares of stock of the liquidating corporation must be owned by the corporate parent receiving the property. Moreover, the required level of ownership must exist at all times, beginning on the date of the adoption of the plan of liquidation until all property is received.6 This 80% ownership requirement is in fact the differentiating factor between Code §332 and Code §331, since all the other conditions that apply to Code §332 apply also to Code §331.7

Since the 80%-ownership requirement can be controlled by a shareholder, a sole corporate parent can prevent Code §332 from applying by disposing enough shares of the liquidating subsidiary prior to the adoption of the plan of liquidation. Once there are at least two shareholders and the parent corporation holds less than 80% of the liquidating corporation, the two shareholders may adopt a plan of liquidation. That liquidation would be outside the realm of Code §332 and, instead, would trigger loss recognition under Code §331.8

The Granite Trust Case

In Granite Trust Co. v. U.S., 9 the I.R.S. was unsuccessful in challenging the effect of a disposition of shares in a wholly owned subsidiary immediately before the adoption of a plan of liquidation.

The taxpayer owned 100% of a subsidiary corporation. Over the course of several years, the value of the subsidiary's shares dropped significantly. Wishing to assure recognition of the loss on a purported liquidation of the subsidiary and to avoid nonrecognition treatment, the taxpayer sold or otherwise transferred enough shares to reduce its ownership in the subsidiary corporation to less than 80%. The transferee was a friendly party in relation to the taxpayer and was well aware of the subsidiary's situation and the taxpayer's intention to have the subsidiary liquidated. It is fair to say that the transferee acted as an accommodation party for the taxpayer, enabling the taxpayer to recognize a capital loss.

The I.R.S. challenged the application of the predecessor of Code §331. It argued that the sale of shares should be ignored in light of the step transaction doctrine. Under that doctrine, a series of transactions may be collapsed into mere steps of a single integrated transaction for income tax purposes because each individual step is meaningless or unnecessary to achieve the end-result.10 Here, the I.R.S. argued that the end result was the complete liquidation of a wholly owned subsidiary of the taxpayer. The disposition of shares that preceded the adoption of the plan of liquidation had no purpose other than to move the governing tax law provision from the predecessor of Code §332 to the predecessor of Code §331. Consequently, it should be ignored. In addition, the I.R.S. argued that the sale should be ignored because it was transitory and meaningless, within the meaning of Gregory v. Helvering. 11


1. Provided certain conditions are met. See Code §1211 and the regulations promulgated thereunder.

2. Code §1211(a).

3. Code §1221 allows the loss to offset the gain, provided the stock is not held by the taxpayer primarily for the sale in the ordinary course of trade or business.

4. Note that gain or loss may be recognized by the shareholder upon the deemed sale of the subsidiary shares and potentially by the liquidating subsidiary upon the deemed sale of its property to the shareholder.

5.See Code §332(b) and the regulations promulgated thereunder for the conditions of Code §332(a).

6. Code §§332(b)(1) and 1504(a)(2)

7. The other conditions for Code §332 to apply are outside the scope of this article

8. Provided the underlying conditions for Code §331 are met.

9. 238 F.2d 670 (1956).

10. See, for example, King Enterprises, Inc. v. U.S., 418 F.2d 511, 516 (Cl. Ct. 1969)

11. 293 U.S. 465 (1935).

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