Covil Insulation Co. v. Commissioner

*364 Respondent determined deficiencies of *28 $ 36,366.19 and $ 62,306.08 in petitioner's Federal corporate *365 income taxes for 1965 and 1969, respectively. The following issues are presented for decision:

(1) Whether petitioner is entitled to deductions for a net operating loss carryback and carryover to its taxable years 1965 and 1969, respectively. The answer to this question depends upon whether petitioner is required, pursuant to section 1.1502-19, Income Tax Regs., to report as income in 1968 and 1969 the amount in its "excess loss account" with respect to the stock of its subsidiary.

(2) Whether petitioner's subsidiary is entitled to a bad debt deduction in its taxable year ended November 30, 1966, with respect to certain alleged debts owed to it by its major shareholder.

FINDINGS OF FACT

Covil Insulation Co., Inc. (hereinafter sometimes referred to as petitioner or Covil), maintained its principal office in Greenville, S.C., at the time its petition was filed. It kept its books and records on the basis of the calendar year, employing the accrual method of accounting. For 1965 and 1966, petitioner filed its corporate tax return with the District Director of Internal Revenue for South Carolina.

J. L. Wynn & Co. (hereinafter *29 Wynn), incorporated in December 1954, was engaged in business as a heating and air-conditioning contractor. Wynn frequently obtained subcontracts from petitioner. Wynn encountered severe financial difficulties and, by 1965, owed petitioner a substantial amount of money.

On April 26, 1965, petitioner acquired all of Wynn's outstanding stock for a total purchase price of $ 5. As of that date, Wynn changed its name to Imesco, Inc. (hereinafter Imesco). As of December 31, 1966, Imesco owed petitioner $ 89,314.32. In December 1966, petitioner capitalized $ 45,000 of this indebtedness, thus increasing its capital investment in Imesco by that amount.

Prior to petitioner's acquisition of its stock, Imesco had used a fiscal year ended November 30, 1966. It filed a separate income tax return for the taxable period December 1 through December 31, 1966. Petitioner filed consolidated returns for itself and Imesco for 1967 and 1968 and a purported consolidated return for itself and Imesco for 1969.

*366 On the 1967, 1968, and 1969 returns, petitioner reported the following amounts of consolidated and separate taxable income (or loss) for itself and Imesco:

On *30 March 13, 1968, Imesco filed a claim for refund for its separate taxable year ending November 30, 1966, based upon a claimed net operating loss for the short period December 1 through December 31, 1966, and the entire taxable year 1968. After audit of the claim, respondent allowed the claimed net operating loss carrybacks in the amounts of $ 3,497.70 and $ 25,705.34, respectively.

In the process of the audit of Imesco's refund claim, respondent disallowed a bad debt deduction taken by Imesco in the year ending November 30, 1966, in the amount of $ 4,019.14. The claimed bad debt deduction consisted of accounts receivable in the amount of $ 2,889 from James L. Wynn, the major shareholder of Wynn prior to its sale to petitioner, and the cost of a 1960 Cadillac automobile with a book value of $ 1,130.14 owned by Imesco and used by Mr. Wynn. No legal proceedings were brought by Imesco to collect the alleged debt.

On April 27, 1970, petitioner filed a claim for refund of income taxes it paid for 1965, based upon the carryback of its reported net operating loss in 1968 in the amount of $ 79,309.39 and a claimed unused investment credit in the amount of $ 1,071.78. Petitioner's claim was *31 allowed, and a refund of $ 39,140.29 was issued. Petitioner's claimed net operating loss for 1968 was due, in part, to a bad debt deduction in the amount of $ 187,026.19. Included in that deduction were receivables due from Imesco totaling $ 175,418.42. Respondent allowed this deduction on the ground that Imesco was insolvent and the debt was worthless.

On its 1969 return, petitioner claimed as a deduction a net operating loss carryover attributable to Imesco's unused 1968 net operating loss of $ 143,709.27. Petitioner later agreed that a part of that loss should be carried back to 1967, for which a consolidated return was filed. Accordingly, on May 5, 1972, petitioner filed a claim for refund for 1967, and $ 54,938.28 of the claimed 1968 consolidated net operating loss of $ 223,018.66 was *367 applied against 1967 income. This claim for refund was allowed by respondent.

Imesco's balance sheets for the years ending December 31, 1967, and December 31, 1968, were as follows:

*32 At the end of 1968, Covil had an "excess loss account" within the meaning of section 1.1502-32(e)(1), Income Tax Regs., with *368 respect to its Imesco stock in the amount of $ 118,661.01. Respondent computed this figure under section 1.1502-32(b)(1) and (2), Income Tax Regs., as follows: ¹

Petitioner's 1968 return contains various statements concerning the liquidation of Imesco. A separate schedule, attached to the 1968 return, entitled "Loss From Sales of Equipment and Assets" shows the following: *369

In addition, on Schedule M-2, entitled "Analysis of Unappropriated Retained Earnings Per Books," attached to the 1968 return, it is stated:

The minutes of petitioner's board of directors meeting dated August 12, 1968, state, in part, the following:

The progress of the liquidation of Imesco, Inc., a subsidiary, was discussed. A part or all of the equipment will be transferred to the main building.

Final liquidation is planned for the end of September, 1968, or earlier if possible.

The minutes of petitioner's board of directors meeting dated October 4, 1968, provide, in part, as follows:

Mr. *34 Covil also reported that in order to take advantage of income tax savings, the liquidation of Imesco, Incorporated could not be carried out as earlier recommended. Sale of some of the equipment is in process and liquidation is proceeding.

In his notice of deficiency, respondent determined that petitioner realized income equal to the balance ($ 118,661.01) in its excess loss account as of December 31, 1968, and since Imesco was insolvent, increased the consolidated net income by that amount. The result of this increase in the consolidated taxable income is that there is no net operating loss in 1968 and hence no carryback to petitioner's taxable year 1965. Respondent also determined that petitioner was not entitled to file a consolidated return with Imesco for 1969 and that, therefore, petitioner could not reduce its taxable income in that year by a net operating loss carryover attributable to Imesco. Respondent's determination is based upon his finding that Imesco was liquidated in 1968 and thus was not an includable corporation within the meaning of sections 1501 ³ and 1504. In the alternative, respondent determined that, if the 1969 return is a consolidated return, *370 petitioner *35 must recognize excess loss account income in that year equal to any of the carryover attributable to Imesco.

OPINION

Section 1501 ^4*36 permits an affiliated group of corporations to file a consolidated income tax return, in lieu of separate returns, for each taxable year. In granting this privilege, Congress did not attempt to prescribe detailed rules governing the determination of the income tax liability of members of the affiliated group. Rather, section 1502 ⁵ authorizes the Secretary or his delegate to prescribe such regulations as he may deem necessary in order to clearly reflect the affiliated group's income tax liability.

Under the prescribed regulations, the current earnings or losses of each member of the consolidated group enter into the computation of consolidated *37 income, section 1.1502-11, Income Tax Regs. The losses of one affiliate may offset the profits of another and thus serve to reduce or eliminate consolidated income. Losses of a subsidiary may be utilized in this matter without limitation, even if the amount of utilized losses exceeds the group's basis in the affiliate's stock. As a result, the group's tax liability may be distorted since the tax losses may exceed the economic losses. This distortion is eliminated, however, through the vehicle of compensating adjustments to the group's basis in the affiliate's stock.

Section 1.1502-32, Income Tax Regs., entitled "Investment adjustment," and section 1.1502-19, Income Tax Regs., entitled "Excess losses," deal with this problem. Under section 1.1502-32, ^6*39 *371 Income Tax Regs., the impact of the subsidiary's losses (and gains) is reflected in annual adjustments to the group's basis in the subsidiary's stock. The adjustments are of two kinds -- positive and negative. Generally, the subsidiary's undistributed earnings and profits, which contribute to consolidated income, necessitate a positive adjustment which increases the group's basis in the stock. Losses of the subsidiary used to reduce *38 the group's consolidated income require negative adjustments which decrease the group's basis in that stock. The adjustments are netted at the end of each taxable year. If the net negative adjustments exceed the group's basis in the stock, an "excess loss account" -- a negative basis for the stock -- results. Sec. 1.1502-32(e)(1), ^7*40 Income Tax Regs.

When all of the subsidiary's stock is disposed of, the members of the affiliated group owning the stock are required to include the balance of the "excess loss account" in income. See sec. *372 1.1502-19(a)(1), ⁸ Income Tax Regs. The income, in most cases, is taxable as gain from the sale or exchange of stock. However, where, as in the instant case, the subsidiary is insolvent, the income is treated as ordinary income. Sec. 1.1502-19(a)(2), ^{9*41 *42} Income Tax Regs.

The term "disposed of" or "disposition" is given a rather broad meaning. Sec. 1.1502-19(b)(2), ^10*43 Income Tax Regs. With exceptions not here relevant, a member is considered to have disposed of all its shares in the subsidiary on the last day of its *373 taxable year in which, among other situations, the subsidiary's stock is wholly worthless or in which 10 percent or less of the face amount of any obligation for which the subsidiary is liable is recoverable at maturity by its creditors.

The group is thus able to reduce its consolidated income by loss deductions which are in excess of its true economic losses. It may be that these losses are temporary and the subsidiary will create enough earnings and profits later to eliminate the excess loss account. See Peel, Consolidated Tax Returns 227-228 (2d ed. 1973). If, however, the stock is disposed of prior to the subsidiary's economic turnaround, the utilized *44 excess losses are the practical equivalent of an "amount realized" in excess of the group's investment and are logically includable in consolidated income. Sec. 1.1502-19(a), Income Tax Regs.

Petitioner concedes that its Imesco stock was worthless in 1968, that Imesco could not pay its debts at the end of that year, that Imesco was insolvent within the meaning of applicable regulations, and that these regulations, if valid, would require the excess loss account of $ 118,661.01 to be included in the consolidated income for 1968. But petitioner contends that section 1.1502-32(e), Income Tax Regs., requiring a parent corporation filing a consolidated return to reduce its basis in its subsidiary's stock to a figure below zero is invalid. Petitioner also challenges the validity of section 1.1502-19(a), Income Tax Regs., requiring the parent to include in income the amount of the excess loss account upon a disposition of the subsidiary's stock.

In weighing petitioner's attack on these consolidated return regulations, we begin with the principle that the Income Tax Regulations "should not be overruled except for weighty reasons." Commissioner v. South Texas Co., 333 U.S. 496, 501 (1948). *45 Moreover, section 1502 expressly authorizes the issuance of regulations in this area to deal with the complex problems created by the filing of consolidated returns, thus providing an added reason for upholding such a regulation unless it is clearly contrary to the will of Congress. Commissioner v. South Texas Co., supra at 503; Regal, Inc., 53 T.C. 261, 263-264 (1969), affd. per curiam 435 F.2d 922 (2d Cir. 1970); Union Electric Co. of Missouri v. United States, 158 Ct. Cl. 479, 486, 305 F.2d 850, 854 (1962).

*374 Further, exercise of the privilege of filing consolidated returns required petitioner to "consent to all the consolidated return regulations prescribed under section 1502 prior to the last day prescribed by law for the filing of such return." Sec. 1501; Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934). As emphasized by petitioner, this consent does not preclude a challenge to arbitrary regulations. See Joseph Weidenhoff, Inc., 32 T.C. 1222, 1242 (1959). However, when petitioner filed its first consolidated return in 1967, it was no doubt aware that the regulations permitted it to utilize Imesco's losses to offset its income even if those losses exceeded its basis in the Imesco stock *46 and that the same regulations, in clearly defined circumstances, provide for a recapture of such excess deductions. The burden of the excess loss account provisions must be accepted with the benefit of unlimited access to the subsidiary's losses. See Georgia-Pacific Corp., 63 T.C. 790, 802 (1975).

We think the challenged regulations reflect a permissible exercise of the rulemaking power granted by section 1502. Indeed, the facts of this case amply demonstrate their reasonableness. Petitioner's investment in Imesco was only $ 45,005, comprised of the $ 5 paid to acquire Imesco's stock and the $ 45,000 indebtedness which petitioner capitalized. Yet Imesco's losses, allowed as deductions in computing the tax results of the consolidated group, far exceeded that investment. They are as follows:

The disputed regulations require this difference of $ 118,661.01 to be included in petitioner's income for 1968. In so providing, the regulations merely bring the tax results in line with the economic results of petitioner's ownership of Imesco's stock. The *375 regulation might have been drafted to limit the deductible losses to petitioner's basis in Imesco's stock, but such a regulation would be unnecessarily cumbersome where the loss situation is expected to be temporary. See Peel, supra at 227-228. We cannot say that the excess loss account provisions of the regulations are not a permissible alternative technique for limiting the tax deduction to the amount of the group's economic loss. ^11*48 Georgia-Pacific Corp., supra at 801-802.

Petitioner attacks the regulation on the ground that its negative basis adjustment provisions are inconsistent with other Code provisions and the "common law" of taxation which denies that property can have a negative basis. See American Water Works Co. v. Commissioner, 243 F.2d 550 (2d Cir. 1957). ¹² It is true that sections 705(a) and 733 provide that the basis of a partner's interest may not be reduced below zero, see Milton Falkoff, 62 T.C. 200, 208-209 (1974). It is also true that, under section *49 1376(b)(1) and (2), which provides for the passthrough of the losses of an electing small business corporation, a shareholder's adjusted basis in his stock may not be reduced below zero. Also, the basis adjustment provisions of sections 1011 through 1022 do not comtemplate bases below zero.

However, the law relating to consolidated returns is unique. It is designed to coordinate the details of treating several corporations as a tax unit. Among the unique features of consolidated returns is the allowance of deductions for a member's losses in amounts in excess of the group's basis in that member for computing consolidated income. Passthrough of losses in the case of a partnership or a small business corporation, in contrast, is specifically limited to the partners' or shareholders' basis in the *376 business enterprise. *50 Since such losses are so limited, reduction of the partners' or the shareholders' basis below zero is unnecessary to prevent tax deductions in excess of economic losses. The Supreme Court has recognized that a parent's basis for stock in a subsidiary is reduced for losses deducted in a consolidated return, Ilfeld Co. v. Hernandez, supra, an adjustment not described in any of the sections cited by petitioner. The disputed regulations merely codify this principle, and those regulations specifically preempt the field. Sec. 1.1502-80, Income Tax Regs.¹³

Nor do we find any merit in petitioner's contention that the definition of the term "disposition" or "disposed of," contained in section 1.1502-19(b)(2), Income Tax Regs., which triggers recapture of the excess loss account, *51 leaves too much discretion to the Commissioner. The definition is detailed and is subject to explicit restrictions. True, the Commissioner's determination of the worthlessness of stock requires a factual finding, but so do many other Code provisions, such as a determination of "reasonable" compensation under section 162(a); a "reasonable" allowance for depreciation under section 167(a); when income is "clearly reflected" under section 446(b); and when a reallocation of income is required under section 482 to prevent the avoidance or evasion of a tax. Significantly, petitioner does not claim any abuse of the Commissioner's authority under the regulations in the instant case, but rather concedes that Imesco's stock was worthless in 1968.

Finally, petitioner challenges section 1.1502-19(a)(2)(ii), Income Tax Regs., which provides that, when the subsidiary is insolvent, the amount of the excess loss account is to be taxed as ordinary income rather than capital gain. However, when insolvency occurs, the corporation no longer has assets susceptible to application to its shareholders' claims. The economic loss generated by the insolvent subsidiary is borne by someone other than the shareholder, *52 e.g., a creditor. When the group utilizes those losses, it receives a deduction against ordinary income, unrelated to its then extinct capital investment. ¹⁴ Therefore, the *377 excess loss account is justifiably converted to ordinary income, and the r