When a corporation makes a check the box election, it is treated as having liquidated and then being reestablished as a partnership. In context of an insolvent corporation, this raises questions about worthless stock treatment, bad debts, and other tax consequences. A recent Chief Counsel Memorandum provides the IRS' opinion on these issues.
WORTHLESS SECURITY DEDUCTION. In the deemed liquidation of a solvent corporation, the shareholders realize gain or loss based on the deemed distribution that occurs. However, an insolvent corporation has no net assets to distribute. Therefore, the shareholders do not receive anything and thus there is no sale or exchange to fix gain or loss. See Rev. Rul. 2003 – 125. In this circumstance, however, the shareholders will be entitled to a worthless security deduction in the amount of their basis in their stock pursuant to Code Section 165(g). Code Section 165(g) provides that if any security which is a capital asset (such as a share of stock in a corporation) becomes worthless, a loss from a seller or exchange of that security is deemed to occur.
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