Temp. Regs. Limit Duplicative Stock Losses

Temporary loss-disallowance regulations limit a consolidated group's duplicative losses incurred on the sale of a subsidiary members stock. This article examines two primary rules, the basis-reduction rule and the loss-suspension rule, designed to prevent a consolidated group from obtaining more than one benefit from a single economic loss.
 

Steven C. Thompson, Ph.D., CPA
Professor of Taxation
Department of Accounting, Taxation and Business Law
Florida Gulf Coast University
Fort Myers, FL

Dave N. Stewart, Ph.D., CPA
Rachel Martin Professor of Taxation
School of Accountancy and Information Systems
Brigham Young University
Provo, UT

For more information about this article, contact Dr. Thompson at sthompso@fgcu.edu  or Dr. Stewart at dstewart@byu.edu.
  

Executive Summary

• Temporary regulations address duplicative losses that occur when a group absorbs a subsidiarys inside loss and a group member recognizes a loss on the subsidiarys stock.
• Two primary rules prevent duplicative lossesthe BRR and the LSR.
• The regulations continue a stop-gap approach; Treasury is considering alternative regimes to prevent loss duplication.

In March 2003, Treasury issued final, temporary and proposed regulations to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss.¹ These regulations are a multifaceted response to the governments judicial defeat in Rite Aid Corp.,² as well as concerns about tax-shelter type transactions that were reportedly implementing loss-duplication strategies. The new rules add to the confusion resulting from the IRSs concession that the loss-duplication rule in Regs. Sec. 1.1502-20(c) is invalid. This article is designed to highlight some of the fundamental concepts of these highly complex rules.

Background

In Rite Aid, the Federal Circuit held that the duplicated loss provisions of the loss-disallowance rules (LDR) in Regs. Sec. 1.1502-20 (20) were an invalid exercise of rulemaking authority. On March 7, 2002, in response to this judicial defeat, Treasury issued temporary loss-disallowance regulations which addressed whether, and the extent to which, a loss on the sale of a consolidated subsidiarys stock will be allowed. Unpredictably, these rules were written under Temp. Regs. Sec. 1.337(d)-2T (2T), and not 20, as expected. Until March 7, 2002, the 2T regulations allowed consolidated groups to calculate an allowable loss on the sale of a subsidiarys stock by (1) applying 20 in its entirety, (2) electing to apply a 20 lite version without the duplicated-loss factor or (3) electing to apply the new 2T regulations. After March 7, 2002, the 2T regulations (not the -20 regulations) would govern the allowability of losses.

Because the 2T regulations only addressed loss disallowance and not loss duplication, the IRS also issued Notice 2002-18.³ The notice revealed that additional regulations would be forthcoming to prevent a consolidated group from duplicating losses by means of certain stuffing and disposition transactions.  On Oct. 18, 2002, to complete its regulatory promise, the IRS issued proposed regulations under Regs. Sec. 1.1502-35 to deal with tax-shelter-type transactions in which the same consolidated group could derive a double benefit from a single economic event. On March 11, 2003, to meet the deadline requirements for temporary and final regulations, the IRS issued Temp. Regs. Sec. 1.1502-35T (35T).

The primary thrust of the 35T regulations is to address the following two IRS concerns:

1. A group absorbs an inside loss of a subsidiary member; then, a group member recognizes a loss on a disposition of the subsidiarys stock that is duplicative of the inside loss.

Example 1: In year 1, P Corp., a group member, forms wholly owned S Corp. with a contribution of $80 for 80 shares of S common stock (CS1). In year 2, P contributes Asset A, with a basis of $70 and a fair market value (FMV) of $20, to S for an additional 20 shares of S common stock (CS2). In year 3, S sells A and recognizes a $50 loss, which offsets Ps income on the groups consolidated return. Under the investment-adjustment rules of Regs. Sec. 1.1502-32, Ps basis in its S stock is reduced by a pro-rata share of the $50 loss; thus, CS1s basis is $40 and CS2s basis is $60. In year 4, P sells the CS2 shares for $20 and recognizes a $40 loss, which offsets Ps  income on the groups return. As a result of this transaction, the group has obtained a $90 tax benefit from the single $50 economic loss.

2. A group member recognizes a loss on a disposition of subsidiary-member stock that is duplicative of the subsidiary members inside loss, the subsidiary remains a group member and the group subsequently recognizes the subsidiary members inside loss.

Example 2: In year 1, P Corp. forms S Corp. with a contribution of $80 for 80 shares of S common stock (CS1). In year 2, P contributes Asset A, with a basis of $50 and a FMV of $20, to S for an additional 20 shares of S common stock (CS2). In year 3, P sells the 20 shares of CS2 for $20 and recognizes a $30 loss, which offsets Ps income on the groups consolidated return. The sale of the CS2 does not result in Ss deconsolidation. In year 4, S sells Asset A and recognizes a $30 loss, which also offsets P income on the groups return. Similar to Example 1, above, the group has obtained two tax losses from a single $30 economic loss.

To address the two concerns above, and to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss, the 35T regulations create two primary rulesa basis redetermination rule (BRR) and a loss-suspension rule (LSR).

These new regulations provide a set of ordering rules; according to 35T(b)(6), the BRR must be examined before exploring the consequences of the LSR. Both of these rules are only applied after any required alterations are made under the investment-adjustment rules of Regs. Sec. 1.1502-32 (32). Finally, Temp. Regs. Sec. 1.337(d)-2T must be applied after 35T.

BRR

The BRR, which is a direct response to concern 1 above, attempts to equalize the members tax bases in a subsidiarys stock on the occurrence of certain events. The BRR is necessary because the 32 investment-adjustment rules are generally blind as to the source of a stocks basis amount and some taxpayers manipulate the basis assigned to a particular stock. Accordingly, a subsidiarys basis must be redetermined immediately before the disposition of a members stock. The BRR will not apply unless the subsidiarys stock has a basis that exceeds its value and there is a disproportionate basis in more than one block of stock. Further, the BRR will not apply if all of the subsidiarys stock is sold in one or more fully taxable transactions within a single tax year, because the group will be unable to derive a double tax benefit or accelerate a loss.

When the BRR applies, the convention for accomplishing the redetermination depends on whether the (1) subsidiary remains a member of the group or (2) disposition causes a deconsolidation of the subsidiary. If the subsidiary remains a group member, all group members must aggregate their bases in the subsidiarys stock; the combined total is then reapportioned to each block of stock in an equalizing adjustment. If the subsidiary is no longer a group member (due to a deconsolidation after the stock disposition), a special basis adjustment is made to the members who still retain the subsidiarys stock. Each of these actions is discussed below.⁴

Nondeconsolidating dispositions: If stock of a subsidiary member (with a basis exceeding its value) is exchanged, and the subsidiary member remains a group member, the BRR applies. According to 35T(b)(1), all of the members bases in the subsidiary members stock immediately before such transfer are aggregated. Once aggregated, the basis is proportionately allocated to the subsidiary members preferred stock. The allocation cannot exceed the value of the preferred stockconsequently, a preferred stock disposition cannot result in loss recognition. Any remaining basis is allocated to the subsidiary members common stock held by group members immediately before the transfer in proportion to such shares value.

Example 3: In year 1, P Corp. creates S Corp. by contributing $80 for 80 shares of common stock (CS1) and land with a FMV of $20 and an adjusted basis of $30 for 20 shares of preferred stock (PS1). P and S file consolidated returns. The transaction qualifies under Sec. 351; Ps basis in CS1 becomes $80 and its basis in PS1 is $30. In year 2, P sells PS1 outside of the group for $20. Because Ps basis in PS1 exceeds its FMV immediately prior to the sale and S is a member of the P group immediately after the sale, all of Ps bases in S stock must be redetermined. Ps aggregated basis totals $110; $20 is first allocated to PS1 (FMV on the date of sale) and the remaining $90 is allocated to CS1. Thus, under the BRR, Ps sale of PS1 results in zero loss recognition.

This example demonstrates that, without the BRR, the group could have recognized an immediate loss on the sale of PS1, and, at a later time when S sold the land, the group might have recognized a second tax benefit. As it stands, the BRR neutralizes the loss on the sale of PS1. The $10 economic loss inherent in the land remains inside the group and will be available for recognition whenever P disposes of CS1 or S sells the land.

An interesting phenomenon seemingly occurs whenever multiple blocks of common stock are used in lieu of preferred stock. As indicated above, no gain or loss can be recognized on a later sale of preferred stock (after a 35T(b)(1) adjustment), due to the value ceiling for basis adjustments. However, if P in Example 3 above, had received 20 shares of common stock (CS2) for the land, instead of PS1, the redetermined basis of the 20 CS2 shares would be $22 ($110 x 20%). Thus, on a subsequent sale of 20 CS2 shares for its FMV of $20, P could recognize a $2 loss; however, 35T(c) (discussed below) contains a rule that will suspend any P losses on the sale of CS2.

Deconsolidating dispositions: If the transfer or exchange of a subsidiary members stock results in a deconsolidation of that member, and any share the group owns has a basis in excess of FMV, the BRR of 35T(b)(2) applies. A different BRR needs to be em-ployed, because the subsidiary is no longer a group member, and any members that retain stock in that subsidiary are no longer bound by the consolidated return regulations after the deconsolidation. To accommodate this condition, 35T(b)(2) requires that, for all shares of a subsidiary members stock held immediately before the deconsolidation, a special basis adjustment be made to the basis of every share that a member owns in the subsidiarys stock. This special adjustment is known as the reallocable basis amount (RBA); it equals the lesser of:

The aggregate loss in the loss shares of the subsidiarys stock owned by members; and,

The total of the subsidiarys deductions and losses allocated under 32 to its non-loss shares owned by the members.

Once determined, the basis of each share of the subsidiarys stock owned by members is adjusted by the RBA immediately before the deconsolidation, in the following order:

1.To the basis in each loss share owned by members of the group (but not below its FMV), in a manner that unifies (to the greatest extent possible) the basis-to-value ratio in all shares. Such a reduction cannot exceed the RBA.

2.The preferred stock basis is next increased by the RBA, but not in excess of its FMV. The basis adjustment is also done in a manner that unifies (to the greatest extent possible) the basis-to-value ratio in all shares.

3.Any remaining RBA is finally allocated to the common stock basis in a manner that unifies (to the greatest extent possible) the basis-to-value ratios.

Example 4: In year 1, P Corp. creates S Corp. by contributing $50 for 50 shares of common stock (CS1) and land with a FMV of $50 and an adjusted basis of $80 for 50 shares of common stock (CS2). P and S file consolidated returns. The transaction qualifies under Sec. 351, so that Ps basis in CS1 is $50 and $80 in CS2. In year 2, S sells the land for $50, recognizing a $30 loss.  Under the rules of 32, the CS1 basis is reduced by $15 to $35 and the CS2 basis is reduced by $15 to $65. In year 3, P sells CS2 outside of the group for $50, causing Ss deconsolidation. Because Ps basis in CS2 exceeds its value, and because the sale of CS2 caused Ss deconsolidation, Ps basis in the S common stock must be redetermined under 35T(b)(2). The RBA is $15 (the lesser of $15, the built-in loss inherent in the CS2 owned by P immediately before the deconsolidation, and $15, the total deductions allocated to the non-loss stock (CS1) under 32). Consequently, immediately before the disposition, the CS2 basis must be reduced by $15, resulting in zero gain or loss ($50 sales price $50 adjusted basis ($65 + $15)). The basis in CS1 is increased by $15, resulting in a $50 basis (equal to its FMV).

Once again, the BRR neutralized the potential for a $30 duplicated loss created by the contribution of land to S and the reduction in the CS2 basis. Further, the result appears to be logical, because the P group received the tax benefit of the $30 economic loss when it sold the land; any further losses attributable to the sale of stock would only be duplicative in nature.

LSR

The LSR is the other primary rule found in 35T; it effectively disallows a stock loss if the economic loss giving rise to it can later be reflected on the groups consolidated return. The rationale for this rule is to eliminate the situation illustrated earlier under concern 2. The LSR is carried out through a series of operating rules that serve to suspend the loss, reduce it and then allow it to be deducted.

Suspending the loss: If a group mem- ber recognizes a loss on the disposition of a subsidiarys stock after application of the BRR, and the subsidiary member remains in the group after the disposition, the stock loss is suspended under the LSR to the extent of the duplicated loss on the subsidiarys stock. This definition of a duplicated loss is substantially identical to the one in former Regs. Sec. 1.1502-20(c), except that the other members securities are not excluded from the computation of the subsidiarys aggregate asset bases.⁵

The loss is suspended until certain circumstances (discussed below) occur to either reduce or allow the deferred amount. Further, 35T(c)(3) treats the suspended loss as a noncapital, nondeductible expense incurred by the subsidiary for purposes of applying 32. Consequently, the basis of a higher-tier members stock must be reduced by the suspended loss in the year suspended.

Example 5: In year 1, P Corp. forms S1 Corp. with a contribution of $200 for all of S1s common stock. In the same year, S1 forms S2 Corp. with a contribution of $80 for 80 shares of S2 common stock. P, S1 and S2 file a consolidated return. Also in year 1, S2 purchases Asset A for $80. In year 2, pursuant to Sec. 351, S1 contributes Asset B with a basis of $50 and a FMV of $20 for 20 shares of S2 common stock. In year 3, S1 sells the 20 shares of S2 for $20; S2 is still a member of the P group immediately after the sale. Because S1s basis in S2 exceeds its FMV immediately prior to the sale and because S2 is still a group member immediately after the sale, the BRR applies first.

Of S1s aggregated $130 basis in S2 stock, a proportionate reallocation is made to each of the 100 shares of S2 stock. Accordingly, $26 (20% x $130) is allocated to the S2 stock sold and $104 (80% x $130) is allocated to the S2 stock retained. On S1s sale of the S2 stock for $20, S1 recognizes a loss of $6 ($20 $26). Given that the S2 stock sale does not result in S2s deconsolidation, any loss will be suspended to the extent of loss duplication. The duplicated loss as to the shares sold is $6 (20% x ($130 $100)); thus, the entire $6 loss is suspended. Further, because the suspended loss is treated as a noncapital, nondeductible expense incurred by S1, Ps basis in its S1 stock is reduced from $200 to $194.

The new regulations also include a substitute asset rule that suspends a members loss recognized on an asset disposition (other than of a members stock) when the members basis in the disposed asset was determined by reference to a members basis in stock for which there was a duplicated loss, and immediately after the disposition, the subsidiary is a group member.⁶

Reduction of the suspended loss: In line with the LSR model, suspended losses are reduced as the subsidiarys deductions and losses are taken into account in determining the groups consolidated taxable income. Because the group has been allowed to take the subsidiarys deductions and losses as they are recognized, any duplicated losses inherent in the subsidiarys stock should be eliminated.

Example 6: The facts are the same as in Example 5. In year 4, S2 sells Asset B for $45, recognizing a $5 loss. The $5 loss is absorbed in the P groups consolidated return. As a result, there needs to be (1) a basis adjustment to the S2 stock and (2) a reduction in the suspended loss account. Pursuant to 32, $4 of the $5 loss (80%) must be taken into account to reduce S1s basis in S2 from $104 to $100. Ps basis in S1 stock is also reduced by $4, from $194 to $190. The suspended loss reduction is $1, representing the recognized loss ($5) over the basis actually reduced under 32 by the P group. Thus, the suspended loss is reduced from $6 to $5.

Under an important rebuttable presumption in 35T(c)(4)(i), all deductions and losses are first attributable to the duplicated loss that gave rise to a suspended stock loss. However, to the extent that a taxpayer can establish (via tracing) that any deductions or losses are not reflected in its suspended stock losses, it will not have to reduce its suspended loss account. Thus, in Example 6 above, if S2 could establish that the $5 loss arose from the sale of recently acquired asset C, the suspended loss would still remain at $6.

Allowable suspended stock loss: When a subsidiary leaves a consolidated group, the regulations provide that the remaining suspended loss is permitted to the extent otherwise allowable. The loss is included for the consolidated return year that includes the last day that the subsidiary was a group member. To claim a suspended loss, 35T(c)(5)(iii) requires that a separate statement be filed with the taxpayers return for the year in which the loss is allowable. The statement must be entitled ALLOWED LOSS UNDER Reg. 1.1502-35(c)(5) and contain the name and employer identification number of the subsidiary, the stock of which gave rise to the loss.

Example 7: The facts are the same as in Example 6. In year 5, S1 sells its remaining S2 common stock for $100. Because S1s basis in its remaining S2 stock is $100, it recognizes no gain or loss. Further, now that S2 is no longer a group member, any remaining suspended loss in the S2 stock will be allowed on the P groups year 5 return. Accordingly, the P group will be allowed a $5 loss and the appropriate statements must be attached to its year 5 return.

The BRR and Economic Loss Disallowance

The IRS added a BRR under 35T(f) because certain events (such as worthlessness or insolvency) could allow a subsidiary to cease to exist in a taxable transaction, but allow a portion of the groups consolidated net operating or capital loss to remain with the group.⁷ When the current regulations were first proposed in October 2002, some commentators felt that a group could be denied even a single tax deduction for a true economic loss.

Example 8: P Corp. forms S Corp. with $20 for all of Ss stock and S borrows $24 from a lender. S loses $30, none of which is used to offset the groups income and thus becomes a $30 consolidated net operating loss (CNOL) carryover. P discontinues Ss operations and the lender forecloses on the note, taking the remaining $14 of Ss assets. Under Sec. 108(a), S may exclude its $10 of debt cancellation; but, under Sec. 108(b), S must reduce its share of the CNOL from $30 to $20. Taking into account the excluded debt cancellation and CNOL reduction will cause no net change to Ps basis in Ss stock. If P then dissolves S, the dissolution does not qualify as a liquidation under Sec. 332 and P does not succeed to the remaining $20 CNOL attributable to S. Further, under the proposed regulations, P must reduce its basis in its S stock as if the $20 CNOL carryovers were absorbed. Consequently, instead of being allowed a $20 worthless stock deduction, Ps entire $20 economic loss will be disallowed.

The temporary regulations address this situation by providing in 35T (f)(1) that unabsorbed losses generated by the subsidiary do not remain available to the group. In other words, these loss carryforwards are expired, but not absorbed by the group, as of the beginning of the groups subsequent tax year following worthlessness. Thus, in Example 8 above, P will no longer have to reduce its basis in S as if the $20 CNOL had been absorbedthe $20 worthless stock deduction would be allowed. Moreover, because the loss has expired, there is no possibility of a later duplicative use of the CNOL carryforwards.

Situations similar to Example 8 also led taxpayers to fear that the LSR might be applied to permanently disallow deductions for economic losses outside of insolvency or worthlessness. Accordingly, the temporary regulations provide that (1) the LSR (as discussed earlier) is limited in the amount of its reduction and (2) under 35T(c)(8), the LSR is not to be applied in a manner that permanently disallows a deduction for an otherwise allowable economic loss.

Anti-Avoidance Rules

The rules of 35T(g) share the IRSs concern that, in certain cases, taxpayers may structure transactions to avoid the application of the BRR and LSR in a manner not consistent with the purpose and intent of the regulations. Noteworthy situations include:

• Shares of subsidiary stock (with a basis no lower than FMV) deconsolidated to avoid the BRR;

• Tax-free transfers of loss property to avoid the BRR or LSR;

• Transactions structured to avoid gain by invoking the application of the BRR; and

• Subsidiaries sold at losses that are reimported within 10 years of deconsolidation.

Effective Dates

The temporary regulations generally apply to events occurring after March 6, 2002, and no later than March 11, 2006, but only during a tax year for which an original return is due after March 14, 2003 (excluding extensions). The reimportation prohibitions apply to reimporting events that occur after Oct. 17, 2002 and no later than March 11, 2006.

Conclusion

The new 35T regulations continue a stop-gap approach to the loss-disallowance dilemma that has not completely addressed all of the issues embedded in the investment-adjustment rules.

As the 35T rules came to press, the IRS acknowledged they are continuing to study the comments received on the proposed regulationsincluding, among other things, an application of Sec. 704(c) principles embedded in loss disallowance. Moreover, Treasury is considering alternative regimes that would prevent the duplication of loss within a groups structure. If these studies become prognostications of additional guidance, the already lengthy history of loss disallowance will become an even murkier quagmire.