Regs. Sec. 1.1502-20 "Disallowed Loss" Rule Was Valid

In 1984, Corporation R acquired 80% of the stock of P Corporation, a discount bookstore. From 19841994, P experienced net negative earnings and profits (E&P) and borrowed money from R. During this period, R annually adjusted its basis in the P stock to reflect P's E&P.

In 1994, R sold P to an unrelated buyer. The transaction was set up as a stock sale; the buyer refused to make a Sec. 338(h) election (which would have allowed asset sale treatment). R estimated that it suffered an economic loss of $22 million on the sale.

On its 1995 consolidated return, R claimed a loss on the sale of the P stock (based on P's negative earnings and its loans from R). The IRS disallowed the loss based on Regs. Sec. 1.1502-20, which denies deductions for losses that a group member recognizes on the disposition of a subsidiary's stock. Because P's "duplicated loss" under Regs. Sec. 1.1502-20 exceeded R's "economic loss," the IRS denied R a loss deduction on the sale. R brought suit, challenging the validity of Regs. Sec. 1.1502-20.

The Court of Federal Claims (opinion Hewitt, J.) holds for the Service; the duplicated loss rule of Regs. Sec. 1.1502-20 is a valid interpretation of Sec. 1502.

Regs. Sec. 1.1502-20 was promulgated in connection with Secs. 15011505, which provide for the filing of consolidated returns by certain affiliated groups. The consolidated return provisions are an exception to the general rule that each taxpayer has responsibility for a separate return. The portion of the Code establishing the consolidated return regime contemplates a regulatory framework unique to consolidated return filers to which corporations availing themselves of the privilege of filing consolidated returns are deemed to consent.

Under Sec. 1502, the Treasury has authority to draft implementing regulations, extending both to the affiliated group and to each corporation in the group, both during and after the time periods covered by the consolidated returns.

This case can be resolved on the basis of the plain meaning of Sec. 1502, which authorizes Treasury to promulgate regulations that affect the tax liability of both "any affiliated group of corporations making a consolidated return" and "each corporation in the group." Sec. 1502 further provides that such regulations may affect the group or each corporation "both during and after the period of affiliation." Regs. Sec. 1.1502-20 appears to fall well within the purview of Sec. 1502, affecting as it does the affiliated group's tax liability for a matter arising because of the disaffiliation of one of its members. The duplicated loss rule prohibits the opportunity that would otherwise exist for the affiliated group to recognize a loss on a sale of a subsidiary's stock, and for the purchaser to recognize the same loss. By prohibiting the use of the same loss in the hands of both seller and purchaser, Regs. Sec. 1.1502-20 assists in achieving the purpose of all regulations issued under Regs. Sec. 1502—to "clearly reflect the income tax liability" of both members and former members of the affiliated group and to "prevent avoidance of such tax liability."

The court does not agree that the effect of Regs. Sec. 1.1502-20 is in derogation of Sec. 165(a), which affords the taxpayer a deduction for a "loss sustained during the taxable year and not compensated for by insurance or otherwise." R had an opportunity (which it did not avail itself of) to structure the sale transaction for the subsidiary in a way that would have allowed it to recognize the losses that the duplicated loss rule disallowed. R could have structured the transaction as a sale of P's assets, allowing R to recognize loss on the difference between the sale price and R's basis in P's assets. R could even have structured the transaction as a stock sale, subject to the requirement that both the seller and buyer elect to treat the transaction as an asset sale under Sec. 338(h)(10). In addition, because of the possible value of the losses to the buyer, the court does not believe that the seller's loss is not "compensated for" in some fashion ("or otherwise") as contemplated by Sec. 165(a).

Rite-Aid Corp., Ct. Fed. Cls., 4/21/00