Consolidated Sec. 108(b) Attribute Reduction—Post-United Dominion

The Supreme Court's decision in United Dominion Industries, 532 US 822 (2001), raises the question of whether it provides any insight into the hotly debated Sec. 108(b) attribution-reduction issue, as it relates to "troubled-company" debt restructuring. Should only tax attributes of a separate member be reduced (the separate-member approach), or are consolidated tax attributes fair game (the single-entity approach)?

Attribute Reduction—Sec. 108(b)

If a creditor discharges a taxpayer's debt (in whole or in part), the taxpayer generally must include the cancellation of debt (COD) in gross income, unless an exclusion applies. Sec. 108(a) generally allows the taxpayer to exclude the COD income if the taxpayer is in a bankruptcy proceeding or is insolvent. If the latter, the taxpayer could exclude COD income only to the extent of insolvency. The cost of excluding COD income is tax-attribute reduction, pursuant to a specific ordering rule set forth in Sec. 108(b).

Sec. 108(b) does not provide clear guidance as to whether the single-entity or separate-member approach should be applied in a consolidated-group context. Questions include:

• Under Sec. 108(b), who is the taxpayer in a consolidated group? The amount of debt being discharged and the insolvency are determined using a separate-member approach; see Sec. 108(d)(3).
• How does a single-entity approach mesh with Sec. 108(b)(5), which provides a specific mechanism for reducing tax basis in depreciable property of affiliated corporations? (That is, what would be the need for Sec. 108(b)(5) if a single-entity approach were the correct standard?)
• How does a separate-member ap-proach to attribute reduction reconcile with the existence of a consolidated net operating loss (CNOL), which is apportioned to the separate member on the occurrence of certain enumerated events?
• Do the answers to these questions square with handling excluded COD income under the consolidated investment-basis adjustment (IBA) and excess loss account (ELA) systems? Does a single-entity approach comport better with these systems than a separate-member approach? Letter Rulings 9121017 and 9650019 seemed to favor a separate-member approach, but recently the IRS appears to have changed course in favor of the single-entity theory; see Field Service Advice (FSA) 9912007 and Chief Counsel Advice (CCA) 200149008.
• Does United Dominion—with which the Supreme Court grappled as to whether the separate-member or single-entity approach was appropriate when applied to product liability losses (PLLs)—support the single-entity approach, because the Court refused to recognize the concept of a separate-member NOL in a consolidated group?

United Dominion

United Dominion involved proper calculation of a consolidated group's PLL, which was eligible for a 10-year carryback under Sec. 172(f). A PLL is the lesser of a taxpayer's product liability expenses (PLEs) or its NOL. If a separate-member approach was re-quired, as the IRS argued, and the member with qualifying PLEs generated a tax profit on a separate-company basis, a PLL would not result for that member. On the other hand, if a single-entity approach was adopted, as urged by the taxpayer, PLEs for each consolidated-group member would be aggregated and compared to the CNOL.

The Supreme Court held that a consolidated group's PLL is determined on a single-entity basis, rather than by segregating the PLLs on a member-by-member basis. In general, the Court rejected the concept of a "separate" NOL, as PLEs cannot be compared with any NOL to produce a PLL until a CNOL has been calculated.

IBA and ELA Systems

The question arises as to whether the single-entity approach in United Dominion comports with the IBA and ELA rules. The IBA rules are designed generally to neutralize the impact of excluded COD income on a member's stock basis. Hence, under the current regulations, a member's COD income, excluded from gross income under Sec. 108(a) but not applied to reduce tax attributes, is not treated as tax-exempt income (i.e., does not increase stock basis).

The classification of COD income as tax-exempt is significant if an ELA exists in the member's stock. An ELA (negative stock basis) generally is created when a member's basis in a subsidiary's stock is reduced under the IBA rules, and the reductions exceed its basis in that stock. An ELA in a subsidiary member's stock is taken into account if COD income is excluded from gross income and not treated as tax-exempt income. Thus, the consolidated group recaptures deductions in excess of its investment in the subsidiary, and distributions in excess of the group's investment are subject to taxation.

This rule represents an expansion of the general "stock worthlessness" rule. The stated purpose of the general rule was to:

More fully implement the single entity treatment of a consolidated group. Viewing P's investment in S's stock as an investment in S's assets, the proposed rules generally do not treat S's stock as worthless until substantially all of S's assets are treated as disposed of, abandoned, or destroyed within the meaning of Sec.165(a) (see the preamble to proposed amendments to the consolidated return regulations (CO-32-92)).

While fully implementing single-entity treatment was the general rule's purported purpose, the preamble actually suggests a separate-member approach, by looking only to the assets of the member whose stock became worthless. According to the preamble, the special rule relating to Sec. 108(a) was needed because "after its indebtedness is discharged, [the member] is unlikely to be treated as worthless under the general rule."

Accordingly, a separate-member approach appears to comport better with the stated objectives of the IBA and ELA systems, inasmuch as a single-entity approach may not neutrally affect a particular member's stock basis under the IBA rules and not promote the ELA rules' separate-member objectives. The following two examples illustrate the separate-member and single-entity approaches, respectively, and the ability to shift basis among consolidated group members if a single-entity approach were applied.

Example 1: P, the parent of a consolidated group, forms S with a $100 capital contribution. S borrows $1,000 from a bank. During year 1, it has a $1,000 NOL, $800 of which is absorbed in year 1, offsetting P's income for that year. Thus, at the close of year 1, as a result of the IBA rules, P has a ($700) ELA in its S shares ($100 initial basis, less $800 negative adjustment for absorbed NOLs). At the beginning of year 2, the bank discharges $900 of S's debt.

Under Sec. 108(a), because S has a $900 insolvency ($1,000 of liabilities, less $100 in assets), all of S's COD income in year 2 is excluded from the P group's gross income. Under Sec. 108(b), S's remaining $200 NOL carryover from year 1 is reduced to zero, and no other tax attributes exist that can be reduced. Thus, $200 of the $900 of excluded COD income is treated as tax-exempt income; the $200 NOL permanently disallowed by Sec. 108(b) is treated as a noncapital, non-deductible expense (i.e., zero net impact on stock basis).

The remaining $700 of discharged income excluded under Sec. 108(a) is not treated as tax-exempt income for IBA purposes and therefore has no effect on stock basis. P's $700 negative ELA in the S stock is taken into account at the time of the discharge of the remaining $700 COD income.

Example 2: The facts are the same as in Example 1, except that in year 1 S had only an $800 NOL that was totally absorbed by the group in that year (i.e., S had no NOL carryfoward into year 2 or beyond). At the end of year 1, S has $300 cash (consisting of $100 equity, plus $200 remaining debt proceeds), and liabilities of $1,000—a $700 insolvency. Also, P owns another member, X.

In year 2, S breaks even and X has a $3,000 NOL, none of which was absorbed by the group in year 2. $700 of S's debt is then discharged in year 3 (as opposed to the $900 discharged in Example 1).

S can exclude the $700 of COD income from its gross income, because it is still insolvent for that amount. If a single-entity approach were applied similar to that in United Dominion (and FSA 9912007 and CCA 200149008), Sec. 108(b) could operate to eliminate permanently $700 of the year 2 CNOL attributable to X. As a result, P's basis in its X stock would be reduced by $700. However, from S's perspective, because $700 of tax attributes were reduced under Sec. 108(b), the entire $700 of Sec. 108(a) excluded income would be considered tax-exempt. Hence, P's basis in its S stock would be zero; the ELA in its stock would be eliminated (($700) ELA, plus $700 of tax-exempt income). The single-entity approach allows the group to shift $700 of stock basis from X to S and avoid restoring the $700 ELA in S's stock.

In Example 2, S did not have an NOL carryforward into year 3 that could be reduced under Sec.108(b) after S's debt discharge. What if, as in Example 1, S had a $200 NOL carryforward into year 2 and beyond at the time of the debt discharge and attribute reduction? Should the CNOL be apportioned first to S for attribute reduction, with the remaining CNOL reduction apportioned to other members under some method (e.g., a modified Regs. Sec. 1.1502-21(b)(2)(iv) approach)? Alternatively, should the CNOL be reduced first under Sec. 108(b), with the reduction apportioned to the group members (FSA 9912007 seems to suggest such an approach)? What impact should the ordering rule of Sec. 108(b)(4)(B) have on this analysis? That section generally provides that an NOL for the tax year of discharge is reduced first, after which the carryovers are reduced in the order of the tax years in which they were incurred.

Could the single-entity approach fit just as well as it does for a CNOL with other tax attributes listed for reduction under Sec. 108(b)(2)? For example, the following attributes are determined on a consolidated basis:

• General business credits (Regs. Sec. 1.1502-3);
• Foreign tax credits (Regs. Sec. 1.1502-4); and
• Passive activity losses (Regs. Sec. 1.469-1(h)(4)).

Would the group switch back to a separate-member approach for basis reduction carried out under Secs. 108(b)(2)(E) and 1017? Put simply, does a hybrid of the single-entity and separate-member approaches apply?

From Steven Heffernen, M.B.A., J.D., LL.M., and Brian Ciszczon, CPA, M.B.A., J.D., Washington, DC