Often-Overlooked Stock Basis Adjustments

The parent of a consolidated group may not track the adjusted basis of its subsidiary stock annually. Taxpayers often perform this analysis only when needed, such as prior to disposition of a subsidiary. However, certain stock basis adjustments may be overlooked when not addressed yearly; this item highlights two such adjustments—for nonqualified stock options (NQSOs) and dual consolidated losses (DCLs).

NQSOs

An employee’s exercise of a NQSO generally results in a compensation deduction. Whether an employee performing services for a subsidiary receives its stock or parent stock, Sec. 83(h) and Regs. Sec. 1.83-6 provide that the entity for which the services are rendered (i.e., the subsidiary) can take the deduction. If the subsidiary is a consolidated group member, the deduction will cause the parent’s adjusted basis in the subsidiary’s stock to be reduced under Regs. Sec. 1.1502-32’s investment adjustment rules.

If a subsidiary’s employees receive only cash compensation for services rendered, and the parent funds such compensation, the subsidiary incurs a deductible compensation expense and its basis must be reduced under Regs. Sec. 1.1502-32. However, the subsidiary’s stock basis increases by the cash contributed, which offsets the stock basis reduction resulting from the subsidiary’s compensation deduction. In essence, this transaction has no net effect on the subsidiary’s stock basis.

Sec. 1032: The same tax consequences should result whether the employees receive cash or exercise NQSOs. Regs. Sec. 1.1032-3(b)(2) governs a subsidiary’s employees’ exercise of a parent’s NQSOs; the parent is deemed to have contributed to its subsidiary the excess of (1) the total fair market value of the parent stock issued to the subsidiary’s employees, over (2) the total payments made by the subsidiary’s employees on each exercise. The subsidiary is then treated as purchasing its parent’s stock with the money received from the parent and its employees. Although Regs. Sec. 1.1032-3 was issued May 12, 2000 on a prospective basis, the IRS will not challenge a taxpayer’s position taken in a prior period that is consistent with the final regulations; see the preamble to TD 8883.

Basis calculations often fail to consider the positive effect Regs. Sec. 1.1032-3 provides for NQSOs exercised by a subsidiary’s employees (especially for exercises that pre-date the regulations and for those occurring after a subsidiary leaves the consolidated group).

To the extent not already accounted for, the parent should increase its basis in its subsidiary stock for the cash contribution under Regs. Sec. 1.1032-3(b)(2) deemed to occur when the subsidiary’s employees exercise NQSOs to acquire parent stock. This increase should offset the negative basis adjustment that occurs as a result of the subsidiary’s compensation deduction. In sum, the exercise of NQSOs by the employees of a wholly owned subsidiary in a consolidated group should not cause a net reduction in the parent’s stock basis in such subsidiary.

DCLs

Generally, under Regs. Sec. 1.1502-32(b)(2), each year, a parent’s basis in member stock is increased by the member’s taxable and tax-exempt income and decreased by the member’s losses, certain nondeductible expenses and distributions. For taxable losses, Regs. Sec. 1.1502-32(b)(3)(i)(A) provides that a parent’s basis in member stock is adjusted in the year such losses are absorbed by the group (i.e., a member’s loss carried forward to future years generally does not reduce the parent’s basis in the member’s stock until such future years).

However, Regs. Sec. 1.1503-2(d) provides different rules on the timing of basis adjustments resulting from a DCL. Regs. Sec. 1.1503-2(d)(3)(i)(A) states that a parent’s basis in a member’s stock does not increase by a DCL incurred by the member, but not absorbed by the consolidated group, in a particular year. Thus, a member’s stock basis is reduced by the total DCL in the year incurred, regardless of when the loss is absorbed. Regs. Sec. 1.1503-2(d)(3)(i)(B) confirms this concept, stating that a parent’s basis in a member’s stock is not reduced in a subsequent tax year as a result of the consolidated group absorbing a DCL carried forward from a prior year (i.e., basis is not reduced twice by the same DCL).

The modified basis adjustment rules in the DCL regulations do not alter merely the timing of basis adjustments. Under Regs. Sec. 1.1503-2(d)(3)(i)(A), a parent’s basis in a member’s stock does not increase when the member recognizes income from recapturing a previously deducted DCL. Although this provision may appear contrary to Regs. Sec. 1.1502-32(b)(2)(i), which provides for an increase in stock basis for taxable income a member recognizes, it is consistent with the overall policy underlying the DCL provisions.

Allowing a company to increase its basis in a member subsidiary’s stock for a recaptured DCL could indirectly result in the consolidated group ultimately receiving a benefit for an otherwise nondeductible loss.

Example: Consolidated group member A incurs a DCL in year 1; the loss is absorbed by the consolidated group. Its parent, B, reduces its basis in A’s stock by the DCL. In year 2 a “triggering” event occurs, causing A to recognize taxable income equal to the DCL previously deducted by the group. In year 3, B sells its A stock. If B’s basis in A’s stock had been increased in year 2, the gain recognized on the sale of A’s stock in year 3 would have been decreased (or the recognized loss increased) by the recaptured income. In other words, B would have received a benefit for the nondeductible DCL in the form of a lower capital gain (or higher capital loss).

The IRS pointed out in the preamble to Regs. Sec. 1.1503-2 that income from the recapture of DCLs should not increase a parent’s basis in a member’s stock; see TD 8434 (9/9/92).

Ensuring Adjustments Are Captured Properly

The IRS requires taxpayers to maintain books and records to substantiate their basis in member stock. Taxpayers should maintain such information on a regular (i.e., annual) basis, to ensure that all required adjustments are properly taken into account. By updating basis calculations regularly, taxpayers increase the likelihood of taking into account all required stock basis adjustments.

From John Michalowski, CPA, Washington, DC