Are the New Loss Duplication Regulations Out of Date?

On March 6, 2006, the IRS issued final “loss duplication” regulations (Regs. Sec. 1.1502-35), designed to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. The new regulations represent the government’s latest response to the Federal Circuit’s decision in Rite Aid, 255 F3d 1357 (2001), which held that the “duplicated loss” factor of the loss disallowance rule (LDR) found in former Regs. Sec. 1.1502-20 was invalid. (For additional information on the LDR, see Mason and Choate, “The Loss Disallowance Rule—Round Three,” TTA, May 1992, p. 267; Hayes, Tax Clinic, “Rite Aid Precipitates Issuance of Prop. and Temp. Regs.,” TTA, June 2002; and Thompson and Stewart, “Temp. Regs. Limit Duplicative Stock Losses,” TTA, January 2004.)

Both the final loss duplication regulations and new Sec. 362(e) (discussed below) limit a taxpayer to one tax benefit from a single economic loss.

This item explores the lack of symmetry between these two provisions and how this affects corporations filing a consolidated return.

Basis Redetermination

The loss duplication regulations generally operate through a “basis redetermination rule,” as illustrated in the following example.

Example 1: Corp. P forms Corp. S by transferring $20 in exchange for common stock, asset Z, with a $130 basis and a $100 fair market value (FMV), and preferred stock. P and S join in filing a consolidated return. Because the transfer qualifies as a Sec. 351 transaction, P’s basis in the common stock is $20 and its basis in the preferred stock is $130. The FMV holds constant and P subsequently sells the preferred stock to a third party for $100. The duplicated loss regulations prevent the consolidated group from recognizing a loss on the sale of the preferred stock (because S remains a member of the consolidated group), by allocating basis away from the preferred stock to the common shares, leaving basis in the preferred stock equal to its FMV. Thus, the $30 loss inherent in the preferred stock is shifted to the common stock, and P recognizes no gain or loss on the preferred stock sale.

The result in Example 1 makes sense, because S inherited Z with a $130 basis, and otherwise there would be a risk of the consolidated group recognizing another loss in the future on S’s sale of Z. However, the American Jobs Creation Act of 2004 (AJCA) enacted Sec. 362(e), which addresses the same loss duplication concern in the context of Sec. 351 transactions, effective for transactions after Oct. 22, 2004. Regs. Sec. 1.1502-35 specifically instructs taxpayers to assume, for purposes of the examples in the regulations, that all transactions are completed before Oct. 22, 2004. By essentially ignoring Sec. 362(e), the examples in the loss duplication regulations are not as helpful as they could have been.

Applying Sec. 362(e)

Prior to the AJCA, the basis in property transferred in a Sec. 351 transaction was preserved in both the inside basis (i.e., in the basis of the assets) and in the outside basis (i.e., in the stock of the transferee corporation). New Sec. 362(e)(2) fundamentally changes the operation of Sec. 351. Under the new rule, built-in gains are still duplicated, but losses are not. If there is a net built-in loss (BIL) in the property transferred, the parties to the exchange must choose to preserve the loss in the inside basis or in the outside basis. (Other rules in Sec. 362(e)(1) eliminate duplicated BILs in certain other Sec. 351 transactions, by requiring the transferee to reduce basis to the FMV. A discussion of these rules is beyond the scope of this item.) Example 2 illustrates the application of Sec. 362(e)(2).

Example 2: The facts are the same as in Example 1, except P transfers only asset Z to S in exchange for common stock. An election is made (as permitted under Sec. 362(e)(2)) to preserve the loss in S’s hands (in Z’s basis). P’s basis in the S stock will increase by only $100 at the time of the contribution, and S’s basis in Z will be $130. S later sells Z for $100, recognizing a $30 loss the group absorbs. By operation of the basis adjustments required under the consolidated return regulations, P’s basis in the S stock will be decreased again by the $30 loss, thus creating a future, artificial $30 gain on the sale of the S stock. This stock gain, when triggered, will offset completely the $30 loss previously incurred by S, thus denying the consolidated group even one tax benefit from the $30 economic loss.

Observations

In the preamble to the loss duplication regulations, the IRS reiterates its intent to continue to study the LDR and loss duplication and its plan to publish integrated proposed regulations in the near future. Given the current apparent disconnect between Regs. Sec. 1.1502-35 and Sec. 362(e)(2), and the very real prospect of consolidated groups being precluded from claiming even one tax benefit from a valid economic loss, one hopes that, at a minimum, these issues will be clarified in any future guidance.

Until further guidance is issued, consolidated groups should plan carefully before contributing BIL property from one group member to another, because of the potential negative tax consequences. Importantly, Sec. 362(e) is likely to require more valuations, because it is necessary to ascertain the FMV of the property transferred in a Sec. 351 transaction. This places an additional burden on taxpayers to document the valuation in the event of an IRS audit.

From Michelle Estrada, CPA, Washington, DC