Alternative Approach for Calculating Loss Disallowance on Disposition or Deconsolidation of Subsidiary Stock

In Notice 2004-58, the IRS formalized the availability of an alternative approach for calculating the loss disallowed on a disposition (or the basis reduced on deconsolidation) of a share of a consolidated subsidiary’s stock under Temp. Regs. Sec. 1.337(d)-2T. The alternative approach is referred to as the “basis disconformity model.”

The notice applies to dispositions and deconsolidations of subsidiary stock occurring on or after March 7, 2002. Additionally, temporary and proposed regulations under Temp. Regs. Sec. 1.1502-20T that were issued concurrently with the notice make the basis disconformity model elective for dispositions and deconsolidations occurring before March 7, 2002. As such, the notice has relevance for the upcoming tax season. Moreover, it may have applicability for some time to come, depending on whether the government proposes to replace Temp. Regs. Sec. 1.337(d)-2T (which is due to sunset on March 7, 2005).

Who Should Use?

Notice 2004-58’s new approach provides three alternatives to the classical tracing method (described below), historically thought to be prescribed by Temp. Regs. Sec. 1.337(d)-2T, and adopts instead the mechanical basis disconformity model. It also clarifies that a modified approach to tracing (discussed below) will still be available. Note: The alternative methods for calculating loss disallowance or basis reduction present an opportunity for a taxpayer with one or more of the following circumstances to claim a loss on the disposition or deconsolidation of subsidiary stock:

1. The taxpayer recognized less than 100% of a loss on the disposition of a subsidiary’s stock using the classical tracing method. Under the basis disconformity model, the taxpayer may be allowed to maximize its stock loss, particularly if it incurred operating losses that reduce net positive adjustments.

2. The taxpayer recognized a loss using the classical tracing method, but is concerned with the approach and quality of the supporting documentation. The basis disconformity model may yield the same or greater loss, but may be much easier to substantiate.

3. The taxpayer has a refund claim for a recognized stock loss under examination, and part of the loss is being disallowed.

4. Finally, any taxpayer that failed to recognize a loss on the disposition of a subsidiary’s stock for transactions going back as far as 1991 should review its filing position for the loss year and consider whether the basis disconformity model would be more advantageous. Further, a taxpayer that has incurred such a loss in the current tax year (or expects to incur one prior to March 7, 2005), should prospectively consider the most advantageous method to calculate and document the loss to be reported on its current or future return.

Brief History of the LDRs

On March 7, 2002, Temp. Regs. Secs. 1.337(d)-2T and 1.1502-20T(i) effectively replaced the loss disallowance rules (LDRs) of Regs. Sec. 1.1502-20 that were invalidated, in part, by Rite Aid Corp., 255 F3d 1357 (Fed. Cir. 2001).

The temporary regulations, which will sunset on March 7, 2005, apply to dispositions and deconsolidations of subsidiary stock occurring on or after March 7, 2002. In general, Temp. Regs. Sec. 1.337(d)-2T disallows any loss recognized by a consolidated group member on a subsidiary stock disposition, except to the extent the consolidated group establishes that the loss is not attributable to the recognition of built-in gain (BIG). For this purpose, Temp. Regs. Sec. 1.337(d)-2T(c)(2) defines BIG as gain “attributable, directly or indirectly, in whole or in part, to any excess of value over basis that is reflected, before the disposition of the asset, in the basis of the share, directly or indirectly, in whole or in part.”

While Temp. Regs. Sec. 1.337(d)-2T applies to transactions occurring on or after March 7, 2002, Temp. Regs. Sec. 1.1502-20T(i) permitted elective application for dispositions or deconsolidations before that date. In general, an election to apply Temp. Regs. Sec. 1.337(d)-2T retroactively was required no later than the extended due date of the original return for the tax year that included March 7, 2002.

Classical Tracing Model

Temp. Regs. Sec. 1.337(d)-2T does not prescribe a method to determine whether a stock loss is not attributable to recognized BIG; however, practitioners have historically relied on a classical tracing model. Under classical tracing, a taxpayer must identify the specific BIGs and built-in losses (BILs) on assets held by a subsidiary on the subsidiary’s acquisition and must determine the extent to which such BIGs and BILs are recognized and reflected in stock basis. To satisfy its burden of proof, a taxpayer must possess adequate historic records and often must obtain a valuation of the subsidiary’s assets.

Because the previous loss disallowance regimes under Regs. Sec. 1.1502-20 specifically rejected a tracing approach, many taxpayers did not maintain the historic records necessary to implement tracing under Temp. Regs. Sec. 1.337(d)-2T. Further, valuations in the absence of arm’s-length transactions are frequently a matter of contention between the IRS and taxpayers. The Service has acknowledged that tracing has proven administratively difficult for both parties.

Basis Disconformity Model

Notice 2004-58 outlines a new method to interpret and apply Temp. Regs. Sec. 1.337(d)-2T. The basis disconformity model is drawn from the “reflected in” language of Temp. Regs. Sec. 1.337(d)-2T and seeks to mechanically calculate loss disallowance to the extent subsidiary stock basis has been increased for recognition of amounts already reflected in or sheltered by the stock basis on acquisition of the subsidiary.

Under the basis disconformity method, the amount of loss disallowed, or by which basis must be reduced, is the least of:

1. The sum of all gains (net of directly related expenses, including taxes) recognized on asset dispositions allocable to the deconsolidated share while the subsidiary is a group member;

2. The amount of basis disconformity, measured before the disposition of the asset. For this purpose, basis disconformity is the excess, if any, of (i) the deconsolidated share’s basis over (ii) its proportionate interest in the subsidiary’s “net asset basis”; or

3. The excess (if any) of cumulative positive adjustments over negative adjustments (other than from distributions) made to the deconsolidated share under Regs. Sec. 1.1502-32.

For purposes of #2 above, “net asset basis” is the excess of (1) the sum of the subsidiary’s money, basis in assets (other than stock of lower-tier subsidiaries), net operating and capital loss carryforwards that would be carried to a separate return year under Regs. Sec. 1.1502-21, and deductions that have been recognized but deferred; over (2) the subsidiary’s liabilities that have been taken into account for tax purposes.

Example 1: P Corp. purchases 100% of S Corp.’s stock for $100 when S owns one asset with a $75 basis and a $100 value. S subsequently sells the asset for $100, recognizing a $25 gain that increases P’s basis in its S stock to $125. P then sells the S stock for $100.

Under the classical tracing model, all of P’s $25 loss is disallowed, because it is attributable to BIG; it is also disallowed under the basis disconformity method. The disallowance is the least of the (1) $25 gross asset gain, (2) $25 disparity between S’s inside and outside basis before the sale and (3) $25 net positive investment adjustment.

Example 2: P forms S with a $100 contribution. S subsequently purchases an asset for $100, which declines in value to $75. P then sells the S stock for $75.

Under the classical tracing model, all of P’s $25 economic loss is allowed, provided P has adequate records to prove that the loss was attributable to the asset’s decline in value and not to BIG recognition. If there are no such records, the loss will be disallowed under the general rule of Temp. Regs. Sec. 1.337(d)-2T. The basis disconformity method also permits the $25 economic loss. The disallowance is the least of the (1) zero gross asset gain, (2) zero disparity between S’s inside and outside basis before the sale and (3) zero net positive investment adjustment.

Example 3: P purchases 100% of S’s stock for $100 when S owns two assets—asset A with a zero basis and a $100 value and asset B with a $100 basis and zero value. S sells A for $100, recognizing a $100 gain that increases P’s basis in its S stock to $200. P then sells its S stock for $100.

Under the tracing model, all of P’s $100 loss is disallowed, because all of S’s $100 gain is BIG. The basis disconformity method, however, allows the $100 loss. The disallowance is the least of the (1) $100 gross asset gain, (2) zero disparity between S’s inside and outside basis before the sale and (3) $100 net positive investment adjustment.

Example 4: P acquires S for $100. S holds three assets—A with a zero basis and value; B with a zero basis and $50 value; and C with a $50 basis and value. Later, A’s value increases to $50 and C’s decreases to zero. B and C are sold; A subsequently declines in value back to zero. P sells its S stock for $50.

Under the tracing model, P’s $50 loss is disallowed, because it is attributable to BIG on B. Note: The loss on C does not offset the gain, because it was not a BIL when P’s basis in S was determined. However, the $50 loss is allowed under the basis disconformity method. The disallowance is the least of the (1) $50 gross asset gain, (2) $50 disconformity between S’s inside and outside basis before the sale and (3) zero cumulative net positive investment adjustments.

Modified Tracing

According to Notice 2004-58, the IRS will accept methods other than basis disconformity for determining the amount of stock loss or basis not attributable to BIG recognition. Taxpayers may use the basis disconformity model to their benefit, but also retain the right to prove economic loss via other means, including tracing.

However, the IRS has clarified in the notice that the approach to tracing under Temp. Regs. Sec. 1.337(d)-2T does not correspond to the classical tracing approach historically relied on by taxpayers and practitioners. The tracing approach that will be accepted must account for events subsequent to the acquisition of a share that create or alter the disconformity between that share’s basis and its interest in the aggregate basis of assets, the disposition of which would adjust the share’s basis (“modified tracing”). Such events may include an intragroup spinoff, an acquisition of assets with BIG, a merger or a contribution of property to a subsidiary under Sec. 351 in exchange for additional shares.

When a taxpayer has undergone one of the above transactions, modified tracing can provide a different (and, sometimes, less favorable) result than classical tracing.

Example 5: P forms S1 with $200 cash. S1 buys assets A1 and A2 for $100 each. After A1 appreciates to $180 and A2 depreciates to $20, S1 transfers A2 to its newly formed subsidiary, S2, in exchange for all of S2’s stock. Immediately thereafter, S1 distributes the S2 stock to P in a Sec. 355 transaction. As a result, P’s basis in S1 is allocated between S1 and S2 in accordance with their relative fair market values. (P’s basis in S1 is $180; its basis in S2 is $20.) S1 subsequently sells A1, recognizing an $80 gain. P’s basis in S1 is increased by $80 to $260. P then sells S1 for $180 and recognizes an $80 loss.

The classical tracing model would have allowed the $80 loss, because it was not attributable to the recognition of BIG that existed on P’s acquisition of S1. The $80 loss, however, is disallowed under modified tracing, because it was reflected in P’s redetermined basis in its S1 stock following the intragroup spinoff. (The loss disallowed under the basis disconformity method would also be $80, the least of the (1) $80 gross asset gain, (2) $80 basis disconformity before the asset sale and (3) $80 net positive adjustment.)

Reliance on Notice 2004-58 and Related Relief Provisions

Because the basis disconformity method is derived from the language of Temp. Regs. Sec. 1.337(d)-2T, it applies to all dispositions and deconsolidations on or after March 7, 2002—the period to which Temp. Regs. Sec. 1.337(d)-2T applies. No election is necessary to apply this method for post-March 6, 2002 transactions.

In addition, the new temporary regulations issued with Notice 2004-58 make the basis disconformity method elective for dispositions and deconsolidations occurring before March 7, 2002. The regulations reopen the elections previously available under Temp. Regs. Sec. 1.1502-20T(i). Taxpayers may elect to apply Temp. Regs. Sec. 1.337(d)-2T (using tracing or basis disconformity) to pre-March 7, 2002 dispositions and deconsolidations or may elect Regs. Sec. 1.1502-20 without regard to the duplicated loss factor. Additionally, they may amend prior elections and change from the application of Regs. Sec. 1.1502-20 without the duplicated loss factor to Regs. Sec. 1.337(d)-2T or vice versa. Finally, a taxpayer may revoke a prior election and, thus, revert back to Regs. Sec. 1.1502-20 in its entirety. If a taxpayer elects to do that, the notice specifies that under these regulations, reattribution of subsidiary losses under Regs. Sec. 1.1502-20(g) will not be available.

According to Temp. Regs. Sec. 1.1502-20T(i)(6)(ii), an election, a revocation or an amendment must be filed with, or as part of, an amended return filed before the original return for the tax year that includes Aug. 26, 2004 is due (including any extensions). Such elections, revocations and amendments apply only to open tax years. (An election may also be filed for a loss on a disposition or deconsolidation that occurred in a closed tax year, but which is carried forward to an open tax year.)

Implications

The new approach to the LDRs provides taxpayers several opportunities, including:

1. Possible refund claims, if the basis disconformity method produces a better result than the tracing model for prior-period returns.

2. Additional defenses for taxpayers with loss disallowance claims under audit.

3. The ability to choose the method of calculating loss disallowance that yields the best result for stock dispositions and deconsolidations reported on current returns.

4. Increased value for loss carryovers, regardless of limits, because losses may decrease the amount of disallowance in the mechanics of the basis disconformity method.

As stated above, if a taxpayer has failed to recognize a loss on the disposition of subsidiary stock in transactions going back as far as 1991, it should review its filing position for the loss year and consider whether the basis disconformity method provides a better result. Further, if a taxpayer has incurred a loss on a disposition of a subsidiary’s stock in the current tax year or expects to incur such a loss prior to March 7, 2005, it should prospectively consider the most advantageous method to calculate and document the loss to be reported on its current or future return.

Future Regulations

Notice 2004-58 indicates that for purposes of future regulations (the current regulations sunset March 7, 2005), the IRS and Treasury are studying various approaches to loss disallowance, including a number of tracing regimes and a basis disconformity approach. The basis disconformity approach they are considering would be the same as that outlined above, except it would not distinguish between the recognition of gain and income and, thus, would determine disallowed loss without regard to an asset disposition.

In Notice 2004-58, the IRS and Treasury requested comments on the scope of future regulations and the approach to loss disallowance that such regulations should adopt.

From Jared H. Gordon, J.D., LL.M., and Sally Morrison, CPA, M.Acc., Washington, DC