Notice 2002-11: IRS Reversal on Rite Aid

In Jan. 31, 2002, Treasury issued Notice 2002-11, discussing the IRS's position on Rite Aid Corp., 25 F3d 1357 (Fed. Cir. 2001).

Rite Aid addressed the loss-disallowance rules (LDR) that apply to sales of stock of a consolidated group member. In Rite Aid, the Federal Circuit held that the duplicated-loss component of Regs. Sec. 1.1502-20, which disallows certain losses on sales of stock of a consolidated group member, was an invalid exercise of regulatory authority.

Regs. Sec. 1.1502-20 disallows a deduction for a consolidated group member's investment loss on the sale of a subsidiary, to the extent of the parent's positive investment adjustments in its subsidiary in prior years, any extraordinary-gain dispositions and what Treasury believes is a duplicated-loss factor (DLF). A DLF is the excess of the subsidiary's adjusted basis in its assets over the value of its assets immediately after the sale, combined with net operating losses (NOLs) that leave the group with the subsidiary. Since Rite Aid's subsidiary's DLF exceeded its investment loss, the LDR regulations prohibited an otherwise valid deduction for Rite Aid's loss on the sale of the subsidiary's stock.

Rite Aid argued that the DLF of the LDR regulations taxes income of corporations filing consolidated returns that would not otherwise be taxed. The reasons put forth were that Sec. 165 allows a deduction of losses from the sale of property; the loss would be allowed if the subsidiary was not part of the consolidated return group; other provisions police any duplication of tax benefits (i.e., Sec. 382); and the denial of the deduction imposes a tax on income that would not otherwise be taxed.

The Federal Circuit found the LDR regulations to be manifestly contrary to the Code. In the absence of a problem created from filing consolidated returns, the court determined that the Service has no authority to change the application of other Code provisions for a group of affiliated corporations filing a consolidated return.

In a Chief Counsel Notice (CC-2001-42) issued in August 2001, the IRS advised chief counsel attorneys that it disagreed with the appellate court's decision in Rite Aid. The Justice Department then filed a petition for rehearing en banc with the Federal Circuit. The en banc hearing was unanimously rejected.

Despite the rehearing rejection, Notice 2002-11 indicates that the Service still believes that the court's analysis and holding were incorrect. However, absent a split in appellate courts on the issue, the Supreme Court will probably not consider the IRS's appeal. Rite Aid was litigated in the Federal Circuit, which applies to all taxpayers. Therefore, the Service decided not to continue to litigate the validity of the DLF of the LDR regulations.

According to Notice 2002-11, the IRS will promulgate interim regulations that, prospectively, will require consolidated groups to determine the allowable loss on a sale or disposition of subsidiary stock under an amended Regs. Sec. 1.337(d)-2 instead of under Regs. Sec. 1.1502-20. For transactions that taxpayers complete before the Service issues new regulations (including those for which taxpayers have filed a return already) or for which a binding contract exists before that time, the notice states, "groups will be allowed certain choices with respect to the disposition of subsidiary stock, including a choice to apply 1.337(d)-2 as amended."

The use of amended Regs. Sec. 1.337(d)-2 contains two inherent problems. First, the regulation requires tracing. It would permit a taxpayer to recognize loss on the sale of a subsidiary if the taxpayer can show the loss is not attributed to recognized built-in-gain (BIG). The regulations presume that the loss was attributable to recognized BIG unless the taxpayer proves otherwise, and, as noted, proof requires tracing. The original LDRs avoided using a tracing approach, because it was not considered administrable.

Second, Sec. 337(d) was only meant to deal with the repeal of the General Utilities doctrine. The problems with the LDRs are entirely different from the problems created by the repeal of the General Utilities doctrine (which involves avoiding tax on unrecognized BIG).

While Notice 2002-11 corrected what had been a fundamental inequity in the administration of the corporate income tax and was an important step in allowing taxpayers to deduct true economic losses, issues still remain when they sell unprofitable businesses.

For example, Treasury will need to figure out how to protect transactions for which the LDRs provided taxpayers a benefit, because it permitted loss reattribution for the seller. In this instance, a seller can elect to retain NOLs of the disposed subsidiary when losses are otherwise disallowed under the LDRs. As it stands currently, the seller must recognize the potentially unusable capital losses on the subsidiary's disposition. Executed transactions have relied on this ability. One approach to alleviate this inequity is to have the final regulations require loss reattribution when the DLF is a result of NOLs.

Another hurdle will be the actual drafting of the interim rules, because there is significant interplay between the LDRs and other consolidated-return rules. While it may be technically possible to extricate the DLF from the other two factors, it has to be done in an unsophisticated manner, as it would require a tax practitioner to pick a point in time to measure a BIG. Rules needed for measuring a BIG for these purposes would require elaborate valuations and the use of tracing rules.

If the interim temporary regulations cannot adequately separate the other two LDR factors, an argument would exist that the regulations covering those factors are also invalid. This could potentially result in the elimination of the LDRs altogether if and when challenged. On March 7, 2002, the Service issued interim guidance in the area (see "Interim-Loss Disallowance Regulations," p. 279, this issue.)

From Randy A. Schwartzman, CPA, MST, Melville, NY