Consolidated return election may mitigate stock basis decrease from phantom item.

Rules for determining the stock basis of a subsidiary (including an excess loss account (ELA)) in a consolidated group are set forth in regulations issued in August 1994. These new regulations replace the rules in the consolidated return regulations issued in 1966, and are effective for determinations of stock basis and ELAs in consolidated return years beginning after 1994. If a subsidiary's stock basis or ELA is determined in a consolidated return year beginning after 1994, the new regulations generally apply as if they have always been in effect.

In general, the new regulations delink the calculation of stock basis from the calculation of earnings and profits (E&P). The rules are similar to those for determining basis in partnership interests and basis in stock in S corporations. Stock basis adjustments are determined by reference to a modified taxable income - taxable income or loss, increased by tax-exempt income, reduced by non-capital, nondeductible expenses, and reduced by distributions - rather than to E&P.

General rule on basis reduction

Under Regs. Sec. 1. 1502-32(b)(3)(iii), in general, losses (including net operating loss (NOL) carryovers and capital loss carryovers) that expire unused are considered noncapital, nondeductible expenses. Accordingly, when an NOL expires, a corporation's basis in subsidiary stock is reduced by the amount of the expired loss. This occurs even if limitations imposed by provisions such as Sec. 382 have made the loss carryover unavailable to offset consolidated taxable income. In such cases, taxpayers will need to decrease stock basis for a phantom item.

Example 1: P, a domestic corporation, is the parent of a consolidated group. On Dec. 31, 1995, P acquires unrelated domestic corporation Z for $75. As a result, Z joins the P consolidated group as of Jan. 1, 1996. Z has one nondepreciable asset, with a basis of $10. Z also has an NOL carryover of $100, which expires in 1996. Z's NOL is subject to a Sec. 382 annual limitation of $5 per year. In addition, use of Z's NOL carryover is subject to the separate return limitation year (SRLY) rules pursuant to Regs. Sec. 1. 1502-21(c). Based on the limitations on Z's NOL carryover, only $5 of the NOL can possibly be used unless Z has recognized built-in gain (i.e., $95 of the NOL carryover will definitely expire because of the Sec. 382 limitation).

Z has no taxable income or loss during 1996, so that even the available $5 of NOL cannot be used. Under the new regulations, at the end of 1996 (when Z's NOL carryover expires), Z will have a noncapital, nondeductible expense of $100. Thus, P's stock basis in Z will be reduced by $100, creating an ELA of $25. The ELA will be included in P's taxable income if the Z stock is disposed of, even though the P consolidated group never received a benefit from the $100 NOL.

The basis in a subsidiary will not be reduced for the expiration of a SRLY loss carryover if the subsidiary was acquired in a consolidated return year beginning before 1995 (Regs. Sec. 1.150232(h)14)). Note that this rule applies only to losses subject to the SRLY limitation. Because stocklineasis in a subsidiary is redetermined as if the new regulations had always been in effect, expired losses in prior years must be identified when determining basis in subsidiary stock. Thus, if a subsidiary incurred a loss during a consolidated return year or a non-SRLY separate return year (for example, in 1975), and the loss (including an NOL or capital loss) subsequently expired unused during a consolidated return year (for example, in 1980), the loss expiration is a noncapital, nondeductible expense that reduces the stock basis of the subsidiary because the loss was not incurred in a SRLY. SRLY and separate return year are defined in Regs. Sec. 1.1502-1.

An election

The new regulations provide limited relief from the result in Example 1. Regs. Sec. 1.150232(b)(4) generally permits the acquiring consolidated group to make an irrevocable election to treat all or part of a SRLY NOL carryover as expiring immediately before the acquired corporation becomes a member of the consolidated group (a deemed expiration). This election will not have any effect on the selling consolidated group. The result of the deemed expiration will depend on how the corporation is acquired.

If 80% of a corporation is acquired by purchase in a 12-month period (a qualifying transaction), the deemed expiration of the NOL carryover will not have any effect on the stock basis of any member of the consolidated group (other than acquired tiered corporations). However, if a corporation joins a consolidated group in a transaction that is not a qualifying transaction (a nonqualifying transaction), the deemed expiration will result in a reduction of the acquired corporation's stock basis immediately before it joins the consolidated group. if stock basis in a subsidiary is reduced below the subsidiary's allocable net asset basis as a result of the deemed expiration, a portion of the stock basis will be restored. Stock basis in the subsidiary is restored to the allocable portion of the subsidiary's net asset basis. The restoration of stock basis to the allocable portion of net asset basis effectively limits the reduction of stock basis as a result of a deemed expiration.

Example 2: Assume the same facts as in Example 1. If Z is acquired in a qualifying transaction and the P consolidated group elects to waive the entire $100 NOL carryover, the deemed expiration has no effect; none of the NOL is available for use. If the P consolidated group elects to waive $95 of NOL that will definitely expire unused because of the Sec. 382 limitation (unless Z has recognized built-in gain), the deemed expiration has no. effect. The expiration of the remaining $5 NOL carryover in 1996 will result in a noncapital, nondeductible expense of $5, thereby reducing P's basis in Z.

Alternatively, suppose Z is acquired in a Sec. 368(a)(1)(B) reorganization and P's basis in Z stock would otherwise be $75, pursuant to Sec. 362(b). The acquisition of Z is a nonqualifying transaction. The P consolidated group elects to waive the entire $100 NOL carryover. P's basis in Z is reduced immediately by the deemed expiration. However, P's basis in Z is restored to the allocable portion of Z's net asset basis. Therefore, P's basis in Z is reduced by $ 1 00 (the deemed expiration) and then restored to $10, the allocable net asset basis of Z. P's basis in Z is $10 when Z joins the P consolidated group. Compare this result to P's $25 ELA in Z at the end of 1996 if the P consolidated group makes no election to waive the SRLY NOL carryover.

Although the effect of the deemed expiration of a SRLY NOL carryover is relatively straightforward when only two corporations are involved, the effect of the deemed expiration is somewhat more complicated when tiers of corporations are involved.

Example 3: X owns all of the stock of Y; Y owns all of the stock of Z. X, Y and Z are all domestic corporations filing a consolidated return. X's only asset is the stock of Y, which has a basis of $40. Y's only asset is the stock of Z, which has a basis of $60. Z has one nondepreciable asset with a basis of $10. Z also has an NOL carryover of $100, which will expire in 1996.

P owns all of the stock of S and has a basis of $180 in the S stock. P and S are both domestic corporations and file a consolidated return. On Dec. 31, 1995, S acquires unrelated X for $75. As a result, X, Y and Z join the P consolidated group as of fan. 1, 1996. As a result of the acquisition of X, there is a Sec. 382 annual limitation on the use of Z's NOL of $5 per year. In addition, use of Z's NOL carryover is subject to the SRLY rules pursuant to Regs. Sec. 1.1502-21(c). Z has no taxable income or loss during 1996.

No election

If no election is made, at the end of 1996 (when Z's NOL carryover expires), Z will have a noncapital, nondeductible expense of $100. Thus, Y's stock basis in Z will be reduced by $100 and Y will have an ELA of $40 ($60 - $100) with respect to Z stock. Y's reduction in stock basis of Z is tiered up (Regs. Sec. 1.1502-32(a)(3)(iii)), so that X reduces its basis in Y by $100, creating an ELA of $60 ($40 - $100). The tiering up continues so that S reduces its basis in X by $100, creating an ELA of $25 ($75 - $100). P reduces its basis in S by $100 to $80 ($180 - $100).

Election - qualifying

transaction

If the P consolidated group elects to waive the entire $100 NOL, Z's NOL is deemed to expire immediately before X joins the P consolidated group. The deemed expiration is a noncapital, nondeductible expense for purposes of determining Y's basis in Z. Y's stock basis in Z is reduced by $100; however, Y's stock basis in Z is restored to the allocable portion of Z's net asset basis of $10. Therefore, Y's basis in Z stock as a result of the deemed expiration is $10.

Furthermore, Y's reduction in Z as a result of the deemed expiration is tiered up, so that X's basis in Y is reduced by $100. The restoration to Z's net asset basis is not tiered up. However, X's basis in Y is restored to the allocable portion of Y's net asset basis. Because Y's only asset is Z stock (which has a basis of $10), X's basis in Y is restored to $10.

As discussed, the deemed expiration has no effect in a qualifying transaction other than on acquired tiered corporations. Therefore, because X is acquired in a qualifying transaction, the deemed expiration has no effect on S's basis in X stock and has no effect on P's basis in S stock.

Election - nonqualifying

transaction

Suppose instead that S acquires X in a Sec. 368(a)(1)(B) reorganization and S's basis in X would otherwise be $75, pursuant to Sec. 362(b). If the P consolidated group elects to waive the entire $100 Z SRLY NOL in the nonqualifying transaction, the effect is generally the same as the qualifying transaction, except for one item. In a nonqualifying transaction, S's basis in its X stock is reduced for the deemed expiration. However, S's basis in X stock is restored to the allocable portion of X's net asset basis. Because X's only asset is Y stock (with a basis of $10), S's basis in X stock is $10. The deemed expiration has no effect on P's basis in S stock.

Summary

A side-by-side comparison on page 353 illustrates the differences in stock basis/ELA in Example 3, at the end of 1996.

The irrevocable election to waive all or part of an acquired corporation's SRLY loss carryover must be made in the consolidated group's return for the year the acquired corporation joins the group. The preamble to the new regulations states that the waived loss carryover cannot be identified using a formula. What a formula is for this purpose is not defined. it is possible that a formula may not include a waiver of all losses in excess of a specified dollar amount or an amount calculable as of the acquisition date. Observation: The new regulations require loss planning to occur before filing the first consolidated tax return that includes the acquired corporation. If the Sec. 382 limitation limits use of the SRLY loss carryover, it may be easier to determine if a portion of the loss carryover should be waived. Even in this case, however, circumstances may make the decision difficult (e.g., the presence of a net unrealized built-in gain or the possibility of reducing Sec. 382 limited loss carryovers under Sec. 108(b)).

             Consolidated Return Election Comparison

                           No         Qualifying      Nonqualifying
                         election     transaction     transaction

P's basis in S stock       $80          $180             $180
S's basis in X stock       (25)           75               10
X's basis in Y stock       (60)           10               10
Y's basis in Z stock       (40)           10               10