New consolidated investment adjustment rules may have significant effect on certain corporate acquisitions.

The long-awaited consolidated return investment adjustment regulations (Regs. Sec. 1.1502-32) were finalized last August and are effective for tax years beginning on or after Jan. 1, 1995. One of the negative adjustments to be made to a subsidiary's stock is for the subsidiary's loss carryovers (ordinary or capital) that expire during the year; see Regs. Sec. 1.1502-32(b)(3)(iii)(A). Although the new investment adjustment rules generally have retroactive effect for subsidiaries, the negative adjustment required for expiring losses will not apply to expiring separate return limitation year (SRLY) losses unless the subsidiary joins the consolidated group in a tax year beginning on or after Jan. 1, 1995 (Regs. Sec. 1.1502-32(h)(4)). Thus, this particular adjustment is prospective.

Regs. Sec. 1.1502-32(b)(4) introduces a new concept by which a loss carryover of a newly acquired subsidiary may be waived. If a subsidiary has an SRLY net operating loss (NOL) or capital loss carryover when it becomes a member of a consolidated group, the group may make an irrevocable election to treat all or a portion of the loss carryover as expiring immediately before the subsidiary joins the group. If the subsidiary was also a member of another consolidated group before joining the new group, this "deemed expiration" is considered as occurring immediately after the subsidiary leaves the previous group. The effect of the waiver of a loss carryover on the new subsidiary's stock basis depends on the type of acquisition. If the subsidiary was acquired in a single taxable transaction, there will be no effect. However, if the subsidiary is acquired in a tax-free transaction, its basis must be reduced (with certain limitations) immediately before it joins the acquiring group. Other rules apply when the loss relates to a lower-tier subsidiary of the acquired company.

The election to waive a loss carryover is irrevocable and must be filed with the consolidated return for the year of acquisition.

The waiver option can have a significant effect on acquisitions of companies with capital or NOL carryovers. At a bare minimum, the waiver option is another item to be added to the acquisition checklist and, depending on its importance, may cause the parties to change the transaction from a tax-free to a taxable one or from an acquisition of stock to an acquisition of assets.

There are several reasons why a company might waive the loss. A Sec. 382 limitation may apply or sufficient projected future income may not be generated during the remaining life of the SRLY loss carryover. It is important to remember that when a corporation joins a consolidated group it uses two years of the carryover period, an especially difficult result for capital loss carryovers, which only have a five-year carryover life.

The scenarios in which the rule must be considered seem endless. For example, if the target is a group of affiliated companies and the corporation with the loss carryover is a lower-tier company, the waiver would affect the basis of a higher-tier company in the target group. This higher-tier company may be one which the acquiring company plans to dispose of shortly after its acquisition. In this case, planning must occur before the acquisition to determine whether and how a restructuring could occur so that the basis of the stock of the higher-tier company will not be reduced.

In conclusion, the waiver rule must be considered in every acquisition of a loss carryover company. Careful analysis must include estimating future income during the carryover period and planning for the effect of the loss expiration.