New elections available in wake of final consolidated return regulations.

The final intercompany transaction regulations released on July 12, 1995, and the final investment adjustment and related rules released on Aug. 12, 1994, introduced six new elections (four to be reviewed annually and two one-time elections) that should be considered before returns are filed.

Elections to Be Considered Annually

1. Regs. Sec. 1.1502-13 (f) (5) (ii)--Relief From Double Taxation Or Loss Disallowance In Certain Intercompany Stock Transactions: Double taxation may occur if a deferred gain exists with respect to stock. For example, the Sec. 332 liquidation of a subsidiary whose stock was previously sold intercompany at a gain triggers the gain (Regs. Sec. 1.1502-13(f) (7), Example (5) (b) ). Then, gain of the same amount may be reported when the former subsidiary's assets are sold by its parent, which acquired them with a carryover basis on the liquidation.

The same result can occur if the subsidiary is sold in a Sec. 338(h) (10) transaction, because such a transaction is deemed to be a Sec. 332 liquidation. The gain may also be taken into account if the subsidiary is distributed within the group pursuant to Sec. 355 (Regs. Sec. 1.1502-13(f) (7), Example (6)).

A different problem arises if there is an intercompany stock loss. As with deferred stock gain, a deferred stock loss is always triggered by a Sec. 332 liquidation or Sec. 338(h) (10) sale of the subsidiary, and is sometimes triggered by an intragroup Sec. 355 distribution. However, unlike a gain (which is reportable by the group when triggered), a stock loss is redetermined to be nondeductible by the regulations when it is triggered in one of these transactions; see Regs. Sec. 1.150213 (f) (7), Example (5) (c). Thus, the group never gets the benefit of the previously deferred stock loss.

Regs. Sec. 1.1502-13(f) (5) (ii) provides some elective relief from the double tax and loss disallowance problems. The extent of the relief varies, depending on the event that would cause the intercompany stock gain or loss to be taken into account. If the triggering event is a Sec. 332 liquidation (or similar transaction, such as a downstream merger), the intercompany stock gain or loss may continue to be deferred, if substantially all of the liquidated subsidiary's assets are transferred to a new subsidiary within a specified period (Regs. Sec. 1.150213(fl (5) (ii) (B) and -13(f) (7), Example (5) ). If the triggering event is a Sec. 338(h) (10) transaction (or similar transaction, e.g., a forward cash merger described in Rev. Rul. 69-6), the intercompany stock gain may be partially or wholly offset by a deemed stock loss created to mitigate the double tax problem (Regs. Sec. 1.150213(0 (5) (ii) (C)). However, no relief is provided for Sec. 338(h) (10) transactions triggering a previously deferred stock loss. If the triggering event is a Sec. 355 transaction, the intercompany stock gain or loss may continue to be deferred; however, additional intercompany stock gain or loss may result (Regs. Sec. 1.1502-13(f) (5) (ii) (D) and-13(fl(7),Example (6)(d)).

To obtain this relief, a consolidated group must make an election signed by the common parent and filed with the group's return for the year of the triggering event; a separate election must be made for each transaction for which relief is sought. The election must specify which provision of Regs. Sec. 1.1502-13(f)(5)(ii) applies end how it alters the otherwise applicable results.

This election generally applies only for intercompany stock gain or loss subject to the new intercompany transaction rules, i.e., gain or loss arising in tax years beginning after duly 11, 1995. However, a special one-time effective date election (election #5, below) permits similar relief for intercompany transactions subject to the former intercompany transaction regulations.

2. Regs. Sec. 1.1502-32(b)(4)--Waiver Of Loss Carryovers From Separate Return Limitation Years: In general, the final investment adjustment regulations provide that losses (including net operating loss (NOL) carryovers) of a subsidiary that expire unused are considered noncapital, nondeductible expenses that require a reduction in the owning member's basis in the subsidiary (Regs. Sec. 1.1502-32(b) (3) (iii) (A)). Regs. Sec. 1.1502-32(b)(4) allows an election that provides limited relief from this basis reduction, by permitting an acquiring consolidated group to treat all or part of an acquired subsidiary's loss carryover as expiring immediately before the subsidiary becomes a member of the group. This election does not affect a selling consolidated group's basis in the subsidiary. Its effect on the acquiring group depends on the type of acquisition.

If the subsidiary is acquired in a qualifying transaction (i.e., a purchase of at least 80% of its stock in a 12-month period), the deemed loss expiration does not cause a reduction in its stock basis or the stock bases of any higher-tier subsidiaries in the acquiring group. However, if the loss belongs to a lower-tier subsidiary of the acquired subsidiary, the deemed expiration causes the stock basis of the lower-tier subsidiary (and any intermediate subsidiaries) to be reduced.

In a nonqualifying transaction, the stock basis of the acquired subsidiary (and the bases of its lower-tier and intermediate subsidiaries if the loss belongs to a lower-tier subsidiary) is reduced by the deemed expiration, but the stock bases of any higher-tier subsidiaries in the acquiring group are not reduced.

In both qualifying and nonqualifying transactions, any required stock basis reduction is limited, so that the stock basis of a subsidiary after the reduction is not less than its net asset basis (i.e., asset basis plus loss carryovers not deemed to expire minus liabilities).

Making this election in a qualifying transaction prevents the unusable losses of an acquired subsidiary from causing a stock basis reduction, and limits the reduction for its lower-tier loss subsidiaries (or intermediate subsidiaries) to their net asset bases. For a nonqualifying transaction, making the election prevents a stock basis reduction for any higher-tier members of the acquiring group, and permits application of the net asset basis limitation.

This irrevocable election must be filed with the group's consolidated return for the year the subsidiary becomes a member, and it must be signed by the common parent and the subsidiary. The election statement must identify the amount of each loss carryover deemed to expire (or deemed not to expire), the basis of any stock reduced and the computation of the basis reduction.

3. Regs. Sec. 1.1502-31(e)--Waiver Of Loss Carryover Of Former Common Parent: Regs. Sec. 1.1502-31 (e) permits an irrevocable election to treat all (or any portion) of a loss carryover attributable to the common parent as expiring immediately before a group structure change. A group structure change is a transaction in which the common parent of a continuing group becomes a subsidiary, or transfers its assets to a subsidiary and dissolves. If this election is made, the stock basis of the former common parent (or its successor) is not reduced under Regs. Sec. 1.150232(b) (3) (iii) (A) by the waived losses, either at the time of the election or at the end of what would otherwise have been the normal carryforward periods for those losses.

This election must be filed with the consolidated return for the year that includes the group structure change and must be signed by both the former and new common parents. The election statement must identify the amount of each loss carryover deemed to expire (or deemed not to expire).

4. Regs. Sec. 1.1502-76(b) (2) (ii) (D)- Determination Of Items Included In Separate And Consolidated Returns: A consolidated return includes the common parent's items of income, gain, deduction, loss and credit for the entire consolidated return year, and each subsidiary's items for the portion of the year the subsidiary is a member of the consolidated group. If a subsidiary joins or leaves a consolidated group on a date other than its normal year-end, the subsidiary's income must be allocated between the period before joining (or leaving) the group and the period after joining (or leaving) the group.

Regs. Sec. 1.1502-76(b) (2) contains rules for allocating the income and deductions of a subsidiary when it joins or leaves a consolidated group In general, the allocation is based on a closing of the books, with items divided between two periods that are treated as separate tax years.

The election provides an alternative under which items are allocated ratably--except for extraordinary items, which are allocated to the day on which they arose. Generally, extraordinary items are nonoperating income or deductions, including capital and Sec. 1231 gains or losses, gains or losses from bulk sales of noncapital assets, gains or losses from the sale of a trade or business, NOL carryovers, Sec. 481 adjustments, debt discharge income, certain compensation-related deductions, Sec. 304 dividends, certain tax credits, and items determined by the IRS to be income-distortive if ratably allocated.

This election must be signed by the subsidiary and the common parent of each affected consolidated group, and must be filed with the returns including the items for the years ending and beginning with the subsidiary's change in status. The election statement must identify the extraordinary items, the ratably allocated items and the allocation of each item, along with the name and employer identification number of each affected group's common parent. The election is not available if the subsidiary is required to change its tax year-end or accounting method as a result of its acquisition or disposition.

One-Time Elections

5. Regs. Sec. 1.1502-13(1)(3)--Retroactive Election To Apply The New Intercompany Regulations To "Stock Elimination Transactions": As discussed earlier, limited elective relief from double taxation is provided under Regs. Sec. 1.1502-13(f) (5) (ii), if stock of a company previously sold in an intercompany transaction is liquidated under Sec. 332 or deemed liquidated under Sec. 338(h) (10). This double taxation problem was also present under the former intercompany transaction regulations, but those regulations contained no relief provision. Beyond the double taxation problem, there was the potential under the former regulations of prematurely triggering intercompany stock gains by means of an intragroup merger or spin-off; see former Regs. Sec. 1.150213(f) (1) (vi). The new regulations avoid this potential by providing successor and multiple intercompany transaction rules under Regs. Sec. 1.1502-13(j).

The general effective date rule of Regs. Sec. 1.1502-13(1)(1) provides that the former regulations continue to determine the reporting of intercompany items from transactions that occurred in tax years beginning before July 12, 1995, even if the triggering event occurs on or after that date. However, Regs. Sec. 1.150213(1) (3) provides a one-time election to apply the new regulations to all intercompany stock gains and losses incurred in pre-July 12,1995 tax years, if the triggering event occurs on or after that date and is a stock elimination transaction (i.e., an actual or deemed cancellation/redemption of the stock (e.g., under Sec. 332 or 338(h)(10)), a distribution of the stock, or an exchange of the stock for member stock).

Making the Regs. Sec. 1.150213(1) (3) election permits a consolidated group to elect relief from double taxation under Regs. Sec. 1.150213(f) (5) (ii) and to avoid premature triggering of stock gains by application of Regs. Sec. 1.1502-13(j). Note, however, that this one-time election also subjects intercompany stock losses incurred under the former regulations to the new regulations, which may cause losses that would otherwise be allowable to be disallowed (see the discussion under election #1).

The election under Regs. Sec. 1.1502-13(1) (3) is made by the common parent of a consolidated group with its timely filed original return (including extensions) for the tax year that includes July 12,1995. If the group also chooses to make an election under Regs. Sec. 1.1502-13(f) (5) (ii), the procedure discussed earlier should be followed (see election #1) .

6. Regs. Sec. 1.1502-33(d) (5) (ii) (B)--Election To Conform Tax Allocations For Subsidiary Stock Basis And Earnings And Profits Adjustments: Regs. Sec. 1.1502-33 provides rules for adjusting the earnings and profits (E&P) of a subsidiary and any member owning the subsidiary's stock. One item affecting the calculation of E&P is the allocation of Federal income tax among members of a consolidated group under Sec. 1552 and Regs. Sec. 1.1502-33(d). Ordinarily, once a tax allocation method under these provisions has been adopted by a group, it cannot be changed without IRS consent; see Rev. Proc. 90-39. However, because the new investment adjustment rules mandate a specific tax allocation method for subsidiary stock basis adjustments under Regs. Sec. 1.150232(b) (3) (iv) (D), groups are permitted a one-time election to conform their E&P tax allocation to this method without consent (Regs. Sec. 1.150233(d) (5) (ii) (B) ). This election offers a choice between conforming the allocation only for years beginning after Dec. 31, 1994, or conforming it as if the method had been in effect for all prior years.

This election must be signed by the common parent and must be attached to the consolidated group's return for the first tax year beginning after Dec. 31,1994. The election statement must indicate whether the method has been conformed only for years beginning after Dec. 31, 1994, or as if the method had been in effect for all prior years. Absent this election, the method effective for the last tax year beginning before Jan. 1, 1995 remains in effect. The statement must also describe any adjustments made necessary by the method change to prevent amounts from being duplicated or omitted. Making this election will obviate the use of two separate Federal income tax allocations.

FROM STEVEN K. RAINEY, CPA, AND RICHARD F. YATES, J.D., WASHINGTON, D.C.