Proposed loss disallowance regulations.

Proposed Loss Disallowance Regulations

Temp. Reg. [section] was issued on March 9, 1990, disallowing a loss recognized on the disposition of stock of a consolidated subsidiary on or after that date. This "loss disallowance rule" far exceeded the scope of the regulations taxpayers had been led to anticipate by Notice 87-14, which promised only to deny an increase in stock basis attributable to recognized built-in gains in order ot prevent circumvention of the repeal of the General utilities doctrine. Because the loss disallowance approach, unlike notice 87-14, required no appraisals, the regulations also applied without regard to when a subsidiary was acquired. This was as shocking to taxpayers as the scope of the regulations. The Notice had stated that the disposition of subsidiaries acquired before January 7, 1987, would be "grandfathered" under the forthcoming regulations. As it turned out, the rules contemplated by Notice 87-14 were promulgated as transitional regulations (Temp. Reg. [section] 1.337(d)-IT) applicable only to dispositions of subsidiaries at a loss before March 9, 1990.

The Treasury Department and the internal Revenue Service concluded that the loss disallowance rule was the only administrable approach for preventing circumvention of the repeal of General utilities and for preventing another concern not addressed in Notice 87-14 -- loss duplication. The government acknowledged, however, that losses attributable to overpaying for the stock or a decline in the value of a subsidiary's built-in gain assets should not be disallowed. Comments were invited on how such "economic losses" might be allowed without imposing heavy administrative burdens. After receiving wide-ranging comments, the government withdrew the March 1990 regulations on November 19, 1990, and replaced them with Prop. Reg. [section] 1.1502-20. The proposed regulations (CO-93-90) were reprinted at 1990-51 I.R.B. 20.

Prop. Reg. [section] 1.1502-20 retains the loss disallowance approach but provides relief for economic losses. having foregone substantial revenue by adopting an approach that has no effect on investment adjustments attributable to a subsidiary's built-in gains when the subsidiary is sold at a gain, not suprisingly the government's proposed relief for economic losses is narrow. The effective date of the modified loss disallowance rule was also delayed. The proposed regulations would apply to dispositions after january 31, 1991. Substantial changes also were made in the transitional regulations (Treas. Reg. [section] 1.337(d)-1 and Temp. Reg. [section] 1.337(d)-2T). These final and temporary regulations (T.D. 8319) were reprinted at 1990-51 I.R.B. 4.

This article briefly discusses the background of the loss disallowance regulations, explains the new rules, and explores various tax-planning ideas.

I. Background of Regulations

A. Government's Concerns

1. duplication of Loss. Since 1966, the consolidated return regulations have adjusted the basis of consolidated subsidiary ("S") stock to reflect S's earnings and profits and distributions in order to reduce duplications of gain or loss when a member of the consolidated group ("P") sells its S stock.

Two concerns caused the government to consider striking changes in the regulations. One, which was not caused by the filing of a consolidated return, involved unrealized losses when P sells S. The regulations do not eliminate the duplication of S's gain or loss after S leaves th P group. if S, for example, had an unrealized loss (or loss carryover) when P sold it, P's stock loss could be duplicated by S, subject to various restrictions on use of S's loss (or loss carryover), after S left the P group when S sold its assets (or S's loss carryover was absorbed). This duplication of loss would occur only if the S stock were sold by P before S sold its assets. Although any S gain also could be so duplicated, the government became concerned that duplication was a one-way street; taxpayers had the power to sell assets first to avoid duplication of gain, but sell stock first to duplicate loss.

If a holding company were used, stock losses based on S's loss might be multiplied by more than two taxpayers, if the stocks of the holding company and of S were sold from the "top down" before S sold its assets.

2. Avoidance of Tax on Built-In Gain

A. Recognition of Built-In Gain. The duplication-of-loss concern focused on S's unrealized loss when S left the P consolidated group. After the 1986 repeal of the General Utilities doctrine, the government became concerned with another matter -- when S joined the P consolidated group with unrealized ("built-in") gain. In connection with that repeal, section 337(d)(1) authorized Treasury to prescribe regulations to carry out the purposes of the amendments made by Subtitle D of Title VI of the Tax Reform Act of 1986, including regulations to ensure that the purposes may not be circumvented through the use of any provision of law or regulation (including the consolidated return regulations).

Soon after the 1986 legislation was enacted, the IRS announced in Notice 87-14 that regulations would be promulgated denying P stock basis for its S stock to the extent the basis was attributable to investmetn adjustments for recognized built-in gains. The investment adjustment rules had made it possible in certain situations for the P group to effectively dispose of built-in gain assets owned by S in a cost-basis transaction without a corporate level tax, thereby circumventing repeal of the General Utilities doctrine. As illustrated in Examples 4 and 5, this was possible because P's cost basis assets. investment adjustments attributable to built-in gain assets. Investment adjustments attributable to S's earning and profits derived from recognition of built-in gains would increase P's S stock basis without a corresponding increase in value. this would create a potential loss on the disposition of the S stock to offset S's recognized built-in gains.

Apparently because of the difficulties of retroactively appraising assets for older subsidiaries, Notice 87-14 stated that the regulations would not apply to the disposition of a subsidiary if it was acquired before January 7, 1987 (the date Notice 87-14 was released).

B. Conversion of Built-In Gain. In developing the regulations, the government officials became concerned that they had underestimated the scope of the problem when Notice 87-14 was released. specifically, they determined that the conversion of wasting built-in gain assets, as well as the recognition of built-in gain, was in conflict with the repeal of General Utilities.

3. Administrability. Having become convicted that the conversion of wasting built-in gain assets was a problem, the government concluded that the tracing of investment adjustments attributable to built-in gains contemplated by Notice 87-14 was not administrable.

B. March 9, 1990, Regulations

1. Loss disallowance Rule. On March 9, 1990, Temp. Reg. [section] 1.1502-20T was issued. it retained the present investment adjustment rules but disallowed any loss on the disposition by P of its S stock on or after March 9, 1990. The government acknowledged that not only would stock losses reflecting built-in gains and duplicated losses be disallowed, but true economic losses would be disallowed as well. Accordingly, the Preamble to the temporary regulations invited comments on how exceptions might be made to the loss disallowance rule for economic losses without imposing heavy administrative burdens.

2. Transitional Regulations. for a disposition of stock of a consolidated subsidiary before March 9, 1990, Temp. Reg. [section] 1.337(d)-IT disallowed any loss recognized on the disposition of such a subsidiary acquired after January 6, 1987, or any subsidiary that was a higher-tier subsidiary with respect to such "transitional subsidiary," except to the extent the taxpayer established that the loss was not attributable to the recognition of built-in gain. This loss limitation rule roughly reflected what had been annouced in Notice 87-14, except that it applied only to a loss subsidiary.

3. comments

a. Relief for Economic Losses. The March 1990 regulations drove a wedge between taxpayers with loss subsidiaries and those with gain subsidiaries. Some taxpayers proposed more focused rules for gain and loss subsidiaries that would provide symmetry with the treatment of unconsolidated affiliated groups. Other taxpayers argued for fairly narrow relief for economic losses within the framework of the loss disallowance rule (see Sheppard, Loss Disallowance Rule Encourages Creative Thinking -- A Lesson in Regulation Writing, 48 Tax Notes 120 (1990); Preamble to the November 1990 regulations).

b. Effective Date of Loss Disallowance Rule. Many taxpayers argued that the effective date of any loss disallowance rule, as modified to provide relief for economic losses, should be postponed because the regulatios would far exceed the scope of those contempated by Notice 87-14.

II. November 19, 1990, Regulations

On November 19, 1990, modified loss disallowance regulations were proposed in place of the March 1990 regulations. The most important modifications to the earlier regulations were to provide narrow relief for economic losses and to postpone the effective date to dispositions after January 31, 1991. Other important changes were made in the transitional rules.

A. Relief for Economic Losses

The general rule of the revised regulations still is to disallow a deduction for any loss recognized by a member of a consolidated group on the desposition of stock of a consolidated subsidiary (Prop. Reg. [sections] 1.1502-20(a)(1) and (2)). (5) To allow relief for economic loss, loss disallowance does not apply to stock of a subsidiary to the extent the loss exceeds a share's allocable part of the sum of (1) the aggregate earnings and profits resulting in positive investment adjustments and distributions from current earnings and profits (determined without regard to extraordinary gain dispositions described below) for all consolidated return years, (2) earnings and profits from certain extraordinary gains after November 18, 1990, net of directly related expenses, for all consolidated return years, and (3) the amount of duplicated loss (Prop. Reg. [section] 1.1502-20(c)(1)).

To reduce the possibility that the allowed stock loss would refect built-in gain, these rules assume that the earnings and profits resulting in aggregate positive investment adjustments for all taxable years (without reduction for net negative investment adjustments in other taxable years) are attributable to built-in gain. distributions of current earnings and profits are included in this factor because they do not eliminate the effect of recognized built-in gain.

Earnings and profits from extraordinary gains are distinguished from other earnings and profits to reduce the amount of recognized built-in gains that may be offset by recognized losses that were not built-in. Although such gains do not increase the basis of the S stock, they prevent post-acquistion losses from reducing the basis of the stock. An "extraordinary gain disposition" is a disposition, net of directly related expenses, after November 18, 1990, resulting in a gain for purposes of computing earnings and profits, of (1) a capital asset, (2) a section 1231 asset, (3) an asset described in section 1221 (1), (3), (4), or (5), if substantially all the assets in such category from the same trade or business are disposed of in one transaction (or series of related transactions), and (5) assets disposed of in an applicable asset acquisition under section 1060(c). Discharge of indebtedness income after November 18, 1990, also is treated as an extraordinary gain disposition (Prop. Reg. [section] 1.1502-20(c)(2)(i)). (6)

Except for the netting of earnings and profits from "ordinary income" with those from "ordinary and extraordinary loss" within the same taxable year (which is permitted for administrative convenience), these rules in effect assume that all income is attributable to built-in gain and all loss is attributable to post-acquisition loss.

This built-in gain factor includes earnings and profits attributable to prior consolidated groups, but only if these amounts continue to be reflected in the basis of the subsidiary's stock because the stock of the subsidiary was not acquired directly by purchase (Prop. Reg. [section] 1.1502-20(c)(2)(iv)(B)).

The duplicated loss factor is the excess of (1) the sum of the aggregate asset basis (other than basis of stock and securities that the subsidiary owns in another consolidated subsidiary), loss carryovers attributable to the subsidiary, and deferred deductions of the subsidiary, over (2) the value of the subsidiary's assets (Prop. Reg. [section] 1.1502-20(c)(2)(iii)). The value of the subsidiary's assets is assumed to be the sum of the value of the subsidiary's stock, any liabilities of the subsidiary, and "any other relevant items" (Prop. Reg. [section] 1.1502-20(c)(2)(iii)(B)). if the subsidiary has a lower-tier consolidated subsidiary, the lower-tier subsidiary's tax attributes and liabilities are included in the calculations (Prop. Reg. [section] 1.1502-20(c)(2)(iii)(B)). If 80 percent or more in value of the stock of a subsidiary is acquired by purchase in a single transaction (or in a series of relted transactions during any 12-month period), the value of the subsidiary's stock may be no greater than the purchase price of the stock divided by the percentage of the stock (according to value) so purchased (Prop. Reg. [section] 1.1502-20(c)(2)(iii)(B)).

To obtain the relief for economic los, a "statement of allowed loss" also must be filed with the taxpayer's return for the year fo the disposition. This statement requires information that will aid the audit of the transaction (Prop. Reg. [section] 1.1502-20(c)(3)).

The relief for economic losses is illustrated by Examples 7 through 9.

If loss would be disallowed upon disposition of stock of a subsidiary, a common parent may elect to reattribute to itself any portion of a loss carryover attributable to the subsidiary (or lower-tier subsidiary), so long as the amount reattributed does not exceed the amount that would be disallowed if the election were not made (Prop. Reg. [section] 1.1502-20(g)(1)). The common parent succeeds to the reattributed loss as if the loss were succeeded to on the day of the disposition in a transaction to which section 381 applies (Prop. Reg. [section] 1.1502-20(g)(1)). Any loss so reattributed is treated as absorbed by the subsidiary (or lower-tier subsidiary) immediately before the disposition for purposes of determining investment adjustments and earnings and profits. (Prop. Reg. [section] 1.1502-20(g)(3)). Thus, in Example 9, relief could be obtained from loss disallowance by reattributing $50 of S's $150 loss carryover to P. Because the loss carryover was subject to the separate return limitation year ("SRLY") restrictions of Treas. Reg. [section] 1.1502-21(c) and is treated as acquired under section 381, the loss may be offset by P's income but not by income of any other member of the P consolidated group (see Rev. Rul. 75-378, 1975-2 C.B. 355). The reattributed loss is treated as absorbed by P as a negative investment adjustment with respect to the S stock immediately before the disposition (see Treas. Reg. [section] 1.1502-32(b)(2)(iii)). This reduces the basis of P's S stock by $50 to $600, and P's stock loss is reduced by $50 to $500, all of which is allowed.

A loss carryover of a subsidiary may not be reattributed to the extent that the subsidiary and all higher-tier subsidiaries are insolvent (treating certain preferred stock as a liability) within the meaning of section 108(d)(3) at the time of the disposition (Prop. Reg. [section 1.1502-20(g)(2)).

B. Other Provisions

With minor changes, most of the other aspects of the March 1990 regulations were carried over to the November 19, 1990, regulations. In summary, these provisions, as modified, are as follows:

1. Single Entity Treatment of Gain and Loss. Loss disallowance does not apply to the extent gain is taken into account by members with respect to common stock of the same subsidiary that is sold to the same purchaser under a single plan (Prop. Reg. [section] 1.1502-20(a)(3)). Gain is taken into account with respect to shares on which loss is recognized under the plan in proportion to the amount of loss deduction that would have been disallowed if this rule did not apply (Prop. Reg. [section] 1.1502-20(a)(3)).

2. Anti Avoidance Rules

a. Basis Reduction on deconsolidation. The loss disallowance rule applies only to a disposition of stock of a subsidiary included in the consolidated group. To prevent avoidance of loss disallowance by deconsolidating a subsidiary before its stock is sold, the basis of P's S stock is reduced to its fair market value immediately before any S stock is deconsolidated (Prop. Reg. [section] 1.1502-20(b)(1)). The basis reduction is limited, however, to the extent the basis reflects built-in gain and duplicated loss, under the same assumptions used to distinguish between disallowed loss and allowable loss for dispositions (Prop. Reg. [section] 1.1502-20(c)). In addition, if P sells its S stock within two years after the deconsolidation, a statement must be filed with its return providing information that will aid in auditing the transaction (Prop. Reg. [section] 1.1502-20(b)(4)). If the statement is not filed, no deduction is allowed for any loss recognized on the disposition.

b. Successor in Interest. Prop Reg. [section] 1.1502-20 applies to any property the basis of which is determined by reference to the basis of P's S stock to the extent necessary to carry out the purposes of the regulations (Prop. Reg. [section] 1.1502-20(d)(1)).

c. Anti-Stuffing Rule. The proposed regulations contain an anti-stuffing rule to prevent the P group from avoiding loss disallowance by P transferring appreciated property to S after March 8, 1990, within two years of a direct or indirect disposition or deconsolidation of stock with a view to avoiding the disallowance of loss on the disposition or basis reduction on the deconsolidation of stock of S, or the recognition of the unrealized gain on the transferred asset (see Prop. Reg. [section] 1.1502-20(e)(1)). If the anti-stuffing rule applies, the basis of the S stock is reduced, immediately before the disposition or deconsolidation, to cause recognition of gain in an amount equal to the loss disallowance or basis reduction, or the gain recognition, otherwise avoided by reason of the transfer (Prop. Reg. [section] 1.1502-20(e)(2)).

3. Investment Adjustments and Earnings and Profits. For purposes of computing investment adjustments of P with respect to S and earnings and profits of P, any deduction that is disallowed or any amount by which basis is reduced under the proposed regulations is treated as an allowed loss (Prop. Reg. [section] 1.1502-20(f)(1)(i)).

The proposed regulations also provide that a basis reduction in the S stock under Prop. Reg. [section] 1.1502-20(b) is treated as a negative investment adjustment with respect to such stock under Treas. Reg. [section] 1.1502-32(e) (Prop. Reg. [section] 1.1502-20(f)(2)(iv)).

C. Postponed Effective Dates

Reflecting to some degree the comments filed on the March 1990 regulations, the effective date of Prop. Reg. [section] 1.1502-20 was postponed. Subject to special rules for certain binding contracts, the proposed regulations apply to dispositions and deconsolidations after January 31, 1991 (Prop. Reg. [section] 1.1502-20(h)(1)). For this purpose, transactions deferred under Treas. and Temp. Reg. [sections] 1.1502-13, 1.1502-13T, 1.1502-14, and 1.1502-14T are deemed to occur when the deferred gain or loss is taken into account unless the stock was deconsolidated before February 1, 1991. A consolidated group, however, may elect to apply Prop. Reg. [section] 1.1502-20 to all its members, in lieu of Temp. Reg. [section] 1.337(d)-2T described below, with respect to all dispositions and deconsolidations after November 18, 1990 (Prop. Reg. [section] 1.1502-20(h)(2)).

D. Transitional Rules

One of two transitional rules to Prop. Reg. [section] 1.1502-20 may apply to a disposition or deconsolidation of a consolidated subsidiary, depending on when the disposition or deconsolidation occurs.

1. Treas. Reg. [section] 1.337(d)-1. For dispositions after January 6, 1987, and before November 19, 1990, Treas. Reg. [section] 1.337(d)-1 denies a deduction for any loss recognized by a member on the disposition of stock of a "transitional subsidiary" (or any subsidiaries that are higher-tier subsidiaries to the transitional subsidiary), except to the extent the taxpayer establishes that the loss is not attributable to the recognition of built-in gain as distinguished from earnings and profits from the conversion of wasting built-in gain assets. A transitional subsidiary is any corporation that became a consolidated subsidiary after January 6, 1987. Treas. Reg. [section] 1.337(d)-1 roughly reflects what was announced in Notice 87-14, except that it applies only to a loss subsidiary. If stock of a transitional subsidiary was deconsolidated before November 19,1990, and the deconsolidated stock is not subject to Temp. Reg. [section] 1.337(d)-2T (described below), the subsidiary continues to be a transitional subsidiary and any loss on its disposition remains subject to Treas. Reg. [section] 1.337(d)-1 (see Treas. Reg. [section] 1.337(d)-1(a)(5), Ex. (1)(ii)).

2. Temp. Reg. [section] 1.337(d)-2T. For dispositions or deconsolidations after november 18, 1990, and before February 1, 1991, Temp. Reg. [section] 1.337(d)-2T carries over the principles of Treas. Reg. [section] 1.337(d)-1 but is applicable to all consolidated subsidiary stock (not just stock of transitional subsidiaries and higher-tier subsidiaries). Temp. Reg. [section] 1.337(d)-2T allows a consolidated group to establish that loss is not attributable to the recognition of built-in gain during consolidated return years, but only if the group's entire equity interest in the subsidiary is disposed of in one or more transactions to specified unrelated persons before the effective date of Prop. Reg. [section] 1.1502-20. For example, a stock loss recognized as a result of the stock becoming worthless between November 19, 1990, and January 31, 1991, would not be a disposition to such an unrelated person. If only a portion of the stock held by the group is timely disposed of, or it the stock is sold to a related party, during this period, the loss is simply disallowed. Taxpayers may elect, however, to apply the rules of Prop. Reg. [section] 1.1502-20, in lieu of Temp. Reg. [section] 1.337(d)-2T, in those situations.

Temp. Reg. [section] 1.337(d)-2T also contains a decondolidation rule and an anti-stuffing rule.

E. Deconsolidation of Group

The Preamble to the proposed regulations states that a revenue procedure would be forthcoming granting permission to deconsolidate a consolidated group as a consequence of the new rules. That revenue procedure--Rev. Proc. 91-11-- was issued on January 18, 1991. The revenue procedure, which will become effective on the date the proposed regulations are superseded by final regulations, generally applies to any consolidated group that filed (or was required to file) a consolidated return for the taxable year preceding the taxable year that includes November 19, 1990. to obtain permission, the group must file an applications with the National Office of the IRS before July 1, 1991, and each member must enter into a closing agreement with the IRS. Permission to discontinue filing consolidated returns will be effective for the taxable year that includes November 19, 1990.

The most important effects of deconsolidating area, as follows: (1) each member of the group will be treated as ceasing to be a member on the last day of the taxable year immediately preceding the taxable year that includes November 19, 1990, and an amended return must be filed for that year; (2) the members of the group are subject to all the usual consequences of deconsolidating, such as restoration of deferred gains, inclusion of excess loss accounts, and the application of Treas. Reg. [section] 1.337(d)-1 (discussed in Part II.D.1); and (3) except as provided in the revenue procedure, each former member of the group must file separate returns during the 60-month period following deconsolidation.

III. Tax-Planning Ideas

A. Avoiding Tax on S's Built-In Gains when S

Stock Is Not Sold at a Loss

The winners under the modified loss disallowance rule are taxpayers with gain subsidiaries. The rule has no effect when P has no loss on the sale of its S stock.

One fundamental tax planning idea, therefore, is to package a consolidated subsidiary, subject to the limitations of section 269 and the anti-stuffing rule of Prop. Reg. [section] 1.1502-20(e), to improve the likelihood that the stock of the subsidiary will be sold at a gain rather than a loss. The anti-stuffing rule of the proposed regulations applies only if the stuffing transfer is followed within two years by a direct or indirect disposition or a deconsolidation of stock. The two-year period is extended if the disposition is pursuant to an agreement, option, or other arrangement entered into within the two-year period. Subject to section 269 considerations, it may be possible to restructure potential loss subsidiaries with a long-term view (i.e., a view longer than two years) to avoiding loss disallowance.

B. Timing Loss Transactions to Minimize Built-In

Gain Factor of Relief for Economic Loss

As discussed in Part II.A, a deficit in earnings and profits may be used to reduce the amount of positive earnings and profits (except earnings and profits from extraordinary gain dispositions) assumed by the proposed regulations to be attributable to built-in gain, but only if the deficit is incurred in the same taxable year as the positive earnings and profits. For this reason, the disposition of loss assets of a potential loss subsidiary may be timed to shelter ordinary earnings and profits of a year that otherwise would be treated by the proposed regulations as being attributable to built-in gain.

C. Accelerating Effective Date of the November

19, 1990, Regulations

In the same vein, the netting rule, the reattribution rule, or other provisions of Prop. Reg. [section] 1.1502-20 may provide a better result than the transitional rules of Temp. Reg. [section] 1.337(d)-2T. The consolidated group is permitted to take advantage of Prop. Reg. [section] 1.1502-20, if it elects to accelerate the effective date of those regulations (see Prop. Reg. [section] 1.1502-20(h)(2)).

D. Using Intercompany Debt to Reduce Effect of

Loss Disallowance

Because Prop. Reg. [section] 1.1502-20 in effect disallows stock basis deemed to reflect built-in gain and duplicated loss, there is an incentive to shift stock basis to debt basis in certain situations.

E. Deconsolidating P Group to Take Advantage of

Separate Return Rules

Subject to any adverse effects of deconsolidating the P group, deconsolidating the group under Rev. Proc. 91-11 (see Part II.E.) may be desirable in order to take advantage of more favorable separate return rules. For example, the dividends-received deduction (DRD) might be used to avoid tax on S's built-in gains, subject to the limitations of section 1059. The 100-percent DRD prevents a parent from duplicating its unconsolidated subsidiary's affiliation-year income when the stock of the subsidiary is sold. To avoid double taxation, the dividend must be a "qualifying dividend" within the meaning of section 243(b)(1) entitling the parent to the 100-percent DRD, and the dividend must not be an "extraordinary dividend" that would result in a reduction in the basis of the subsidiary stock under section 1059.

Prior to 1988, section 1059 did not apply to dividends qualifying for the 100-percent DRD. Section 1059(e)(2), as amended in 1988, " clarifies" that such dividends do not qualify for relief, except as provided in regulations, to the extent they are out of earnings and profits attributable to built-in gain property. Those dividends result in a basis reduction if they also are either (1) part of a redemption in partial liquidation under section 1059(e)(1)(A) or (2) extraordinary under the rules of sections 1059(a) and (c).

Section 1059(e)(1)(A) requires that, except as provided in the regulations, when stock is redeemed in a partial liquidation (within the meaning of section 302(e)) of the subsidiary, any amount treated as a dividend for the redemption is treated as an extraordinary dividend without regard to the taxpayer's holding period for the stock. This provision is broader than its literal language suggests because the redemption requirement has been ignored for partial liquidation purposes if the distributing corporation is wholly-owned (see Fowler Hosiery Co. v. Commissioner, 301 F.2 394 (7th Cir. 1962); Rev. Rul. 81-3, 1981-1 C.B. 125).

Under sections 1059(a) and (c), a disqualifying dividend described in section 1059(e)(2) will be treated as extraordinary if the parent owned the subsidiary stock for less than two years before the dividend announcement date and the dividend equalled or exceeded a threshold percentage (10 percent for stock that is not preferred as to dividends) of the parent's adjusted basis for the stock. In addition, such dividends with ex-dividend dates during the same 365-day period are treated as extraordinary if the aggregate of the dividends exceeds 20 percent of the parent's basis in the stock. The fair market value of the stock is substituted for basis in testing extraordinary dividend status, if the parent can establish such value (section 1059(c)(4)).

Section 1059 is the mechanism for preventing unconsolidated affiliated groups from using the DRD to circumvent the repeal of General Utilities, and those rules may not be as restrictive as Prop. Reg. [secion] 1.1502-20. Consequently, P may have an incentive to deconsolidate the P group (see generally Goldman & Warner, May 29, 1990, Letter to Kenneth W. Gideon, reprinted as Tax Notes Doc. 90-4078; Freeman, Response to Loss Disallowance Rule: Partial Deconsolidation, 47 Tax Notes 1349 (1990)).

IV. Observations

The November 1990 regulations may mute much of the criticism the government received regarding the scope and effective date of the loss disallowance approach. Taxpayers who have only gain subsidiaries obviously are satisfied with this approach. The relief for economic losses, though narrow, also may win the support of many taxpayers with a mixture of gain and loss subsidiaries.

On the other hand, many taxpayers with loss subsidiaries have compelling complaints about the unevenness of the propose rules. They will question why the regualtions do not simply trace recognized built-in gains as contemplated by Notice 87-14. Most of the complexity of the tracing approach is caused by the government's controversial concerns about wasting built-in gains and loss duplication and by the retroactive application of the regulations without regard to when a subsidiary was acquired. Yet, in the name of simplification, the proposed regulations give virtually every benefit of the doubt to the government and to taxpayers with gain subsidiaries versus taxpayers with loss subsidiaries.

The validity of the loss disallowance approach presumably will be challenged on the ground it exceeds the proper scope of the consolidated return regulations. For example, it can be argued that unconsilidated groups can use the DRD to circumbent the General Utilities repeal and that the congressional response was to amend section 1059 in a way that requires the same tracing of built-in gains that the government considered unadministrable for consolidated groups (see Part III.E). For this reason, it is questionable whether the aim of the 1986 amendments described in section 337(d) is broader than the 1988 amendments to section 1059 that prevent using the DRD to circumvent General Utilities repeal. (8) Further, the concerns about loss duplication are not attributable to the filing of a consolidated return (see generally Goldman & Warner, May 29, 1990, Letter to Kenneth W. Gideon, reprinted as Tax Notes Doc. 90-4078). [9] As stated in the Preamble to the November 1990 regulations, the government's response is likely to be that symmetry with separate returns is not required because filing consolidated returns provides many benefits that are not available to corporations filing separate returns. In addition, Rev. Proc. 91-11 will provide consolidated groups an election to apply Notice 87-14 type rules (Treas. Reg. [section] 1.337(d)-1) if they are willing to deconsolidate for at least 60 months.

Although the final word on the validity of the loss disallowance approach, if adopted in final regulations, must await the judgment of the courts, the effective date provisions of the proposed regulations contain an intriguing hedge. The tracing-of-recognized-built-in-gains approach of Temp. Reg. [section 1.337(d)-2T technically would apply to dispositions or deconsolidations after November 18, 1990, "but only to the extent the disposition or deconsolidation is not subject to [section] 1.1502-20." In other words, the tracing approach by its terms would apply if the loss disallowance approach is held invalid.

In a broader sense, the proposed regulations may reflect the government's frustrations in attempting to prevent perceived abuses of the consolidated return rules in an era of scarce resources. The message for consolidated groups may be this: Be wary of the tax arrangements of others. If the government has its way, you will be paying for them.

(5) More precisely, loss disallowance applies to a disposition by a "member" of a "subsidiary." These terms refer to members of an affiliated group rather than to a consolidated group (see Treas. Reg. [section] 1.1502-1(a), (b), and (c) and Temp. Reg. [section] 1.1502-1T).

(6) Federal income taxes are not treated as directly related expenses that reduce the amount of earnings and profits from an extraordinary gain disposition unless rflected as negative investment adjustments with respect to the share and not reimbursed (Prop. Reg. [section] 1.1502-20(c)(2)(i)).

(8) Prior to the 1988 revision of section 1059, section 1059 was not intended to apply to a corporate shareholder receiving a dividend from a consolidated subsidiary (see Staff of Joint Comm. on Taxation, General Explanation of the Revenue Provision of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 140 (1984); Staff of Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 286 (1987)). The legislative history to the 1988 amendments to section 1059(e)(2)(B) supports the application of section 1059 to dividends paid by a consolidated subsidiary to its parent in a manner consistent with the treatment of an affiliated group filing a separate return (see S. Rep. No. 100-445, 100th Cong., 2d Sess. 44 (1988)).

(9) In the Preamble to the November 1990 regulations, it was implied that Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934), is the foundation of the consolidated return rules aimed at preventing the duplication of loss. This may be true of the 1966 consolidated return regulations, but that case does not readily support the November 1990 regulations. This is because Ilfeld Co. involved the duplication of loss by the same consolidated group. By contrast, the November 1990 regulations are concerned with duplication of P's stock loss after S leaves the P consolidated group.

JAMES C. WARNER is a partner in the Washington, D.C., law firm of Lee, Toomey & Kent and an adjunct professor at the Georgetown University Law Center. He holds B.A., J.D., and LL.M. degrees, and is also a certified public accountant. Mr. Warner specializes in consolidated returns and mergers and acquisitions, and is a former chair of the Subcommittee on Affiliated Group Acquisitions of the ABA Section of Taxation. He is a frequent lecturer before Tax Executives Institute, TEI Education Fund, and other professional organizations. Mr. Warner was formerly an attorney-advisor for the IRS Office of Chief Counsel and for Judge William M. Drennen of the United States Tax Court.