Tax Court reversed in Idaho First National Bank.

The Ninth Circuit recently reversed the Tax Court decision in Idaho First National Bank, 1993, rev'g 95 TC 185 (1990), on the "rehabilitation" exception to the built-in deduction rules of Regs. Sec. 1.1502-15.

Under Regs. Sec. 1.1502-15, "built-in deductions" are those corporate deductions or losses economically accrued in a separate return limitation year (SRLY), but recognized either in a consolidated return year or in a (non-SRLY) separate return year and carried over in the form of a net operating or net capital loss to a consolidated return year. The built-in deductions of a member are subject to limitations similar to those applying to net operating loss carryovers (or net capital loss carryovers) from SRLYs; i.e., the built-in deductions are deductible only to the extent of the member's own contribution to consolidated taxable income (or consolidated net capital gain).

Regs. Sec. 1. 1502-15(a)(2)(i) provides that the term "built-in deductions" does not include deductions or losses incurred in rehabilitating a corporation. Since 1982, however, the IRS's position, as expressed in GCM 38864, has been that only rehabilitation deductions and losses excluded from the definition of built-in deductions are those economically accruing in postaffiliation years. GCM 38864 further stated that rehabilitation deductions and losses were specifically excluded (in order to counter any argument that foreseeable deductions and losses were, in general, to be considered built-in deductions), citing as an example postacquisition expenses of fixing assets that have deteriorated prior to acquisition.

The Idaho First National Bank decision involved the ability of a bank holding company to benefit from a loss recognized on the sale of certain assets of a troubled bank subsidiary that had been acquired in a transaction assisted by the Federal Deposit Insurance Corporation. The Tax Court rejected the IRS's position and allowed the acquiring group to use the losses, on the grounds that the regulations specifically allow for the rehabilitation of a corporation notwithstanding that the expenses had economically accrued before the acquisition.

The Ninth Circuit's decision was based, in part, on the Service's assertion that Regs. Sec. 1.1502-15 should be construed by reference to the prior regulatory language, which had clearly excluded rehabilitation expenses that had not accrued in a separate return year from the definition of built-in deductions. According to the IRS argument, the 1973 modification to the regulations was merely a technical correction, and was not intended to result in a substantive change.

The Ninth Circuit's decision can be criticized for not following the clear and unambiguous language of a legislative regulation. Since the definition of a built-in deduction is limited to deductions or losses that accrue in an SRLY (and, accordingly no special rule is necessary for deductions or losses that accrue in a postaffiliation year), this decision effectively removes any exception for rehabilitation expenses. In addition, proposed regulations, which would conform the built-in deduction rules to those applicable to Sec. 382, do not contain an exception for rehabilitation expenses.