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Are the loss disallowance final regs. the final word?

In March 2005, the IRS issued long-awaited final regulations on the loss disallowance rules (LDRs) under Secs. 337 and 1502; see TD 9187. Contrary to expectations, they adopt the 2002 temporary regulations (which were set to expire March 7, 2005) without substantive change. The final rules generally apply to dispositions and deconsolidations after March 2, 2005.


Before 2001, the original LDRs disallowed a loss on the sale of a consolidated subsidiary's stock to the extent of:

* Positive investment adjustments;

* Extraordinary gain dispositions; and

* Duplicated loss.

In Rite Aid Corp., 255 F3d 1357 (Fed. Cir. 2001), rev'g 46 FedC1 500 (2000), the Federal Circuit held that the duplicated-loss factor was invalid, because it denied losses that would have been available to the taxpayer had it not filed a consolidated return.

In response, the IRS issued Temp. Regs. Sec. 1.337(d)-2T, which was much more taxpayer-friendly. Under that rule, a loss on a subsidiary stock sale is not disallowed to the extent that a taxpayer establishes that the loss is not attributable to the recognition of built-in gain (BIG) on an asset disposition. This "tracing methodology" essentially requires the taxpayer to trace each increase in stock basis attributable to gain recognition, to prove that it did not recognize any BIGs. (Gain recognized on an asset disposition is BIG to the extent attributable to any excess of value over basis, as reflected in the share's basis immediately before the asset disposition.) In effect, this version of the LDRs was limited to the "extraordinary gain" factor of the original rules, with certain modifications.

The IRS responded to the "duplicated loss" concern by promulgating Temp. Regs. Sec. 1.1502-35T, which was designed to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. Temp. Regs. Sec. 1.1502-35T(b)(1) and (2) require the basis of a subsidiary's stock to be redetermined immediately before a (1) disposition of a portion of that stock to a nonmember or (2) deconsolidation of the subsidiary, if any consolidated group member has a built-in loss (BIL) in subsidiary stock (except when the consolidated group disposes of all the subsidiary's stock during the tax year in a taxable transaction) . Temp. Regs. Sec. 1.1502-35T(b)(1) also requires taxpayers to suspend certain losses on subsidiary stock sales if the subsidiary remains a group member after the disposition.

The effect of the basis redetermination is to override the general rule of specific identification and to allocate the aggregate basis across all shares. It generally eliminates gains and losses on preferred stock and equalizes gains and losses on common stock, but may not necessarily eliminate all duplicated losses.

Since the enactment of Sec. 362(e) by American Jobs Creation Act of 2004 Section 836(a), questions have arisen about the continuing need for Temp. Regs. Sec. 1.1502-35T. Sec. 362(e) eliminates a net BIL on an asset transfer in certain nonrecognition transfers in the transferee's hands (absent a Sec. 362(e) (2)(C) election to reduce the transferor's stock basis instead).

Notice 2004-58

When the original LDRs were introduced in 1991 (TD 8364), the IRS insisted that tracing recognized BIGs, as a method of determining the amount of disallowed loss, would be completely unadministerable. Thus, taxpayers concluded that it would not be necessary to retain records to prove the BIG that existed at the time a subsidiary joined a consolidated group. Despite its earlier concerns, the IRS made tracing the backbone of the revised LDRs in the 2002 temporary regulations (TD 8984). However, after receiving comments on the difficulties of that method, it issued Notice 2004-58, which provided other methods for determining recognized BIG.

Under Notice 2004-58, a recognized BIG--and, thus, the disallowed loss--equals the least of the:

* Gain amount (the sum of all gains recognized on asset dispositions by the subsidiary while it was a consolidated group member);

* Disconformity amount (the excess of stock basis over asset basis, measured as a snapshot on the sale date); or

* Net positive investment adjustments, excluding distributions.

Gain: This factor presumes that all gains recognized during a subsidiary's fife as a consolidated group member are BIGs. While this presumption eliminates the administrative burden of tracing the BIGs recognized after the subsidiary joins the group, it may result in a larger disallowed loss than would occur under tracing. This is because the extraordinary gain under tracing is limited only to recognized BIG, while it captures gain recognized on assets purchased after the subsidiary joined the group.

Disconformity: The second factor allows a taxpayer to rely solely on "inside/outside basis differences" to determine disallowed loss. It is similar to the duplicated-loss factor in the original LDRs.

Net positive investment adjustments: The last factor is generally the same as the positive investment adjustments in the original LDRs, with some important modifications. While the original LDRs disallowed loss to the extent of all positive investment adjustments during a subsidiary's fife as a consolidated group member, Notice 2004-58 provides that only the net positive investment adjustments are taken into account, except for distributions. Thus, if the subsidiary's cumulative taxable losses exceed its cumulative taxable income, the net positive investment adjustment is zero under the notice. Under the original rules, the loss would have been disallowed to the extent of any positive investment adjustments during the subsidiary's life as a group member.

The preamble to the final regulations states that the Service will continue to accept the alternative methods for calculating disallowed loss prescribed in Notice 2004-58.

Future Guidance

In the preamble to the final regulations, the IRS noted that it is continuing to study comments received on the temporary regulations and the basis disconformity method, as well as on the repeal of the General Utilities doctrine in the consolidated return context. These issues are to be addressed in proposed regulations.

The final regulations are likely to be the most taxpayer-friendly LDRs that will be published. There is much speculation on future final guidance, including whether such rules might disallow not only losses on stock sales, but also losses on portions of stock basis when a subsidiary is sold at a gain. IRS officials have informally suggested that future guidance may provide only one method of calculating an allowable loss, eliminating the current flexibility of choosing among various methods. Consequently, taxpayers contemplating future dispositions of subsidiaries should be aware that the LDRs may change yet again.

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Author:Parker, Carrie
Publication:The Tax Adviser
Date:Jul 1, 2005
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