Temp. regs. limit duplicative stock losses.
In March 2003,Treasury issued final, temporary and proposed regulations to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. (1) These regulations are a multifaceted response to the government's judicial defeat in Rite Aid Corp., (2) as well as concerns about tax-shelter type transactions that were reportedly implementing loss-duplication strategies. The new rules add to the confusion resulting from the IRS's concession that the loss-duplication rule in Regs. Sec. 1.1502-20(c) is invalid. This article is designed to highlight some of the fundamental concepts of these highly complex rules.
In Rite Aid, the Federal Circuit held that the "duplicated loss" provisions of the loss-disallowance rules (LDR) in Regs. Sec. 1.1502-20 (-20) were an invalid exercise of rulemaking authority. On March 7, 2002, in response to this judicial defeat, Treasury issued temporary loss-disallowance regulations which addressed whether, and the extent to which, a loss on the sale of a consolidated subsidiary's stock will be allowed. Unpredictably, these rules were written under Temp. Regs. Sec. 1.337(d)-2T (-2T), and not -20, as expected. Until March 7, 2002, the -2T regulations allowed consolidated groups to calculate an allowable loss on the sale of a subsidiary's stock by (1) applying -20 in its entirety, (2) electing to apply a -20 "lite" version without the duplicated-loss factor or (3) electing to apply the new -2T regulations. After March 7, 2002, the -2T regulations (not the -20 regulations) would govern the allowability of losses.
Because the -2T regulations only addressed loss disallowance and not loss duplication, the IRS also issued Notice 2002-18. (3) The notice revealed that additional regulations would be forthcoming to prevent a consolidated group from duplicating losses by means of certain "stuffing" and disposition transactions. On Oct. 18, 2002, to complete its regulatory promise, the IRS issued proposed regulations under Regs. Sec. 1.1502-35 to deal with tax-shelter-type transactions in which the same consolidated group could derive a double benefit from a single economic event. On March 11,2003, to meet the deadline requirements for temporary and final regulations, the IRS issued Temp. Regs. Sec. 1.1502-35T (-35T).
The primary thrust of the -35T regulations is to address the following two IRS concerns:
1. A group absorbs an inside loss of a subsidiary member; then, a group member recognizes a loss on a disposition of the subsidiary's stock that is duplicative of the inside loss.
Example 1: In year 1, P Corp., a group member, forms wholly owned S Corp. with a contribution of $80 for 80 shares of S common stock (CS1). In year 2, P contributes Asset A, with a basis of $70 and a fair market value (FMV) of $20, to S for an additional 20 shares of S common stock (CS2). In year 3, S sells A and recognizes a $50 loss, which offsets P's income on the group's consolidated return. Under the investment-adjustment rules of Regs. Sec. 1.1502-32, P's basis in its S stock is reduced by a pro-rata share of the $50 loss; thus, CS1's basis is $40 and CS2's basis is $60. In year 4, P sells the CS2 shares for $20 and recognizes a $40 loss, which offsets P's income on the group's return. As a result of this transaction, the group has obtained a $90 tax benefit from the single $50 economic loss.
2. A group member recognizes a loss on a disposition of subsidiary-member stock that is duplicative of the subsidiary member's inside loss, the subsidiary remains a group member and the group subsequently recognizes the subsidiary member's inside loss.
Example 2: In year 1, P Corp. forms S Corp. with a contribution of $80 for 80 shares of S common stock (CS1). In year 2, P contributes Asset A, with a basis of $50 and a FMV of $20, to S for an additional 20 shares of S common stock (CS2). In year 3, P sells the 20 shares of CS2 for $20 and recognizes a $30 loss, which offsets P's income on the group's consolidated return. The sale of the CS2 does not result in S's deconsolidation. In year 4, S sells Asset A and recognizes a $30 loss, which also offsets P income on the group's return. Similar to Example 1, above, the group has obtained two tax losses from a single $30 economic loss.
To address the two concerns above, and to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss, the -35T regulations create two primary rules--a basis-redetermination rule (BRR) and a loss-suspension rule (LSR).
These new regulations provide a set of ordering rules; according to -35T(b)(6), the BRR must be examined before exploring the consequences of the LSR. Both of these rules are only applied after any required alterations are made under the investment-adjustment rules of Regs. Sec. 1.1502-32 (-32). Finally, Temp. Regs. Sec. 1.337(d)-2T must be applied after -35T.
The BRR, which is a direct response to concern 1 above, attempts to equalize the members' tax bases in a subsidiary's stock on the occurrence of certain events. The BRR is necessary because the -32 investment-adjustment rules are generally blind as to the source of a stock's basis amount and some taxpayers manipulate the basis assigned to a particular stock. Accordingly, a subsidiary's basis must be redetermined immediately before the disposition of a member's stock. The BRR will not apply unless the subsidiary's stock has a basis that exceeds its value and there is a disproportionate basis in more than one block of stock. Further, the BRR will not apply if all of the subsidiary's stock is sold in one or more fully taxable transactions within a single tax year, because the group will be unable to derive a double tax benefit or accelerate a loss.
When the BRR applies, the convention for accomplishing the redetermination depends on whether the (1) subsidiary remains a member of the group or (2) disposition causes a deconsolidation of the subsidiary. If the subsidiary remains a group member, all group members must aggregate their bases in the subsidiary's stock; the combined total is then reapportioned to each block of stock in an equalizing adjustment. If the subsidiary is no longer a group member (due to a deconsolidation after the stock disposition), a special basis adjustment is made to the members who still retain the subsidiary's stock. Each of these actions is discussed below. (4)
Nondeconsolidating dispositions: If stock of a subsidiary member (with a basis exceeding its value) is exchanged, and the subsidiary member remains a group member, the BRR applies. According to -35T(b)(1), all of the members' bases in the subsidiary member's stock immediately before such transfer are aggregated. Once aggregated, the basis is proportionately allocated to the subsidiary member's preferred stock. The allocation cannot exceed the value of the preferred stock--consequently, a preferred stock disposition cannot result in loss recognition. Any remaining basis is allocated to the subsidiary member's common stock held by group members immediately before the transfer in proportion to such shares' value.
Example 3: In year 1, P Corp. creates S Corp. by contributing $80 for 80 shares of common stock (CS1) and land with a FMV of $20 and an adjusted basis of $30 for 20 shares of preferred stock (PS1). P and S file consolidated returns. The transaction qualifies under Sec. 351; P's basis in CS1 becomes $80 and its basis in PS1 is $30. In year 2, P sells PS1 outside of the group for $20. Because P's basis in PS1 exceeds its FMV immediately prior to the sale and S is a member of the P group immediately after the sale, all of P's bases in S stock must be redetermined. P's aggregated basis totals $110; $20 is first allocated to PS1 (FMV on the date of sale) and the remaining $90 is allocated to CS1. Thus, under the BRR, P's sale of PS1 results in zero loss recognition.
This example demonstrates that, without the BRR, the group could have recognized an immediate loss on the sale of PS1, and, at a later time when S sold the land, the group might have recognized a second tax benefit. As it stands, the BRR neutralizes the loss on the sale of PS1. The $10 economic loss inherent in the land remains inside the group and will be available for recognition whenever P disposes of CS1 or S sells the land.
An interesting phenomenon seemingly occurs whenever multiple blocks of common stock are used in lieu of preferred stock. As indicated above, no gain or loss can be recognized on a later sale of preferred stock (after a -35T(b)(1) adjustment), due to the "value ceiling" for basis adjustments. However, if P in Example 3 above, had received 20 shares of common stock (CS2) for the land, instead of PS1, the redetermined basis of the 20 CS2 shares would be $22 ($110 X 20%). Thus, on a subsequent sale of 20 CS2 shares for its FMV of $20, P could recognize a S2 loss; however, -35T(c) (discussed below) contains a rule that will suspend any P losses on the sale of CS2.
Deconsolidating dispositions: If the transfer or exchange of a subsidiary member's stock results in a deconsolidation of that member, and any share the group owns has a basis in excess of FMV, the BRR of -35T(b)(2) applies. A different BRR needs to be employed, because the subsidiary is no longer a group member, and any members that retain stock in that subsidiary are no longer bound by the consolidated return regulations after the deconsolidation. To accommodate this condition, -35T(b)(2) requires that, for all shares of a subsidiary member's stock held immediately before the deconsolidation, a special basis adjustment be made to the basis of every share that a member owns in the subsidiary's stock. This special adjustment is known as the reallocable basis amount (RBA); it equals the lesser of:
* The aggregate loss in the loss shares of the subsidiary's stock owned by members; and,
* The total of the subsidiary's deductions and losses allocated under -32 to its "non-loss" shares owned by the members.
Once determined, the basis of each share of the subsidiary's stock owned by members is adjusted by the RBA immediately before the deconsolidation, in the following order:
1. To the basis in each loss share owned by members of the group (but not below its FMV), in a manner that unifies (to the greatest extent possible) the basis-to-value ratio in all shares. Such a reduction cannot exceed the RBA.
2. The preferred stock basis is next increased by the RBA, but not in excess of its FMV. The basis adjustment is also done in a manner that unifies (to the greatest extent possible) the basis-to-value ratio in all shares.
3. Any remaining RBA is finally allocated to the common stock basis in a manner that unifies (to the greatest extent possible) the basis-to-value ratios.
Example 4: In year 1, P Corp. creates S Corp. by contributing $50 for 50 shares of common stock (CS1) and land with a FMV of $50 and an adjusted basis of $80 for 50 shares of common stock (CS2). P and S file consolidated returns. The transaction qualifies under Sec. 351, so that P's basis in CS1 is $50 and $80 in CS2. In year 2, S sells the land for $50, recognizing a $30 loss. Under the rules of -32, the CS 1 basis is reduced by $15 to $35 and the CS2 basis is reduced by $15 to $65. In year 3, P sells CS2 outside of the group for $50, causing S's deconsolidation. Because P's basis in CS2 exceeds its value, and because the sale of CS2 caused S's deconsolidation, P's basis in the S common stock must be redetermined under -35T(b)(2).The RBA is $15 (the lesser of $15, the built-in loss inherent in the CS2 owned by P immediately before the deconsolidation, and $15, the total deductions allocated to the "non-loss" stock (CS1) under -32). Consequently, immediately before the disposition, the CS2 basis must be reduced by $15, resulting in zero gain or loss ($50 sales price--$50 adjusted basis ($65-$15)). The basis in CS1 is increased by $15, resulting in a $50 basis (equal to its FMV).
Once again, the BRR neutralized the potential for a $30 duplicated loss created by the contribution of land to S and the reduction in the CS2 basis. Further, the result appears to be logical, because the P group received the tax benefit of the $30 economic loss when it sold the land; any further losses attributable to the sale of stock would only be duplicative in nature.
The LSR is the other primary rule found in -35T; it effectively disallows a stock loss if the economic loss giving rise to it can later be reflected on the group's consolidated return. The rationale for this rule is to eliminate the situation illustrated earlier under concern 2.The LSR is carried out through a series of operating rules that serve to suspend the loss, reduce it and then allow it to be deducted.
Suspending the loss: If a group member recognizes a loss on the disposition of a subsidiary's stock after application of the BRR, and the subsidiary member remains in the group after the disposition, the stock loss is suspended under the LSR to the extent of the duplicated loss on the subsidiary's stock. This definition of a duplicated loss is substantially identical to the one in former Regs. Sec. 1.1502-20(c), except that the other member's securities are not excluded from the computation of the subsidiary's aggregate asset basses. (5)
The loss is suspended until certain circumstances (discussed below) occur to either reduce or allow the deferred amount. Further, -35T(c)(3) treats the suspended loss as a noncapital, nondeductible expense incurred by the subsidiary for purposes of applying -32. Consequently, the basis of a higher-tier member's stock must be reduced by the suspended loss in the year suspended.
Example 5: In year 1, P Corp. forms S1 Corp. with a contribution of $200 for all of S1's common stock. In the same year, S1 forms S2 Corp. with a contribution of $80 for 80 shares of S2 common stock. P, S1 and S2 file a consolidated return. Also in year 1, S2 purchases Asset A for $80. In year 2, pursuant to Sec. 351, S1 contributes Asset B with a basis of $50 and a FMV of $20 for 20 shares of S2 common stock. In year 3, S1 sells the 20 shares of S2 for $20; S2 is still a member of the P group immediately after the sale. Because S1's basis in S2 exceeds its FMV immediately prior to the sale and because S2 is still a group member immediately after the sale, the BRR applies first.
Of S1s aggregated $130 basis in S2 stock, a proportionate reallocation is made to each of the 100 shares of S2 stock. Accordingly, $26 (20% x $130) is allocated to the S2 stock sold and $104 (80% X $130) is allocated to the S2 stock retained. On S1's sale of the S2 stock for $20, S1 recognizes a loss of $6 ($20-$26). Given that the S2 stock sale does not result in S2's deconsolidation, any loss will be suspended to the extent of loss duplication. The duplicated loss as to the shares sold is $6 (20% x ($130-$1(100)); thus, the entire $6 loss is suspended. Further, because the suspended loss is treated as a noncapital, nondeductible expense incurred by S1, P's basis in its S1 stock is reduced from $200 to $194.
The new regulations also include a substitute asset rule that suspends a member's loss recognized on an asset disposition (other than of a member's stock) when the member's basis in the disposed asset was determined by reference to a member's basis in stock for which there was a duplicated loss, and immediately after the disposition, the subsidiary is a group member. (6)
Reduction of the suspended loss: In line with the LSR model, suspended losses are reduced as the subsidiary's deductions and losses are taken into account in determining the group's consolidated taxable income. Because the group has been allowed to take the subsidiary's deductions and losses as they are recognized, any duplicated losses inherent in the subsidiary's stock should be eliminated.
Example 6: The facts are the same as in Example 5. In year 4, S2 sells Asset B for $45, recognizing a $5 loss. The $5 loss is absorbed in the P group's consolidated return. As a result, there needs to be (1) a basis adjustment to the S2 stock and (2) a reduction in the suspended loss account. Pursuant to -32, $4 of the $5 loss (80%) must be taken into account to reduce S1's basis in S2 from $104 to $100. P's basis in S1 stock is also reduced by $4, from $194 to $190.The suspended loss reduction is $1, representing the recognized loss ($5) over the basis actually reduced under -32 by the P group. Thus, the suspended loss is reduced from $6 to $5.
Under an important rebuttable presumption in -35T(c)(4)(i), all deductions and losses are first attributable to the duplicated loss that gave rise to a suspended stock loss. However, to the extent that a taxpayer can establish (via tracing) that any deductions or losses are not reflected in its suspended stock losses, it will not have to reduce its suspended loss account. Thus, in Example 6 above, if S2 could establish that the $5 loss arose from the sale of recently acquired asset C, the suspended loss would still remain at $6.
Allowable suspended stock loss: When a subsidiary leaves a consolidated group, the regulations provide that the remaining suspended loss is permitted to the extent otherwise allowable. The loss is included for the consolidated return year that includes the last day that the subsidiary was a group member. To claim a suspended loss, -35T(c)(5)(iii) requires that a separate statement be filed with the taxpayer's return for the year in which the loss is allowable. The statement must be entitled "ALLOWED LOSS UNDER Reg. [section] 1.1502-35(c)(5)" and contain the name and employer identification number of the subsidiary, the stock of which gave rise to the loss.
Example 7: The facts are the same as in Example 6. In year 5, S1 sells its remaining S2 common stock for $100. Because S1's basis in its remaining S2 stock is $100, it recognizes no gain or loss. Further, now that S2 is no longer a group member, any remaining suspended loss in the S2 stock will be allowed on the P group's year 5 return. Accordingly, the P group will be allowed a $5 loss and the appropriate statements must be attached to its year 5 return.
The BRR and Economic Loss Disallowance
The IRS added a BRR under -35T(f) because certain events (such as worthlessness or insolvency) could allow a subsidiary to cease to exist in a taxable transaction, but allow a portion of the group's consolidated net operating or capital loss to remain with the group. (7) When the current regulations were first proposed in October 2002, some commentators felt that a group could be denied even a single tax deduction for a true economic loss.
Example 8: P Corp. forms S Corp. with $20 for all of S's stock and S borrows $24 from a lender. S loses $30, none of which is used to offset the group's income and thus becomes a $30 consolidated net operating loss (CNOL) carryover. P discontinues S's operations and the lender forecloses on the note, taking the remaining $14 of S's assets. Under Sec. 108(a), S may exclude its $10 of debt cancellation; but, under Sec. 108(b), S must reduce its share of the CNOL from $30 to $20. Taking into account the excluded debt cancellation and CNOL reduction will cause no net change to P's basis in S's stock. If P then dissolves S, the dissolution does not qualify as a liquidation under Sec. 332 and P does not succeed to the remaining $20 CNOL attributable to S. Further, under the proposed regulations, P must reduce its basis in its S stock as if the $20 CNOL carryovers were absorbed. Consequently, instead of being allowed a $20 worthless stock deduction, P's entire $20 economic loss will be disallowed.
The temporary regulations address this situation by providing in -35T (f)(1) that unabsorbed losses generated by the subsidiary do not remain available to the group. In other words, these loss carryforwards are expired, but not absorbed by the group, as of the beginning of the group's subsequent tax year following worthlessness. Thus, in Example 8 above, P will no longer have to reduce its basis in S as if the $20 CNOL had been absorbed--the $20 worthless stock deduction would be allowed. Moreover, because the loss has expired, there is no possibility of a later duplicative use of the CNOL carryforwards.
Situations similar to Example 8 also led taxpayers to fear that the LSR might be applied to permanently disallow deductions for economic losses outside of insolvency or worthlessness. Accordingly, the temporary regulations provide that (1) the LSR (as discussed earlier) is limited in the amount of its reduction and (2) under -35T(c)(8), the LSR is not to be applied in a manner that permanently disallows a deduction for an otherwise allowable economic loss.
The rules of -35T(g) share the IRS's concern that, in certain cases, taxpayers may structure transactions to avoid the application of the BRR and LSR in a manner not consistent with the purpose and intent of the regulations. Noteworthy situations include:
* Shares of subsidiary stock (with a basis no lower than FMV) deconsolidated to avoid the BRR;
* Tax-free transfers of loss property to avoid the BRR or LSR;
* Transactions structured to avoid gain by invoking the application of the BRR; and
* Subsidiaries sold at losses that are "reimported" within 10 years of deconsolidation.
The temporary regulations generally apply to events occurring after March 6, 2002, and no later than March 11, 2006, but only during a tax year for which an original return is due after March 14, 2003 (excluding extensions). The reimportation prohibitions apply to reimporting events that occur after Oct. 17, 2002 and no later than March 11, 2006.
The new -35T regulations continue a stop-gap approach to the loss-disallowance dilemma that has not completely addressed all of the issues embedded in the investment-adjustment rules.
As the -35T rules came to press, the IRS acknowledged they are continuing to study the comments received on the proposed regulations--including, among other things, an application of Sec. 704(c) principles embedded in loss disallowance. Moreover, Treasury is considering alternative regimes that would prevent the duplication of loss within a group's structure. If these studies become prognostications of additional guidance, the already lengthy history of loss disallowance will become an even murkier quagmire.
(1) TD 9048 (3/14/03); Temp. Regs. Sec. 1.1502-21T, -32T and -35T,
(2) Rite Aid Corp., 255 F3d 1357 (Fed. Cir. 2001), reh'g den,
(3) Notice 2002-18, 2002-1 CB 644.
(4) The temporary regulations also include a look-through rule that applies the BRR to stock of lower-tier subsidiary members when there is a disposition or deconsolidation of a higher-tier member's stock. Situations involving these transactions are beyond the scope of this article.
(5) Temp. Regs. Sec. 1502-35T(d)(4) defines a duplicated loss as the excess of (1) the sum of the aggregate bases of the subsidiary member's assets (excluding stock in other subsidiary members of the group), the subsidiary member's losses corned to its first tax year after the disposition and the subsidiary member's deductions recognized but deferred under another provision, over (2) the sum of the value of stock of the subsidiary member and the subsidiary member's liabilities taken into account for tax purposes.
(6) See Temp. Regs. Sec. 1.1502-35T(e), Example 6, for a detailed discussion.
(7) The LSR only applies if there has been a disposition of a member's stock and the subsidiary remains a group member immediately after the disposition.
* Temporary regulations address duplicative losses that occur when a group absorbs a subsidiary's inside loss and a group member recognizes a loss on the subsidiary's stock.
* Two primary rules prevent duplicative losses--the BRR and the LSR.
* The regulations continue a stop-gap approach; Treasury is considering alternative to prevent loss duplication.
For more information about this article, contact Dr. Thompson at email@example.com or Dr. Stewart at firstname.lastname@example.org.
Steven C. Thompson, Ph.D., CPA
Professor of Taxation
Department of Accounting, Taxation and Business Law
Florida Gulf Coast University
Fort Myers, FL
Dave N. Stewart, Ph.D., CPA
Rachel Marti, Professor of Taxation
School of Accountancy and Information Systems
Brigham Young University
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|Author:||Stewart, Dave N.|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 2004|
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