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Think twice before selling that subsidiary: without proper planning, the new IRS regulations could prevent taking deductions for a loss.


Without proper planning, the new IRS regulations could prevent taking deductions for a loss.

When the Internal Revenue Service took aim at "son of mirror" transactions, it caught all other consolidated group subsidiary dispositions in its net. In March 1990 the IRS issued temporary regulations designed to combat the son of mirror deals that were tax-motivated and could be used by a group to avoid tax on the disposition of appreciated assets. This was accomplished by taking a loss on the disposition of subsidiary stock and using that loss to offset the gain on the disposition of the subsidiary's appreciated assets.

Unfortunately, for subsidiary stock dispositions occurring after March 8, 1990, the new regulations will prove unexpectedly harsh. They disallow not only artificial, son of mirror losses but also actual economic losses. In some cases, they can apply even if the stock isn't sold at a loss. Moreover, the loss disallowance rule applies to all subsidiaries--whether or not they were acquired or created by the group. There are also transitional rules that apply to certain transactions.

The application of the new regulations could have unfortunate consequences for corporations that fall within their scope. This article discusses the new regulations and planning opportunities to mitigate or avoid their harsh effects in many cases.


More than three years before release of the new regulations, the IRS warned it intended to prevent companies from engaging in son of mirror transactions. The warning, contained in Notice 87-14, said the IRS would take steps to prevent a consolidated group from realizing a loss on the sale of a subsidiary's stock if the loss had the effect of offsetting income attributable to the subsidiary's built-in gains--that is, the appreciation in the subsidiary's assets when it was acquired by the group (see exhibit 1). However, when the new regulations were released March 9, 1990, they applied to a far broader range of transactions than those previously addressed in the 1987 notice.

A transitional rule applies to subsidiaries acquired after January 6, 1987, and only to artificial, son of mirror losses. However, the loss disallowance rule applies to any post-March 8, 1990, disposition of subsidiary stock at a loss, regardless of the source of the loss and regardless of when the subsidiary was acquired by the parent. (See exhibit 2.)


According to the regulations, a consolidated group can't deduct a loss on a post-March 8, 1990, disposition of subsidiary stock. For this purpose, a disposition is any event causing gain or loss to be recognized, in whole or in part. Thus, a disposition includes taking a worthless stock deduction, a taxable liquidation and even a deferred intercompany transaction.

Two minor exceptions to the loss disallowance rule permit the stock loss deduction to be used to the extent

* The group member disposing of the stock at a loss also disposes of other stock in the same subsidiary at a gain in the same transaction.

* The disposition of the subsidiary stock causes the group to report gain that was previously recognized, but deferred, in an intragroup transfer of the subsidiary stock.

"Antiabuse" rules. Three rules designed to prevent its circumvention buttress the loss disallowance rule:

1. No longer a group member. If a subsidiary ceases to be a member of a consolidated group but group members continue to own some of its stock, the members must reduce their basis in the retained stock to fair market value if that basis exceeded the stock's value immediately before the deconsolidation. If the retained subsidiary stock is disposed of at a loss within two years after a basis reduction, the regulations mandate a statement must be filed with the group's income tax return for the disposition year. If the statement isn't filed, the loss will be disallowed.

2. A successor rule prevents circumventing the new regulation via an entity receiving the stock or assets of a subsidiary in a nonrecognition transaction.

3. The "antistuffing" rule. As discussed below, the loss disallowance rule permits sheltering postacquisition appreciation in a subsidiary's assets. The antistuffing rule is designed to ensure the appreciation being sheltered is on assets needed by the subsidiary in its business operations and not on assets contributed to it simply to avoid loss disallowance. The antistuffing rule applies only to post-March 8, 1990, asset transfers to the subsidiary within two years of its disposition. Generally, the rule requires gain recognition to the extent of the loss disallowance that otherwise would be avoided by reason of the transfers.

The reattribution rule. The regulations provide for an irrevocable election by the group's common parent to retain the subsidiary's unused losses (whether ordinary or capital) up to an amount equal to the loss that would be disallowed on the subsidiary's disposition. The parent's election to retain the losses causes a negative adjustment in the subsidiary stock basis. This reduces or eliminates the loss that otherwise would be recognized on the disposition. The election doesn't apply to the subsidiary's losses incurred in separate return years (that is, years before it joined the group and years during which the group did not file consolidated returns). The regulations detail the procedure for making this election: It must be made in a statement signed by both the common parent and the subsidiary.

The new regulations also include rules describing the effect of the loss disallowance and the deconsolidation basis reduction rules on the consolidated earnings and profits and stock basis adjustment rules. And they contain a binding contract rule to determine the date a subsidiary was disposed of, deconsolidated or had assets transferred to it.


The loss disallowance rule can be extremely harsh because of its scope. However, proper planning can avoid--or at least mitigate--the harsh effects in many cases. Techniques to avoid loss disallowance are specific to each transaction and must be tailored to each corporation's situation. This puts a premium on knowing why a subsidiary's disposition would generate a loss.

No loss, (almost) no problem. The loss disallowance rule applies only if the basis of the subsidiary stock exceeds its value immediately before disposition or deconsolidation. Hence, if after a group acquires a subsidiary some of the subsidiary's assets decline in value but others appreciate by an equal or greater amount, there will be no loss on the disposition and the rule won't apply. The rule thus effectively permits postacquisition losses to shelter postacquisition appreciation. (See exhibit 3, example 1.)

The loss disallowance rule permits sheltering postacquisition appreciation even if there has been no economic loss. This son of mirror effect can be achieved because the rule allows a subsidiary stock basis increase attributable to built-in gain recognition to offset postacquisition appreciation in the subsidiary's assets (see exhibit 3, example 2).

Caveat: One cloud hangs over this ability to shelter a subsidiary's postacquisition appreciation. The preamble to the new regulations indicates the IRS is considering limiting it. The IRS believes this ability might be used to facilitate corporate breakups because, in many cases, the assets of a breakup target that are intended to be sold reflect separate market values not fully reflected in the price paid for the target. The preamble says if an antibreakup rule is adopted, it will prevent sheltering postacquisition appreciation when a target is disposed of within two years after the group acquired it and the rule will apply retroactively from March 9, 1990.


Subject to the two-year waiting period in the antistuffing rule (and the possible application of an antibreakup rule), a group is free to contribute appreciated assets to a subsidiary to even up the stock basis and value of the subsidiary. This would eliminate a parent's taking a loss on a disposition of the subsidiary stock. (See exhibit 3, example 3).


Inside basis techniques can be used to avoid the loss disallowance rule if the subsidiary has assets with basis higher than value. In that case, the group can recognize losses on these assets by making a section 338(h)(10) sale of the subsidiary's stock or by having the subsidiary sell selected assets at a loss.

Section 338(h)(10) election. Before the loss disallowance rule was issued, a consolidated group selling a subsidiary generally benefited from making a code section 338(h)(10) election jointly with the purchaser if the aggregate inside basis of the subsidiary's assets (net of liabilities) equaled or exceeded its outside stock basis. The loss disallowance rule now provides another reason to make a section 338(h)(10) sale under these circumstances. In this type of transaction, the seller is treated as if it sold the subsidiary's assets, not stock, so the loss disallowance rule can't apply. Note that a section 338(h)(10) election can be made only if the purchaser is a corporation.

A section 338(h)(10) election should be considered even if inside basis is lower than outside basis. An election in this situation may be advisable if, for instance, the selling group has otherwise unusable losses to offset the gain on the deemed asset sale.

Selected asset sales. If the selling group doesn't want to make a section 338(h)(10) election because the subsidiary's inside basis is lower than the outside basis, the group may be able to take loss deductions by having the subsidiary sell individual assets at a loss in anticipation of, or in conjunction with, the group's disposition of the subsidiary's stock. (See exhibit 3, example 4.)


As noted above, the common parent of the selling group can elect to retain a subsidiary's unused capital or ordinary losses to the extent the group is denied a deduction under the loss disallowance rule--provided the unused losses aren't from separate return years of the subsidiary. By making this election, the group can benefit from the unused losses realized by the subsidiary during its consolidation with the group. This election overrides the otherwise applicable consolidated return loss apportionment rules.

A prospective purchaser of a subsidiary should consider the potential impact of this election in negotiations with the selling group and always should inquire whether the seller intends to make this election. If a selling group wants to make the election, it should obtain the subsidiary's signature on the election statement before the sale.


If all else fails, a consolidated group may request the IRS's permission to elect out of filing a consolidated return. The IRS is likely to grant such requests if the group can demonstrate a substantial adverse effect from the loss disallowance rule. In fact, the IRS seriously is considering granting blanket permission for groups to make such elections. However, it may condition permission to elect out on obtaining its consent before a group is permitted to reelect filing consolidated returns.

Before making a decision to elect out, a group should consider all the benefits of consolidation it would lose. Conversely, groups that haven't elected yet to file consolidated returns should consider carefully the possible adverse effects of the loss disallowance rule before making the election.


As a practical matter, the only losses disallowed by the transitional rule are artificial, son of mirror losses. The rule generally prevents a consolidated group from deducting a loss on subsidiary stock acquired after January 6, 1987, and disposed of before March 9, 1990 (a "transitional subsidiary"). However, this general rule is subject to a major exception that permits a group to deduct a loss on the disposition of transitional subsidiary stock if the group can demonstrate the loss is not attributable to a basis increase resulting from the subsidiary's recognition of built-in gains.

The exception is available only if the group files the statement described in the regulation with its return for the year of the transitional subsidiary's disposition (or if the return is due or filed before May 16, 1990, with the first subsequent return).

To qualify for the exception, corporations will have to conduct appraisals of all the assets owned by a transitional subsidiary when it was acquired so they can identify the built-in gain assets and the amount of the gain. Also, tracing will be necessary to show how much of the gain on asset dispositions was not built-in gain. These tasks will be complicated because the appraisals and tracing will be done after the group has disposed of the subsidiary and, in many cases, the subsidiary's assets as well.

The transitional rule also applies to a consolidated group's disposition between January 6, 1987, and March 9, 1990, of a group member that's not itself a transitional subsidiary but that owns, directly or indirectly, stock of a transitional subsidiary (a "transitional parent"). Like the transitional subsidiary rule, the transitional parent rule presumes any loss on the disposition is disallowed, unless the presumption can be rebutted with appraisals and tracing to demonstrate the source of the loss is not built-in gain recognized by a transitional subsidiary.


The severity of the new loss disallowance rule may come as a shock to many, and it certainly presents a tax trap for the unwary. Because of heavy criticism of the new regulations, the IRS will hold hearings on June 26-27. Comments are due June 12.


A typical son of mirror transaction

P Corp. purchased T Corp. from an unrelated individual for $100. T has two assets, each with a fair market value of $50 and a zero basis. P wants to keep one of these assets and not recognize gain on the disposition of the other. P also would like a stepped-up basis in the asset it retains. Accordingly, P and T elect to file a consolidated return, T distributes the wanted asset to P and P later sells T to an unrelated buyer for $50.

Distributing the asset to P causes T to recognize a $50 gain that's deferred under the consolidated return rules. Under these rules, the sale of T triggers that deferred gain and P increases its T stock basis by the $50 gain but also reduces that basis by the $50 distribution. Thus, immediately before P sells T, P's basis in T is $100 ($100 + $50 - $50).

On T's sale, P recognizes a $50 loss ($50 sales price - $100 basis), which offsets T's $50 gain on the distribution (ignoring possible income characterization differences). Furthermore, P has a $50 basis in the wanted asset.

The effect of the transaction was to eliminate the tax on the appreciation in the wanted asset and avoid triggering the tax on the disposition of the unwanted asset.


Which rules apply and when?

This table indicates which set of rules applies to the disposition of a subsidiary. It's based on the dates the subsidiaries were acquired and disposed of.
Date subsidiary Date subsidiary Applicable
 acquired disposed of rule
Anytime After March 8, 1990 Loss disallowance
After January 6, 1987 Before March 9, 1990 Transitional
Before January 7, 1987 Before March 9, 1990 None. Son of mirror
 transaction allowed


How to avoid the loss disallowance rule

Example #1: Offsetting gains and losses The P consolidated group purchases T Corp. for $100 when T had two assets, each with a basis of zero and a fair market value of $50. P later sells T to an unrelated buyer for $100 after one of T's assets declines to $5 in value but the other asset appreciates to $95.

Because P has no loss on the sale, the loss disallowance rule doesn't apply.

Example #2: Sheltering postacquisition gain The facts are the same as in exhibit 1 on page 69, except that, when P sells T, the asset remaining in T has appreciated by $50, so the unrelated buyer pays $100 for T.

As in exhibit 1, P's basis in T immediately before the sale is $100. Thus, P recognizes no gain or loss on the sale, and the loss disallowance rule does not apply.

P, however, must pay the tax on the built-in gain recognized when the wanted asset was distributed to it, but pays no tax on the $50 postacquisition appreciation in T.

Example #3: Waiting it out The facts are the same as in the first example, except that the second asset didn't appreciate in value and P contributed an asset with a basis of zero and $45 value to T at least two years before P sold T.

Because neither the loss disallowance rule nor the antistuffing rule applies, P has no tax consequences from the sale.

Example #4: Selling assets at a loss P and T file a consolidated return. P's basis in T is $120. T has two assets, one with a basis of $60 and value of $10, the other with a basis of zero and value of $60.

If P sells T to an unrelated buyer for $70, P's $50 loss on the stock sale will be disallowed. However, P probably would prefer this result to making a code section 338(h)(10) election for T because the election would cause P to recognize $10 of net gain [($60 - 0) + ($10 - 60)].

Alternatively, if immediately before P sells T, T sells the first asset outside the group for $10, the P group can deduct the $50 loss on the asset sale. The recognition of this loss reduces P's basis in T to $70 under the consolidated return basis adjustment rules.

Thus, P recognizes no loss on the T stock sale and the loss disallowance rule does not apply.

DICK YATES, JD, is a tax manager with Coopers & Lybrand in Washington, D.C. He specializes in corporate and consolidated return matters. He is a member of the American, Oklahoma and District of Columbia Bar Associations.
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Author:Yates, Dick
Publication:Journal of Accountancy
Date:Jun 1, 1990
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