Consolidated return election may mitigate stock basis decrease from phantom item.

• Author: Frankel, Mike

Rules for determining the stock basis of a subsidiary (including an excess loss account (ELA)) in a consolidated group are set forth in regulations issued in August 1994. These new regulations replace the rules in the consolidated return regulations issued in 1966, and are effective for determinations of stock basis and ELAs in consolidated return years beginning after 1994. If a subsidiary's stock basis or ELA is determined in a consolidated return year beginning after 1994, the new regulations generally apply as if they have always been in effect.

In general, the new regulations delink the calculation of stock basis from the calculation of earnings and profits (E&P). The rules are similar to those for determining basis in partnership interests and basis in stock in S corporations. Stock basis adjustments are determined by reference to a modified taxable income - taxable income or loss, increased by tax-exempt income, reduced by non-capital, nondeductible expenses, and reduced by distributions - rather than to E&P.

General rule on basis reduction

Under Regs. Sec. 1. 1502-32(b)(3)(iii), in general, losses (including net operating loss (NOL) carryovers and capital loss carryovers) that expire unused are considered noncapital, nondeductible expenses. Accordingly, when an NOL expires, a corporation's basis in subsidiary stock is reduced by the amount of the expired loss. This occurs even if limitations imposed by provisions such as Sec. 382 have made the loss carryover unavailable to offset consolidated taxable income. In such cases, taxpayers will need to decrease stock basis for a phantom item.

Example 1: P, a domestic corporation, is the parent of a consolidated group. On Dec. 31, 1995, P acquires unrelated domestic corporation Z for $75. As a result, Z joins the P consolidated group as of Jan. 1, 1996. Z has one nondepreciable asset, with a basis of $10. Z also has an NOL carryover of $100, which expires in 1996. Z's NOL is subject to a Sec. 382 annual limitation of $5 per year. In addition, use of Z's NOL carryover is subject to the separate return limitation year (SRLY) rules pursuant to Regs. Sec. 1. 1502-21(c). Based on the limitations on Z's NOL carryover, only $5 of the NOL can possibly be used unless Z has recognized built-in gain (i.e., $95 of the NOL carryover will definitely expire because of the Sec. 382 limitation).

Z has no taxable income or loss during 1996, so that even the available $5 of NOL cannot be used. Under the new...