Judicial deference, consolidated returns, and loss disallowance: could LDR survive a court challenge? Amending section 1502 to deal comprehensively with single entity issues.

• Author: Salem, Irving

1. OVERVIEW

   The loss disallowance regulations published in March and November 1990 (LDR) are historic -- economic losses will be disallowed despite the unbroken congressional and regulatory directive to allow such losses since 1918. In a court challenge, the Internal Revenue Service will heavily rely on the single entity theory of consolidation and the deference the courts accord legislative regulations. This article concludes that:

   * The doctrine of judicial deference runs contrary to the premise of Marbury v. Madison that the judiciary is under a "duty" to "say what the law is." It also places great weight on the judgment of the Department of the Treasury and the IRS, even though they are burdened with a potential conflict of interest that may force them to promulgate regulations testing the outer limits of reasonableness.

   * The precise origins of judicial deference are obscure. The original source appears to be the notion that the administrators have superior knowledge in that they help write the laws and therefore are the "masters of the subject." Other origins incude: avoidance of complex areas and the desire for stability.

   * Two separate and distinct origins could be viewed as deference to the legislature since Congress (i) requested the IRS in section 7805(a) to adopt all needful regulations (for "enforcement" purposes) and (ii) is deemed to endorse certain regulations under the "legislative reenactment" doctrine. This last origin, as currently interpreted, is the strongest pillar of judicial deference.

   * Except in rare cases, the deference principle fails to provide meaningful help for the IRS. Although not to be invalidated except for "weighty reasons," or if "plainly inconsistent" with the Code, the courts have not quantified or otherwise refined these amorphous tests. Rather, the courts essentially make a de novo review of the issues and arguments, and the IRS must be right on the merits if it expects to have its regulations upheld by a court.

   * Although regulations play an essential role in the administration of the tax laws, the evolving tighter standard of deference may be appropriate since it provides the required judicial check of overreaching executive action. A similar tightening is occurring outside the tax law.

   * The validity of eleven 1954 Code regulations has been challenged before the Supreme Court and the taxpayer is batting a strong .363 (4 for 11).

   * A portion of LDR is likely to be invalidated, particularly the portion dealing with duplicated losses. The anti-duplication portion of LDR will fail primarily because it changes the law. Losses on the disposition of a subsidiary -- regardless of the potential for duplication -- have been allowed by the Code and the consolidated return regulations since 1918. Several Supreme Court cases fiercely defend the taxpayer's right to recapture its investment.

   * The legislative reenactment doctrine is applicable to consolidated returns and would deem the current regulations to have the force and effect of law since (i) the regulations have historically approved of the double use of losses by unrelated parties, (ii) Congress from 1986-1989 handcrafted four Code provisions that could limit losses arising in consolidation, and (iii) Congress specifically rejected a proposal to eliminate duplicated losses by unrelated parties (see section 336(d)) filing separate returns.

   * The legislative standard for consolidated return regulations ("clearly to reflect the income tax liability") is barren of meaningful guidance since it avoids the basic question -- should income be reflected on a single or separate entity basis?

   * Because of the present structure of the regulations, the existing separate entity precedent, many difficult policy decisions, and the potential for being whipsawed, the IRS is unlikely to deal with other single entity issues on a comprehensive basis without a clear statutory statement on...