Desirability, mechanics of making sec. 362(e) (2) elections for state tax returns.

• Author: Friedel, David B.

When a parent corporation contributes a built-in-loss asset to its subsidiary in a transaction that qualifies for tax-free treatment under Sec. 351, the subsidiary--absent any barriers--can take a carryover basis in the asset and potentially duplicate the loss in the basis that the parent has in the subsidiary stock, resulting in both the parent and subsidiary benefiting from the built-in-loss amount.

Sec. 362(e)(2) acts as a barrier to prevent two taxpayers from obtaining the benefit associated with the built-in loss amount, by requiring an election to preserve the loss in either the parent or subsidiary.

Consider the following examples, which focus primarily on domestic companies:

Example 1 (built-in-gain asset transfers): P transfers assets ($100 fair market value (FMV) and adjusted basis of $70) to S, a wholly owned subsidiary, in exchange for S stock with an adjusted basis of $300. What is the effect of the transfer on T's basis in the S stock and on S's basis in the asset?

The transaction qualifies for tax-free treatment under Sec. 351 in a state that has separate-return filing rules and also in a state that follows the federal consolidated-return rules.

States that have separate-return filing rules: The asset has a built-in gain, so Sec. 362(e)(2) does not apply. S takes asset A with a carryover adjusted basis of $70 under Sec. 362(a)(1). Under Sec. 358, P takes the S stock with an increased adjusted basis of $370 ($300 basis in the stock plus $70 basis in the asset).

States that follow the federal consolidated-return filing rules: For built-in-gain assets, the result in a state following the federal consolidated filing rules is the same as described above for separate filing states.

Example 2 (built-in-loss asset transfers): P transfers asset A ($100 FMV and adjusted basis of $150) to S, a wholly owned subsidiary, in exchange for S stock with an adjusted basis of $150. What is the effect of the transfer on T's basis in the S stock and on S's basis in the asset?

The transaction qualifies for tax-free treatment under Sec. 351 in a state that has separate-return filing rules and also in a state that follows the federal consolidated-return rules.

States that have separate-return filing rules: The asset has a built-in loss, so the default rule of Sec. 362(e)(2) (A) applies to preserve the built-in loss in T's hands with a corresponding limit of S's basis in the asset to the FMV of the asset. Therefore, under the default rule of Sec...