Are the loss disallowance final regs. the final word?

• Author: Parker, Carrie

In March 2005, the IRS issued long-awaited final regulations on the loss disallowance rules (LDRs) under Secs. 337 and 1502; see TD 9187. Contrary to expectations, they adopt the 2002 temporary regulations (which were set to expire March 7, 2005) without substantive change. The final rules generally apply to dispositions and deconsolidations after March 2, 2005.

Background

Before 2001, the original LDRs disallowed a loss on the sale of a consolidated subsidiary's stock to the extent of:

* Positive investment adjustments;

* Extraordinary gain dispositions; and

* Duplicated loss.

In Rite Aid Corp., 255 F3d 1357 (Fed. Cir. 2001), rev'g 46 FedC1 500 (2000), the Federal Circuit held that the duplicated-loss factor was invalid, because it denied losses that would have been available to the taxpayer had it not filed a consolidated return.

In response, the IRS issued Temp. Regs. Sec. 1.337(d)-2T, which was much more taxpayer-friendly. Under that rule, a loss on a subsidiary stock sale is not disallowed to the extent that a taxpayer establishes that the loss is not attributable to the recognition of built-in gain (BIG) on an asset disposition. This "tracing methodology" essentially requires the taxpayer to trace each increase in stock basis attributable to gain recognition, to prove that it did not recognize any BIGs. (Gain recognized on an asset disposition is BIG to the extent attributable to any excess of value over basis, as reflected in the share's basis immediately before the asset disposition.) In effect, this version of the LDRs was limited to the "extraordinary gain" factor of the original rules, with certain modifications.

The IRS responded to the "duplicated loss" concern by promulgating Temp. Regs. Sec. 1.1502-35T, which was designed to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. Temp. Regs. Sec. 1.1502-35T(b)(1) and (2) require the basis of a subsidiary's stock to be redetermined immediately before a (1) disposition of a portion of that stock to a nonmember or (2) deconsolidation of the subsidiary, if any consolidated group member has a built-in loss (BIL) in subsidiary stock (except when the consolidated group disposes of all the subsidiary's stock during the tax year in a taxable transaction) . Temp. Regs. Sec. 1.1502-35T(b)(1) also requires taxpayers to suspend certain losses on subsidiary stock sales if the subsidiary remains a group member after the disposition.

The effect of...