The loss disallowance rule - round three; is this the final chapter?

• Author: Mason, Donald J.

The IRS issued the final regulations covering the loss disallowance rule (LDR) on Sept. 13, 1991. Anyone familiar with the history of these regulations might wonder whether it was simply a coincidence or an event with greater significance that these highly criticized regulations were finalized on Friday the 13th. In previous articles, the authors have covered the details of the temporary regulations (1) and the proposed regulations, (2) and dealt with the background underlying such regulations and some of the rationale used by the IRS in issuing such controversial rules. Although some important changes were made, the final regulations continue the same basic disallowance approach adopted in Prop. Regs. Sec. 1.1502-20 (Nov. 19, 1990) and the provision of Temp. Regs. Sec. 1.1502-20T (Mar. 9, 1990). This article will analyze the final regulations and provide guidance for minimizing some of their negative effects.

The General Rule

In general, "[n]o deduction is allowed for any loss recognized by a member with respect to the disposition of stock of a subsidiary," (3) Regs. Sec. 1.1502-20 (a)(2) defines a disposition as "any event in which gain or loss is recognized, in whole or in part."

The final regulations modify the treatment of a loss on the disposition of subsidiary stock when such loss is not recognized immediately due to other provisions of the Code or regulations. In general, Regs. Sec. 1.1502-20 (a)(3) provides a coordination mechanism between the LDR and the other loss deferral and loss disallowance provisions, under which the LDR is applied after the other rules are applied. In other words, if the loss is deferred under any other provision, the LDR applies when the loss is taken into account. Likewise, if a loss is disallowed under another provision, the LDR is inapplicable. This ordering rule is subject to an exception for what the regulations call "overriding events." If an overriding event occurs before a deferred loss is taken into account, the LDR applies to the loss immediately before the event occurs even though the loss may not be taken into account until a later time. Regs. Sec. 1.1502-20(a)(3)(ii) indicates that overriding events occur when the subsidiary stock (1) ceases to be owned by a member of the consolidated group, (2) is canceled or redeemed (regardless of whether it is retired or held as Treasury stock) or (3) is disposed of within the meaning of Regs. Sec.. 1.1502-19(b)(2) (other than Regs. Sec. 1.1502-19(b)(2)(ii)).

Example 1: P is the common parent of a consolidated group, consisting of wholly owned subsidiary S, and T which is a recently purchased wholly owned subsidiary of S. S has a $200 basis in the T stock and T owns one asset (basis, $50; fair market value (FMV), $200). T sells the asset for $200, recognizing a gain of $150, which causes an upward basis adjustment from $200 to $350 in the T stock owned by S. S sells the T stock to P for $200 in a deferred intercompany transaction, recognizing a loss of $150 ($200 - $350), which is deferred under Sec. 267(f) and Regs. Sec. 1.1502-13(c). P subsequently sells the T stock for $200 to Z, which is a member of the same controlled group as P but is not a member of the P consolidated group. (4)

The application of the general rule to S's $150 loss is deferred because S's loss is deferred under Sec. 267(f) and Regs. Sec. 1.1502-13(c). Absent the overriding events exception, Temp. Regs. Sec. 1.267(f)-2T(d)(2) would provide that S's loss is not taken into account because Z is a member of the same controlled group as P and S. However, since T's stock is no longer owned by a member of the P consolidated group, an overriding event has occurred that causes S's deferred loss to be eliminated immediately before the sale and not to be taken into account under Sec. 267(f).

The final regulations continue to permit the netting of gains and losses on the disposition of stock in the same subsidiary. However, in a modification of the proposed regulations, Regs. Sec. 1.1502-s0(a)(4) adds the requirement that the stock must have the same material terms. Further, the final regulations allow the netting rule to apply whether or not all dispositions are to the same purchaser, provided such dispositions were part of the same plan or arrangement. The netting rule may also apply whether the amount of gain or loss is currently recognized or is a previously deferred amount that is currently taken into account.

Example 2: P is the common parent of a consolidated group. P owns one-half of the stock of T with a basis of $200. The remaining T stock is owned by S, a wholly owned subsidiary of P, with a basis of $75. All of the T stock has the same terms. P and S sell all of the T stock to different purchasers for an aggregate price of $200 pursuant to the same plan. As a consequence of the sale, P recognizes a loss of $100 and S recognizes a gain of $25. Since the sale was part of the same plan or arrangement, even though to different purchasers, the amount of P's loss disallowed under the LDR is limited to $75 ($100 -$25). (5)

As noted above, the netting rule applies only to stock of the same subsidiary having the same material terms. Thus, loss from the sale of the common stock of a subsidiary may not be netted against gain from the sale of such subsidiary's preferred stock. In addition, loss from the sale of one subsidiary may not be netted against gain from the sale of another subsidiary. However, beyond these obvious situations, it is not clear what is meant by the requirement of the "same material terms." No definitive guidance is provided by the final regulations. The preamble to the regulations (6) indicates that the netting of "gains and losses on sales of different classes of a subsidiary's stock, of the same class of a subsidiary's stock taken into account at different times, or of stock of different subsidiaries, may be unrelated to each other, and netting of such gains and losses may permit circumvention of General Utilities repeal." Again, these situations are fairly obvious. Do the same material term exist when two different classes of common stock possess slightly different terms yet represent essentially the same investment with comparable values? As an example, consider two classes of common stock, A and B, where the only difference is the number of directors each class can elect. Is the material terms requirement aimed at this type of situation? Additional clarification certainly appears warranted.

The final regulations also amend the elective...