Intercompany transaction and loss disallowance relief provisions.

• Author: Michalowski, John

Certain transfers or dispositions of member stock can trigger tax consequences that appear to be inconsistent with the policy intentions underlying the consolidated return regulations. For this reason, the IRS included, under Regs. Sec. 1.1502-13(f)(5)(ii), three forms of "relief." This item focuses on the second of those relief provisions, Regs. Sec. 1.1502-13 (f)(5)(ii)(C), for cases in which member stock is transferred within a group and then disposed of in a Sec. 338(h)(10) transaction.

Example 1: A consolidated group disposes of a member's stock. The parent, P, wholly owns subsidiary 1, S, which wholly owns subsidiary 2, T. P wants to divest itself of T's business operations. T's stock has a $100 fair market value (FMV) and a $30 adjusted basis, and the net adjusted basis of the assets inside T is $15 (leaving $85 of "inside" appreciation). S sells T for $100 in a Sec. 338(h)(10) transaction and distributes the proceeds to P. "Old" T recognizes an $85 gain on its asset appreciation, all of which is included in the calculation of the P group's consolidated taxable income. The distribution of the proceeds by S to P does not generate any additional consolidated taxable income within the P group. The P group recognizes only one level of gain on the transaction.

Example 2: The facts are the same as in Example 1, except S first distributes the T stock to P, then P sells T in a Sec. 338(h)(10) transaction. S recognizes a $70 gain on the distribution of T to P, under Sec. 311(b) (i.e., gain resulting from the "outside" appreciation in T's stock (deferred momentarily under Regs. Sec. 1.1502-13)). Additionally, the sale of T in a Sec. 338(h)(10) transaction still results in "old" T recognizing an $85 gain (i.e., from the "inside" appreciation in T's assets). Absent any other provision, distributing the stock of T before the Sec. 338(h)(10) transaction results in the P group recognizing two levels of gain.

From an economic standpoint, P ends up in the exact same financial position in Example 2 as in Example 1. However, the tax consequences of distributing the T stock before the sale differ drastically from those of distributing the proceeds resulting from the sale.

Relief for Example 2

Under Sec. 301(d), P's basis in the T stock received in the distribution from S equals the T stock's FMV on the distribution date, or $100. This "increase" in the T stock basis (from the $30 basis in S's hands) mirrors the $70 of Sec. 311(b) gain recognized...