Are the new loss duplication regulations out of date?

• Author: Estrada, Michelle

On March 6, 2006, the IRS issued final "loss duplication" regulations (Regs. Sec. 1.1502-35), designed to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. The new regulations represent the government's latest response to the Federal Circuit's decision in Rite Aid, 255 F3d 1357 (2001), which held that the "duplicated loss" factor of the loss disallowance rule (LDR) found in former Regs. Sec. 1.1502-20 was invalid. (For additional information on the LDR, see Mason and Choate, "The Loss Disallowance Rule--Round Three," TTA, May 1992, p. 267; Hayes, Tax Clinic, "Rite Aid Precipitates Issuance of Prop. and Temp. Regs.," TTA, June 2002, p. 362; and Thompson and Stewart, "Temp. Regs. Limit Duplicative Stock Losses," TTA, January 2004, p. 36.)

Both the final loss duplication regulations and new Sec. 362(e) (discussed below) limit a taxpayer to one tax benefit from a single economic loss.

This item explores the lack of symmetry between these two provisions and how this affects corporations filing a consolidated return.

Basis Redetermination

The loss duplication regulations generally operate through a "basis redetermination rule," as illustrated in the following example.

Example 1: Corp. P forms Corp. S by transferring $20 in exchange for common stock, asset Z, with a $130 basis and a $100 fair market value (FMV), and preferred stock. P and S join in filing a consolidated return. Because the transfer qualifies as a Sec. 351 transaction, P's basis in the common stock is $20 and its basis in the preferred stock is $130.The FMV holds constant and P subsequently sells the preferred stock to a third party for $100. The duplicated loss regulations prevent the consolidated group from recognizing a loss on the sale of the preferred stock (because S remains a member of the consolidated group), by allocating basis away from the preferred stock to the common shares, leaving basis in the preferred stock equal to its FMV Thus, the $30 loss inherent in the preferred stock is shifted to the common stock, and P recognizes no gain or loss on the preferred stock sale.

The result in Example 1 makes sense, because S inherited Z with a $130 basis, and otherwise there would be a risk of the consolidated group recognizing another loss in the future on S's sale of Z. However, the American Jobs Creation Act of 2004 (AJCA) enacted Sec. 362(e), which addresses the same loss duplication concern in the context of Sec. 351...