Often-overlooked stock basis adjustments.

• Author: Michalowski, John

The parent of a consolidated group may not track the adjusted basis of its subsidiary stock annually. Taxpayers often perform this analysis only when needed, such as prior to disposition of a subsidiary. However, certain stock basis adjustments may be overlooked when not addressed yearly; this item highlights two such adjustments--for nonqualified stock options (NQSOs) and dual consolidated losses (DCLs).

NQSOs

An employee's exercise of a NQSO generally results in a compensation deduction. Whether an employee performing services for a subsidiary receives its stock or parent stock, Sec. 83(h) and Regs. Sec. 1.83-6 provide that the entity for which the services are rendered (i.e., the subsidiary) can take the deduction. If the subsidiary is a consolidated group member, the deduction cause the parent's adjusted basis in the subsidiary's stock to be reduced under Regs. Sec. 1.1502-32's investment adjustment rules.

If a subsidiary's employees receive only cash compensation for services rendered, and the parent funds such compensation, the subsidiary incurs a deductible compensation expense and its basis must be reduced under Regs. Sec. 1.1502-32. However, the subsidiary's stock basis increases by the cash contributed, which offsets the stock basis reduction resulting from the subsidiary's compensation deduction. In essence, this transaction has no net effect on the subsidiary's stock basis.

Sec. 1032: The same tax consequences should result whether the employees receive cash or exercise NQSOs. Regs. Sec. 1.1032-3(b)(2) governs a subsidiary's employees' exercise of a parent's NQSOs; the parent is deemed to have contributed to its subsidiary the excess of (1) the total fair market value of the parent stock issued to the subsidiary's employees, over (2) the total payments made by the subsidiary's employees on each exercise. The subsidiary is then treated as purchasing its parent's stock with the money received from the parent and its employees. Although Regs. Sec. 1.1032-3 was issued May 12, 2000 on a prospective basis, the IRS will not challenge a taxpayer's position taken in a prior period that is consistent with the final regulations; see the preamble to TD 8883.

Basis calculations often fail to consider the positive effect Regs. Sec. 1.1032-3 provides for NQSOs exercised by a subsidiary's employees (especially for exercises that pre-date the regulations and for those occurring after a subsidiary leaves the consolidated group).

To the extent not...