Proposed loss disallowance regulations.

• Author: Warner, James C.

Proposed Loss Disallowance Regulations

Temp. Reg. [section] was issued on March 9, 1990, disallowing a loss recognized on the disposition of stock of a consolidated subsidiary on or after that date. This "loss disallowance rule" far exceeded the scope of the regulations taxpayers had been led to anticipate by Notice 87-14, which promised only to deny an increase in stock basis attributable to recognized built-in gains in order ot prevent circumvention of the repeal of the General utilities doctrine. Because the loss disallowance approach, unlike notice 87-14, required no appraisals, the regulations also applied without regard to when a subsidiary was acquired. This was as shocking to taxpayers as the scope of the regulations. The Notice had stated that the disposition of subsidiaries acquired before January 7, 1987, would be "grandfathered" under the forthcoming regulations. As it turned out, the rules contemplated by Notice 87-14 were promulgated as transitional regulations (Temp. Reg. [section] 1.337(d)-IT) applicable only to dispositions of subsidiaries at a loss before March 9, 1990.

The Treasury Department and the internal Revenue Service concluded that the loss disallowance rule was the only administrable approach for preventing circumvention of the repeal of General utilities and for preventing another concern not addressed in Notice 87-14 -- loss duplication. The government acknowledged, however, that losses attributable to overpaying for the stock or a decline in the value of a subsidiary's built-in gain assets should not be disallowed. Comments were invited on how such "economic losses" might be allowed without imposing heavy administrative burdens. After receiving wide-ranging comments, the government withdrew the March 1990 regulations on November 19, 1990, and replaced them with Prop. Reg. [section] 1.1502-20. The proposed regulations (CO-93-90) were reprinted at 1990-51 I.R.B. 20.

Prop. Reg. [section] 1.1502-20 retains the loss disallowance approach but provides relief for economic losses. having foregone substantial revenue by adopting an approach that has no effect on investment adjustments attributable to a subsidiary's built-in gains when the subsidiary is sold at a gain, not suprisingly the government's proposed relief for economic losses is narrow. The effective date of the modified loss disallowance rule was also delayed. The proposed regulations would apply to dispositions after january 31, 1991. Substantial changes also were made in the transitional regulations (Treas. Reg. [section] 1.337(d)-1 and Temp. Reg. [section] 1.337(d)-2T). These final and temporary regulations (T.D. 8319) were reprinted at 1990-51 I.R.B. 4.

This article briefly discusses the background of the loss disallowance regulations, explains the new rules, and explores various tax-planning ideas.

1. Background of Regulations

   1. Government's Concerns

      1. duplication of Loss. Since 1966, the consolidated return regulations have adjusted the basis of consolidated subsidiary ("S") stock to reflect S's earnings and profits and distributions in order to reduce duplications of gain or loss when a member of the consolidated group ("P") sells its S stock.

         Two concerns caused the government to consider striking changes in the regulations. One, which was not caused by the filing of a consolidated return, involved unrealized losses when P sells S. The regulations do not eliminate the duplication of S's gain or loss after S leaves th P group. if S, for example, had an unrealized loss (or loss carryover) when P sold it, P's stock loss could be duplicated by S, subject to various restrictions on use of S's loss (or loss carryover), after S left the P group when S sold its assets (or S's loss carryover was absorbed). This duplication of loss would occur only if the S stock were sold by P before S sold its assets. Although any S gain also could be so duplicated, the government became concerned that duplication was a one-way street; taxpayers had the power to sell assets first to avoid duplication of gain, but sell stock first to duplicate loss.

         If a holding company were used, stock losses based on S's loss might be multiplied by more than two taxpayers, if the stocks of the holding company and of S were sold from the "top down" before S sold its assets.

      2. Avoidance of Tax on Built-In Gain

   1. Recognition of Built-In Gain. The duplication-of-loss concern focused on S's unrealized loss when S left the P consolidated group. After the 1986 repeal of the General Utilities doctrine, the government became concerned with another matter -- when S joined the P consolidated group with unrealized ("built-in") gain. In connection with that repeal, section 337(d)(1) authorized Treasury to prescribe regulations to carry out the purposes of the amendments made by Subtitle D of Title VI of the Tax Reform Act of 1986, including regulations to ensure that the purposes may not be circumvented through the use of any provision of law or regulation (including the consolidated return regulations).

      Soon after the 1986 legislation was enacted, the IRS announced in Notice 87-14 that regulations would be promulgated denying P stock basis for its S stock to the extent the basis was attributable to investmetn adjustments for recognized built-in gains. The investment adjustment rules had made it possible in certain situations for the P group to effectively dispose of built-in gain assets owned by S in a cost-basis transaction without a corporate level tax, thereby circumventing repeal of the General Utilities doctrine. As illustrated in Examples 4 and 5, this was possible because P's cost basis assets. investment adjustments attributable to built-in gain assets. Investment adjustments attributable to S's earning and profits derived from recognition of built-in gains would increase P's S stock basis without a corresponding increase in value. this would create a potential loss on the disposition of the S stock to offset S's recognized built-in gains.

      Apparently because of the difficulties of retroactively appraising assets for older subsidiaries, Notice 87-14 stated that the regulations would not apply to the disposition of a subsidiary if it was acquired before January 7, 1987 (the date Notice 87-14 was released).

   2. Conversion of Built-In Gain. In developing the regulations, the government officials became concerned that they had underestimated the scope of the problem when Notice 87-14 was released. specifically, they determined that the conversion of wasting built-in gain assets, as well as the recognition of built-in gain, was in conflict with the repeal of General Utilities.

      3. Administrability. Having become convicted that the conversion of wasting built-in gain assets was a problem, the government concluded that the tracing of investment adjustments attributable to built-in gains contemplated by Notice 87-14 was not administrable.

   2. March 9, 1990, Regulations

      1. Loss disallowance Rule. On March 9, 1990, Temp. Reg. [section] 1.1502-20T was issued. it retained the present investment adjustment rules but disallowed any loss on the disposition by P of its S stock on or after March 9, 1990. The government acknowledged that not only would stock losses reflecting built-in gains and duplicated losses be disallowed, but true economic losses would be disallowed as well. Accordingly, the Preamble to the temporary regulations invited comments on how exceptions might be made to the loss disallowance rule for economic losses without imposing heavy administrative burdens.

      2. Transitional Regulations. for a disposition of stock of a consolidated subsidiary before March 9, 1990, Temp. Reg. [section] 1.337(d)-IT disallowed any loss recognized on the disposition of such a subsidiary acquired after January 6, 1987, or any subsidiary that was a higher-tier subsidiary with respect to such "transitional subsidiary," except to...