Significant recent developments.

• Author: Schneider, Mark A.
• Position: Consolidated returns by corporations - Tax attribute reduction

This article examines significant recent developments in C corporations and consolidated returns, including temporary regulations on attribute reduction, step transactions and loss duplication, rulings on Sec. 351 and 355 and guidance on built-in gains under Sec. 382.

This article summarizes some of the more significant recent developments in the subchapter C and consolidated return areas. Specifically, it addresses temporary regulations on (1) Sec. 108 tax attribute reduction in a consolidated return setting; (2) tax attribute reduction when the debtor corporation is a target in a Sec. 381 transaction (such as a transfer of assets in a G reorganization); (3) taxpayers' ability to "shut off" the step-transaction doctrine and make a Sec. 338(h)(10) election; and (4) the application of Sec. 382 when certain trusts distribute loss corporation stock to a beneficiary. The article also addresses the Service's new "no ruling" positions on certain aspects of Sec. 355, revenue rulings on Sec. 355 tax-flee distributions and Sec. 351 "substance over form," and a notice on Sec. 382 built-in-gains (BIGs).

Temp. Regs.

Sec. 108 Attribute Reduction

Sec. 108(a) generally provides that a bankrupt or insolvent taxpayer does not include cancellation of debt (COD) income in gross income. The policy is to facilitate the debtor's "fresh start" on its emergence from bankruptcy. However, to prevent the debtor from deferring tax on a permanent, rather than a temporary basis, Sec. 108(b) requires taxpayers to reduce their tax attributes to the extent of the excluded COD income. Sec. 108(b) sets forth a prescribed ordering rule for such attributes, beginning with the debtor's net operating losses (NOLs). (1)

Treasury and the Service were concerned that consolidated taxpayers might take a separate-member, rather than a single-entity, approach to Sec. 108(b) attribute reduction. For example, when the debtor member is the common parent and is also a holding company (which often is the case), it is likely that its share of the group's tax attributes--particularly the consolidated NOL (CNOL) under Temp. Regs. Sec. 1.1502-21T(b)--might be minimal. Indeed, most of the CNOL likely would be allocated to the group's underlying operating subsidiaries. In such a case, consolidated taxpayers might take a separate-member approach to attribute reduction and reduce only the parent's portion of the CNOL, even if the total excluded COD income was well in excess of such portion. To prevent this result, Treasury issued Temp. Regs. Sec. 1.1502-28T, (2) which adopts a somewhat blended separate- and single-entity approach, but generally operates to prevent the type of taxpayer position discussed above.

The temporary regulations first take a separate-member approach. Temp. Regs. Sec. 1.1502-28T(a)(2)(i) provides that, for a member realizing excluded COD income in a tax year, the tax attributes attributable to that member, including the basis of assets and losses and credits arising in separate return limitation years (SRLYs), must be reduced under the general rules of Secs. 108 and 1017. (3) The basis of subsidiary stock, however, is not reduced below zero. For purposes of this rule, the consolidated tax attributes attributable to a member must be determined under Temp. Regs. Sec. 1.1502-21T(b)(2)(iv). (4)

Temp. Regs. Sec. 1.1502-28T(a) (3)(ii) provides an interesting "look-through rule" that blends separate- and single-entity principles. Under that rule, if the basis of a lower-tier member's stock owned by another member is reduced, the lower-tier member must be treated as realizing excluded COD income in an amount equal to such basis reduction. Accordingly, the regulations provide that the tax attributes attributable to such lower-tier member are then reduced under Secs. 108 and 1017. Finally, Temp. Regs. Sec. 1.1502-28T(a)(4) sets forth the single-member approach, as somewhat of a safety net. It provides that, to the extent excluded COD income is not applied to reduce the tax attributes attributable to the member that realizes the excluded COD income (including the application of the look-through rule above), such amount must be applied to reduce the remaining consolidated tax attributes of the group as provided in Sec. 108 and the temporary regulations. The reduction of each tax attribute is made in the order prescribed in Sec. 108 and Temp. Regs. Sec. 1.1502-21T(b)(1).

Example: (5) P Corp. is the common parent of a consolidated group with subsidiaries S1 Corp. and S2 Corp. In year 1, the P group sustained a $250 CNOL. Under applicable regulations, $125 of the loss was attributable to P and $125 to S1. On day 1 of year 2, S2 joined the P group, bringing along a $50 NOL subject to the SRLY rules. In year 2, the P group sustained a $200 CNOL, attributed as follows: $90 to P, $70 to S1 and $40 to S2. In year 3, S2 realized $200 of COD income excluded under Sec. 108(a). (6) That same year, the P group sustained a $50 CNOL, of which $40 was attributed to $1 and $10 was attributed to $2. At the beginning of year 4, S2 had Asset A, with a $40 basis and $10 fair market value.

The temporary regulations provide that S2's separate-member tax...