Temp. regs. limit duplicative stock losses.

• Author: Thompson, Steven C.

Temporary loss-disallowance regulations limit a consolidated group's duplicative losses incurred on the sale of a subsidiary member's stock. This article examines two primary rules, the basis-reduction rule and the loss-suspension rule, designed to prevent a consolidated group from obtaining more than one benefit from a single economic loss.

In March 2003,Treasury issued final, temporary and proposed regulations to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. (1) These regulations are a multifaceted response to the government's judicial defeat in Rite Aid Corp., (2) as well as concerns about tax-shelter type transactions that were reportedly implementing loss-duplication strategies. The new rules add to the confusion resulting from the IRS's concession that the loss-duplication rule in Regs. Sec. 1.1502-20(c) is invalid. This article is designed to highlight some of the fundamental concepts of these highly complex rules.

Background

In Rite Aid, the Federal Circuit held that the "duplicated loss" provisions of the loss-disallowance rules (LDR) in Regs. Sec. 1.1502-20 (-20) were an invalid exercise of rulemaking authority. On March 7, 2002, in response to this judicial defeat, Treasury issued temporary loss-disallowance regulations which addressed whether, and the extent to which, a loss on the sale of a consolidated subsidiary's stock will be allowed. Unpredictably, these rules were written under Temp. Regs. Sec. 1.337(d)-2T (-2T), and not -20, as expected. Until March 7, 2002, the -2T regulations allowed consolidated groups to calculate an allowable loss on the sale of a subsidiary's stock by (1) applying -20 in its entirety, (2) electing to apply a -20 "lite" version without the duplicated-loss factor or (3) electing to apply the new -2T regulations. After March 7, 2002, the -2T regulations (not the -20 regulations) would govern the allowability of losses.

Because the -2T regulations only addressed loss disallowance and not loss duplication, the IRS also issued Notice 2002-18. (3) The notice revealed that additional regulations would be forthcoming to prevent a consolidated group from duplicating losses by means of certain "stuffing" and disposition transactions. On Oct. 18, 2002, to complete its regulatory promise, the IRS issued proposed regulations under Regs. Sec. 1.1502-35 to deal with tax-shelter-type transactions in which the same consolidated group could derive a double benefit from a single economic event. On March 11,2003, to meet the deadline requirements for temporary and final regulations, the IRS issued Temp. Regs. Sec. 1.1502-35T (-35T).

The primary thrust of the -35T regulations is to address the following two IRS concerns:

1. A group absorbs an inside loss of a subsidiary member; then, a group member recognizes a loss on a disposition of the subsidiary's stock that is duplicative of the inside loss.

   Example 1: In year 1, P Corp., a group member, forms wholly owned S Corp. with a contribution of $80 for 80 shares of S common stock (CS1). In year 2, P contributes Asset A, with a basis of $70 and a fair market value (FMV) of $20, to S for an additional 20 shares of S common stock (CS2). In year 3, S sells A and recognizes a $50 loss, which offsets P's income on the group's consolidated return. Under the investment-adjustment rules of Regs. Sec. 1.1502-32, P's basis in its S stock is reduced by a pro-rata share of the $50 loss; thus, CS1's basis is $40 and CS2's basis is $60. In year 4, P sells the CS2 shares for $20 and recognizes a $40 loss, which offsets P's income on the group's return. As a result of this transaction, the group has obtained a $90 tax benefit from the single $50 economic loss.

2. A group member recognizes a loss on a disposition of subsidiary-member stock that is duplicative of the subsidiary member's inside loss, the subsidiary remains a group member and the group subsequently recognizes the subsidiary member's inside loss.

   Example 2: In year 1, P Corp. forms S Corp. with a contribution of $80 for 80 shares of S common stock (CS1). In year 2, P contributes Asset A, with a basis of $50 and a FMV of $20, to S for an additional 20 shares of S common stock (CS2). In year 3, P sells the 20 shares of CS2 for $20 and recognizes a $30 loss, which offsets P's income on the group's consolidated return. The sale of the CS2 does not result in S's deconsolidation. In year 4, S sells Asset A and recognizes a $30 loss, which also offsets P income on the group's return. Similar to Example 1, above, the group has obtained two tax losses from a single $30 economic loss.

   To address the two concerns above, and to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss, the -35T regulations create two primary rules--a basis-redetermination rule (BRR) and a loss-suspension rule (LSR).

   These new regulations provide a set of ordering rules; according to -35T(b)(6), the BRR must be examined before exploring the consequences of the LSR. Both of these rules are only applied after any required alterations are made under the investment-adjustment rules of Regs. Sec. 1.1502-32 (-32). Finally, Temp. Regs. Sec. 1.337(d)-2T must be applied after -35T.

   BRR

   The BRR, which is a direct response to concern 1 above, attempts to...