The impact of unified loss rules on earnings and profits.

• Author: Smith, Annette B.

With the recent reported uptick in merger and acquisition activity, companies are increasingly looking at strategic options to buy or sell subsidiary stock. At the same time, companies may find that the value of their subsidiary stock remains well below its tax basis, potentially resulting in a taxable loss on disposition. If the subsidiary joins in the filing of a consolidated income tax return, the consolidated return regulations may limit or disallow the amount of loss that may be claimed or may require the shareholder to reduce its basis in the stock of the subsidiary, resulting in a reduction of the loss available for regular tax purposes.

A question arises whether the same limitation, disallowance, or basis reduction rules apply for earnings and profits (E&P) purposes. This item explores whether a corresponding adjustment is made for E&P purposes when a member of a consolidated group, S1 is required under Regs. Sec. 1.1502-36 (the unified loss rules) to reduce its basis in the stock of another member, S2, for regular tax purposes upon S1's disposition of the S2 stock at a loss for regular tax purposes.

Calculating E&P Basis in Computing E&P Gain or Loss

A consolidated group member's basis in the stock of another member may differ for regular tax purposes and E&P purposes. As a threshold matter, S1 must compute its basis in the stock of S2 for E&P purposes before determining whether it will recognize a loss from the disposition of its S2 stock. To properly compute S1's E&P basis in its S2 stock, the stock basis adjustment rules of Regs. Sec. 1.1502-32 are used, substituting the E&P items and timing rules for taxable income. Common differences relate to net operating losses (NOLs) and depreciation.

Exhibit 1 contains a simple example of the impact of NOLs on the calculation of tax basis and E&P basis. With a tax basis in S2 of $3,400 and an E&P basis of $3,100, if the S2 stock were sold for $3,150, S1 would anticipate a $250 capital loss on the sale for regular tax purposes but would recognize a $50 gain for E&P purposes. Stated differently, the S2 stock would be considered loss shares only for regular tax purposes. If S1 were required to reduce its basis in the S2 shares by $100 under the unified loss rules (and thus claim a $150 capital loss on the sale), it would appear that no further E&P adjustments would be needed. S1 would recognize $50 of E&P gain on the sale, that current E&P would "tier up" to the parent under the normal rules...