IRS Proposes Unified LDR Theory, Part 2
Proposed consolidated return regulations dealing with both loss duplication and loss disallowance in a unified manner.
February 14, 2008
by George White
In last month’s column, I disclosed what “thought experiments” entail and the problems with loss disallowance. Here’s a closer look at how to deal with loss shares and the ramifications of surviving the basis reduction rule of prop. reg. section 1.1502-36(c).
Example: P purchases 100 percent of S's stock, and S recognizes a gain that was inherent in S's assets at the time that P purchased S's stock (a built-in gain, or BIG). Under the investment adjustment system, S's gain increases P's basis in S stock basis above its fair market value, thus setting the stage for P to recognize an “uneconomic” loss.
Q. How does prop. reg. section 1.1502-36(c) deal with S's loss shares?
A. In a separate return world, a loss is a loss is a loss, and thus deductible — but not necessarily so in the world of consolidated returns. Prop. reg. section 1.1502-36(c) attempts to filter out uneconomic losses, as explained above. It does so by reducing the basis of a loss share by the lesser of two amounts — that is, to be deductible, an S stock loss must exceed the lesser of two thresholds: the share's net positive adjustments and the share's disconformity amount.
Q. The first threshold looks familiar, but what's a disconformity amount?
A. That concept was introduced in 2004 with Notice 2004-58.16. The fundamental notion is that S stock losses are excessive, or uneconomic, to the extent they are attributable to the recognition of BIG whose appreciation is reflected in the basis of S stock. BIGs, when recognized, inflate S stock basis over FMV, thus setting the stage for an uneconomic loss on S stock. One way to quantify a BIG is to measure the excess of outside (stock) basis over net inside (assets/attributes less liabilities) basis. The excess is the disconformity amount.
Q. Is there any connection between the two concepts?
A. One way to look at the two is to consider them as being in different stages of existence: The first (net positive adjustments) are BIGs that have already occurred (actual gains); the second (disconformity amounts) are BIGs that have not yet occurred (potential gains).1
Q. For example . . .
A. Assume P purchases the sole outstanding share of S for $100. S owns two assets: Asset 1 has a basis of zero and an FMV of $40; Asset 2 has a basis and FMV of $60. S's two assets are together worth $100, the price paid by P for S's stock. S sells Asset 1 for $40, thereby recognizing its BIG of $40. P sells the S share for $100 (S is worth the same, $100, before and after recognition of its BIG on Asset 1). S's recognition of its $40 gain increases P's basis in S to $140 — that is, $40 more than its FMV. The S share is now a loss share. (Note: No redetermination of P's basis in S under prop. reg. section 1.1502-36(b) is required because both exceptions apply — P's basis in S is uniform (S has only one share outstanding), and P is disposing of its entire interest in S.) However, a reduction in P's basis in S under prop. reg. section 1.1502-36(c) is required because S is a loss share. The basis of the S share is reduced by $40, which is both the positive adjustment mandated by reg. section 1.1502-32 and the disconformity amount. The latter is the excess of P's basis of $140 in the S share over S's attributes of $100 ($40 in cash from the sale of Asset 1, plus $60 in basis in Asset 2).2
Q. Can there be situations in which the two thresholds are different?
A. Assume P purchases the sole outstanding share of S for $100. S owns two assets: Asset 1 has a basis of $20 and an FMV of $60 (BIG); Asset 2 has a basis of $60 and an FMV of $40 (a built-in loss, or BIL). S's two assets are together worth $100, the price paid by P for S's stock. S sells Asset 1 for $60, thereby recognizing its BIG of $40. P sells the S share for $100 (S is worth the same, $100, before and after recognition of its BIG on Asset 1). S's recognition of its $40 gain increases P's basis in S to $140 — that is, $40 more than its FMV. The S share is now a loss share. (Note: No redetermination of P's basis in S under prop. reg. section 1.1502-36(b) is required, for the same reasons cited above.) However, a reduction in P's basis in S under prop. reg. section 1.1502-36(c) is required because S is a loss share. The basis of the S share is reduced by $20, which is the lesser of the $40 positive adjustment provided by reg. section 1.1502-32 and the disconformity amount of $20. The latter is the excess of P's basis of $140 in the S share over S's attributes of $120 ($60 in cash from the sale of Asset 1, plus $60 in basis in Asset 2). Accordingly, P recognizes a $20 loss on sale of the S share ($120 of basis over sales proceeds of $100).3
Q. What would happen in this scenario if S sold the BIL asset before the BIG asset?
A. Like the old Navy saying about a collision at sea, that could wreck your whole day. Recognition of the $20 BIL would result in a negative investment adjustment of $20, reducing P's basis in S to $80. Consequently, the sale of the S share would result in a $20 uneconomic gain (sales proceeds of $100 over $80 of basis). However, the group could use the loss on the asset sale to offset the stock gain.4 Note: The proposed regulations have no application to this scenario because S is not a loss share.
Q. How are S's attributes reduced?
A. In descending order, from actual to potential losses. Thus, the first hits go against net operating losses and capital loss carryforwards, respectively. Next come deferred deductions; then publicly traded loss property; then asset basis (exclusive of cash and publicly traded loss property). Next, if the required attribute reduction exceeds amounts in those four categories, the excess is suspended to be taken into account by reducing future deductions — for example, those subject to deferral under section 461(h). Finally, if all those categories are insufficient to absorb the required attribute reduction, the excess goes away, into the proverbial black hole of tax. (Indeed, the shadow of Treasury's experience in promulgating reg. section 1.1502-28, regarding excluded cash on delivery income, looms large here.)
Q. For example …
A. Assume S has 100 shares outstanding, all owned by P, which has a per-share basis of $2. S owns land with a basis of $100 and has a NOL of $120. P sells 30 shares for $1 per share — that is, P now owns less than 80 percent of S, which is thereby deconsolidated. P is considered to have transferred all of its S stock. The required attribute reduction is $100, the lesser of the total loss of $100 on all S stock ($200 basis over $100 total value), or $120, S's net inside attributes of $220 ($100 of basis in land plus $120 of NOLs, minus $100 of total value of S stock). P recognizes its $30 loss on disposition of 30 S shares, but S's NOL is reduced by $100 to $20. Note: P has preserved a $70 loss in the 70 S shares retained. In other words, the system has allowed/preserved one loss of $100 ($30 on the S shares sold plus $70 in the S shares retained) while eliminating the duplication of a second $100 loss inside S after it has left the P group (thus, the above reference to the extended P group including former members, like S).5
Q. There's an appealing symmetry to that solution, but what's it got to do with consolidated returns?
A. Actually, nothing. The loss duplication problem exists in separate, as well as consolidated, returns; it's a function of our classical system of corporate taxation under which shareholders (P) are taxed separately from their corporations (S). That was one of the holdings of Rite Aid, in which the duplicated loss factor of the old loss disallowance regulations was invalidated.6 But the rules in the consolidated return regulations are no longer tethered to separate return results, not since the American Jobs Creation Act of 2004 amended Treasury's rule-making authority to delink consolidated return results from comparable separate return results.7
Q. Hmm … let's go back to the example. Take the situation in which buyer B purchases all 100 shares of S stock from P. B's due diligence would give it access to S's tax history, which should yield information about S's attributes — for example, NOLs, asset basis, even section 461(h)-type deductions. But the attribute reduction rule of prop. reg. section 1.1502-36(d) is triggered by P's loss on S stock. How will B know about that?
A. Prop. reg. section 1.1502-36(d) would add a new dimension to due diligence: B will have to expand its horizons to include P's treatment with regard to S stock — that is, gain or loss, and if the latter, how much. (Good luck to B in nailing down the latter amount; P itself may not know how much of a claimed loss will survive IRS audit after application of these proposed regulations.)
Q. How can B protect its interests in this transaction?
A. Some have suggested that B obtain representations from P regarding the amount of S's attributes, but the value of P's representations is no stronger than its creditworthiness. The safer course would seem for B to bargain with P to give up any loss it may have in S stock. Such a waiver is provided in prop. reg. section 1.1502-36(d)(6). Alternatively, P may reattribute S's attributes to itself. The latter course is not available, however, if S remains a member of the P group.8
Q. What is the effective date of the proposed regulations?
A. Generally, the date of publication of final regulations in the Federal Register. However, the preamble indicates that Treasury is open to a request to allow for elective retroactive application.9
There you have it. Loss shares and the ramifications of surviving the basis reduction rule of prop. reg. section 1.1502-36(c) need not be vexing for so many CPAs. You just have to follow a few simple principles as outlines above.
1 Years ago, Prof. James Eustice made a similar distinction between net operating losses (losses already recognized) and built-in deductions (deductions not yet claimed); see Eustice, Carryover of Corporate Tax Attributes, 22 San Diego L. Rev. 117, 118-119 (1985).
2 See prop. reg. section 1.1502-36(c)(8), Example 1.
3 See id., Example 4.
4 This might be thought of as a reverse son-of-mirrors deal, canceling out a corporate-level loss with a shareholder-level gain.
5 See prop. reg. section 1.1502-36(d)(7), Example 1(ii).
6 Rite Aid Corp. v. United States, 255 F.3d 1357, Doc 2001-18688, 2001 TNT 132-10 (Fed. Cir. 2001).
7 Final sentence in section 1502.
8 Prop. reg. section 1.1502-36(d)(6)(iii)(A).
9 See Ivins, Phillips & Barker letter to Treasury dated Apr. 23, 2007, Doc 2007-11267, 2007 TNT 90-16.
Rate this article 5 (excellent) to 1 (poor).
George White is a manager with the American Institute of Certified Public Accountants in Washington and an adjunct professor for tax at the George Washington Graduate School of Business. The author would like to thank his longtime friend, Larry Axelrod of Deloitte Tax LLP, for his assistance in developing this report. This was first published by Tax Notes.