Mergers and acquisitions activity for the near- and midterm will likely involve an unusual amount of bargain purchases, including “carve-outs” from consolidated return groups. In such carve-out transactions, subsidiaries are acquired from existing federal consolidated return groups. The unified loss rules contained in Treasury Regulation section 1.1502-36 may disallow all or part of a seller loss, or may result in a step down in the basis of the stock or assets received by the buyer in such transactions.
The unified loss rules may also disallow all or part of a section 165(g)(3) worthless stock deduction and may also apply when a subsidiary deconsolidates from a federal consolidated return group.1
The current unified loss rules generally apply to transfers of shares of subsidiary stock on or after September 17, 2008.2
This article discusses the current unified loss rules regime at a high level and provides context for the rules.3 Moreover, the article highlights various elections contained in the regulations that may provide more beneficial outcomes depending on a taxpayer’s facts and circumstances.
The investment basis system
The unified loss rules are designed to address certain issues that can arise from the application of the regulation section 1.1502-32 investment basis adjustment system. In a consolidated return group, the tax basis of subsidiary stock is generally adjusted by the net change in the tax basis in the assets of the subsidiary.4 For example, P forms S with $100 on 1/1/X1. During X1, S generates $40 of positive investment basis adjustments (for this example, assume all attributable to generating taxable income). At the end of X1, P’s tax basis in the stock of X1 would be $140 ($100 initial basis + $40 of net positive investment basis adjustments).
Purpose of unified loss rules
The unified loss rules have two principal purposes:
1. Non-economic loss: The first principal purpose is prevent the consolidated return provisions from reducing a group’s consolidated taxable income through the creation and recognition of a non-economic loss.5 In other words, the mechanism of the consolidated return regulations may create tax basis in subsidiary stock that is non-economic.
For example, P acquires the stock of S for $100. S contains one asset with a basis of $10 and a FMV of $100. S then sells the asset for $100 and now has assets with a basis of $100 (the cash). However, under regulation section 1.1502-32, P’s tax basis in the stock of S is adjusted by the $90 gain, resulting in an “outside” tax basis in the stock of $190.6 If P then sold the S stock for $100, absent the unified loss rules, P would be able to take a $90 non-economic loss on the transaction.
2. Duplicated loss: The second principal purpose is to prevent members (including non-members) of the group from collectively obtaining more than one tax benefit from single economic loss.
For example, P acquires S for $200, and S has one asset, a tract of land, with a FMV and tax basis of $200. In a subsequent year, the value of the land has declined to $160. P sells the stock of S to a third party for $160 – reflecting the $40 decline in the value of the asset. The third party thus acquires stock with a basis of $160 which has an asset with a FMV of $160 and basis of $200. The third party sells the land for $160. As such, the loss is “duplicated” as both P has a $40 loss on the sale of the stock and the third-party has a $40 loss on the sale of the land.
Section 1502 of the tax code contains only one paragraph and essentially grants the Secretary of the Treasury to prescribe regulations to clearly reflect income tax liability for a consolidated return group.
In 1966, the Treasury issued extensive consolidated return regulations, which were substantially revised in 1995. These regulations included former regulation section 1.1502-20, which generally disallowed losses due to the recognition of built-in gains (non-economic losses) and duplicated losses, as described above.
In 1994, Rite Aid Corporation (Rite Aid), sold a subsidiary at a loss. The “duplicated loss” as calculated under regulation 1.1502-20 exceeded Rite Aid’s loss, and thus the loss was completely disallowed by the regulations. Rite Aid paid the tax for 1994 exclusive of the loss on the subsidiary, and filed a claim for refund, which the government denied. Rite Aid then sued for a refund. In 2000, The Court of Federal Claims granted summary judgment for the government and found that regulation section 1.1502-20 “is not arbitrary, capricious or manifestly contrary to law".7
In 2001, The United States Court of Appeals for the Federal Circuit reversed the Court of Federal Claims holding that the regulation was not within the authority delegated by Congress under section 1502. Specifically, the Federal Circuit held: “because the regulation does not reflect the tax liability of the consolidated group, the regulation is manifestly contrary to the statute".8 This ruling created a great deal of uncertainty by calling into question many other aspects of the consolidated return regulations, including other portions of the 1.1502-20 regulations. To remedy this issue, in 2004 Congress amended section 1502 to include the sentence: ". . . the Secretary may prescribe rules that are different . . . (from those) that would apply if such corporations filed separate returns.”
In 2008, the Treasury issued the unified loss rules under 1.1502-36, which were the final replacement for the prior section 1.1502-20 loss disallowance regulations. While the unified loss rules are more comprehensive than the section 1.1502-20 regulations, as stated above, they maintain the goal of eliminating losses relating to duplicated and non-economic losses.
The unified loss rules consist of three principal rules that are applied sequentially: (1) the basis redetermination rule; (2) the basis reduction rule; and (3) the attribute reduction rule.
Basis redetermination rule
The first step in the unified loss rules is to determine if there is disparity between different tranches of the subsidiary’s stock.9 For example, P may hold 80 shares of S stock with a $10 gain and 20 shares of S stock with an $8 loss. S might decide to sell the 20 shares and recognize an $8 loss, which could result in a duplicated loss or a non-economic loss.
The basis redetermination rule does not apply if:
- There is no disparity among member’s basis in shares of S stock and no member owns a share of preferred stock with respect to which there is unrecognized gain or loss; or
- All the shares held by the group are transferred to one or more non-members, become worthless under section 165, or a combination thereof in one taxable transaction.10
If the basis redetermination rules apply, under complex rules, the bases of transferred loss shares may be reduced and the bases of gain preferred and common stock may be increased.11 In our example above, the basis in the loss shares might be increased under the basis determination rule and the basis in the gain shares might be reduced. Application of the basis redetermination rules cannot alter the overall amount of basis in shares of S held by members of the consolidated return group.12
Even if all shares are transferred in one taxable transaction or become worthless under section 165, a consolidated group can still elect to apply the basis redetermination rules if they hold shares with disparate bases.13
Stock basis reduction to prevent noneconomic loss
If a transferred share is a loss share after any basis redetermination, then stock basis reduction may reduce the basis in the member’s share.14
The stock basis reduction rules reduce basis in a transferred share of S stock to prevent non-economic stock loss and thus promote a clear reflection of the group’s income. The stock basis reduction rules limit the reduction to the basis in the S share to the amount of net unrealized appreciation reflected in the share’s basis of the transfer (the “disconformity amount”). The rules also limit the reduction to basis in the S share to the portion of the share’s basis that is attributable to investment adjustments made pursuant to the consolidated return regulations.15
Specifically, under the basis reduction rules, basis in the loss shares is reduced, but not below value, by the lessor of:
- The share’s net positive adjustment; and
- The share’s disconformity amount.16
Net positive adjustment is the greater of:
- Zero; and
- The sum of all investment adjustments reflected in the basis of the share.17
A share’s disconformity amount is the excess, if any, of:
- The member’s basis in the share; over
- The share’s allocable portion of S’s net inside attribute amount (which is the sum of net operating and capital loss carryovers, deferred deductions, money, and basis in assets other than money, reduced by the amount of S’s liabilities).
Let’s return to our non-economic loss example:
P acquires the stock of S for $100. S owns one asset with a basis of $10 and a FMV of $100. S then sells the asset for $100 and now has assets with a basis of $100 (the cash). However, under regulation section 1.1502- 32, P’s tax basis in the stock of S is adjusted by the $90 gain, resulting in an “outside” tax basis in the stock of $190. P then sells the S stock for $100.
Under the basis reduction rules, we would determine the positive investment adjustments (which is the $90 gain from the sale of the asset) and the disconformity amount, which is also $90 ($190 basis less $100 of net inside attributes). In this case, both the positive investment adjustments and the basis disconformity amount are the same, so the lesser of the two is $90. As such, the basis in the S shares would be reduced from $190 to $100 as a result of the stock basis reduction rule, and thus would prevent a non-economic loss on the sale of the S stock.
Attribute reduction to prevent duplication of loss
The attribute reduction rules reduce attributes of S to the extent they duplicate a net loss on shares of S stock transferred by members in one transaction. This rule is designed to prevent S from using deductions and losses to the extent that the group or its members have either used, or preserved for later, a corresponding loss in S shares.18
If a transferred share is a loss share after taking into effect any adjustments under basis redetermination or stock basis reduction, S’s attributes are reduced by S’s attribute reduction amount immediately before the transfer. In addition, the attribute reduction rules may apply in the case of certain transfers due to worthlessness and certain transfers not followed by a separate return year.19
An exception to the attribute reduction rule applies if the aggregate reduction amount in the transaction is less than five percent of the aggregate value of the shares transferred by members in the transaction.
Attribute reduction calculations:
S’s attribution reduction amount is the lesser of:
- The net stock loss; and
- S’s aggregate inside loss.
Net stock loss is the excess of:
- The aggregate basis of all shares of S stock transferred by members in the transaction; over
- The aggregate value of those shares.
Aggregate inside loss is the excess, if any, of:
- S’s net inside attribute amount (which is the sum of net operating and capital loss carryovers, deferred deductions, money, and basis in assets other than money, reduced by the amount of S’s liabilities); over
- The value of all outstanding shares of S stock.20
S’s attributes available for reduction are:
- Category A – Capital loss carryovers;
- Category B – Net operating loss carryovers;
- Category C – Deferred deductions;
- Category D – Basis of assets other than cash and cash equivalents.21
If’ S’s attribute reduction amount is less than S’s total attributes in Category A, Category B and Category C, all of S’s attribution amount will be applied to reduce such attributes. However, P may specify the allocation of S’s attribution amount among such assets.22
Let’s return to our duplicated loss example. P acquires S for $200, and S has one asset, a tract of land, with a FMV and tax basis of $200. In a subsequent year, the value of the asset has declined to $160. P sells the stock of S to a third party for $160 – reflecting the $40 decline in the value of its asset. The third party thus acquires stock with a basis of $160, which has an asset with a FMV of $160 and basis of $200. The third party sells the land for $160. As such, the loss is “duplicated” as both P has a $40 loss on the sale of the stock and the third party has a $40 loss on the sale of the land.
S’s attribution reduction amount is the lesser of the net stock loss or S’s aggregate inside loss. In this case, both amounts are $40. As such, S’s basis in the land would be reduced by $40 immediately before the sale to prevent the loss being duplicated by the buyer. As such, the buyer would acquire the shares for $160 and succeed to a stepped-down basis in the land of $160.
P may elect to reduce the potential for loss duplication, and thus reduce or avoid attribute reduction. To the extent of S’s attribution amount tentatively computed, P may elect –
- To reduce all or any portion of member’s bases in transferred loss shares of S stock;23
- To reattribute all or any portion of S’s Category A, Category B and Category C attributes, to the extent they would otherwise be subject to attribute reduction; or
- Any combination thereof.24
Alternatively, assume S had sold the land and recognized a $40 loss that had not been absorbed by the consolidated return group. Without reattribution, the $40 net operating loss would have been reduced under attribute reduction. However, if P elects to reattribute the $40 net operating loss to itself, P’s tax basis in the stock of S would decrease by $40 immediately before the sale. P would thus not have a disallowed loss on the sale and would succeed to S’s $40 net operating loss.25
If S is insolvent within the meaning of section 108(d)(3) at the time of the transfer, S’s losses may be reattributed only to the extent they exceed the amount of insolvency.26
Additional attribute reduction in certain cases
In the case of certain transfers due to worthlessness and certain transfers not followed by a separate return year, any of S’s Category A, Category B and Category C attributes not otherwise reattributed are eliminated.27
For example, P owns the sole share of S. The share is worthless under section 165.28 In addition, S had disposed of all of its assets. P claims a worthless securities deduction with respect to the shares. The worthlessness is a transfer of the S share, a loss share, and thus is subject to attribute reduction. After application of the basis redetermination and basis reduction rules, P’s basis (and thus P’s net stock loss) is $75. S has a $100 net operating loss carryforward. Under the general attribute reduction rules, S’s attribution amount is $75 [the lesser of P’s $75 net stock loss and S’s $100 aggregate inside loss ($100 net inside attribute amount over $0 value of S shares)]. S’s attributes are reduced by $75, from $100 to $25. In addition, if S remains a member of the group, because S is worthless, its remaining $25 of net operating losses are eliminated. M thus recognizes a $75 worthless securities deduction, S has $0 net inside attributes, and the consolidated net operating loss is reduced by a total of $100.29 Note that under the insolvency limitation, S’s losses could not have been reattributed to P.
If in the previous example S does not dispose of all of its assets, P causes S to be legally dissolved, and the S shares are canceled without consideration. The dissolution of S is similarly considered a transfer, and the results would be the same as above. The result would also be the same if instead of being legally dissolved, S was converted into a disregarded entity.30
In history, large events can be triggered by smaller ones. In this case, one US taxpayer, the Rite Aid Corporation, was denied a refund claim by the Internal Revenue Service (IRS), lost at the Court of Claims, and then prevailed at the United States Court of Appeals for the Federal Circuit. This singular tax case threatened to invalidate large swaths of the consolidated return regulations. It took Congress three years to add one sentence to the Section 1502 statute to resolve the regulatory authority issues raised by the Rite Aid case.
In the aftermath of Rite Aid, the Treasury undertook the mammoth project of writing a comprehensive set of regulations to replace the former section 1.1502-20 regulations. In the preamble to the final regulations, the Treasury stated:
The IRS and Treasury Department recognize that the proposed rules are complex. However, as recognized by commentators and practitioners, the complexity of the rules is a result of the balancing of benefits and burdens arising from the presumptions on which the rules are based.31
While the regulations are thus carefully written to prevent non-economic or duplicated losses, the application of the regulations in practice can provide unexpected consequences for both buyers and sellers. As such, both parties should closely consider the effect of the various elections contained in the regulations during stock sale negotiations. Additionally, consolidated return groups attempting to recognize an ordinary loss due to worthlessness of a subsidiary should be cognizant that the worthlessness loss may be partially or completely disallowed. An expert practitioner can apply the uniform loss rules with great precision. An uninformed taxpayer may fall into any number of traps for the unwary contained in the regulations.
1 Section 1501 allows an affiliated group of corporations to file a federal consolidated return. Section 1504(a)(2) requires an affiliated group to possess at least 80% of the total voting power and 80% of total value of the stock of a subsidiary. If a subsidiary falls below the 80% vote or 80% value test, such subsidiary will deconsolidate from the consolidated return group. For example, P owns 80% vote and value of S’s shares in Year 1. On June 1, Year 2, P sells 1% of the shares of S stock. P would thus own 79% of the shares of S, and S would deconsolidate from the P group effective at the end of the day on June 1, Year 2.
2 Regulation Section 1.1502-36(h).
3 The article does not discuss the effects of selling a chain of subsidiaries at a loss.
4 Exceptions to this rule exist. For example, tax basis in subsidiary stock is only reduced when a net operating loss is absorbed or carried back. Regulation Section 1.1502-32(b)(3)(i).
5 Regulation Section 1.1502-36(a)(2).
6 Note that the basis disconformity between “inside” and “outside” tax basis generally remains consistent when subsidiary stock is acquired without a step-up in inside basis. In this case, the basis disconformity amount is $90 both before and after the asset was sold. In general, there is no basis disconformity if the subsidiary was formed or acquired in an asset or deemed asset [e.g., in a Section 338(h)(10)] acquisition].
7 Rite Aid Corp. v. United States, 46 Fed. Cl. 500 (2000).
8 Rite Aid Corp. v. United States, 255 F.3d 1357 (Fed Cir. 2001).
9 Regulation Section 1.1502-36(b)(1)(i).
10 Regulation Section 1.1502-36(b)(1)(ii).
11 Regulation Section 1.1502-36(b)(2).
12 Regulation Section 1.1502-36(b)(1)(i).
13 The election is made in the manner provided in Regulation Section 1.1502- 36(e)(5).
14 Regulation Section 1.1502-36(a)(3)(i).
15 Regulation Section 1.1502-36(c)(1)
16 Regulation Section 1.1502-36(c)(2).
17 Regulation Section 1.1502-36.
18 Regulation Section 1.1502-36(d)(1).
19 Regulation Section 1.1502-36(d)(1)(i).
20 Regulation Section 1.1502-36(d)(3).
1 Regulation Section 1.1502-36(d)(4).
22 Regulation Section 1.1502-36(d)(4)(ii)(A). The election is made in the manner provided in Regulation Section 1.1502-36(e)(5).
23 The reduction is allocated among all such shares in proportion to the amount of loss on each share. Regulation Section 1.1502-36(d)(6)(iv).
24 Regulation Section 1.1502-36(d)(6). The election is made in the manner provided in Regulation Section 1.1502-36(e)(5). Although such elections are irrevocable, they have no effect if there no attribute reduction amount or to the extent S’s attribute reduction is less than the amount specified in the election.
25 Note that the $40 net operating loss may be more valuable to P than to the seller after taking into account the section 382 limitation that would have been imposed if P had sold S with the $40 net operating loss. Moreover, under Regulation Section 1.1502-95(d)(5), P may reattribute to itself all or any part of a section 382 limitation.
26 Regulation Section 1.1502-36(d)(6)(iv)(B).
27 Regulation Section 1.1502-36(d)(7)(i).
28 See “Worthless Stock Losses in Consolidated Return Groups: Tread Carefully,” Forrest Lewis. AIRA Journal, Vol. 26 No. 5 – 2013.
29 Regulation Section 1.1502-36(d)(7)(iii) Example (i).
30 Regulation Section 1.1502-36(d)(7)(iii) Example (ii).