Reg. §1.1502-36

In September 2008, the Treasury finalized the consolidated return loss disallowance rule, now known as the unified loss rule, bringing to some sort of conclusion a 20-plus year saga that began with the repeal of the General Utilities doctrine by the Tax Reform Act of 1986.

What You Need to Know

Like many consolidated return regulations, this one will be approached by many taxpayers and professionals on a need-to-know basis. It contains tremendous detail about things you won’t need to know unless you are ensnarled in one of the covered stock transfers; therefore, the main things you need to know are a) when it applies and b) what it can do to the parties to the stock transfer (including the member whose stock is transferred).

(1) Consolidated group member selling stock of another member and expecting to recognize a loss. By now (since 1987), most tax professionals know that recognizing the loss on the disposal of group member stock is likely to be hard, and so they will be forewarned to delve into this regulation when the loss is in the offing. The short answer is that, to the extent the loss results from positive investment basis adjustments, the group very likely cannot recognize it. Also, to the extent the stock loss results from an atypically high basis in the particular share sold, it likely cannot be recognized due to a required variety of stock basis leveling.

(2) Person buying subsidiary out of a consolidated group. To the extent the stock loss results from neither of the two causes identified in the prior paragraph, but rather from duplication of loss in the stock of the sold subsidiary (S) and the assets of S (that is, the sub’s assets’ values went down), the seller, M, likely can recognize the loss, but S will suffer a loss of inside tax attributes to the extent of the group’s recognized loss, which can be very upsetting to the buyer of the S stock. Hence, the buyer of stock of a consolidated group member, S, out of the group, finds himself in the second situation where even the casual observer will need to know about the new regulations.

The person buying such loss share will be quite grumpy if S unexpectedly loses its tax attributes (basis and NOLs, although the NOLs might be §382 limited anyway), because M recognized a loss that was a duplicated loss, meaning a loss that is duplicated in the assets of S, and the Treasury thinks that allowing the recognition of both of those losses in the tax world is contrary to the consolidated return regime, even if that means disallowing losses to S after it leaves the group that sold its stock.

The Three Regimes Employed by the New Regulation

From the foregoing you may discern that the regulations focus on three things, and can be considered to involve three regimes in one regulation: (1) reversing investment basis adjustments in S’s stock that otherwise would produce a “noneconomic loss” in the stock, meaning tax loss deductions that do not reflect real economic losses in the consolidated group, (2) preliminary stock basis leveling rules and (3) a final reduction of tax attributes in the sold subsidiary where the group was allowed to enjoy the loss in its stock, which is presumed to be a duplicated loss, inside and outside of the sold subsidiary. Keeping these three regimes straight will aid in understanding the regulation.

How we got here

Before the Tax Reform Act of 1986, a corporation, in many cases, could distribute an appreciated asset to shareholders without recognizing the appreciation and the shareholder would take a fair market value basis at the price of paying tax on a dividend or redemption or liquidation receipt. That was known as the General Utilities doctrine. The 1986 Act eliminated that very favorable combination of results.

Thereafter, corporations searched for ways to replicate the General Utilities results, and found ways based on using the investment basis adjustment rules of the consolidated return regulations. Reg. §1.1502-32 somehow had managed never to be corrected for the fact that the following could occur: M buys S for $100 and S enters M’s consolidated group; S owns asset worth $100, basis of zero; S sells the asset for $100; M’s basis in S is increased to $200 pursuant to the normal application of the investment basis adjustment rules; M sells S stock for $100 and recognizes a $100 loss, which may negate the $100 of income recognized in the group and, hence, it was thought, negate the repeal of the General Utilities doctrine. Section 337(d) authorized regulations to prevent such abuse of the repeal of the doctrine.

The Treasury initially decided that the simplest solution was to disallow all losses recognized on the sale of group member stock, hence the original loss disallowance rule (LDR). Taxpayers argued that they should be able to trace the inappropriate basis increases and back them out of stock basis, leaving appropriate losses in stock that could be recognized (which probably would be duplicated losses). The Treasury stoutly insisted that “tracing is impossible,” and moreover discovered that it also did not like duplicated losses, which normally would be the residual stock loss after any inappropriate basis increases were backed out. The Treasury felt it had authority to limit the group to one tax loss for one economic loss, and if that required denying a deduction for a real economic loss on a member’s stock, so be it.

This juxtaposition of (1) trying to correct the inappropriate investment basis adjustments, (2) trying to eliminate one of the two presumed duplicated losses and (3) the refusal to allow tracing in the stock basis adjustments are the three key reasons why this regulation project has lasted so long and produced such a complex result.

Along the way, the Treasury realized that a stepping stone to loss elimination was to level basis of shares of member stock. Hence, an intermediate step in the regulation project was a basis redetermination rule, which remains in the final regulation, formerly in Reg. §1.1502-35. Also, along the way, the Treasury discovered it could put to use the concept of “basis disconformity,” the elimination of which could serve as a floor on the required basis reduction.

Disconformity Amount

“Disconformity amount” term refers to the difference between the “outside basis” and the “inside basis” of the member stock, and the assets inside the member. The existence of such a difference is thought to be a signal that something is not going to work right in the consolidated return stock basis regime. Generally, if M forms S and S earns money or loses money, M’s outside basis in the S stock and S’s net inside basis in its assets (plus the amount of its other tax attributes) rise and fall together. The netting out of liabilities of S is necessary because S can always borrow money and create inside basis in assets, but that does not make S stock more valuable and does not affect M’s basis in the S stock.

But if M buys S after it has been an existing operating corporation, it is highly likely that the inside and outside basis will differ.

Example. M buys all of the stock of S for $100. S owns assets worth $200, basis of $125 and owes liabilities of $100. The disconformity amount is $75 ($100 - ($125 - $100 = $25)). Reg. §1.1502-36(c)(4). The appreciation in S’s assets is $75 over basis. Thus the disconformity amount is the “net unrealized appreciation reflected in the share’s basis.” Reg. §1.1502-36(c)(1).

Conclusion

Most of the complexity of the unified loss rule is attributable to the decision, made by the Treasury 20 years ago, that taxpayers could not be allowed to trace and correct the inappropriate investment basis adjustments resulting from built in gain. Nevertheless, taxpayers will have to have very exact records of their subsidiaries’ investment basis adjustments to comply with this regulation, should the need arise.