Excess Loss Accounts: Avoiding Unanticipated Recaptures

By James J. Weinclaw, CPA, Marcum & Kliegman, LLP

In planning for and preparing tax returns for consolidated return groups and in transactional planning, the excess loss account provisions under Treasury Regulations section 1.1502-19 should be carefully considered. In determining the tax liability of a consolidated group, subsidiary losses may be used to offset income from other members of the group, even when a parent has no net positive investment (i.e., basis) in the stock of the subsidiary. By allowing losses from subsidiaries for which a parent has no positive tax basis to be used in consolidation, negative basis can be created [Treasury Regulations section 1.1502-19(2)(A)(ii)]. In leveraged buyouts, those funds borrowed at the target level that are distributed to a holding company also create negative basis adjustments. Where the tax basis falls below zero, an excess loss account (ELA) is created. The ELA represents negative tax basis and can create unexpected recapture of income under many circumstances. Proper planning, however, can defer or eliminate the recapture of negative subsidiary basis.

Subsidiary Basis Adjustments and ELA Recapture

The investment adjustment rules in Treasury Regulations section 1.1502-32 must be applied in calculating a parent’s tax basis in a subsidiary. Generally, subsidiary stock basis is increased for taxable income, tax-exempt income, and capital contributions; it is decreased for taxable loss, noncapital and nondeductible expenses, and distributions with respect to the subsidiary stock. Tax-exempt income increases basis because otherwise additional gain would be recognized on the sale of the stock and the exempt income would become taxable. Note that noncapital and nondeductible expenses are generally deductions and losses that are taken into account but are permanently disallowed or eliminated by applicable law. For example, expiring subsidiary net operating losses (NOL), net capital losses, federal tax payments, or attributed reductions to an NOL under IRC section 108(b) would be a negative adjustment to basis [see Treasury Regulations sections 1.1502-32(b)(3)(iv)(D), 1.1502-33(d)(3), and 1.1502-32(b)(3)(ii)(C)].

To illustrate the subsidiary basis adjustment and excess loss provisions, assume the following:

Recapture provisions. The ELA provisions require that a parent’s negative basis with respect to subsidiary stock be recaptured as taxable income when a triggering event occurs—generally, a parent disposing of stock in a subsidiary. For recognition purposes ELA recapture occurs (among other triggers) when a parent ceases to own 80% of the shares, when a parent recognizes gain or loss with respect to the shares, upon a deconsolidation in which either parent or subsidiary become nonmembers, or upon worthlessness of subsidiary stock.

To illustrate ELA recapture on a disposition, assume the same fact pattern as in the above example (P has a $500 ELA). P disposes of S stock for $1,000. As a result, P recognizes a $1,000 capital gain on the sale of stock and $500 ELA recapture, for a total gain of $1,500.

A deconsolidation occurs when a member is treated as having a separate return year. This occurs when a parent’s ownership percentage in a subsidiary falls below 80% because the subsidiary issues additional shares, or because a parent disposes of shares, or when, for any reason, S ceases to be part of the consolidated group. There are exceptions to the disposition rules. For example, when a new group acquires the assets or stock of the old common parent, or there is a downstream merger of the old parent pursuant to Treasury Regulations section 1.1502-75(d)(2), or there is a reverse acquisition pursuant to Treasury Regulations section 1.1502-75(d)(3), the ELA is not recognized.

Worthless stock. When a parent holds worthless subsidiary stock, it is treated as having disposed of such stock. Worthless, in the context of Treasury Regulations section 1.1502-19(c)(1)(iii), does not mean insolvent. The regulations intentionally delay ELA recapture if the underlying assets retain some value until they are disposed of, abandoned, or destroyed for federal income tax purposes. If not for this rule, ELA recapture would be triggered under the IRC section 165(g) standard. For consolidated return years after January 1, 1995, subsidiary stock is not treated as worthless under IRC section 165(g) before the stock is treated as disposed of under Treasury Regulations section 1.1502-19(c)(1)(iii).

There are two special rules about worthless stock. First, if there is discharge of indebtedness (DOI) excluded from gross income under IRC section 108(a) that exceeds the amount of reduction in tax attributes under section 108(b), a member’s stock is deemed worthless. Second, if a parent takes a bad debt deduction or loss for an subsidiary’s uncollectable debt and the subsidiary fails to recognize the same amount of income in the same tax period, the stock is also deemed worthless.

Antiavoidance provisions. Treasury Regulations section 1.1502-19(e) contains provisions that allow the IRS to apply the regulations or make necessary adjustments to an ELA in order to avoid certain abuses. For example, the IRS can invoke the antiavoidance provisions and require income recognition if—

• a consolidated group member has an ELA,
• the member is in default on loans upon which the creditor neither discharges nor initiates collection actions because of the absence of assets, or
• operations have substantially ceased but ownership continues with the principal purpose of avoiding the ELA trigger.

Allocation Among Classes of Stock

Treasury Regulations sections 1.1502-32(b)(2)(i) and (ii) require a consolidated group member that has an ELA in a class of stock and that subsequently contributes capital and receives additional shares of the same class to first apply the contribution to the ELA and then to the basis in the new shares. If the contribution does not exceed the ELA, the basis in the new shares is zero. The same rule would apply if no new shares were issued.

When there is more than one class of common stock, adjustments must be “based on consistently applied assumptions, by taking into account the terms of each class of stock and all other facts and circumstances relating to the overall economic arrangement. The allocation must generally reflect the manner in which the classes participate in the economic benefit or burden (if any) corresponding to the items of income, gain, deduction, or loss allocated.” Once the allocation among stock classes is determined, the allocation rules should first be applied to eliminate any ELA within that class of stock.

Character of ELA recapture income. When a taxpayer is required to recapture an ELA, the income is normally treated as capital gain on the sale of the stock. However, when an ELA is recaptured due to the disposition of an insolvent subsidiary, the ELA gain is characterized as ordinary income to the extent the subsidiary is insolvent immediately preceding the disposition. Treasury Regulations section 1.1502-19(b)(4) defines insolvency for this purpose as the excess of liabilities over the fair market value of the assets at the time the gain is recognized. The amount characterized as ordinary income with respect to an insolvent subsidiary is reduced to the extent the subsidiary’s ELA includes any negative adjustments for distributions.

Planning for Subsidiaries with ELA

There are a number of options available to a parent corporation looking to manage a subsidiary with an ELA. Planning should be done well in advance of the possibility of an ELA being recognized as income. Remember that the IRS can employ the antiavoidance rules on a facts and circumstances basis; the IRS’s chances of success become much greater when planning is done after the fact, and a virtual certainty if done after the year-end.

When a parent corporation would like to leave the corporate structure intact, generally there are two methods available. First, income-producing assets or business segments can be contributed into the corporation along with the ELA. The additional capital contributions will reduce the ELA to the extent of the properties’ tax basis, and the income generated will further reduce the ELA (of course, this may subject the contributed assets to claims of the subsidiary’s creditors). Alternatively, the subsidiary with the ELA can be left alone; however, it must have assets with more than a nominal value and an ongoing business with substantial operations to avoid the worthless subsidiary rule that triggers ELA recognition. Although this will not eliminate the ELA, it will defer any recognition.

Corporate reorganizations can be used for eliminating or deferring an ELA. Generally, an ELA is eliminated when a solvent subsidiary whose stock has an ELA is liquidated or merged upstream into the parent corporation in a tax-free reorganization. The downstream merger of a parent into a subsidiary will produce the same result. Alternatively, a subsidiary can be merged into another subsidiary of the consolidated group. If such a merger qualifies as a tax-free reorganization, it will not trigger the ELA provisions. The ELA does not disappear as it would with a parent-subsidiary merger; rather, it is transferred to the parent’s stock basis in the acquiring affiliate corporation.

As noted previously, a disposition of subsidiary stock to an unrelated party will trigger an ELA in that stock. If the selling shareholder can make an IRC section 338(h)(10) election, however, the ELA will be eliminated provided the deemed liquidation qualifies under IRC section 332 (i.e., the target is solvent and it is a tax-free reorganization).

The ELA reorganization issues are relatively simple to understand. In practice, however, the ELA issue is one of many to consider in dealing with the large, complex body of tax law applicable to corporate reorganizations. Due care should be given to the following, as well as other tax and nontax issues, when reorganizing the consolidated group structure: Records necessary to support subsidiary stock basis calculations must be maintained. Whenever stock transactions or debt restructuring is anticipated, stock basis calculations should be done. Having a basis study done and rolled forward will avoid the problems of last-minute basis calculations covering many past years that could be inaccurate for various reasons (such as the failure to locate reliable records) or could produce unanticipated results where an ELA triggering event has occurred. Planning for an ELA triggering event will usually reduce or eliminate the potential tax from ELA recapture.

Editors:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Stephen Sacks, CPA, JD, LLM
Ernst & Young, LLP

Ira H. Inemer, CPA

©2009 The New York State Society of CPAs. Legal Notices