Prior to 1987, assets were permitted to leave a corporation and take a stepped-up basis in the hands of the shareholders without imposition of a corporate level tax. The non-recognition of gain referred to as the "General Utilities" rule, effectively created a permanent exemption from corporate income tax for appreciated corporate assets. As part of TRA 86, the General Utilities rule was repealed. The repeal was intended to require the corporate level recognition of gain on a corporation's sale or distribution of appreciated property. In enacting Sec. 337(d), Congress granted authority to the IRS to issue regulations to ensure that the repeal of General Utilities is not circumvented through the consolidated return regulations.

The consolidated return regulations provide for an investment adjustment to the basis of a parent's investment in a subsidiary. In part, the basis of the parent is adjusted upwards to reflect the operating income of its subsidiary and downwards to reflect the operating losses of its subsidiary. The effect of the investment rules is that the parent corporation could either recognize a loss as a result of a basis increase attributable to an acquired "built-in-gain" or recognize a loss which will be duplicated by the subsidiary when its assets are sold. The Treasury Department believes that Congress intended the repeal of General Utilities to prevent losses in both situations. The potential abuses are illustrated as follows.

1. Built-in-Gain. Corporation S has an asset with a FMV of $100 and an adjusted basis of $20. Corporation P acquires the stock for $100. P's basis in the stock of S is $100. Subsequently, S sells its asset for $110, recognizing a gain of $90. In the same year, S has an operating profit of $40. Under the investment adjustment rules, P's basis in the stock of S has increased to $230. P then sells the stock of S for $140, realizing a loss of $90. Of the $90 loss realized by P, $80 of the loss is attributable to appreciation of an asset of S which occurred prior to its acquisition by P. Therefore, $80 of the loss is attributable to a built-in-gain of S. The remaining $10 of loss is attributed to an economic decrease in the value of S, which is incurred by P.

2. Duplication of Loss. S has an asset that has a basis of $90 and a FMV of $100. P buys the stock of S for $100. Subsequently, the value of the asset declines to $40. P sells all of the stock for $40 and recognizes a loss of $60. In this situation, duplication of loss results as P has loss on the sale of stock of $60, and S new has a "built-in" unrealized loss on its asset of $50. The amount of duplication of loss is $50. The amount of duplication of loss is $50. Such duplication regularly occurs in a separate return situation where an individual owns the stock of a corporation. However, in a consolidated return situation, the shareholder is a corporation, not an individual. In this sense, the Treasury Department considers the duplication of loss as avoidance of the repeal of General Utilities.

The Treasury's Solution

The Treasury's response has been to issue regulations that as a general rule disallow all losses on a sale of subsidiary stock. The Treasury acknowledges that an absolute limitation on losses would not be fair in situations where the parent has a true economic loss. This is reflected in Reg. 1.337(d)-(1) which disallows losses on sales of subsidiary stock, but allows an exception for losses that can be substantiated as not attributable to built-in-gains. The exception to the loss limitation rule is referred to as the tracing rule. The tracing exception applies only to dispositions prior to November 19, 1990.

On November 19, 1990, Prop. Reg. 1.1502.20 was issued. The regulation does not provide for a tracing exception. Such an exception was deemed by the Treasury to be administratively burdensome, and subject to taxpayer manipulation. The proposed regulation generally disallows all losses on sales of subsidiary stock. However, in recognition that true economic loss should be allowable, the regulation provides for an exception to allow loss in certain circumstances.

The regulation also provides for rules preventing avoidance of loss disallowance by asset stuffing or deconsolidation. The regulation does provide that a parent may elect to reattribute to itself an unused net operating loss, limited to loss disallowed which is attributable to the subsidiary leaving the group. In view of the harshness of the regulation, the IRS issued a procedure whereby groups may elect to deconsolidate.

Rev. Proc. 91-39 provides that an election to deconsolidate may be filed no 1.1502-20 is issued as final. The election will be effective as of the beginning of the taxable year which includes November 19, 1990. Therefore, for a calendar-year taxpayer, the election would be effective as of January 1, 1990. If the electon is made, no member can become a member of a new consolidated group for 60 months.

Prop. Reg. 1.1502-20

1. Loss Disallowance. As stated, the regulation generally disallows losses on all sales or other dispositions of subsidiary stock. However, in an effect to allow true economic losses, the regulation allows a loss to the extent it exceeds the sum of the following:

* Extraordinary Gain Dispositions. These include dispositions made after November 18, 1990, of capital assets, Sec. 1231 assets, and bulk asset dispositions that result in a gain. Dispositions producing gain are not offset by dispositions producing losses.

* Positive Investment Adjustment. These include any positive investment adjustments from operations net of distributions in a taxable year. Positive and negative adjustments occurring in different taxable years are not netted.

* Duplicated Loss. This is equal to the sum of the aggregate adjusted basis of assets of the subsidiary net of liabilities, and any unnetted net operating losses over the FMV of the subsidiary's stock.

2. Anti-Stuffing Rule. The regulation provides that if any transger of an asset to a subsidiary is followed within two years by a disposition or deconsolidation of stock, basis of the stock will be reduced by an amount sufficient to cause recognition of gain, equal to loss disallowance avoided by reason of the transfer.

For example, S has an asset with a basis of zero and a FMV of $100. P buys the stock of S for $100. P sells the asset for $100, which increases P's basis in the stock to $200 (if P sold the stock at this point for $100, the resulting loss of $100 would be subject to disallowance). Subsequently, P transfers to S an asset with a basis of zero and FMV of $100 tax-free pursuant to Sec. 351. P's basis in the stock remains at $200, but the FMV has increased to $200. P then sells the stock, within two years of the asset transfer for $200, which produces no gain or loss. Under the anti-stuffing rule, P's basis in the stock would be reduced by $100, thereby resulting in a $100 gain to be recognized on the sale.

3. Deconsolidations. This is defined as an event that causes a share of stock of a subsidiary to be no longer owned by a member of the group of which the subsidiary was a member. The regulaton provides that in the event of a deconsolidation, the basis of the remaining shares held in the group is reduced to its value.

For example, P forms S in exchange for all 100 shares of S stock. The value of S declines from $100 to $50, and P sells 60 shares of S stock for $30. The sale causes a deconsolidation of the remaining 40 shares held by P. Under the regulation, P must reduce the basis of the remaining 40 shares from $40 to $20.

4. Reattribution of Unused NOL. A common parent may elect to reattribute to itself a portion of NOL that would otherwise be apportioned to a subsidiary leaving the group. Reattribution is available only to the extent that the parent is subject to loss disallowance with respect to the sale or other disposition of the subsidiary stock. The reattribution election applies to NOL's generated by the subsidiary whether or not the losses arose within the consolidated group (SRLY or non-SRLY). Reattribution is not permitted to the extent the disposed of subsidiary is insolvent. The election should be attached to the consolidated return in the year of the disposition, and delivered to the acquirer prior to the time the acquirer's return is to be filed.

Planning and Negotiation

Generally, buyers want to purchase assets to avoid unrecorded corporate liabilities and to be able to revalue depreciable assets for tax purposes. Sellers decide whether to sell assets or stock based on their tax cost. The proposed regulations may lead both buyer and seller to an asset sale.

Another consideration is a seller's right to a reallocate the net operating losses on a stock sale. The ability to reallocate net operating losses on sale of a subsidiary (losses generally go to the buyer) may cushion the negative effect of not being able to record a loss on a sale of the stock.

A Sec. 338(h)(10) election gives the seller of stock the right to treat the transaction as a sale of assets. Given the choice between a disallowed loss on sale of stock or allowable losses on a deemed sale of assets, the seller will want to make this election. Therefore, if for business reasons a stock deal is preferred, the ability of the seller to make a Sec. 338(h)(10) election will be part of the negotiations. The following illustrates the implications of the new rules.

Example. P contributes $10 million to S, a newly formed subsidiary. S purchases operating assets for $10 million. In year 1, s produces operating income of $1 million. In year 2, S has a taxable loss of $500,000. The loss is fully utilized by the consolidated group's other taxable income. Due to adverse market conditions, the value of S at the end of year 2 declines to $8 million. Under the loss disallowance rules, the recognized capital loss of a $2.5 million sale of stock would be limited to zero, illustrated as follows:

BasisofPinSstock

Investment$10,000,000

Year1profit1,000,000

Year2loss(500,000)

BasisatendofYear2$10,500,000

LossDisallowance

Recognizedloss($2,500,000)

CalculationofLimitation

1.E&Pfromextraordinary

gaindispositons-0-

2.Aggregateamountof

positiveadjustmentsfor

E&Pnotincludedin1.1,000,000

3.Duplicationofloss:

a.aggregatebasisof

assetsnetof

liabilities10,500,000

b.unusedNOL-0-

c.FMVofstock(8,000,000)

2,500,000

Lossdisallowance3,500,000

Lossislimitedto:$-0-

The loss disallowed is essentially attributable to the $2.5 million built-in loss that the new owner of the subsidiary may avail itself of.

The potential loss disallowance of $2.5 million would change our negotiating approach. In the past, a sale of either stock or assets would produce a loss of $2.5 million. Assuming the capital loss could be utlized, we would be in a position to sell either stock or assets. However, under the new regulations an asset sale would produce a $1 million ordinary loss as opposed to a zero capital loss. Therefore, an asset sale would be preferred in this situation. If the purchaser insisted on a stock deal, we would want to negotiate a Sec. 338(h)(10) deemed asset sale electon.

As illustrated, the regulation is a harsh and inflexible rule that will disallow losses in most situations. Although Congress authorized regulations in this area, it remains to be determined by the courts whether the Treasury has overstepped its mandate. However, until the regulation or parts thereof are found to be invalid, we must consider the regulation as fully binding to all potential sales of subsidiary stock.