Greenberg Traurig Alert

IRS Will Not Litigate Loss Disallowance Rules

February 2002
By Harry J. Friedman, Greenberg Traurig, Phoenix Office

  View or download the PDF version of this Alert here.

As a result of the Solicitor General’s decision not to file an appeal with the Supreme Court in Rite Aid Corp. v. United States, the Internal Revenue Service (the "Service") has decided not to continue to defend the validity of the "loss disallowance rules" contained in the consolidated return regulations (Treasury Regulations Section 1.1502-20). Instead, the Service intends to promulgate new rules governing the treatment of losses on sales of stock of a member of a consolidated group. Interim Temporary Regulations, according to the Service, that will apply prospectively from the date of issuance, will require consolidated groups to determine the allowable loss on a sale or disposition of subsidiary stock under Treasury Regulations Section 1.337(d)-2 instead of Section 1.1502-20.

Harry J. Friedman

The loss disallowance rules were promulgated to attack a problem perceived by the Treasury Department in applying the consolidated return regulations to the repeal of the General Utilities Doctrine in the 1986 Tax Act. In particular, the Treasury was concerned about the possible sale of appreciated property by a subsidiary resulting in an increase in basis in the stock of the subsidiary. A subsequent sale of the stock of the subsidiary would result in a loss to the parent corporation. Purportedly for the sake of simplification, the Treasury rejected a tracing of built-in gain asset transactions for what it considered a simple rule, disallowing losses on the sale of the stock of a subsidiary by a member of a consolidated group. Under the Treasury Regulations, the amount of the loss disallowed is limited to the sum of the extraordinary gain dispositions, positive investment adjustments and duplicated loss. Extraordinary gain dispositions captures the earnings and profits attributed to the disposition of assets by the subsidiary. Positive investment adjustments are annual earnings and profit adjustments in the stock of the subsidiary required under the consolidated return regulations.

The duplicated loss amount is the loss carryforwards and net built-in losses attributable to the shares of stock of the subsidiary. Duplicated losses are present when a parent corporation sells the stock of a subsidiary in exchange for an amount less than the adjusted tax basis of the stock where the aggregate tax basis of the assets of the subsidiary also exceed their fair market value. In such circumstances, the parent corporation is entitled to a loss and the subsidiary can also incur a loss on the disposition of its assets. While the same problem could occur outside the consolidated return group, an issue the Treasury understood, the loss disallowance rules were used to address this problem, as well as the investment adjustment concerns.

Thus, the loss disallowance rules were intended to prevent the creation of an artificial loss from the sale of appreciated property through the investment adjustment rules of the consolidated return regulations, as well as to address the Treasury’s perceived concern about duplicated losses.

The loss disallowance rules were first addressed by the Court of Federal Claims in Rite Aid Corp. v. United States. In Rite Aid Corp., the taxpayer had sold the stock of a subsidiary that was a member of its affiliated group at a substantial loss. The duplicated loss of the subsidiary exceeded Rite Aid’s loss on the stock transaction. The Court of Federal Claims agreed with the Service that the regulations were proper in disallowing a loss incurred by Rite Aid on the sale of the stock of a subsidiary because of the duplicated loss.

However, the Federal Circuit Court of Appeals reversed the Court of Federal Claims, holding that "the Regulation is not within the authority delegated by Congress under Section 1502, which authorizes the promulgation of consolidated return regulations." The Court concluded that "in the absence of a problem created from the filing of consolidated returns, the Secretary is without authority to change the application of other tax code provisions to a group of affiliated corporations filing a consolidated return." The Court invalidated the duplicated loss rule because the duplication of loss that could be realized upon the sale of the former subsidiary’s assets after the sale of its stock would also occur outside of the consolidated tax return and, therefore, was not a "problem resulting from the filing of consolidated income tax returns."

The importance of this issue can be evidenced from the Service’s Petition for Rehearing En Banc in the Court of Appeals for the Federal Circuit. In its Petition, the Service noted that "in a preliminary survey of 1600 consolidated return filers (out of approximately 60,000) recently conducted by the IRS has determined that issues involving the validity of Treasury Regulation Section 1.1502-20 have already arisen in at least 33 audits over the last 3 years and that the issue involves approximately $1.2 Million in tax in those 33 cases alone." The Petition for Rehearing notes that this issue arises solely with respect to large corporate taxpayers. This alone makes the dollars involved significant.

The Service on January 31, 2002 announced in Notice 2002-11 that it would not pursue litigation in the Rite Aid case. This resulted from the Solicitor General’s determination that, in the absence of a conflict among the Circuit Courts of Appeal, an appeal to the Supreme Court would not be successful.

The Interim Temporary Regulation will require consolidated return groups to determine the allowable loss on the sale or disposition of the stock of a subsidiary under rules that will not include the duplicated loss rule, which was rejected by the Court of Appeals. The Interim Regulation will require consolidated groups to determine the loss on a sale of subsidiary stock under an amended Treasury Regulation Section 1.337(d)-2. These regulations will likely require tracing of transactions by subsidiaries and the impact on the basis of the subsidiary stock in the hands of the parent corporation. Presumably, these rules will deal with the positive investment adjustment and extraordinary gain disposition factors of the existing regulation without considering the duplicate loss factor rejected by the Court of Appeals.

Considering the controversies when the loss disallowance rules were first promulgated, we expect much more from the Treasury and tax practitioners on this subject.

© 2002 Greenberg Traurig

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