Academic journal article Journal of Accountancy

Think Twice before Selling That Subsidiary: Without Proper Planning, the New IRS Regulations Could Prevent Taking Deductions for a Loss

Academic journal article Journal of Accountancy

Think Twice before Selling That Subsidiary: Without Proper Planning, the New IRS Regulations Could Prevent Taking Deductions for a Loss

Article excerpt


Without proper planning, the new IRS regulations could prevent taking deductions for a loss.

When the Internal Revenue Service took aim at "son of mirror" transactions, it caught all other consolidated group subsidiary dispositions in its net. In March 1990 the IRS issued temporary regulations designed to combat the son of mirror deals that were tax-motivated and could be used by a group to avoid tax on the disposition of appreciated assets. This was accomplished by taking a loss on the disposition of subsidiary stock and using that loss to offset the gain on the disposition of the subsidiary's appreciated assets.

Unfortunately, for subsidiary stock dispositions occurring after March 8, 1990, the new regulations will prove unexpectedly harsh. They disallow not only artificial, son of mirror losses but also actual economic losses. In some cases, they can apply even if the stock isn't sold at a loss. Moreover, the loss disallowance rule applies to all subsidiaries--whether or not they were acquired or created by the group. There are also transitional rules that apply to certain transactions.

The application of the new regulations could have unfortunate consequences for corporations that fall within their scope. This article discusses the new regulations and planning opportunities to mitigate or avoid their harsh effects in many cases.


More than three years before release of the new regulations, the IRS warned it intended to prevent companies from engaging in son of mirror transactions. The warning, contained in Notice 87-14, said the IRS would take steps to prevent a consolidated group from realizing a loss on the sale of a subsidiary's stock if the loss had the effect of offsetting income attributable to the subsidiary's built-in gains--that is, the appreciation in the subsidiary's assets when it was acquired by the group (see exhibit 1). However, when the new regulations were released March 9, 1990, they applied to a far broader range of transactions than those previously addressed in the 1987 notice.

A transitional rule applies to subsidiaries acquired after January 6, 1987, and only to artificial, son of mirror losses. However, the loss disallowance rule applies to any post-March 8, 1990, disposition of subsidiary stock at a loss, regardless of the source of the loss and regardless of when the subsidiary was acquired by the parent. (See exhibit 2.)


According to the regulations, a consolidated group can't deduct a loss on a post-March 8, 1990, disposition of subsidiary stock. For this purpose, a disposition is any event causing gain or loss to be recognized, in whole or in part. Thus, a disposition includes taking a worthless stock deduction, a taxable liquidation and even a deferred intercompany transaction.

Two minor exceptions to the loss disallowance rule permit the stock loss deduction to be used to the extent

* The group member disposing of the stock at a loss also disposes of other stock in the same subsidiary at a gain in the same transaction.

* The disposition of the subsidiary stock causes the group to report gain that was previously recognized, but deferred, in an intragroup transfer of the subsidiary stock.

"Antiabuse" rules. Three rules designed to prevent its circumvention buttress the loss disallowance rule:

1. No longer a group member. If a subsidiary ceases to be a member of a consolidated group but group members continue to own some of its stock, the members must reduce their basis in the retained stock to fair market value if that basis exceeded the stock's value immediately before the deconsolidation. If the retained subsidiary stock is disposed of at a loss within two years after a basis reduction, the regulations mandate a statement must be filed with the group's income tax return for the disposition year. …

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