Magazine article The CPA Journal

Loss Disallowance Sale of Subsidiary Stock

Magazine article The CPA Journal

Loss Disallowance Sale of Subsidiary Stock

Article excerpt

On November 19, 1990, the IRS issued Prop. Reg. 1.1502-20 and made final Temp. Reg. 1.337(d)-(1), which was issued as temporary on March 9, 1990. The regulations are intended, with some exceptions, to disallow losses on sale of subsidiary stock. Reg. 1.337(d)-(1), which was more restrictive, is effective for sales of subsidiary stock made after January 6, 1987, but prior to November 19, 1990. Prop. Reg. 1.1502-20 is effective for sales of subsidiary stock made after November 19, 1990.

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 As part of TRA 86, the General Utilities rule was repealed.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 now has a "built-in" unrealized loss on its asset of $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. …

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