Magazine article The CPA Journal

Excess Loss Accounts: Avoiding Unanticipated Recaptures

Magazine article The CPA Journal

Excess Loss Accounts: Avoiding Unanticipated Recaptures

Article excerpt

THE ELA REPRESENTS NEGATIVE TAX BASIS and can create unexpected recapture of income under many circumstances.

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 1.150219(2XA)(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 1.150232(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:

P invests $1,000 in S and will file a consolidated tax return. In addition, S borrows $2,000 from an unrelated party and incurs a tax loss of $1,500 in the current year that will offset taxable income attributable to P on a consoli dated basis. Since P's investment basis is only $1,000, there is insufficient basis to absorb the loss generated by S. Therefore, P must set up an excess loss account to track the negative basis of $500. If P could not use the loss generated by S, no ELA would arise until the NOL was utilized. However, if NOLs attributable to S expire unutilized, a negative adjustment must be made to the basis to account for the nondeductible, noncapital expense.

Recapture provisions. The EIA 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 EIA 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 EIA 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. …

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