The Impact of Unified Loss Rules on Earnings and Profits

Editor: Annette B. Smith, CPA

Gains & Losses

With the recent reported uptick in merger and acquisition activity, companies are increasingly looking at strategic options to buy or sell subsidiary stock. At the same time, companies may find that the value of their subsidiary stock remains well below its tax basis, potentially resulting in a taxable loss on disposition. If the subsidiary joins in the filing of a consolidated income tax return, the consolidated return regulations may limit or disallow the amount of loss that may be claimed or may require the shareholder to reduce its basis in the stock of the subsidiary, resulting in a reduction of the loss available for regular tax purposes.

A question arises whether the same limitation, disallowance, or basis reduction rules apply for earnings and profits (E&P) purposes. This item explores whether a corresponding adjustment is made for E&P purposes when a member of a consolidated group, S1, is required under Regs. Sec. 1.1502-36 (the unified loss rules) to reduce its basis in the stock of another member, S2, for regular tax purposes upon S1’s disposition of the S2 stock at a loss for regular tax purposes.

Calculating E&P Basis in Computing E&P Gain or Loss

A consolidated group member’s basis in the stock of another member may differ for regular tax purposes and E&P purposes. As a threshold matter, S1 must compute its basis in the stock of S2 for E&P purposes before determining whether it will recognize a loss from the disposition of its S2 stock. To properly compute S1’s E&P basis in its S2 stock, the stock basis adjustment rules of Regs. Sec. 1.1502-32 are used, substituting the E&P items and timing rules for taxable income. Common differences relate to net operating losses (NOLs) and depreciation.

Exhibit 1 contains a simple example of the impact of NOLs on the calculation of tax basis and E&P basis. With a tax basis in S2 of $3,400 and an E&P basis of $3,100, if the S2 stock were sold for $3,150, S1 would anticipate a $250 capital loss on the sale for regular tax purposes but would recognize a $50 gain for E&P purposes. Stated differently, the S2 stock would be considered loss shares only for regular tax purposes. If S1 were required to reduce its basis in the S2 shares by $100 under the unified loss rules (and thus claim a $150 capital loss on the sale), it would appear that no further E&P adjustments would be needed. S1 would recognize $50 of E&P gain on the sale, that current E&P would “tier up” to the parent under the normal rules of Regs. Sec. 1.1502-33, and the parent would also increase its E&P basis in S1’s stock by $50.

But what if the fair market value of the S2 stock were $2,000 rather than $3,150? Exhibit 2 summarizes the tentative amount of loss that would be recognized for regular tax and E&P purposes. The issue then becomes whether—if any portion of the $1,400 regular tax loss is reduced under Regs. Sec. 1.1502-36—any further adjustments need to be made to the E&P loss of $1,100.

Application of Loss Disallowance/Unified Loss Rule Regimes to E&P

Prior to 1995, adjustments made for stock basis and E&P were linked. The loss disallowance rules under former Regs. Sec. 1.1502-20 required a reduction in E&P under Regs. Sec. 1.1502-33 for the entire amount of the disallowed loss (see former Regs. Sec. 1.1502-20(f)(2), Example (ii)), not to exceed the loss computed when considering the E&P basis.

In 1995, the IRS overhauled the stock basis and E&P adjustment rules, delinking the two concepts. As part of this undertaking, former Regs. Sec. 1.1502-20 was amended, and some of the technical provisions and examples relating to the stock basis effects of loss disallowance were eliminated. The preamble to the 1995 regulations noted that the interdependence of the rules had created undesirable complexities and distortions as a result of significant timing disparities between E&P and taxable income.

Subsequent to the IRS overhaul of the stock basis and E&P adjustment rules in 1995, and as a result of the decision in Rite Aid Corp., 255 F.3d 1357 (Fed. Cir. 2001), a portion of former Regs. Sec. 1.1502-20 was held to be an invalid exercise of regulatory authority. In response to this decision, the IRS issued a series of regulations, including Regs. Secs. 1.337(d)-2 and 1.1502-35, attempting to provide guidance with respect to the amount of loss allowable upon a member’s disposition of another member’s stock.

Each set of regulations modified the determination of the amount of loss allowable for regular tax purposes but did not explicitly address the E&P impact of a loss disallowed for regular tax purposes, creating ambiguity. One possible conclusion as to the government’s view was that the treatment of an E&P loss under Regs. Sec. 1.1502-33 resulting from disposition of another member’s stock remained consistent from the issuance of Regs. Sec. 1.1502-20 through the issuance of Regs. Sec. 1.1502-36.

The loss disallowance rules in effect up until the issuance of Regs. Sec. 1.1502-36, including Regs. Secs. 1.337(d)-2 and 1.1502-35, focused on the disallowance of all or part of the potential regular tax loss. However, no specific E&P adjustment, other than as provided in Regs. Sec. 1.1502-20(f)(2), Example (1(ii)), was addressed. The release of Regs. Sec. 1.1502-36 and the movement away from a loss disallowance regime to a basis reduction regime raised an issue as to the proper E&P effects of the potential basis reduction under Regs. Sec. 1.1502-36, as these regulations are silent with respect to the impact for E&P purposes. The unified loss rules of Regs. Sec. 1.1502-36 are a revision to the loss disallowance rules that focus on the reduction of a potential loss recognized for regular tax purposes. The fact that the unified loss rules are silent with respect to E&P continues the ambiguity—arguably, general principles continue to apply, including those under Regs. Sec. 1.1502-33 for consolidated taxpayers.

Under this approach, E&P loss associated with the disposition of the subsidiary stock should be entitled to be deducted from E&P to the extent such loss depletes the assets of the disposing subsidiary regardless of whether the loss is allowed for regular tax purposes (see Regs. Secs. 1.1502-33 and 1.312-6(b), and Rev. Rul. 75-515, made obsolete by Rev. Rul. 2003-99).

Conclusion

As the loss disallowance rules have evolved into the unified loss rules, numerous changes in concepts for regular tax purposes have been developed. While the original guidance was clear with respect to the E&P impact of a loss disallowed for regular tax purposes, Regs. Sec. 1.1502-36 is silent about its impact for E&P purposes.

Under general E&P principles, including Regs. Sec. 1.1502-33, it seems appropriate to reduce the selling member’s E&P for losses to the extent the losses have depleted the assets of a corporation. Returning to Example 2, with respect to S1’s disposition of the S2 stock, no further adjustment should be made to S1’s E&P basis in S2’s stock. S1’s $1,100 E&P loss should be allowed in full even if a portion of the $1,400 regular tax loss is precluded because of a reduction to the regular tax basis in the S2 shares under Regs. Sec. 1.1502-36.

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.