Desirability, Mechanics of Making Sec. 362(e)(2) Elections for State Tax Returns

Editor: Annette B. Smith, CPA

State & Local Taxes

When a parent corporation contributes a built-in-loss asset to its subsidiary in a transaction that qualifies for tax-free treatment under Sec. 351, the subsidiary—absent any barriers—can take a carryover basis in the asset and potentially duplicate the loss in the basis that the parent has in the subsidiary stock, resulting in both the parent and subsidiary benefiting from the built-in-loss amount.

Sec. 362(e)(2) acts as a barrier to prevent two taxpayers from obtaining the benefit associated with the built-in loss amount, by requiring an election to preserve the loss in either the parent or subsidiary.

Consider the following examples, which focus primarily on domestic companies:

Example 1 (built-in-gain asset transfers): P transfers asset A ($100 fair market value (FMV) and adjusted basis of $70) to S, a wholly owned subsidiary, in exchange for S stock with an adjusted basis of $300. What is the effect of the transfer on P’s basis in the S stock and on S’s basis in the asset?

The transaction qualifies for tax-free treatment under Sec. 351 in a state that has separate-return filing rules and also in a state that follows the federal consolidated-return rules.

States that have separate-return filing rules: The asset has a built-in gain, so Sec. 362(e)(2) does not apply. S takes asset A with a carryover adjusted basis of $70 under Sec. 362(a)(1). Under Sec. 358, P takes the S stock with an increased adjusted basis of $370 ($300 basis in the stock plus $70 basis in the asset).

States that follow the federal consolidated-return filing rules: For built-in-gain assets, the result in a state following the federal consolidated filing rules is the same as described above for separate filing states.

Example 2 (built-in-loss asset transfers): P transfers asset A ($100 FMV and adjusted basis of $150) to S, a wholly owned subsidiary, in exchange for S stock with an adjusted basis of $150. What is the effect of the transfer on P’s basis in the S stock and on S’s basis in the asset?

The transaction qualifies for tax-free treatment under Sec. 351 in a state that has separate-return filing rules and also in a state that follows the federal consolidated-return rules.

States that have separate-return filing rules: The asset has a built-in loss, so the default rule of Sec. 362(e)(2)(A) applies to preserve the built-in loss in P’s hands with a corresponding limit of S’s basis in the asset to the FMV of the asset. Therefore, under the default rule of Sec. 362(e)(2)(A), S takes asset A with an adjusted basis of $100 (equal to the asset’s FMV). P takes the S stock with an increased adjusted basis of $300 ($150 basis in the stock plus $150 basis in the asset).

Protective Sec. 362(e)(2) election: If the taxpayer does not desire the above result, the taxpayer can make an election under Sec. 362(e)(2)(C) to flip the tax consequences by allowing S to preserve the tax basis of the asset and limit the adjustment to the outside basis in the shares to the FMV of the asset as applied to the stock in P’s hands.

Therefore, with a Sec. 362(e)(2)(C) election, S takes asset A with an FMV of $100 and adjusted basis of $150. P takes the S stock with an adjusted basis of $250 ($150 basis in the stock plus $100 additional basis, limited to the FMV of the asset transferred).

States that follow the federal consolidated-return filing rules: Sec. 362(e)(2) does not apply in a consolidated- return year under Regs. Sec. 1.1502-80(h). Therefore, with Sec. 362(e)(2) shut off for consolidated returns, S takes the higher carryover basis in the asset so its adjusted basis is $150. P also takes the stock with an increased $150 basis transferred from the asset—an adjusted basis of $300 ($150 basis in the stock plus $150 basis transferred from the asset).

Choosing and Making the Election

The Sec. 362(e)(2)(C) election avoids the default treatment in the basis adjustment. But when is it advisable to make the election?

For practical and tactical reasons, if the taxpayer does not know that the asset has built-in loss, or the taxpayer knows of the built-in loss and wants to avoid costly valuation challenges from the state—such as a claim that S failed to step down the basis to FMV—the taxpayer may consider making a protective Sec. 362(e)(2)(C) election to preserve the basis in S’s hands.

Most states require the federal election before application of any corresponding benefit on the state side. However, with Regs. Sec. 1.1502-80(h) shutting off Sec. 362(e)(2) for consolidated returns, how is the Sec. 362(e)(2)(C) election made to preserve basis in S’s hands when filing the state return in a state that follows the federal consolidated-return rules?

As a technical matter, should the Sec. 362(e)(2)(C) election statement be attached to the federal consolidated return (even though the attachment would have no impact on the federal consolidated return) to have a valid election for state tax purposes? Or should a state-only election be made by attaching a document to the state returns? The mechanics of making the election can be tricky; in the absence of guidance from the state, it may be prudent to attach the Sec. 362(e)(2)(C) election statement to the federal consolidated return to preserve, for state tax purposes, S’s high basis in the built-in-loss property.

What happens if a state requires the election to be made with the federal consolidated return and the taxpayer fails to attach the election statement? Does the taxpayer need IRS permission to obtain a certain tax treatment at the state level? Would the IRS even allow it by granting relief to file the Sec. 362(e)(2)(C) election statement late even though the filing would have no effect on the federal return?

The IRS has indicated a willingness to grant Sec. 9100 relief for late elections that may have no U.S. federal income tax impact, but that may have other ancillary consequences (e.g., state tax depreciation or financial accounting implications) (see Letter Ruling 201418034, which is conditioned on the satisfaction of other factors that may be material).

Observations

Regs. Sec. 1.1502-80(h) shuts off Sec. 362(e)(2) for intercompany transactions occurring on or after Sept. 17, 2008. However, taxpayers have the option of voluntarily applying Regs. Sec. 1.1502-80(h) to transactions occurring on or after Oct. 22, 2004, in which case the Sec. 362(e)(2) election would not apply.

Potential retroactive election: Note that the statute of limitation may limit the opportunity to retroactively apply Regs. Sec. 1.1502-80(h) and shut off Sec. 362(e)(2) for prior transactions. Even so, the opportunity is not entirely eliminated. For transactions occurring on or after Oct. 22, 2004, but before Sept. 17, 2008, the taxpayer can elect to retroactively apply Regs. Sec. 1.1502-80(h) if doing so would result in the availability of basis that is substantial in a closed year, and in the buildup of larger net operating losses that could be carried forward to an open year.

EditorNotes

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

For additional information about these items, contact Ms. Smith at 202-414-1048202-414-1048 or annette.smith@us.pwc.com.

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

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