Third Circuit relies on Ilfeld doctrine to deny consolidated group deductions for duplicated losses

By Bruce Feinstein, CPA, J.D., LL.M., Philadelphia

Editor: Mark Heroux, J.D.

On June 18, 2018, the U.S. Supreme Court denied certiorari to hear an appeal of the Third Circuit's 2017 decision in Duquesne Light Holdings, Inc., 861 F.3d 396 (3d Cir. 2017), cert. denied, No. 17-1151 (U.S. 6/18/18). This discussion focuses on the Third Circuit's decision in that case.

The Third Circuit considered the propriety of deductions of duplicated losses relating to the same economic net investment by Duquesne Light Holdings Inc. (DLH) and its subsidiaries. The first loss arose when the DLH group sold a block of high-basis stock in one of its subsidiaries at a loss. The second set of losses arose when that same subsidiary sold built-in loss assets (100% of the stock of an entity owned by the subsidiary). Based on a strict reading of the consolidated tax return rules that were then in effect, the foregoing duplicated losses were not subject to disallowance. Nevertheless, the Third Circuit sustained the government's position that the duplicated losses should be disallowed based on the Ilfeld doctrine to achieve a sensible tax result.

The Ilfeld doctrine takes its name from the 1934 U.S. Supreme Court decision in Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934), in which the Court held that a taxpayer should not be permitted to claim a double deduction for a loss absent a clear declaration of intent by Congress. Notably, Ilfeld was decided before the 1939 Internal Revenue Code was enacted, yet it still has vitality today, particularly in the consolidated tax return context. The Ilfeld case is discussed below. Presumably, if the DLH fact pattern arose after the Sept. 17, 2008, effective date of the current unified loss rules set forth at Regs. Sec. 1.1502-36, the DLH case might never have gone the distance and the Ilfeld doctrine may not have been invoked, even if some duplicated losses survived the current unified loss rule regime. Nevertheless, the DLH case is worth discussing because of the continuing vitality of the Ilfeld doctrine.

Rite Aid overturns the 1990 loss-duplication rules and the DLH saga begins

The DLH saga began after the demise of the 1990 consolidated tax return loss disallowance rules that were then codified at Regs. Sec. 1.1502-20 (the 1990 regulations). The 1990 regulations were issued to prevent a consolidated group from claiming double deductions for the same loss by treating the consolidated group as a single entity. The 1990 regulations applied when the common parent of the group sold subsidiary stock before the subsidiary recognized losses on devalued assets (see Duquesne,861 F.3d at 400). The Federal Circuit invalidated the loss-duplication sections of the 1990 regulations in Rite Aid Corp., 255 F.3d 1357 (Fed. Cir. 2001). In Notice 2002-11, the IRS announced it would not litigate the validity of the loss-duplication sections of the 1990 regulations.

The Third Circuit noted that the invalidation of the loss-duplication sections of the 1990 regulations left a gaping hole in the consolidated tax return regime. No other regulatory bar existed at that time to prevent a double deduction when a parent realized a loss on the sale of subsidiary stock before the subsidiary realized a loss on its assets (see Duquesne,861 F.3d at 401). That said, the court observed that the consolidated tax return regime still prevented loss duplication if the subsidiary sold its assets at a loss before the parent sold the subsidiary stock, through the mechanism of the stock basis investment rules codified at Regs. Sec. 1.1502-32 (id.). The aforementioned gap and the similarly porous IRS regulatory response to Rite Aid motivated DLH to undertake a series of transactions that resulted in several loss-duplication transactions that ultimately landed DLH in Tax Court and the Third Circuit Court of Appeals.

To understand the DLH case and the reasons the Tax Court and the Third Circuit resorted to the ancient Ilfeld doctrine to deny DLH's attempt to claim duplicated-loss deductions for the same net economic investment, an overview of the factual and regulatory landscape of the case is helpful.

DLH's loss transactions

Shortly after the Rite Aid decision was issued, DLH arranged a series of transactions in which it incurred a loss on a block of high-basis AquaSource (Aqua) stock. DLH organized Aqua in the late 1990s as a wholly owned subsidiary. DLH funded Aqua through numerous capital contributions in exchange for Aqua stock. The Third Circuit noted that through February 2001, DLH contributed approximately $223 million to Aqua in exchange for 50,000 shares of Aqua stock. DLH continued to make significant capital contributions to Aqua in the years thereafter and received an additional 1.2 million shares of Aqua stock. Aqua used the contributed funds to purchase 50 water utility companies, which were both assets and subsidiaries of Aqua. The Aqua subgroup, however, began to lose money, prompting DLH in 2000 to start to consider various strategies to sell Aqua's assets (principally, Aqua's subsidiary stock) (see Duquesne,861 F.3d at 401).

On Dec. 31, 2001, DLH transferred 50,000 shares of Aqua stock to Lehman Brothers as payment for Lehman's services to Aqua. Lehman valued the Aqua stock at $4 million. Perhaps not coincidentally, the 50,000 shares of Aqua stock that were transferred to Lehman Brothers were the same shares that DLH had acquired before February 2001 and thus had an original unadjusted cost basis of $223 million. DLH claimed, after various adjustments, a capital loss of $199 million on the foregoing transfer (the 2001 loss) (see Duquesne,861 F.3d at 401).

Later, the DLH group incurred additional losses when Aqua sold assets (100% of the stock in lower-tier subsidiaries) through a series of transactions beginning after March 2002 and continuing into 2003. The 2002 transactions resulted in capital losses totaling $59.5 million (the 2002 losses). The 2003 transactions yielded another $192.8 million of capital losses (the 2003 losses) (see Duquesne,861 F.3d at 401-2).

To summarize, the DLH group deducted approximately $252.3 million in capital losses that arose in 2002 and 2003 from the sale of Aqua's assets (100% of the stock in lower-tier subsidiaries). The foregoing losses, when combined with the $199 million loss realized in 2001 from the DLH group's sale of a block of Aqua stock, resulted in aggregate losses of approximately $451.3 million (see Duquesne,861 F.3d at 402). The Third Circuit noted from the factual record that "the IRS determined the [DLH] group deducted far more in aggregate capital losses than its net investment in [Aqua], the difference being $281 million" (Duquesne,861 F.3d at 405 (emphasis added)). Based on the Third Circuit's review of the record, it held that the Tax Court properly found that $199 million of the DLH group's losses comprised duplicated deductions for the same underlying economic loss (see Duquesne,861 F.3d at 406-7).

The regulatory aftermath following Rite Aid

The IRS responded to Rite Aid by enacting two sets of temporary regulations that governed stock losses arising in a consolidated group. DLH was able to skillfully navigate through, under, and around the rocky shoals of the replacement regulatory regime that the IRS enacted to address the partial demise of the 1990 regulations. Indeed, it was DLH's technical end run around that regulatory regime that caused the IRS and the Third Circuit to fall back on the Ilfeld doctrine to prevent DLH from claiming duplicated losses from a unitary economic arrangement (see Duquesne,861 F.3d at 407-9).

The first set of regulations, issued in March 2002, included Temp. Regs. Sec. 1.337(d)-2T. These regulations generally disallowed a loss realized from the sale of subsidiary stock, unless the taxpayer was able to establish that the loss was not attributable to the subsidiary's recognition of built-in gains on the disposition of its assets (including stocks and securities). DLH argued that Aqua's subsidiaries had declined in value and that none of the 2002-2003 losses reflected built-in gains. Hence, Temp. Regs. Sec. 1.337(d)-2T did not apply (see Duquesne, 861 F.3d at 411).

In Notice 2002-18, the IRS acknowledged that Temp. Regs. Sec. 1.337(d)-2T would "not disallow [a] stock loss that reflects net operating losses or built-in asset losses of a subsidiary member." As a result, the IRS announced that it intended "to issue regulations that will prevent a consolidated group from obtaining a tax benefit from both the utilization of a loss from the disposition of stock (or another asset that reflects the basis of stock) and the utilization of a loss or deduction with respect to another asset that reflects the same economic loss."

The second set of promised regulations was issued in temporary form in 2003 in Temp. Regs. Sec. 1.1502-35T. The temporary regulations were retroactively effective as of March 7, 2002. The stated purpose of the temporary regulations was to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. The Third Circuit noted that these regulations attempted to achieve their stated purpose through the following loss-suspension rule set forth at Temp. Regs. Sec. 1.1502-35T(c)(1) (later finalized by T.D. 9254):

Any loss recognized by a member of a consolidated group with respect to the disposition of a share of subsidiary member stock shall be suspended to the extent of the duplicated loss with respect to such share of stock if, immediately after the disposition, the subsidiary is a member of the consolidated group of which it was a member immediately prior to the disposition (or any successor group). [Duquesne,861 F.3d at 414(citing Temp. Regs. Sec. 1.1502-35T(c)(1))]

The Third Circuit found that the "-35T" regulations did not prevent DLH from claiming a double deduction because the loss-suspension rule applied only when a member of a consolidated group sold stock in a subsidiary and the subsidiary remained a member of the group after the sale. Here, since Aqua sold 100% of the stock in its subsidiaries to third parties, the Aqua subsidiaries left the DLH group after the 2002-2003 losses were incurred, and the loss-suspension rule did not apply (see Duquesne,861 F.3d at 414).

The court applies the Ilfeld doctrine

DLH argued that the Ilfeld doctrine should not be applied to disallow its duplicated losses. DLH asserted that it "complied with the requirements of both on-point regulations and an on-point statute" (Duquesne,861 F.3d at 410 (citation to another authority omitted)). Hence, the court should rule in its favor by applying the regulations and the Code as written (id.).

In Ilfeld,the petitioner, Ilfeld Co., was the common parent of an affiliated group of corporations that included two subsidiaries. Ilfeld Co. had a considerable cost basis in the stock of the two subsidiaries. In addition, Ilfeld Co. advanced significant amounts of cash to the two subsidiaries to support their operations. The two subsidiaries generated losses for most of the years they were affiliated with Ilfeld Co. In November 1929, the two subsidiaries sold all their assets to unrelated persons and settled their debts with others. In December 1929, the two subsidiaries distributed any cash remaining and dissolved (seeIlfeld, 292 U.S. at 63).

Ilfeld Co. amended its 1929 consolidated tax return in an attempt to claim a refund based on losses incurred on the liquidation of its two subsidiaries. The IRS denied the refund claim, and Ilfeld Co. filed suit. The case made its way to the U.S. Supreme Court. The question before the Court was whether Ilfeld Co. was entitled to deduct any part of its 1929 losses relating to the liquidation of its two subsidiaries (Ilfeld, 292 U.S. at 65).

The Court observed that if the petitioner's claimed losses relating to its subsidiaries were allowed, it would have permitted the petitioner to double-count its subsidiaries' losses when computing consolidated taxable income (Ilfeld, 292 U.S. at 68). The Court held that "[t]here is nothing in the Act that purports to authorize double deduction of losses or in the regulations to suggest that the commissioner construed any of its provisions to empower him to prescribe a regulation that would permit consolidated returns to be made on the basis now claimed by petitioner" (Ilfeld, 292 U.S. at 68).

Notably, in an exhibit attached to the Ilfeld opinion, the Court found that the subsidiaries' combined operating losses claimed and deducted for years prior to 1929 were $190,431.66. The combined investment loss claimed in 1929 was $130,792.11. The aggregate losses claimed were $321,223.77. By comparison, Ilfeld Co.'s actual total investment in the subsidiaries (stock plus advances) was $168,812.48. In short, the petitioner was looking to deduct combined losses relating to its subsidiaries that were 1.9 times its actual economic investment.

In the DLH case, the Third Circuit summarized the Ilfeld doctrine as follows: "[F]or consolidated taxpayers it continues to require that a statute and/or regulation specifically authorize a double deduction for an underlying economic loss" (see Duquesne,861 F.3d at 407). To satisfy the Ilfeld standard, the court noted that there is a presumption that statutes and regulations do not permit double deductions for the same loss (id. at 409). To overcome the presumption, the court stated that there must be "a clear declaration in statutory text or a properly authorized regulation" (id.).

The Third Circuit rejected DLH's argument that Sec. 165(a) satisfied Ilfeld's "clear statement of intent to authorize" a duplicated deduction (Duquesne,861 F.3d at 410 and 412). DLH next argued its compliance with the various IRS regulations mentioned above was alone sufficient to overcome the Ilfeld doctrine. The court rejected DLH's alternative argument and held that "future losses cannot be added to past losses already deducted for the same group of assets" (id. at 415). In summary, the Third Circuit concluded that "[f]or consolidated-return taxpayers, implied authorizations are not enough; they must be clear statements that can fairly be read to allow double deductions for the same economic loss, and here that did not occur" (id.).

Ilfeld might give way to the unified loss rules

As mentioned above, if the same fact pattern arose after the effective date of the unified loss rules set forth at Regs. Sec. 1.1502-36, the DLH group's duplicated losses would likely have been disallowed in whole or significant part. Shortly after the DLH decision was handed down, Tax Notes Today reported that at an American Bar Association Section of Taxation meeting held in Austin, Texas, on Sept. 15, 2017, a number of practitioners had previously expressed concern that if the Ilfeld doctrine were strictly applied, it would result in an overlay to the mechanical unified loss rules (see Foster,"Ilfeld Doctrine May Have Limited Application, IRS Official Says,"2017 TNT 180-4 (Sept. 19, 2017)). A senior IRS Chief Counsel attorney at the meeting commented that if the unified loss rules did apply to a particular situation, the IRS might accept the possibility that some consolidated group duplicated losses would be allowed, notwithstanding the Ilfeld doctrine. The Chief Counsel attorney surmised that the IRS might entertain a letter ruling request.

Definitive guidance encouraged

The contours and edges of whether Ilfeld applies in a case that squarely falls within the unified loss rules are not well-defined. Indeed, it is unsettling that the IRS coyly encouraged taxpayers to pursue a private letter ruling to resolve potential overlaps. The IRS should issue definitive guidance to confirm that compliance with the unified loss rules will trump application of the Ilfeld doctrine, even if some duplicated losses survive the process.


Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.

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