Managing excess loss accounts

By Kevin Ainsworth, CPA, J.D., Boston

Editor: Kevin D. Anderson, CPA, J.D.
 
When there is a sale of the stock of a C corporation subsidiary of a consolidated return group, a common trap that arises is the triggering of income to recapture negative stock basis. Consolidated returns are subject to specific regulations under Sec. 1502, including the investment adjustment rules of Regs. Sec. 1.1502-32. The investment adjustment rules require consolidated members to make annual adjustments to subsidiary share basis in an effort to maintain parity between inside and outside basis. Unlike stock basis in a stand-alone C corporation, the investment adjustment rules allow subsidiary stock basis to fall below zero and become negative. These negative basis balances are referred to as excess loss accounts (ELAs) and are subject to an additional set of rules within Regs. Sec. 1.1502-19. This discussion provides a primer on identifying how an ELA can occur, and potential methods to minimize or eliminate these balances before they are recaptured into taxable income.
Identifying an ELA

An ELA most commonly occurs when a member of the consolidated group funds operations with debt and the member generates net operating losses (NOLs) that are absorbed by other consolidated group members. This absorption creates a negative basis adjustment under Regs. Sec. 1.1502-32(b)(3)(i), without the offsetting positive adjustment that arises from operations funded with equity. If the adjustment is not later offset by shareholder investment, member income, or the tier-up of lower-tier member positive investment adjustments, an ELA results.

Example 1: P is a consolidated group parent that owns 100% of S, its only subsidiary. P funds S with $100 of equity, and S separately issues $200 of third-party debt. At the end of year 1,P has a $100 initial share basis in S as a result of the capital contribution. In year 2, if P generates $300 of taxable income and S generates a loss of $150, the absorption by P of S's loss will result in a negative $150 basis adjustment to the stock of S. This results in the S share basis in the hands of P being reduced from $100 to an ELA of ($50).

ELAs are also created when excess liabilities are contributed to a consolidated group member. Ordinarily, Sec. 357(c) would cause gain where liabilities contributed in a Sec. 351 exchange exceed the aggregate tax basis of the assets transferred. In consolidation, Regs. Sec. 1.1502-80(d) turns off Sec. 357(c) and instead creates an ELA to the extent of the amount normally treated as gain.

Understanding basis following more complex transactions can be critical to recognizing whether an ELA has occurred. Sec. 304 transfers can sometimes result in a carryover basis at the first-tier subsidiary level, even if transferors recognize gain on the transfer. Similar issues can result under the specific basis provisions of Regs. Sec. 1.1502-30, which applies to triangular reorganizations, and Regs. Sec. 1.1502-31, which applies to group structure changes. A careful analysis of these provisions is critical to understanding beginning share basis. The investment adjustment rules can be applied correctly, but if the initial basis is incorrect, a taxpayer may have an ELA without realizing it.

Triggering an ELA

An ELA is taken into account when the shareholder member is treated as disposing of the stock in which the ELA exists under Regs. Sec. 1.1502-19(c). Stock is treated as disposed of not only when it is sold to a third party but also when the subsidiary member is deconsolidated from the group or becomes worthless. Tracking specific blocks of stock may be necessary, and income may be triggered even in a partial sale of the ELA member's stock where the affiliation requirements to consolidate continue to be met (i.e., the parent sells 5% of a 100%-owned subsidiary with an ELA to a third party). However, there is an exception for group acquisitions through a sale or reorganization of an existing common parent under Regs. Sec. 1.1502-19(c)(3), which is why the trap extends primarily to subsidiary sales.

If a disposal occurs, the shareholder member includes the ELA in taxable income, and the disposal is treated as gain from a sale or exchange. To the extent the disposed subsidiary is insolvent, the gain may be recognized as ordinary income under Regs. Sec. 1.1502-19(b)(4). The ordinary portion is computed without regard to distributions that reduced the member's basis and is limited to the extent of insolvency.

Worthlessness ELA triggers can take several forms. Under Regs. Sec. 1.1502-80(c), member stock is treated as worthless upon the earlier of the subsidiary's ceasing to be a member of the group or the member's becoming worthless under Regs. Sec. 1.1502-19(c)(1)(iii), which requires all of the assets of the subsidiary to be treated as disposed of, abandoned, or destroyed. Worthlessness also occurs where debt of the subsidiary is discharged and any part of the amount is not included in gross income and is not treated as tax-exempt income under the investment adjustment rules. Lastly, worthlessness occurs where a member takes into account a deduction or loss for an intercompany debt, and the debtor member does not take into account a corresponding amount of income or gain, although this is rare in practice.

Minimizing or eliminating ELAs

Contributing additional capital decreases an ELA. When an ELA is caused by intercompany debt, it may be possible to eliminate the balance through transfers within the consolidated group, with the direct shareholder member ultimately contributing the debt to capital, therefore increasing share basis. However, a contribution of the stock of a member with an ELA to another member with positive basis does nothing to eliminate the negative balance. In a Sec. 351 contribution of stock of a group member, the ELA would reduce basis in the transferee member, and the target entity would continue to have its existing ELA.

In a qualifying reorganization between group members where no shares are issued, an ELA may be netted against another member's share basis.

Example 2: In a brother-sister statutory merger under Sec. 368(a)(1)(A), if parent P has a share basis in subsidiary S1 of $150 and an ELA in the shares of subsidiary S2 of ($100), the merger of S1 and S2 results in a net basis of $50 under Sec. 358 and Regs. Sec. 1.1502-19(a)(2)(ii). If the acquiring entity issues shares, the ELA may be attached to the new shares, but allocation rules allow positive share basis in the same entity to be redistributed to eliminate the negative balance under Regs. Sec. 1.1502-19(d)(2).

In an internal distribution of ELA stock, the distributing member will have disposed of ELA shares, but any gain would be carried as an intercompany item deferred under the matching rule of Regs. Sec. 1.1502-13. If the distribution qualifies as tax-free under Sec. 355, an ELA in the stock of the controlled corporation may be eliminated, as the basis of the distributing corporation is allocated between the stock of distributing and the stock of controlled after the transaction. Given the complexity of Sec. 355 and the fact an ELA is triggered for spinoffs outside the consolidated group, it is unlikely these provisions would be used strategically for elimination (alternatives are simpler to carry out).

Before any internal restructuring is undertaken, a liquidation of the ELA member should first be considered. A valid subsidiary liquidation under Sec. 332 eliminates stock basis, including an ELA, tax-free. However, a Sec. 332 liquidation requires solvency, and insolvency often develops in tandem with an ELA. A downstream reorganization of a shareholder member into its subsidiary may accomplish the same result, but it comes with the additional requirements applicable under Sec. 368. Caution is advised before undertaking these transactions to make sure a taxable transaction, and therefore a triggering event, does not occur.

Still, an even simpler solution may be to sell assets instead of stock. If the assets of a consolidated group member are sold, inside gain may minimize or eliminate the ELA that remains in the group. In a stock deal with an election under Sec. 338(h)(10) or Sec. 336(e), the hypothetical sale of assets includes a deemed Sec. 332 liquidation of the target, which can also eliminate the ELA under the aforementioned liquidation analysis. For a tiered target, elections down the chain may be needed to avoid a lower-level ELA trigger.

Summary

Generally, the consolidated regulations allow taxpayers to defer potential gain associated with an ELA, provided one of the aforementioned triggering events is avoided. However, an understanding of Regs. Sec. 1.1502-19 and its interplay with common Subchapter C transactions and the broader consolidated return regulations is important in identifying, managing, or otherwise eliminating an ELA before it becomes a current tax issue.

EditorNotes

Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

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

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