Duplicate Loss on Disposition of Subsidiary
Before the Tax Reform Act of 1986 amended IRC section 336, it was possible for owners to remove assets from a corporation without a corporate-level tax. Section 336 now requires taxpayers to recognize a gain or loss on any assets they remove from a corporation in a liquidation. As a result CPAs have been looking for methods to help clients remove unwanted assets from corporations without triggering a tax. The consolidated return regulations under IRC section 1502 offered some effective methods—termed “mirror subsidiary transactions.” The Treasury Department subsequently wrote regulations section 1.1502-20 to curb these perceived abuses. It disallows most losses by a consolidated group on the disposition of an affiliated subsidiary.
In 1984 Rite Aid Corp. acquired 80% of Penn Encore in an asset sale; it acquired the remaining stock in 1988. Rite Aid included Penn Encore in its consolidated return filing. Penn Encore was marginally profitable for several years, but then had large losses immediately before Rite Aid disposed of the stock. In 1994 Rite Aid sold the company to an unrelated party. The purchaser did not make an IRC section 338(h)(10) election to treat the transaction as an asset sale. Rite Aid reported a $22,136,739 loss on the sale.
Regulations section 1.1502-20 disallows “duplicated losses” on a consolidated group’s disposition of an affiliated subsidiary. A duplicated loss is the excess of a subsidiary’s adjusted basis in its assets over the value of those assets immediately after a sale. Penn Encore’s duplicated loss exceeded the loss Rite Aid reported, so the IRS disallowed Rite Aid’s deduction. The company paid the taxes and sued for a refund in the Court of Federal Claims. The court agreed with the IRS and disallowed the loss. Rite Aid appealed to the Federal Circuit Court of Appeals.
Result. For the taxpayer. The appeals court held that Rite Aid could deduct a duplicated loss on its disposition of an affiliated subsidiary. It based this finding on its opinion that Treasury had overstepped its authority in disallowing duplicated losses.
The opinion discusses the section 1502 regulations that delegate to the secretary of the Treasury the responsibility for writing regulations that insure consolidated returns clearly reflect a group’s income tax liability and prevent the efforts to avoid such a liability. The election to file a consolidated return requires corporations to consent to all the relevant regulations. But another case, American Standard (602 R.2d at 261), pointed out section 1502 does not authorize the secretary to choose a method that imposes a tax on income that otherwise would not be taxed.
The court agreed with the taxpayer that disallowing the duplicated loss would distort rather than reflect the group’s tax liability and the regulation’s requirement would “contravene Congress’ otherwise uniform treatment of limiting deductions for a subsidiary’s losses.” Consequently, the court determined the regulation is “manifestly contrary to the statute.”
As a note of caution, a loss on the disposition of a subsidiary’s stock is generally a capital loss that taxpayers can use to offset only capital gains. According to Arkansas Best (83 TC 640) and many other cases, ordinary loss treatment is available only if the taxpayer holds the stock for one of the exceptions detailed in IRC section 1221.
There had been a great deal of discussion and objection when the Treasury Department proposed, amended and eventually finalized regulations section 1.1502-20. This is the first court decision to directly refute the controversial regulation. Consolidated groups that accepted the disallowance of duplicated losses should consider amending any open years’ tax returns and eventually appealing the IRS disallowance to the Court of Federal Claims.
Rite Aid Corp., 88 AFTR2d 2001-5058, 7/06/2001.
Prepared by Karyn Bybee Friske, CPA, PhD, assistant professor of accounting, and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both at the T. Boone Pickens College of Business, West Texas A&M University, Canyon.