Tackling Taxes
Tax Planning with Respect to an Insolvent
Subsidiary in a Consolidated Return Group—
Part II
By Paul C. Lau, Ronald Marcuson and Kurt Piwko*
I
n the April 2014 column in this series dealing with insolvent subsidiaries in
a consolidated return context, our focus was on the subsidiary’s indebtedness
and the deemed satisfaction and reissuance rule for transactions involving
intercompany obligations. We will continue in this column by examining the
da d return rules regarding cancella
io of indebtedness. We will then
consolidated
cancellation
look aat th
mitations regarding
rdin thee claiming
aimin of a loss with res
ect tto
thee rule
ruless and limitations
respect
the sto
ck in
n tthee subsid
ia
stock
subsidiary.
Consolidated Tax Attribute Reduction
PAUL C. LAU is a Tax Partner with Plante
Moran in Chicago. RONALD MARCUSON
is a Professor and the Director of MST Program at DePaul University. KURT PIWKO
is a Senior Tax Manager with Plante Moran
in Macomb.
OCTOBER 2014
Gen
Generally, if a taxpayer is insolvent or is in title 11 bankruptcy proceedings, Code
Sec. 108(a) excludes some or all of its cancellation of indebtedness income (“COD”)
from taxable income.1 The price to pay is a reduction in the attributes listed in
Code Sec. 108(b). As we noted in the first column, Reg. §1.1502-13(g)(4)(i)(C)
turns off Code Sec. 108(a) with respect to cancellation of intercompany obligations. However, Code Sec. 108(a) still applies with respect to cancellation of
non-intercompany obligations and so must be examined.
Until first temporary and then final consolidated return regulations were issued, there was significant uncertainty in the application of Code Sec. 108 to a
consolidated return group. For example, some practitioners felt that Code Sec.
108 should be applied using an entity-by-entity approach while others argued for
a hybrid or full consolidated approach.2 With the adoption of the final regulations
a lot of uncertainty has been eliminated but additional complexity has been added.
The application of Code Sec. 108 to a consolidated group has two parts. First,
there is the determination of COD. Reg. §1.1502-28(a)(1) provides: “Section
108(a)(1)(A) and (B) is applied separately to each member that realizes excluded
COD income.” In other words, the taxpayer must compute the amount of COD
for an insolvent subsidiary on a stand-alone basis (i.e., based only on the assets
©2014 CCH INCORPORATED. ALL RIGHTS RESERVED.
17
TACKLING TAXES
(including stock and securities of other members) and
liabilities (including liabilities to other members) of the
insolvent subsidiary.
The second part deals with applying the attribute reduction rules in Code Sec. 108(b) in a consolidated group.
Reg. §1.1502-28(a)(2)-(4) provides three main consolidated attribute reduction rules:
1. First, the debtor member reduces its own tax attributes
(the debtor-first rule).3
2. Second, to the extent that the debtor member reduces
basis in stock of a subsidiary, this subsidiary reduces
its tax attributes (the subsidiary look through rule).4
3. Third, to the extent that the excluded COD income
exceeds the tax attributes of the debtor member reduced under the debtor-first rule, the remaining COD
income reduces other consolidated group members’
tax attributes other than basis of their assets.5
Under Code Sec. 108(b)(2), the debtor member (and
the subsidiary whose stock basis is reduced by the debtor
member), reduces the following tax attributes6 in the following order:
1. Net operating losses.
2. General business credits.
3. Minimum tax credit.
4. Capital loss carryovers.
is of asse
aasset (both depreciable and nondepreciable).
5. Basi
Basis
P
sive
i activi
aactivity
i ity
i loss and credit carryovers.
6. Pass
Passive
7. Fore
eign tax ccred
arryovers
Foreign
credit carryovers.
The amount
The
amou
unt of
o a consolidated
solidated tax
tax attribute
attrib te ((e.
e.g., a
onssolid
dated
d net operating
op
pera g loss) that
tha is attributable
attribut le too a
consolidated
em
mberr shall
shall bee determined
eter
te
ed pursuant
pursu
th principles
pr ncip es
member
to the
§ 15
§1
50
of Reg. §1.1502-21(b)(2)(iv)
.7 For example, the percent-
With the adoption of the final
regulations a lot of uncertainty
has been eliminated but additional
complexity has been added.
age of the consolidated net operating loss attributable to
a member is equal the separate net operating loss of the
member for the year of the loss divided by the sum of the
separate net operating losses for that year of all members
having such losses.
The reductions to the net operating losses and the capital
loss carryovers are made first in the loss for the tax year
of the discharge and then in the carryovers to such tax
year in the order of the tax years from which each such
carryover arose.8 The reductions to the general business
18
TAXES The Tax Magazine ®
credits and foreign tax credit carryovers are made in the
order in which carryovers are taken into account for the
tax year of the discharge.9
Instead of reducing tax attributes in the above-prescribed
order, a debtor member can elect under Code Sec. 108(b)(5)
to reduce first the basis of depreciable property. In reducing the basis of stock in a subsidiary, the reduction cannot
cause a negative stock basis (i.e., ELA). Therefore, the basis
of stock in a subsidiary cannot be reduced if the basis in
the subsidiary is an ELA.10
Code Sec. 108(b)(4)(A) provides that tax attributes
(including basis of assets) are reduced after the determination of tax liability for the year of debt discharge.
Code Sec. 1017(a) and Reg. §1.1502-28(b)(3)(i) further state that asset tax basis reduction applies only
to property held at the beginning of the tax year following the year of debt discharge. In the preamble to
the regulations, the IRS stated that “the reference in
section 1017 to the property held by the taxpayer at the
beginning of the taxable year following the taxable year
in which the discharge occurs merely identifies those
properties the basis of which are subject to reduction.
It does not prescribe that basis of property should not
be reduced until the beginning of the taxable year following the taxable year in which the discharge occurs
... However, only the basis of property held as of the
beginning of the taxable year following the taxable
h the excluded
exclu
year in which
COD income is realized is
available for reduction.”
redu on ”11
available
deb corporation
corpor io is no longer
l nger in ex
stence on the
If a debtor
existence
first day ffollowing
wing the yea
h it had excluded
cluded C
yearr in wh
which
COD
income, Reg. §1.1502-28(b)(9)(i) provides that the debtor
corporation’s successor member would be treated as the
debtor for purposes of adjusting its tax attributes under
Code Sec. 108(b)(2). If there is no successor member,
Reg. §1.1502-28(b)(8) provides that attribute reduction
is made in the year of the excluded COD income immediately after the determination of the tax for the group
in such year.
Reg. §1.1502-28(b)(10) defines a successor member as a
member of the consolidated group that acquires the assets
of the debtor member in a transaction to which Code Sec.
381(a) applies. In a liquidation of insolvent subsidiary,
there should be no successor member since the liquidation
is not a transaction subject to Code Sec. 381(a). While
attribute reduction is made in the year of the excluded
COD income, there appears to be no tax-effective reduction in basis of assets when an insolvent member with
no subsidiary is liquidated.12 This seems to be the result
because the basis of assets in the hands of the distributee
member (a non-successor) should be fair market value,
OCTOBER 2014
rather than the carryover basis from the insolvent subsidiary, in a taxable liquidation. Reg. §1.1502-28(b)(11)
makes it clear that an insolvent subsidiary’s excluded
COD income cannot be treated as realized in the first
day following the day it becomes a nonmember under
the “next-day” rule of Reg. §1.1502-76(b)(1)(ii)(B) for
purposes of attribute reduction.
Example. P is the common parent of a consolidated
group that includes subsidiary S1. P owns 100 percent
of the stock of S1. In Year 1, the P group sustained a
$250 consolidated net operating loss. Under the principles of Reg. §1.1502-21(b)(2)(iv), of that amount,
$125 was attributable to P and $125 was attributable
to S1. On Day 1 of Year 2, P acquired 100 percent
of the stock of S2, and S2 joined the P group. As of
the beginning of Year 2, S2 had a $50 net operating
loss carryover from Year 1, a separate return limitation year. In Year 2, the P group sustained a $200
consolidated net operating loss. Under the principles
of Reg. §1.1502-21(b)(2)(iv), of that amount, $90
was attributable to P, $70 was attributable to S1, and
$40 was attributable to S2. In Year 3, S2 realized
$200 of excluded COD income from the discharge
of non-intercompany indebtedness. In that same
ar, the
t P group
gr
year,
sustained a $50 consolidated net
op
peratting
i loss,
l
o which $40 was attributable to S1
operating
of
an
nd $10
$10 was
w attributable
attr
aattri
ble to S2 under
und the principles
ri ip
and
Reg. §1.1502-21(b)(2)(iv)
§1.1502(2)(iv). As of the bbeginning
eg nningg
off Reg.
Yeaar 4, S2 had
h As
ue off
off Year
Asset A with a fa
fairr marke
market vvalue
$10
10. A
comp
m
on of ta
mpose for
fo Year
$10.
Afterr the computation
tax imposed
d before
b f the application of Code Secs. 108 and
3 and
28, Asset
Asset A had
ha a basis of
1017 and Reg. §1.1502-28
$40 and no liabilities.
The tax attributes attributable to S2 must first be reduced to take into account its excluded COD income
in the amount of $200. The excluded COD will first
go to reduce S2’s allocable share of the current year
consolidated loss (i.e., $10) to $0. It will then go to
reduce S2’s NOL from separate return years (i.e., $50
from Year 1) to $0. Finally, its allocable share of any
NOL from consolidated return years (i.e., $40) will
be reduced to $0. That will leave remaining excluded
COD of $100.
Now S2 must reduce the basis of any assets it had on
Day 1 of Year 4 by the remaining excluded COD of
$100. It only has Asset A with a basis of $40, which
will be reduced to $0. At this point the remaining
excluded COD is $60.
OCTOBER 2014
Since S2 has no more attributes and does not have a
subsidiary, the remaining excluded COD will reduce
the attributes of other members of the consolidated
group. You first look to current year (i.e., Year 3)
losses. S1 had a loss of $40, which is reduced to $0. P
did not have a loss in the current year. The remaining
excluded COD reduces the Year 1 consolidated loss
from $250 to $230.13
We will look at this Example later on in the column
and address the impact of the COD provisions on the
taxpayer’s basis in the insolvent subsidiary.
Worthless Stock Deduction
In order to claim a worthless stock deduction one must
meet the requirements of Code Sec. 165. To be allowable
as a deduction under Code Sec. 165(a), a loss must be
evidenced by closed and completed transactions, fixed
by identifiable events, and, actually sustained during the
tax year.14 Examples of events that may justify a worthless stock deduction in the case of an insolvent subsidiary
include (1) liquidation, (2) complete termination of business, and (3) bankruptcy. The most common of these is
probably a liquidation. The regulations are very clear that
no loss is allowed on account of mere market fluctuation
in the value of such security.15
cts of the
the worthless stock deduction which
Three aspects
must be considered
c
dere are
re (1)
1) thee amount
mount of the
the deduction,
ded ction
must
(2 the
he character
ch ter of the
t e deduction
d du io and (3) the
the timing
timin of
o the
(2)
d uctio While the rules
rul s in Code
C e Sec
1 are re
ati
deduction.
Sec. 165
relatively
straightforward on these aspects, we will see that some of
the provisions are modified extensively by the consolidated
return regulations.
Amount of Deduction—
Investment Adjustment Rules
The amount of the worthless stock deduction is the
shareholder’s adjusted basis in such subsidiary’s stock.16
The consolidated return regulations impact the amount
of deduction in two ways. First, there are the investment
adjustment rules that must be considered. Second, the
amount of the deduction may be limited by the unified
loss rules and the circular basis rules. We will look at the
two limitations in future columns.
The general principle behind the consolidated return
regulations is to tax the group members as a single entity,
while maintaining the members’ separate entity tax attributes. In effect, the consolidate group regime represents
a blending of separate and single entity tax concepts. A
©2014 CCH INCORPORATED. ALL RIGHTS RESERVED.
19
TACKLING TAXES
member must maintain the basis of its stock ownership in
another member under the investment adjustment rules
of Reg. §1.1502-32.
General Overview. The purpose of the investment adjustment rules is to prevent items that are recognized by
a subsidiary from being recognized again (as gain or loss)
when its parent disposes of its stock. The investment adjustment rules are similar to the stock basis adjustment rules
for S corporations. These rules should eliminate virtually
all of the disparity between a subsidiary’s inside and outside
basis (except for pre-consolidation differences). Therefore,
the rules also eliminate virtually all of the tax differences
between a sale of a subsidiary’s stock and a sale of its assets if
the subsidiary has always been a member of the group. The
investment adjustment rules are very extensive, but basically
require that basis be increased by a subsidiary’s taxable and
tax-exempt income and decreased by the subsidiary’s tax loss,
nondeductible and noncapital expenses, and distributions.17
Taxable income increases stock basis upon recognition.
Tax loss is generally taken into account only when the loss
is absorbed in the consolidated return.18 For example, a loss
is treated as a tax loss in the tax year in which it arises if it
is absorbed in that year or in earlier years from a loss carry
back. A loss that is carried forward and absorbed in a future
year is treated as a tax loss in the tax year it is absorbed.
x-exxemp
pt income
in
Tax-exempt
is defined as income that is recogzeed
d but
bbu
ut permanently
peermaane
nized
excluded from gross income. A
om
mmon
n item
m is ttax
mpt interest inc
nc me that
common
tax-exempt
income. Income
m y deferred
defferred
d is not tax-exempt income.
income.19 A
Any
ny ga
gain
ain
iss merely
efeerred
d in a like-kind
likee-kind exchange
change under
un er Code Sec.
S 1031
1 31
deferred
n exa
ample of d
ampl
ferr
er income.
come
is an
example
deferred
i l and nondeductible expenses are expenses
Noncapital
manently disallowed
disall
that are recognized, but permanently
as a dealized as an asset.
asset For example,
duction and cannot be capitalized
federal taxes are noncapital, nondeductible expenses. In
addition, certain basis decreases and attribute reductions
are treated as noncapital, nondeductible expenses. However, a deduction deferred under Code Sec. 267 is not a
noncapital, nondeductible expense.20
Finally, distributions reduce stock basis if they are
distributions to which Code Sec. 301 applies. Therefore,
payments of dividends reduce the subsidiary’s stock basis. A distribution is accounted for when the member is
entitled to receive it, not when it is actually received.21 If
the basis adjustments result in a negative tax basis in the
stock of a member, this negative basis is termed the excess
loss account (ELA).22
COD Income Basis Rules. The investment adjustment
rules for COD income deserve special attention for an
insolvent subsidiary. If the subsidiary has taxable COD
(i.e., it is with respect to an intercompany obligation), the
20
TAXES The Tax Magazine ®
tax basis of the insolvent subsidiary is increased. However,
if the insolvent subsidiary has excluded COD the answer is
not as straightforward. Excluded COD income is treated
as tax-exempt income only to the extent it reduces tax
attributes attributable to any member of the group under Reg. §1.1502-28. Two things to note: (1) attributes
include various tax credits, and (2) the regulation refers
to any member of the consolidated group, including the
parent, not just the insolvent subsidiary.23 COD income
is not tax-exempt income if it is excluded from income,
but is not applied to reduce tax attributes. In other words,
excluded COD income increases stock basis (the positive
adjustment) only to the extent of a corresponding attribute reduction. With few exceptions, the corresponding
reduction in tax attributes reduces stock basis (the negative
adjustment). The reduction of basis in an asset is treated
as a noncapital, nondeductible expense that would reduce
stock basis.24 A reduction in losses (e.g., a loss carryforward) is treated as equivalent to a reduction in basis.25
Note that the same is not true for a reduction in credits.
At first it would seem that the positive adjustment for
the excluded COD income would be offset by the negative adjustment for the reduction in basis. However, that
is not always the case as excluded COD income is treated
as tax-exempt income which could increase the stock basis
of the debtor subsidiary to the extent that consolidated tax
attributes attributable to any other member (as opposed
butes of
of the
t debtor subsidiary) are reduced.
to the tax attributes
effect,
tock basis
is off the debtor
debtor subsidiary
subsid
diary could
could be
b
In eff
ect, the stock
in ased by the
he excluded
exc d d COD income,
ncome, while
while the
th stock
st
increased
b s of another
a
er member
member could be reduced
reduce by a negative
n ga
basis
basis adjustment due to a reduction of its tax attributes.
A similar situation occurs when the excluded COD income offsets a general business credit. A reduction of a
general business credit under Code Sec. 108(b)(2)(B) by
a consolidated group member does not reduce stock basis.
Example. In the previous example dealing with COD
in a consolidated group, we saw that S2 had excluded
COD of $200. The excluded COD reduced the following attributes:
$10 S2’s current year loss
50 S2’s SRLY loss from Year 1
40 S2’s allocable share of Year 2 consolidated loss
40 S2’s basis in Asset A
40 S1’s current year loss
10 S1’s allocable share of Year 1 consolidated loss
10 P’s allocable share of Year 1 consolidated loss
_________
$200 Total
OCTOBER 2014
Since S2’s excluded COD has all been used to reduce
attributes, P’s basis in S2 is increased by $200. However, S2’s basis in assets and losses has been reduced
by $140 so P’s basis in S2 is decreased by $140. The
net impact is an increase in P’s basis of S2 in the
amount of $60.
P’s basis in the S1 stock is decreased by $50 since S1’s
losses were reduced.
To summarize, generally the intent of the investment
adjustment rules with respect to COD income is to prevent the income from increasing stock basis unless the
income is taxable. If the COD income were excluded
from income, there would be no basis increase in the
debtor stock unless there is an offsetting reduction of
tax attributes. The offsetting attribute reduction can be
a reduction of tax attributes of any member of the group
(including credits). Thus, it is possible to have a shift of
a parent’s stock basis from one member that has a tax attribute reduction to the member with the excluded COD
income. The exceptions are when attributes and losses of
the parent are reduced.
Another key issue is the timing of the investment
adjustments rules since they must be integrated with
ming rule
the tim
timing
rules with respect to attribute reduction.
ti e ther
h re was a concern about the meaning of
Att oone time
there
he phra
ase ““after
afterr th
termination oof tax forr tthee yyear”
the
phrase
the determination
n Code
C e Sec
c. 10
08(b
A). Reg. §1
1502-32(b)(1) ii)
in
Sec.
108(b)(4)(A)
§1.1502-32(b)(1)(ii)
prov
vides a sp
peciaal rrule
ule for the timin
iv investn stprovides
special
timing of posi
positive
en
nt ad
djusttmen
n fo
OD inco
excl ded under
under
ment
adjustments
for COD
incomee excluded
0 (and negative adjustments for attribute
Code SSec. 1108
8(b) and 11017 and Reg.
reduction under Code Secs.. 10
108(b)
on st
ates:
§1.1502-28). The regulation
states:
Adjustments under this section resulting from the
realization of discharge of indebtedness income of a
member that is excluded from gross income under
Section 108(a) (excluded COD income) and from
the reduction of attributes in respect thereof pursuant to Sections 108 and 1017 and Reg. §1.1502-28
( including reductions in the basis of property) when
a member ( the departing member) ceases to be a
member of the group on or prior to the last day of
the consolidated return year that includes the date
the excluded COD income is realized are made
immediately after the determination of tax for the
group for the taxable year during which the excluded
COD income is realized (and any prior years) and
are effective immediately before the beginning of
the taxable year of the departing member following
OCTOBER 2014
the taxable year during which the excluded COD
income is realized.
Accordingly, all adjustments are made in the year of
debt cancellation immediately after the determination of
tax for the consolidated group and all of the adjustments
related to the debt cancellation are taken into account at
the end of the year. The timing rules of Code Secs. 108
and 1017(a) do not apply to defer the positive and negative investment adjustments to subsidiary stock basis on
excluded COD income and attribute reduction. There are
unclear issues on how this approach correlates with the
provisions of Reg. §1.1502-11(c) on circular stock basis
adjustments when there is excluded COD. We will be
looking at this in a future column.
Character of Worthless Stock Deduction
The general rule in Code Sec. 165(a) provides that if any
security which is a capital asset becomes worthless during
the tax year, the loss resulting therefrom will be treated
as a loss from the sale or exchange, on the last day of the
tax year, of a capital asset. The exception to the general
rule is found in Code Sec. 165(g)(3) which provides for
an ordinary loss if an ownership test and a gross receipts
test are met.
The gross receipts test is met if more than 90 percent
ary’s aggregate
ag re
of the subsidiary’s
gross receipts for all tax years
m sources
sou s other
h than
h n royalties,
oyal es, rents (except
excep
has been from
r
der
n l of properties
pr perties to employees
emplo ee of
rents
derived
from rental
The regulations are very clear that
no loss is allowed on account of mere
market fluctuation in the value of
such security.
the corporation in the ordinary course of its operating
business), dividends, interest (except interest received on
deferred purchase price of operating assets sold), annuities,
and gains from sales or exchanges of stocks and securities.
The ownership test is met if the shareholder owns at
least 80 percent of the voting power and 80 percent of the
value of the outstanding stock (other than plain vanilla
preferred stock) of the subsidiary. It is key to note that the
aggregation rule in Reg. §1.1502-34 is applicable; that is,
stock owned by one member of the consolidated group
is treated as being owned by every other member of the
consolidated group.
©2014 CCH INCORPORATED. ALL RIGHTS RESERVED.
21
TACKLING TAXES
Timing of Worthless Stock Deduction
For separate tax return purposes, a stock is worthless
when it has no current liquidating value and no potential
value.26 Consolidated return regulations provide additional
requirements on the timing of worthlessness. Specifically,
Reg. §1.1502-80(c) provides that stock of a subsidiary is
not treated as worthless under Code Sec. 165 until immediately before the earlier of the time (1) the stock is
worthless within the meaning of Reg. §1.1502-19(c)(1)(iii),
or (2) the subsidiary ceases to be a member of the consolidated group.
Reg. §1.1502-19 provides rules for a member of a
consolidated group to include in income its excess loss
account (ELA) in the stock of another member. Specifically, Reg. §1.1502-19(c)(1)(iii) provides three events
evidencing worthlessness. The primary event is that a
subsidiary is worthless at the time all of S's assets (other
than its corporate charter and those assets, if any, necessary to satisfy state law minimum capital requirements
to maintain corporate existence) are treated as disposed
of, abandoned, or destroyed for federal income tax purposes.27 An asset of a subsidiary, however, is not treated
as disposed of or abandoned to the extent the disposition
is in complete liquidation of the subsidiary under Code
Sec. 3322 or iis in exchange for consideration (other than
lieeff from
ffroom indebtedness).
i d bbt
indeb
relief
Based on this definition of
wor
rthlesssnesss, a su
iary may not be worthless
th ss if it
worthlessness,
subsidiary
hold
ds an
n ins
substtan
mount of as
ets. Ca
holds
insubstantial
amount
assets.
Caree must be
xerrcised
d in iden
ntifyin all of the su
idiary’s assets.
as ts For
or
exercised
identifying
subsidiary’s
am
mpleee, thee IRSS held
el in AM 201
03 th
ubsid
example,
2012-003
that a subsidl i to a share of a tax refund under state law or
iary’s claim
ors oorr officers cconstitutes an
a legal claim against directors
bsidiary.28
asset in the hands of the subsidiary.
This definition of worthlessness generally has the effect of: (1) delaying the timing of worthlessness, and (2)
providing a degree of certainty as to when the subsidiary
is worthless, in comparison to the general “no potential
value” test for separate returns.29
The other two events of worthlessness are dependent
on the status or treatment of the subsidiary’s indebtedness. First, stock of a subsidiary is treated as worthless
if COD income is excluded from gross income and tax
attributes (e.g., NOL, basis of assets) are not reduced to
the extent of the excluded COD income.30 Second, stock
of a subsidiary is also treated as worthless when a member
of the consolidated group claims a bad debt loss deduction, but the subsidiary does not report a corresponding
amount of income in the same tax year.31 Note that while
an event identified in either Reg. §1.1502-19(c)(1)(iii)(B)
or (C) (dealing with debt cancellations) will likely occur
22
TAXES The Tax Magazine ®
in connection with an event identified in Reg. §1.150219(c)(1)(iii)(A), either may occur independently.
In liquidation, the insolvent subsidiary ceases to be a
member of the consolidated group. Therefore, under Reg.
§1.1502-80(c), the stock should be treated as worthless
upon liquidation, provided that it was not treated as
worthless in a prior year due to COD income or bad debt
loss rules described above.
Excess Loss Account (ELA)
In many cases, the shareholder of an insolvent subsidiary is
not trying to claim a worthless stock deduction as discussed
in the prior section. Instead, the shareholder is trying to
avoid recognizing an ELA as income. An ELA in effect
represents a negative stock basis in a share of stock. In many
cases, an insolvent subsidiary will have an ELA because it
has financed its operating losses with debt as opposed to
equity. The operating losses, if utilized in the consolidated
return, will decrease the shareholder’s basis in the insolvent
subsidiary’s stock to such an extent that there is an ELA.
If an insolvent subsidiary has an ELA, the regulations
require the parent corporation to recognize income or
gain upon disposition of the subsidiary’s stock. Common
dispositions of an insolvent subsidiary would be liquidation or worthlessness.
We have examined worthlessness under Reg. §1.1502ction. An insolvent subsidiary is consid19 in the priorr ssection.
ered wort
worthlesss if:
insolv nt subsidiary’s
ub dia y’s assets (other
other than
t an its
all of the insolvent
corpo
charte and
and those
thos assets,
ssets if any,
ny necessary
ne es
corporate
charter
to satisfy state law minimum capital requirements to
maintain corporate existence) are treated as disposed
of, abandoned or destroyed for federal income tax
purposes;
the insolvent subsidiary has excluded COD income
that, as a result of no corresponding reduction in tax
attributes, is not treated as tax-exempt income under
Reg. §1.1502-32(b)(3)(ii)(C); or
a member takes into account a deduction or loss
for the uncollectibility of an indebtedness without
the subsidiary taking into account a corresponding
amount of income or gain from the indebtedness in
the same tax year.32
As noted in the prior section, the taxpayer has some
flexibility in determining whether or not an insolvent
subsidiary is worthless by not disposing of all of the
insolvent subsidiary’s assets. While this deferral is disadvantageous in the context of a worthless stock deduction
(see AM 2012-003), it is advantageous in the context of
triggering an ELA.
OCTOBER 2014
How aggressive can you be in using this deferral technique? For example, what if you cease doing all substantial
business but do not dispose of all the assets of the insolvent
subsidiary? Literally, you don’t trigger the ELA. However,
the ELA provisions have a broad anti-avoidance rule.
Reg. §1.1502-19(e) provides: “If any person acts with a
principal purpose contrary to the purposes of this section,
to avoid the effect of the rules of this section or apply the
rules of this section to avoid the effect of any other provision of the consolidated return regulations, adjustments
must be made as necessary to carry out the purposes of this
section.” In addition, Example 6 in Reg. §1.1502-19(g)
indicates that the IRS will apply the anti-avoidance rule
in the above situation.
A disposition under Reg. §1.1502-19 is not a disposition for all purposes of the Code. It is a disposition only
for purposes of recognizing the ELA into income (and for
any other provisions that apply by reference to a disposition under Reg. §1.1502-19). The insolvent subsidiary
continues to be a member of the consolidated group. For
example, assume the ELA was triggered but the insolvent
subsidiary was not liquidated. If the insolvent subsidiary
remained worthless and has a loss in a subsequent year and
the loss is utilized in the consolidated return, another ELA
is created and triggered into income. The net effect is zero
he lo
oss iss offset by the recognized ELA. In addition,
as the
loss
he inso
iinsolvent
olven
l nt sub
b
bs
the
subsidiary’s
net operating loss carryovers,
capi
apiital loss
l carry
ccarryovers,
yov
and credit car
lu
capital
carryovers (i
(including
he inso
olvent sub
bsid
share of suc
h conso
lidated tax
the
insolvent
subsidiary’s
such
consolidated
ttributees) ar
re eli
im na 33
attributes)
are
eliminated.
Thee d
dispoositioon of an insolvent
nsolvent subsidiary,
bsidia y whether
whether
Th
disposition
id
d i or by worthlessness, is treated as a sale or
by liquidation
ermining the ccharacter of the
exchange for purposes of determining
extent of tthe subsidiary’s
income or gain. However, too the extent
insolvency, the income is treated as ordinary income.34 The
income is recognized at the time of the worthlessness or
other disposition and not at the end of the year, as was
the case in prior regulations (i.e., you can no longer make
a capital contribution prior to year-end to eliminate the
ELA and avoid the income recognition).
The parent corporation also faces recognition of the
ELA when a third party debt of its insolvent subsidiary is
discharged. If an insolvent subsidiary has COD income
excluded from gross income but not treated as tax-exempt
income under Reg. §1.1502-32(b)(3)(ii)(C), the parent
corporation must recapture the ELA to the extent such
excluded COD income is not treated as tax-exempt income.35 Under Reg. §1.1502-32(b)(3)(ii)(C), excluded
COD income is treated as tax-exempt income only to the
extent the debt discharge is applied to reduce tax attributes
of the insolvent subsidiary and other group members in
accordance with Reg. §1.1502-28 discussed above. In
effect, the parent corporation must recapture the ELA
to the extent that any excluded COD income does not
reduce any tax attributes.
Conclusion
In this column, we looked at when and how an insolvent
subsidiary’s attributes are reduced in the cancellation of
non-intercompany obligations under the consolidated
tions. We
W also looked at when a worthless
return regulations.
stoc
ded on ccan be claimed
la ed including tthe
he amo
unt oof
stockk deduction
amount
ssuch dedu
on and the
he timing
im g off the dedu
ction. We
W also
deduction
deduction.
lo
ked aat the triggering
triggering of an ELA.
LA In future
ure co
u
looked
columns
we will look at various limitations on the worthless stock
deduction including the unified loss rule and the circular
basis rule.
ENDNOTES
*
1
2
This column represents the views of the authors
and does not necessarily represent the views or
professional advice of Plante Moran and DePaul
University.
If the taxpayer is insolvent, COD income is
excluded to the extent of insolvency. However,
if the taxpayer is in a title 11 bankruptcy proceeding, all the COD income is excluded.
“The IRS and Treasury Department have rejected
a separate entity approach. Such an approach
would reduce only the attributes attributable
to the member with excluded discharge of
indebtedness income. The IRS and Treasury
Department have rejected this approach because it fails to take into account the fact that
consolidated attributes that are attributable
to other members will be available to offset
income of the debtor member as long as the
OCTOBER 2014
debtor is a member of the group. A separate
entity approach could result in the permanent
exclusion of discharge of indebtedness income
when there are other attributes available to the
debtor member.
In the view of the IRS and Treasury Department, the policies underlying section 108
require a consolidated approach that reduces
all attributes that are available to the debtor.
An approach that does not reduce all of such
attributes is inconsistent with Congressional
intent that income realized from debt discharge
generally be deferred and not permanently
eliminated. Furthermore, reducing all of the
consolidated attributes available to the debtor
member reflects the principle enunciated by
the Supreme Court in United Dominion Indus.,
Inc. v. United States , 532 U.S. 822 (2001),
3
4
5
6
that, in general, the only net operating loss
of a consolidated group or its members for a
consolidated return year is the consolidated
net operating loss. Consistent with United
Dominion, the tax attributes subject to reduction under section 108(b) when the debtor is
a member of a consolidated group include the
group's consolidated attributes in their entirety. Therefore, these temporary regulations
provide for the reduction of consolidated net
operating losses and all other consolidated
tax attributes, including consolidated tax attributes that are attributable to members other
than the debtor member.” T.D. 9089.
Reg. §1.1502-28(a)(2).
Reg. §1.1502-28(a)(3).
Reg. §1.1502-28(a)(4).
Note that this appears to be an all-inclusive list
©2014 CCH INCORPORATED. ALL RIGHTS RESERVED.
23
TACKLING TAXES
7
8
9
10
11
12
13
14
15
16
17
18
19
20
of attributes and not a list of examples. Attribute carryovers not in this list, such as interest
limited by Code Sec. 163(j), do not get reduced.
Reg. §1.1502-28(a)(2)(ii).
Code Sec. 108(b)(4)(B).
Code Sec. 108(b)(4)(C).
Reg. §1.1502-28(a)(2)(i).
T.D. 9192, Mar. 22, 2005.
See FSA 200145009 (July 31, 2001) where the
assets were transferred in a G reorganization.
The IRS held that because the taxpayer’s year
terminated pursuant to Code Sec. 381(b)(1)
and the subsidiary had no assets the first
day after the short year, that there was no
reduction in basis. Note that this was before
the current successor rule was put into the
regulations.
Note that the reduction is of each member’s
allocable share. Reg. §1.1502-28(a)(4).
Reg. §1.165-1(b).
Reg. §§1.165-5(f) and 1.165-4.
Reg. §1.165-1(c).
Reg. §1.1502-32(b)(2).
Reg. §1.1502-32(b)(3)(i).
Reg. §1.1502-32(b)(3)(ii)(A).
Reg. §1.1502-32(b)(3)(iii).
21
22
23
24
25
26
27
28
29
Reg. §§1.1502-32(b)(3)(v) and 1.1502-13(f)(2)(iv).
Reg. §1.1502-19(a)(2).
“The IRS and Treasury Department believe that
a positive basis adjustment should be made to
the basis of the stock of a debtor subsidiary even
if the discharge of indebtedness income reduces
an attribute that is attributable to the common
parent.” T.D. 9089.
Reg. §1.1502-32(b)(3)(iii)(B).
Reg. §1.1502-32(b)(3)(iv)(B).
See S. Morton, 38 BTA 1270, Dec. 10,517 (1938)
and “Tackling Unsettled Issues in the Liquidation
of an Insolvent Subsidiary,” TAXES, Oct. 2009, at
15.
Reg. §1.1502-19(c)(1)(iii)(A).
See Harris, AM 2012-003: The IRS Offers Worthwhile Views on Worthless Stock, CORPORATE TAX'N,
Vol. 40, No. 2, Mar.-Apr. 2013.
Before this current definition, the stock of a
subsidiary could be worthless over a number
of years while the subsidiary remained in existence as a member of the consolidated group.
This had the potential effect of income and /
or loss recognition of worthlessness over a
number of tax years. For example, the subsidiary’s ELA is recognized as income in the first
30
31
32
33
34
35
year of stock worthlessness. If the subsidiary
incurred a net operating loss (without any new
capital contribution) in the following taxable
year that offset income of other members, this
would create a new ELA. This new ELA would
then be recognized as ordinary income in the
same taxable year as a result of continued
worthlessness. The net income effect in the
subsequent tax year is that the ELA income
recapture amount would offset the net operating loss. Under these current regulations, it
is less likely and frequent that this continued
worthlessness situation of potential income
and/or loss would happen.
Reg. §1.1502-19(c)(1)(iii)(B).
Reg. §1.1502-19(c)(1)(iii)(C).
Since Code Sec. 108(a) does not apply to intercompany obligations, this event occurs only in
unusual circumstances.
Reg. §1.1502-19(b)(1)(iv), which eliminates an
insolvent subsidiary’s losses, credits and other
attributes when its stock becomes worthless or
when it ceases to exist (i.e., dissolution/liquidation).
Reg. §1.1502-19(b)(4).
Reg. §1.1502-19(b)(l)(ii).
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TAXES The Tax Magazine ®
OCTOBER 2014