George White

IRS Proposes Unified LDR Theory

This article covers the basics in the latest consolidated return regulations dealing with the fallout from the repeal of the General Utilities doctrine in the Tax Reform Act of 1986.

January 10, 2008
by George White

In the convoluted history of these regulations, the watershed event was the Federal Circuit's decision in Rite Aid Corp. v. United States. That decision invalidated one leg — the duplicated loss rule — of the comprehensive regulation (reg. section 1.1502-20) adopted to implement General Utilities repeal. In the years following Rite Aid, the IRS addressed the twin problems of duplicated loss and uneconomic stock loss in separate regulations (reg. sections 1.1502-35 and 1.337(d)-2, respectively). When reg. section 1.1502-35 was finalized in 2006, the IRS stated that it intended to propose a "single integrated approach" to both problems. The author concludes that the proposed regulations discussed in this report fulfill that promise.

“The hardest thing in the world to understand is the income tax,” is a staple in Tax Notes’ annual collection of tax quotes. Earlier this year the IRS proposed its own unified theory, one aimed at what had so far been perceived as discrete problems: loss disallowance and loss duplication.1

Q. What does the IRS perceive as the underlying cause of these problems?

A. Stock basis — there’s too much of it, and sometimes it winds up in the wrong place.

Q. How do these problems manifest themselves?

A. The loss disallowance problem is twofold: The investment adjustment system2 occasionally throws off excessive adjustments, and the adjustments are sometimes misplaced. The loss duplication problem concerns the possibility that the same loss may be claimed twice, either by the same, or a different, taxpayer.

Q. How long has this been going on (as the Gershwin song goes)?3

A. The seeds of the loss disallowance problem go back to 1966, when the consolidated return regulations adopted the current investment adjustment system to increase the basis of S stock to reflect S's earnings. Before 1966 the basis of S stock was generally adjusted in one direction only: downward to reflect any of S's losses that were "availed of" by the consolidated group.4 (Positive adjustments were possible through a clumsy technique known as a "deemed dividend.")5 It's fair to say that this "flaw," if indeed it can be so characterized, was not apparent for the first 20 years after the investment adjustment system was adopted. It was not until 1986, when the Tax Reform Act overturned the General Utilities doctrine, that taxpayers discovered that the investment adjustment system presented a way to neutralize the now near-universal recognition of corporate-level gains.6

Q. Can you give me an example — a "thought experiment"?7

A. P purchases 100 percent of S's stock, and S recognizes a gain that was inherent in S's assets at the time that P purchased S's stock (a built-in gain, or BIG). Under the investment adjustment system, S's gain increases P's basis in S stock basis above its fair market value, thus setting the stage for P to recognize an "uneconomic" loss.8

Q. Under what circumstances can positive adjustments wind up in the wrong place, and why is that a problem?

A. Under the investment adjustment system, all adjustments (positive and negative) are made equally to all S shares, without regard to the particular basis of those shares.9 That can be a problem when the shares have a non-uniform basis, a situation that may have occurred innocently (perhaps P bought S shares at different times), or perhaps not so innocently (P may have contributed BIG assets to S for new S shares and taken back S shares with an imbalance between FMV and basis). If S generates positive adjustments, the gap between basis and FMV on older S shares will be widened — see first example below.

Q. How do the proposed regulations address those problems?

A. In the following order: First, misplaced stock adjustments are dealt with (prop. reg. section 1.1502-36(b)); next, excessive positive adjustments are covered (prop. reg. section 1.1502-36(c)); and finally, loss duplication is addressed by attribute reduction (prop. reg. section 1.1502-36(d)).

Q. How does prop. reg. section 1.1502-36(b) deal with misplaced adjustments?

A. First, on a "transfer" (a technical term that's potentially deceptive to someone with only a layman's understanding of the word) of S stock, specific S shares are identified. Those are any S shares whose basis exceeds value ("loss" shares). The excess is reduced by taking away all positive adjustments previously made to such shares. Prop. reg. section 1.1502-36(b)(2)(i)(A). If the S share is still a loss share, negative adjustments previously made to other S shares are applied to the loss share, further reducing the excess of basis over value. Prop. reg. section 1.1502-36(b)(2)(i)(B). Then, positive adjustments are added back in a manner that will equalize bases.10

Q. Is there a limit on these two adjustments to S's stock basis?

A. Adjustments cease when the S share is no longer a loss share, that is, when the excess of S's stock basis over its FMV is eliminated.

Q. For example …

A. Assume P forms S for $80 cash for four common shares. Later, P contributes a BIG asset (basis zero; FMV $20) to S for an additional common share. P now has two blocks of S common with a total basis of $80, but it's a non-uniform basis. Block 1 (the original four shares) has a per-share basis of $20; Block 2 (the one additional share) has a basis of zero. S later sells the BIG asset for $20, which results in a $20 positive adjustment to all five S shares equally. That increases the per-share basis of each Block 1 share to $24 ($20/5), which means that each share in Block 1 is now a loss share (basis $24; FMV $20). P then sells one share from Block 1. The basis of that S share must be redetermined — the $4 positive adjustment is reallocated to the single Block 2 share. The Block 1 share now has a basis of $20, so its sale for $20 does not produce a loss. (Note: The basis of the single share in Block 2 is increased by $4 to $8; the original basis of zero, plus the investment adjustment of $4, plus $4 reallocated from the Block 1 share.)11

Q. This rule is pretty complex. Is there any way to avoid it?

A. There are two exceptions: when S has only one class of stock and there is a uniform basis in all S shares, or when all S shares are disposed of in the same tax year in fully taxable transactions to nonmembers. Prop. reg. section 1.1502-36(b)(1)(ii)(A) and (B). The reason for the first exception is that when all S shares are of a single class and have the same basis (and, by definition, the same FMV), it's pointless to reduce the basis of only some S loss shares (to eliminate the gap between basis and FMV) because that would only widen the gap on the remaining S shares. The reason for the second exception is similar — when all S shares are disposed of in the same tax year in fully taxable transactions to nonmembers, the entire basis in S shares is consumed, so again it would be pointless to eliminate the gap on only some S loss shares while widening the gap on other S shares.

Q. If a taxpayer can avoid applying the first rule, does that mean it can skip the two remaining rules?

A. No chance, nada, never. The labyrinth of the other two rules must be confronted if S shares are still loss shares after application of either (or both) of the two exceptions to the first rule.12

Next month we’ll look closer at ways to deal with loss shares, and the ramifications of surviving the basis reduction rule of prop. reg. section 1.1502-36(c) and other issues.


1 REG-157711-02, 72 Fed. Reg. 2964-3020, Doc 2007-1212, 2007 TNT 11-8 (Jan. 23, 2007).

2 Reg. section 1.1502-32.

3 The 1927 Gershwin song "How Long Has This Been Going On?" (not to be confused with the mid-'70s hit of the same title by Ace) has been performed by vocalists from Ella Fitzgerald to Ray Charles. A sample verse:

I could cry salty tears; Where have I been all these years? Little wow, tell me now: How long has this been going on?

4 Former reg. section 1.1502-34A(b)(2)(i) (pre-1966 regulations).

5 Positive adjustments were achieved through an election that involved a fictional distribution out of affiliated earnings and profits without a negative basis adjustment, followed by a positive adjustment for a fictional contribution to capital.

6 The transaction of choice gained notoriety as the son-of-mirrors deal.

7 Isaacson, Einstein: His Life and Universe, New York: Simon & Schuster (2007). Isaacson notes that Einstein developed his theories in his mind ("thought experiments"), not the laboratory. For instance, even as a teenager, Einstein imagined what he might observe if he could ride through space alongside a beam of light.

8 This is the classic son-of-mirrors deal.

9 Reg. section 1.1502-32(a). Commentators have noted that there is no counterpart in the consolidated return regulations to the subchapter K rule (section 704(c)), which matches basis adjustments to partnership interests.

10 Prop. reg. section 1.1502-36(b)(2)(ii). In this manner, positive adjustments are not lost, but merely reallocated to other S shares.

11 This example, and the ones that follow, are taken from an unofficial presentation by Treasury and IRS personnel on Feb. 16, 2007, at the Washington law office of Buchanan Ingersoll & Rooney; see Doc 2007-4281 or 2007 TNT 34-6 (Feb. 20, 2007). This particular example tracks prop. reg. section 1.1502-36(b)(3), Example 1(i).

12 According to a government official, most (more than 90 percent) consolidated groups will qualify for one or both of these exceptions.

Rate this article 5 (excellent) to 1 (poor).
Send your responses here.

George White is a manager with the American Institute of Certified Public Accountants in Washington and an adjunct professor for tax at the George Washington Graduate School of Business. The author would like to thank his longtime friend, Larry Axelrod of Deloitte Tax LLP, for his assistance in developing this report. This was first published by Tax Notes.