CCA 200004015: IRS calls for more facts before testing a consolidated stock loss

Plain-English summary

A consolidated group claimed a loss when one member sold stock of a subsidiary after transferring valuable trademarks within the group. A revenue agent questioned the group's basis and loss disallowance calculations under Treasury Regulation § 1.1502-20. Chief Counsel described the rule's components, including extraordinary gains, positive investment adjustments, and duplicated losses, and advised the agent to develop the missing facts. The memo also outlined arguments supporting the regulation's validity. It did not decide whether the claimed loss or the group's calculation was correct; the national office asked to remain involved if the facts showed the rule applied.

Ruling snapshot

• Question: What facts should the agent develop to test the stock loss calculation under the consolidated return loss disallowance rule?
• Outcome: Advice given: further factual development needed before determining the allowable loss.
• Key authorities: IRC §§ 1502, 337(d); Treas. Reg. §§ 1.1502-20, 1.1502-32.

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

OFFICE OF
CHIEF COUNSEL

CC:DOM:FS:CORP : October 26, 1999
TL-N-2445-99

Number: 200004015

Release Date: 1/28/2000

UILC: 1502.20-00

INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE

MEMORANDUM FOR ASSOCIATE DISTRICT COUNSEL,

Attn:

FROM: DEBORAH A. BUTLER
ASSISTANT CHIEF COUNSEL CC:DOM:FS

SUBJECT: Properly Computing Loss Disallowance Rules Under Treas.
Reg. section 1.1502-20

This Field Service Advice responds to your memorandum dated September 13,
1999. Field Service Advice is not binding on Examination or Appeals and is not a
final case determination. This document is not to be cited as precedent.

LEGEND

Ultimate Parent
Group

Ultimate Parent

Ultimate Sub

Target Parent Group

Target Parent

Target Sub 1


2

Target Sub 2 =
Line of Business B =

Line of Business C =
State X =
Asset C =
Asset D =
Individual B =
Month B =
Month C =
Date B =
Date C =
Date D =
Year B =
Year C =
Year D =
Year E =
$B =
$C =
$D =
$E =
$F =
$G =
$H =
$J =

$K =
$L =
$M =
$N =
$O =
$P =
$Q =
$R =

ISSUES

What facts should be developed by the revenue agent in order to determine
whether the disallowed loss reported by Ultimate Parent on the sale of its stock in
Target Parent, a wholly owned affiliated subsidiary, under Treas. Reg. section
1.1502-20 (-20) was properly computed.

CONCLUSIONS

Per your request, we have developed a set of facts that need to be developed in
audit in order to determine whether Ultimate Parent properly applied the loss
disallowance rules ("LDR") of -20. Additionally, we have listed facts that need to be
developed to support the Service's argument that -20 is valid. We recommend that
you develop the facts of your case in accordance with the advice set forth below.
To the extent the factual development of your case leads to a conclusion that the
LDR apply, the national office is interested in being involved in the development of
the case.

FACTS

During the taxable year ended Date B, Ultimate Sub, a wholly-owned affiliate and
member of the Ultimate Parent Group, acquired the stock of the Target Parent
Group for about $B. Target Parent Group consisted of Target Parent, Target Sub
1, a first tier subsidiary, and Target Sub 2, a second tier subsidiary. The Target
Parent Group was principally involved in the Line of Business B. Goodwill, which


included the value of the trademarks,1 was valued in the financial statements at $C
but the goodwill and the trademarks had a $R tax basis.

During subsequent years, the Asset D of the Target Parent Group were sold off to
third parties and Line of Business C was moved to other Ultimate Sub facilities. By
the end of fiscal Year D, the only asset left at the Target Parent Group was a $N
note receivable from a third party and certain valuable trademarks both owned by
Target Sub 1.2 According to your incoming memorandum, Ultimate Sub then
decided to cash out the note receivable,3 which was due on Date D, while retaining
the trademarks which were valued in Month B of Year E at $K-$J.4

According to your incoming memorandum, Target Sub 1 contributed the trademarks
to Target Sub 2 in a section 351 transaction and then had the Target Sub 2 stock
distributed upstream as a section 301 dividend from Target Sub 1 to Target Parent
and then to Ultimate Sub. Target Sub 1 was then merged into Target Parent. On
Date C, the stock of Target Parent was sold by Ultimate Sub to Individual B, an
unrelated third party, for $L. Ultimate Parent claimed a loss on this stock sale of $H
on its return for the year ended Date C.

1We are unclear as to the portion of the $C in goodwill that should be attributable
to the trademarks alone.

2The note would have generated $Q more if Ultimate Sub had held it to maturity.
The note was obtained in Month C Year C from a State X general partnership, which
was unrelated to Ultimate Parent or any of the Target Parent Group, in connection with
the exchange for Asset C which Target Sub 1 owned in State X.

3According to your subsequent correspondence, you indicate that Target Sub 1
always held the note. However, the incoming memorandum indicates Ultimate Sub
held the note. We do not understand the facts. If Target Sub 1 always held the note,
we don’t understand how this can be reconciled with your statement that Ultimate Sub
cashed out the note. If Ultimate Sub received the $N note, we do not understand how
Ultimate Sub received the $N note from Target Sub 1 and how it was treated for tax
purposes.

4As previously indicated, we do not know the fair market value or cost of the
trademarks when purchased in Year B.


This loss was computed as follows:

Amount realized $M
Basis of stock ($E)
                  ($F)

Less loss disallowed
under Treas. Reg.
section 1.1502-20(c) $P

Loss Claimed ($H)5

Ultimate Parent later amended its loss computation thereby increasing the
allowable loss to $G. This computation results from a higher basis of $D for the
stock and a higher disallowed loss under section 1.1502-20(c) of $O.

Ultimate Sub has submitted computations to show how it calculated both its basis in
the Target Parent stock and the loss disallowed under Treas. Reg. section
1.1502-20(c). The revenue agent questions whether this loss disallowance
calculation is correct and seeks guidance as to what facts should be developed in
order to determine whether this loss was properly computed under Treas. Reg.
section 1.1502-20.

Also, according to your incoming memorandum, the trademarks were owned by
Target Sub 2 when Ultimate Sub received the Target Sub 2 stock. Target Parent
was then sold off to Individual B. According to the attachment to your incoming
memorandum, you indicate that the trademarks, which had a fair market value of $J
but a $R tax basis, were not included as either extraordinary gain dispositions or
positive investment adjustments in determining the disallowed loss computation
under Treas. Reg. section 1.1502-20(c). Your incoming memorandum questions
the validity and correctness of Ultimate Sub’s loss computation with respect to
these transactions.

5We assume minor differences are due to rounding.


LAW AND ANALYSIS

The Loss Disallowance Rules

A. Historical Overview

The Tax Reform Act of 1986, Pub. L. 99-514, 1986-3 C.B. (Vol. 1) 1 ("1986 Act")
repealed the General Utilities doctrine. The General Utilities doctrine, which takes
its name from General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935),
was codified in I.R.C. sections 311, 336, and 337 of the Internal Revenue Code of
1954.6 The doctrine provided an exception to the two-level system of corporate
taxation by according nonrecognition treatment to gain or loss resulting from a
corporation’s disposition of appreciated or depreciated property to its shareholders,
either in liquidation (former I.R.C. section 336), or as a dividend (former I.R.C.
section 311), or when it sold the property and distributed the proceeds in liquidation
(I.R.C. section 337). The 1986 Act repealed the General Utilities doctrine by
amending I.R.C. sections 311, 336, and 337 to require, with limited exceptions, the
corporate level recognition of gain on a corporation's sale or distribution of
appreciated property, irrespective of whether it occurs in a liquidating distribution or
a sale in connection with a liquidation.

The statutory amendments under the 1986 Act implemented General Utilities repeal
in the separate return context. Congress enacted I.R.C. section 337(d), which
specifically authorizes the Secretary to prescribe such regulations as may be
necessary or appropriate to carry out the purposes of the amendments made by the
1986 Act, including regulations to ensure that such purposes may not be
circumvented through the use of any provision of law or regulations (including the
consolidated return regulations). The LDR carry out the purposes of these
amendments in the consolidated return context.

In the consolidated return context prior to these amendments, when a target
company sold or distributed appreciated property to members of an acquiring
group, that group could obtain a loss on the subsequent sale of the target company
due to a positive basis adjustment which was made when the target company sold
or distributed the appreciated property. This result was contrary to the repeal of the
General Utilities doctrine. Instead, the shareholders should have reported a gain

6All section references will refer to the Internal Revenue Code of 1986, unless
otherwise specified. For example, Code sections under the Internal Revenue Code of
1954 will be referred to as a "former" section.


on the sale of the target company, and the target company should have paid a tax
on its built-in gains. The -20 regulations were promulgated to provide a result in the
consolidated return context that was consistent with the repeal of the General
Utilities doctrine.

B. Application of LDR

The LDR generally provide that no deduction is allowed for any loss recognized by
a member with respect to the disposition of stock of a subsidiary. "Disposition"
means any event in which gain or loss is recognized, in whole or in part. Treas.
Reg. section 1.1502-20(a)(2). Treas. Reg. section 1.1502-20(c) specifies that the
amount of loss disallowed under paragraph (a)(1) with respect to the disposition of
a share of stock will not exceed the sum of the following three items: (1)
extraordinary gain dispositions; (2) positive investment adjustments; and (3)
duplicated loss.

Extraordinary gains: Loss on the sale of a share of stock is disallowed to the extent
of the share's allocable portion of any member's earnings and profits, net of directly
related expenses (e.g. commissions, legal fees, state income taxes), attributed to
actual or deemed gain dispositions occurring after November 18, 1990, of (1)
capital assets; (2) section 1231(b) property (e.g., depreciable property or land used
in a trade or business); (3) bulk sales or other dispositions of nondepreciable .
business assets, such as inventory, copyrights, or receivables used in the same
trade or business; (4) dispositions of business assets described in section 1060(c);
(5) any positive section 481 adjustments resulting from a change of accounting
method, including a change attributable to pre-November 19, 1990 periods (e.g.,
recovery of LIFO reserve); (6) income from discharge of indebtedness (not
excluded from basis under section 1503(e); and (7) any other event (or item)
identified in revenue rulings and revenue procedures. Treas. Reg. section 1.1502-
20(c)(2)(i). These extraordinary gain dispositions apply only to the extent that
immediately before the disposition of the share, they are directly or indirectly
reflected in the basis of the share after applying the basis adjustment rules of
section 1503(e), Treas. Reg. section 1.1502-32(g), and other applicable provisions.
Treas. Reg. section 1.1502-20(c)(2)(iii).

Positive investment adjustments: In calculating the disallowed loss, the regulations
consider positive investment adjustments. These are the annual earnings and
profits (before distributions) (other than those covered by the extraordinary gain
provisions), that result in positive basis adjustments under Treas. Reg. section
1.1502-32(b)(1)(i) and (c)(1). These earnings and profits adjustments apply only to
the extent that immediately before the disposition of the share, they are directly or
indirectly reflected in the basis of the share after applying the basis adjustment


rules of I.R.C. section 1503(e), Treas. Reg. section 1.1502-32(g), and other
applicable provisions. To a limited extent, deficits of one year can be offset against
earnings and profits of another year for tax years ending on or before September
13, 1991. However, they cannot be netted for years thereafter.

Duplicated loss: The amount of duplicated loss apportioned to each share is the
portion of the loss carryforwards and net built-in losses attributed to the share.
Treas. Reg. section 1.1502-20(c)(2)(vi). The amounts determined under this
paragraph with respect to a subsidiary must include the subsidiary's allocable
portion of corresponding amounts with respect to each of its lower-tiered
subsidiaries. The duplicated loss amount is determined immediately after a
disposition by first adding (1) the aggregate adjusted basis of the subsidiary's
assets, but not the adjusted basis of its stock or securities in a group member; (2)
any losses attributable to the subsidiary and carried to its first taxable year after the
disposition; and (3) any deferred deductions (such as passive losses under I.R.C.
section 469) of the subsidiary. The total amount is then reduced by the sum of (1)

value of the subsidiary's stock; (2) liabilities of the subsidiary; and (3) any other
relevant items.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

A. Relevant Facts

As we previously noted, many facts need to be developed in audit in order to
calculate the maximum loss disallowance in a given case. We have provided you
with a list of questions that need to be addressed. We recommend that you
develop the facts of your case in accordance with the questions set forth below. As
stated above, to the extent the factual development of your case leads to a
conclusion that the -20 regulations apply, we recommend that you seek additional —
Field Service advice in the development of the case.


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There are examples in the regulations (Treas. Reg. section 1.1502-20(c)(4)) which
illustrate the principles of paragraph (c)(1). We recommend you review these
examples and get back to us if you have any questions regarding the application of
the loss disallowance rules and whether or not you need more facts to set up the
issue.

B. Validity of the regulation

The following is a brief discussion of the judicial standard for testing the validity of a
Treasury regulation and some brief discussion on Service position with respect to
this issue. As this case progresses, we would like to work with you to develop the
Service's arguments as to why -20 is valid.

A Treasury regulation is sustained unless unreasonable and plainly inconsistent
with the revenue statutes. Commissioner v. South Texas Lumber Co., 333 U.S.
496, 501 (1948). Regulations promulgated under I.R.C. section 1502 are legislative
regulations, which are entitled to great deference and should not be overruled
"except for weighty reasons." Id. To be sustained, the regulation must be: (1)
reasonable and not arbitrary or capricious; and (2) consistent with the Internal
Revenue Code ("Code") and/or Congressional intent.

7See the Treasury regulation in effect for the years in question.


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The loss disallowance rules represent a reasonable approach to implementing two
objectives mandated by Congress. First, Congress wanted to prevent avoidance of
General Utilities repeal. Second, Congress wanted to prevent loss duplication that
is inconsistent with single-entity treatment of consolidated groups. A complete
discussion of how -20 implements these objectives may be found in the Preambles
accompanying the Proposed, Reproposed, and Final Loss Disallowance
regulations. We recommend that you review these Preambles for arguments to
support the position of the Service that the regulation is reasonable and consistent
with Congressional intent.

The references to these Preambles are as follows:

Regulation Citations

Temp. & Prop. Regs. T.D. 8294

§ 1.1502-20T 55 FR 9426

§ 1.337(d)-1T (filed 3/9/90, pub'd 3/14/90)

1990-1 C.B. 66 & 1990-1 C.B. 558

(Notice of Proposed Rulemaking)
Final Reg. § 1.337(d)-1 T.D. 8319
Temp. Reg. § 1.337(d)-2T 55 FR 49075

(filed 11/19/90, pub'd 11/26/90)

1990-2 C.B. 57

CO-78-87

1990-2 C.B. 696

_ (Notice of Proposed Rulemaking)

Final Regs. § 1.1502-20, T.D. 8364
§ 1.337(d)-2 1991-2 C.B. 43

Other provisions under the consolidated return regulations have been challenged in
the past and the courts have upheld the validity of the regulations. See Garvey,
Inc. v. United States, 726 F.2d 1569 (Fed. Cir. 1984) (Federal Circuit upheld the
validity of Treas. Reg. section 1.1502-32(b)(2)(iii)(b)); Allied Corp. v. United States,
685 F.2d 396 (Ct. Cl. 1982) (Court of Claims upheld validity of Treas. Reg. section
1.1502-79(a); Wolter Construction Co. v. Commissioner, 634 F.2d 1029 (6th Cir.
1980), aff'g 68 T.C. 39 (1977) (Court of Appeals for the Sixth Circuit upheld validity
of Treas. Reg. section 1.1502-21(c); First Chicago Corp. v. Commissioner, 96 T.C.
421 (1991) (Tax Court upheld validity of Treas. Reg. section 1.1502-34); Covil
Insulation Co. v. Commissioner, 65 T.C. 364 (1975) (Tax Court upheld validity of

Treas. Reg. section 1.1502-32(e); Georgia Pacific Corp. v. Commissioner, 63 T.C.


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790 (1975) (Tax Court upheld validity of Treas. Reg. section 1.1502-19); Salem
Packing Co. v. Commissioner, 56 T.C. 131 (1971) (Tax Court upheld validity of
Treas. Reg. section 1.1502-44A); Regal, Inc. v. Commissioner, 53 T.C. 261 (1969),
aff'd per curiam, 435 F.2d 922 (2d Cir. 1970) (Tax Court upheld validity of Treas.
Reg. section 1.1502-11A(a); Valley Paperback Manufacturers, Inc. v.
Commissioner, T.C. Memo. 1975-331 (Tax Court upheld validity of Treas. Reg.
section 1.1502-76(b)).

Please call us at (202) 622-7930 if you have any further questions.

Deborah A. Butler
Assistant Chief Counsel

By:

ARTURO ESTRADA
Acting Branch Chief
(CC:DOM:FS:CORP)

Attachment (1) Ten page Powerpoint Diagram Regarding Facts


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Slide 1

Ultimate Parent Group Entities & Individuals Involved

Ultimate Parent Group

Ultimate Parent

Ultimate Sub

Individual B

Target Parent Group

Target Parent

Target Sub 1

Target Sub 2

1

Slide 2

Ultimate Parent Group

Ultimate Parent

Ultimate Sub

Target Parent Group

Target Parent

Target Sub 1

Target Sub 2

During the taxable year ended Date B, Ultimate Sub, a wholly-owned
affiliate and member of the Ultimate Parent Group, acquired the stock of the
Target Parent Group for about $B. Target Parent Group consisted of Target Parent,
Target Sub 1, a first tier subsidiary, and Target Sub 2, a second tier subsidiary.
The Target Parent Group was principally involved in the Line of Business B.

2

15

Slide 3

After acquisition of stock of Target Parent Group

Ultimate Parent
Ultimate Sub
Target Parent
Target Sub 1
Target Sub 2

3

Slide 4

By the End of Fiscal Year D

Ultimate Parent
Ultimate Sub
Target Parent
Target Sub 1
Target Sub 2

Target Parent Group Assets
$N note receivable from a third party and certain valuable trademarks.
We have determined that Target Sub 1 owned the trademark as well as held the note.

During subsequent years, the production facilities of the Target Parent Group were sold off to third parties and Line of Business C was moved to other Ultimate Sub facilities. By the end of fiscal Year D, the only assets left at the Target Parent Group was a $N note receivable from a third party and certain valuable trademarks. Ultimate Sub then decided to cash out the note receivable, which was due on Date D, while retaining the trademarks which were valued in Month B of Year E at $K-J.

4

Slide 5

After Cashing the Notes Receivable On or About the End of Fiscal Year D

Ultimate Parent
Ultimate Sub

It is our understanding that Ultimate Sub received cash after Target Sub 1 (or Ultimate Sub) cashed out the note

Target Parent
Target Sub 1
Target Sub 2

Target Parent Group Assets
$K-J certain valuable trademarks.

(THE ABOVE SLIDE IS AFTER THIS TRANSACTION)

During subsequent years, the production facilities of the Target Parent Group were sold off to third parties and Line of Business C was moved to other Ultimate Sub facilities. By the end of fiscal Year D, the only assets left at the Target Parent Group was a $N note receivable from a third party and certain valuable trademarks. Ultimate Sub then decided to cash out the note receivable, which was due on Date D, while retaining the trademarks which were valued in Month B of Year E at $K-J.

5

16

Slide 6

Ultimate Parent

Ultimate Sub

Target Sub 2 Stock

2

Target Parent

3

Target Sub 1 merged into Target Parent

Target Sub 1

Target Parent Group Assets

$K-J certain valuable trademarks.

1

Target Sub 2

trademarks

Accordingly,

1. Ultimate Sub caused Target Sub 1 to contribute the trademarks to Target Sub 2 in a section 351 transaction and
2. then had the Target Sub 2 stock distributed upstream as a section 301 dividend from Target Sub 1 to Target Parent and then to Ultimate Sub.
3. Target Sub 1 was then merged into Target Parent.

6

Slide 7

After Contribution of Trademarks to Target Sub 2, Target Sub 2 stock to Ultimate Sub and Target Sub 1 merger into Target Parent

Ultimate Parent

Ultimate Sub

Target Sub 2 stock

Target Sub 2

Target Parent

Assets- trademarks

$K-J certain valuable trademarks.

(THE ABOVE SLIDE IS AFTER THIS TRANSACTION)

1. Ultimate Sub caused Target Sub 1 to contribute the trademarks to Target Sub 2 in a section 351 transaction and
2. then had the Target Sub 2 stock distributed upstream as a section 301 dividend from Target Sub 1 to Target Parent and then to Ultimate Sub.
3. Target Sub 1 was then merged into Target Parent.

7

Slide 8

Date C Target Parent stock sold

Individual B

Ultimate Parent

Ultimate Sub

Target Sub 2 stock

Target Sub 2

Target Parent

Assets- trademarks

$K-J certain valuable trademarks.

On Date C, the stock of Target Parent was sold by Ultimate Sub to Individual B, an unrelated third party, for $L.

8

17

Slide 9

After Date C Sale of Target Parent stock to Individual B

Ultimate Parent
Individual B
Ultimate Sub
Target Parent
Target Sub 2 stock
Target Sub 2
Assets- trademarks
$K-J certain valuable trademarks.

On Date C, the stock of Target Parent was sold by Ultimate Sub to Individual B, an unrelated third party, for $L.
(THE ABOVE SLIDE IS AFTER THIS TRANSACTION)

9

Slide 10

Ultimate Parent Group claim of loss on sale of Target Parent stock

Ultimate Parent
Individual B
Ultimate Sub
Target Parent
Target Sub 2 stock
Target Sub 2
Assets- trademarks
$K-J certain valuable trademarks.

Ultimate Parent Group claimed a loss on this stock sale. The revenue agent has questioned whether this capital loss is allowable under Treas. Reg. § 1.1502-20. Ultimate Sub has submitted computations to show how it calculated both its basis in the Target Parent stock and the loss disallowed under Reg. § 1.1502-20(c). Both the revenue agent and District Counsel question whether this loss disallowance calculation is correct and seek guidance as to what facts should be developed by the agent in order to determine whether this loss was properly computed under Treas. Reg. § 1.1502-20.

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