In previous columns in this series on insolvent subsidiaries in a consolidated

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1 Tackling Taxes Tax Planning with Respect to an Insolvent Subsidiary in a Consolidated Return Group Part V By Paul C. Lau and Ronald Marcuson* In previous columns in this series on insolvent subsidiaries in a consolidated return context, we explored the deemed satisfaction and reissuance rule for transactions in intercompany obligations, cancellation of nonintercompany indebtedness, timing of worthless stock loss, tax attribute reduction caused by cancellation of indebtedness income, triggering of excess loss account, the circular basis adjustment rules with respect to the disposition of stock and the complex unified loss rule (ULR), focusing primarily on the disposition of an insolvent subsidiary with no ownership of any lower-tier subsidiary. In looking at these various rules, we have assumed that the insolvent subsidiary does not own the stock of a lower-tier subsidiary. This is often not the case when you are dealing with the bankruptcy or insolvency of a large consolidated group. This column will begin to look at the application of (1) tax attribute reduction caused by cancellation of indebtedness, and (2) the ULR to situations where the insolvent subsidiary has lower-tier subsidiaries. Tax Attribute Reduction Caused by Cancellation of Indebtedness PAUL C. LAU is a Tax Partner with Plante Moran in Chicago. RONALD MARCUSON is a Professor and Director of the MST Program at De Paul University. In our October 2014 column, we looked at the attribute reduction rules in Code Sec. 108(b) as they apply in a consolidated group. Specifically, Reg (a)(2) (4) provides three main consolidated attribute reduction rules: 1. First, the debtor member reduces its own tax attributes (the debtor-first rule). 2. Second, to the extent that the debtor member reduces basis in stock of a subsidiary, this subsidiary must reduce its tax attributes (the subsidiary look through rule). 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 (the group reduction rule). 1 It is these three rules that we will be examining where the insolvent subsidiary has a second- or third-tier subsidiary. APRIL CCH INCORPORATED. ALL RIGHTS RESERVED 15

2 TACKLING TAXES Debt Cancellation at One Subsidiary When applying the debtor-first rule, Code Sec. 1017(b)(2) limits the basis reduction to the excess of the aggregate of the bases of the property held by the taxpayer immediately after the discharge, over the aggregate of the liabilities of the taxpayer immediately after the discharge. This limitation on basis reduction is done on a separate company basis (i.e., you look to the assets and liabilities of the subsidiary that has the excluded COD). 2 Also, for purposes of this limitation, the basis of a subsidiary that has an excess loss account is to be treated as zero. 3 The subsidiary look through rule only applies if the debtor member and the lower-tier subsidiary are members of the same consolidated group on the last day of the debtor member s tax year that includes the date on which the excluded COD income is realized or the first day of the debtor member s tax year that follows the tax year that includes the date on which the excluded COD income is realized. 4 If the subsidiary look through rule applies, the lower-tier subsidiary is deemed as realizing excluded COD income (deemed excluded COD income) and must reduce its attributes to the extent the higher-tier member has reduced its basis in the lower-tier entity under the debtor-first rule. As described in our October 2014 column, the attributes are reduced in accordance with Code Secs. 108(b)(2) and However, to the extent that the deemed excluded COD income realized by the lower-tier member does not reduce a tax attribute attributable to the lower-tier member, such excluded COD income will not be applied to reduce tax attributes attributable to other members of the consolidated group (i.e., the group reduction rule does not apply to what we have previously referred to as black hole deemed COD). 5 Example 1 Facts: P is the common parent of a consolidated group that includes subsidiaries S1, S2 and S3. P owns 100 percent of the stock of S1, S1 owns 100 percent of the stock of S2, and S2 owns 100 percent of the stock of S3. The P consolidated group sustained consolidated net operating losses in Years 1, 2 and 3 attributable under the principles of Reg (b)(2)(iv) as shown in Table 1. TABLE 1 P S1 S2 S3 Consolidated Year Year Year In addition, in Year 3 S1 realized $170 of excluded COD income from the discharge of non-intercompany indebtedness. At the beginning of Year 4, S1 s only asset was the stock of S2, and S2 s only asset was the stock of S3. After the computation of tax imposed for Year 3 and before the application of the attribute reduction rules, S1 s stock of S2 had a basis of $120 and S2 s stock of S3 had a basis of $180. In addition, none of S1, S2 and S3 had any liabilities. Analysis: In Year 3, S1 had excluded COD income of $170, which first goes to reduce S1 s attributable share of the consolidated Year 3 net operating loss from $10 to zero (i.e., the consolidated Year 3 net operating loss is reduced to $40). It then reduces S1 s attributable share of the consolidated Year 2 net operating loss from $40 to zero (i.e., the consolidated Year 2 net operating loss is reduced to $10). Now S1 must reduce basis in its assets since it has $120 remaining of excluded COD income. S1 only has one asset, the stock in S2, so its basis in the S2 stock is reduced from $120 to zero. 6 Pursuant to the subsidiary look through rule, S2 has deemed excluded COD income of $120 and must reduce its attributes accordingly. S2 s attributable share of the consolidated net operating losses for Year 3 ($20), Year 1 ($50) and Year 2 ($10) are reduced to zero (in that order). That leaves consolidated net operating losses for Year 1, Year 2 and Year 3 of $100, $0 and $20, respectively. After the reduction of S2 s attributable share of $ 80 of consolidated net operating losses, it has deemed excluded COD income remaining of $40. S2 must reduce its $180 basis in the stock of S3 (its only asset) by $40 to $140. Pursuant to the subsidiary look through rule, S3 has deemed excluded COD income of $40 and must reduce its attributes accordingly. S3 s attributable share of the consolidated net operating loss for Year 3 is reduced from $20 to zero. S3 s attributable share of the consolidated net operating loss for Year 1 is then reduced by $20 from $100 to $80. That leaves consolidated net operating losses for Year 1, Year 2 and Year 3 of $80, $0 and $0, respectively. Note that the deemed excluded COD income and the attribute reductions in S2 and S3 are not taken into account for purposes of Reg (b) (i.e., the investment adjustment rules). 7 Example 2 Facts: Same facts as Example 1 except that in Year 1 P s attributable share of the consolidated net operating loss was $100 and S3 s was zero. Also assume S3 had one asset with a basis of $ Taxes The Tax Magazine APRIL 2015

3 Analysis: S3 still has deemed excluded COD income of $40 and must reduce its attributes accordingly. S3 s attributable share of the consolidated net operating loss for Year 3 is reduced from $20 to zero. S3 has deemed excluded COD income of $20 after its attributable share of consolidated net operating losses is reduced to zero. S3 must now reduce its basis in the asset from $10 to zero. After this reduction, there is still deemed excluded COD income of $10. The group reduction rule normally requires that any remaining excluded COD income after application of the subsidiary look through rule reduces attributes of other members of the consolidated group (e.g., P). However the group reduction rule does not to apply to S3 s deemed excluded COD income. So, the remaining $10 of S3 s deemed excluded COD income is treated as black hole COD (i.e., no attributes are reduced). 8 Debt Cancellation at Upper- and Lower-Tier Subsidiaries Another issue that is often confronted is how to apply the excluded COD income rules when more than one entity in the consolidated group has excluded COD income. Reg (b)(1) gives the following ordering rules in situations where a higher-tier member and a lower-tier member both have excluded COD income: The debtor-first rule and the subsidiary look through rule are first applied with respect to the excluded COD income of the higher-tier member. In applying the debtor-first rule and the subsidiary look through rule to the excluded COD income of the higher-tier member, the liabilities that give rise to the excluded COD income of the lower-tier member are not treated as discharged for purposes of computing the limitation on the basis reduction under Code Sec. 1017(b)(2). The debtor-first rule and the subsidiary look through rule are then applied with respect to the excluded COD income of the lower-tier member. The group reduction rule is applied after the above steps. 9 Example 3 Facts: P owns all of S and S owns all of S1. P has thirdparty debt of $20 and S has third-party debt of $50. Currently S is worth $0 and has a basis of $20. S1 is worth $20 with a basis of $60. S1 has one asset worth $20 with a basis of $20 and no liabilities. During the year, the P debt of $20 is canceled. Also, the S debt is written down to $20 (i.e., $30 of the debt was canceled). For simplicity purposes, assume there are no net operating losses. Analysis: P and S have excluded COD income of $20 and $30 respectively. Pursuant to the ordering rules, we first apply the debtor-first rule to P and reduce its basis in S from $20 to zero. Under the subsidiary look through rule, S must reduce the basis of its assets by $20 (i.e., the deemed excluded COD income). However, for purposes of the limitation on basis reduction rule in Code Sec. 1017(b)(2), all $50 of S s third-party debt is still considered outstanding. Therefore S s basis in S1 can only be reduced by $10 (i.e., excess of the basis in S s assets ($60) over S s liabilities ($50)) to $50. After this reduction, S s basis in S1 ($50) equals the amount of S s liabilities deemed outstanding ($50). The remaining $10 disappears as the group reduction rule is not applicable to deemed excluded COD income. Now we consider S s actual excluded COD of $30. This must reduce the basis of S1. The amount of the reduction is still limited by Code Sec. 1017(b)(2) but now S s liabilities that have been discharged ($30) are not considered outstanding. Therefore, the limitation is $30 (i.e., excess of the basis in S s assets ($50) over S s remaining outstanding liabilities ($20)) and the basis of S1 is reduced from $50 to $20. Finally, S1 must reduce the basis of its assets pursuant to the subsidiary look through rule. The basis of the S1 stock was reduced by a total of $40 so S1 has deemed excluded COD income of $40. S1 must reduce its basis in its asset from $20 to zero. The remaining $20 of deemed excluded COD income is black hole excluded COD income as S1 has no other attributes. The group reduction rule is not applicable because under the debtor-first rule both P and S have applied all of their excluded COD income to reduce their respective tax attributes. Unified Loss Rule (ULR) As discussed in our February column, the ULR regulations provides the following three rules of adjustments for the transfer of a loss share (i.e., a share with a tax basis in excess of value) of a subsidiary (herein referred to as a loss subsidiary): 1. The basis redetermination rule The basis reduction rule The attribute reduction rule 12 When a loss subsidiary owns shares in a lower-tier subsidiary the basis redetermination rule is generally not impacted. However, both the basis reduction rule and the APRIL CCH INCORPORATED. ALL RIGHTS RESERVED. 17

4 TACKLING TAXES attribute reduction rule become more complex. Therefore, we will only explore the basis reduction rule and the attribution reduction rule. Under the basis reduction rule, only one specific provision is directed at lower-tier subsidiaries. The purpose of this adjustment is to prevent the lower-tier subsidiary s stock basis or inside attributes from giving rise to noneconomic loss in the loss subsidiary s stock. Under the attribute reduction rule, multiple provisions are provided to deal with issues pertaining to lower-tier subsidiaries. These provisions primarily aim at establishing hypothetical (also referred to as tentative) stock bases in shares of lower-tier subsidiaries for the purposes of determining the attribution reduction amount and then allocating and apportioning the attribute reduction amount to attributes of the loss subsidiary and respective lower-tier subsidiaries. The intent of these provisions is both to prevent loss duplication and at the same time to limit over reduction of attributes or stock basis. In this analysis, we will need to look at rules both covering (1) transactions where the stock in the lower-tier subsidiary is not transferred 13 in the same transaction that a loss share is transferred, and (2) transactions where the stock in the lower-tier subsidiary is also transferred. We will first look at operating rules that apply when both the loss subsidiary and the lower-tier subsidiary are transferred. These operating rules coordinate and set forth the sequential order in the application of the three basis and attribute adjustment rules (i.e., the basis redetermination rule, the basis reduction rule and the attribute reduction rule). Special rules exist with respect to the basis reduction rule and the attribution reduction rule when the lower-tier subsidiary is not transferred. Unfortunately, these rules are not identical and must therefore be analyzed separately. Operating Rules for Transfers of Multiple Subsidiaries Reg (a)(3) provides how the ULR applies when stock of more than one subsidiary is transferred in a single transaction (i.e., when both the loss subsidiary and the lower-tier subsidiary are transferred in the transaction). For example, in the case of a liquidation of an insolvent subsidiary owning a lower-tier subsidiary, it seems that both the insolvent subsidiary and its lower-tier subsidiary are transferred in a single transaction within the meaning of Reg (f)(10). This seems to be the case because (1) the liquidation of insolvent subsidiary is considered a transfer in a transaction in which gain or loss is recognized, and (2) the lower-tier subsidiary is also transferred because the insolvent subsidiary recognizes gain or loss on the stock of the lower-tier subsidiary and they cease to be members in a same consolidated group. Similarly, a worthless stock deduction of an insolvent subsidiary is generally a transfer because to qualify for such deduction the subsidiary generally 14 must have disposed of all its assets (i.e., it will have had to have transferred the stock of the lower-tier subsidiary as part of the transaction). 15 Under Reg (a)(3)(ii), the ULR generally applies first to the lowest-tier subsidiary. If no transferred shares of the lower-tier subsidiary are loss shares, any gain recognized on these lower-tier shares moves up as a positive investment adjustment to the higher-tier shares under Reg If there is a loss share in the lower-tier subsidiary, then the basis redetermination rule and the basis reduction rule apply in sequence to adjust and reduce basis in the loss share. If an election under Reg (d)(6) is made on the lower-tier subsidiary to reduce loss duplication, then the basis reduction in Reg (d) applies, but only to the extent necessary to give effect to the election. 16 After these adjustments, loss is recognized on shares in the lowest-tier subsidiary. Any basis adjustment and loss recognized are tiered up to adjust the basis of stock of the higher-tier subsidiaries. Transferred shares in the next-higher tier (other than the highest tier) are then treated in the same manner. After all adjustments from the lower-tier subsidiaries are tiered up to the highest-tier subsidiary (i.e., what we have referred to as the loss subsidiary), the basis redetermination rule and the basis reduction rule apply in sequence on transferred loss shares. Finally, the attribute reduction rule in Reg (d) applies to the loss shares in the highest tier and then moves successively downward to the loss shares in each successive lower-tier subsidiary. This sequence of application is referred to as the bottom-up/top-down approach. In other words, both the basis redetermination and basis reduction rules are applied bottom-up, while the attribute reduction rule is applied top-down. Unclear Issues 17 It is important to recognize that under the general operating scheme of the ULR, a loss subsidiary is treated as owning the stock of any lower-tier subsidiary that is transferred in the same transaction even when the loss subsidiary has disposed of the stock in the transaction. 18 However, the ULR also accounts for certain effects of the transfer of the shares in the lower-tier subsidiary. In 18 Taxes The Tax Magazine APRIL 2015

5 essence, the ULR recognizes aspects of the transfer of the stock of the lower-tier subsidiary, but holds the group s corporate structure in place in determining noneconomic and duplicate losses. While the ULR treats a loss subsidiary as owning stock in any lower-tier subsidiary transferred in the transaction, it does not provide any guidance on how to treat any consideration received by the loss subsidiary in the transfer of the lower-tier subsidiary shares. For example, if S sold all of the stock of S1 as part of the same transaction in which S s stock was sold, the ULR would treat S as owning the sold S1 shares (with basis adjusted under the basis reduction rule and the attribute reduction rule). However, there is no specific guidance on how the proceeds from the sale of S1 s stock should be accounted for. Presumably, the sales proceeds should be disregarded in light of the overall ULR scheme. It is also uncertain how the ULR applies with respect to multiple transfers when they do not occur on the same day, even when they are considered to have occurred in the same transaction. Reg (f)(9) provides that a transaction includes all steps taken pursuant to the same plan or arrangement. As described above, the regulations provide specific rules regarding the sequence and application of the ULR provisions when shares of stock of more than one subsidiary are transferred in a transaction. For purposes of the basis redetermination and reduction rules, the sequence of application is bottom-up. This ordering rule may be less problematic to apply and understand when the actual sale of the lower-tier subsidiary s stock occurs before the actual sale of the stock in the loss subsidiary. However, it raises significant unanswered issues when the actual order of the sales is reversed. In this case, the sequence of the actual transaction steps are inconsistent with the order of application of the ULR as provided in Reg (a)(3)(ii). For example, if P sells all of S shares in October and S sells all of S1 shares in December, it seems that P must wait and obtain information from S on the sale of S1 shares to apply the ULR with respect to the S shares. Both the basis redetermination rule and the basis reduction rule must be applied bottom-up, which suggests that adjustments to the basis of the lowertier shares under the basis reduction rule will tier up and result in adjustments to the basis in the upper-tier shares. However, what happens if the sales occurred in two different tax years (i.e., sale of S shares in October and sale of S1 shares in January of next tax year)? In summary, the application of the ULR in cases involving multiple transfers that do not occur on the same day is highly complex and uncertain. Future guidance is needed. The General Basis Reduction Rule We now look at the basis reduction rule applicable to a loss subsidiary owning shares in one or more lower-tier subsidiaries. The applicable rule depends on whether the share in a lower-tier subsidiary is transferred. Under the basis reduction rule, the general rule is that the stock basis of a loss share is reduced by the lesser of the share s net positive adjustment or the share s disconformity amount. The net positive adjustment is the greater of zero or the sum of all investment adjustments other than distributions reflected in the basis of the loss share. The disconformity amount is the excess of the basis in the share of stock over the share s allocable amount of the loss subsidiary s net inside attribute amount. 19 Basis Rule for Transferred Lower-Tier Subsidiary Shares When a loss subsidiary owns shares in a lower-tier subsidiary, we must determine the basis in such shares for the purpose of determining the loss subsidiary s net inside attribute amount. As noted above, when a loss is recognized with respect to an insolvent subsidiary, the transaction generating the loss will usually involve the transfer of the lower-tier subsidiary (e.g., a liquidation/dissolution of the insolvent subsidiary or a worthless stock deduction). In these cases, the basis in the stock of any lower-tier subsidiary owned by the loss subsidiary is generally the loss subsidiary s basis in such lower-tier subsidiary under Reg adjusted to reflect any gain or loss recognized (whether allowed or disallowed ) in the transaction on the transfer of the lower-tier subsidiary. 20 This is for the purpose of determining the loss subsidiary s inside attribute amount only. The operating rule discussed above requires the basis reduction rule begin at the lowest tier. If the transferred stock of the lowest-tier subsidiary is not a loss share, then any gain recognized with respect to the stock of the transferred lower-tier subsidiary immediately tiers up and adjusts the basis in the loss subsidiary s stock under Reg However, for purposes of determining the net inside attribute amount, the loss subsidiary appears to be treated as still owning the stock of the lower-tier subsidiary. Since the basis in the loss subsidiary reflects the tax effect on disposition of the lower-tier subsidiary, the loss subsidiary s net inside attribute amount should be adjusted to reflect the tax implication on the transfer of the lower-tier subsidiary s stock. APRIL CCH INCORPORATED. ALL RIGHTS RESERVED. 19

6 TACKLING TAXES Example 4 Facts: Assume P owns all the stock of S. S in turn owns all the stock of S1. S1 is S s only asset. S1 has a FMV of $50 and a basis of $20. S also has debt of $70. S settles $50 of its third-party debt by transferring its S1 stock. P then claims a worthless stock deduction with respect to S. Analysis: Both S and S1 have been transferred for purposes of Reg , 22 so we must look to the ordering rule which applies when more than one subsidiary is transferred in a transaction. We first look to the lowest-tier subsidiary that in this case is S1. Its transfer is at a $30 gain so the $30 gain is recognized and S s basis is increased by $30. Now we look at S. To determine the amount of the allowable loss, we have to apply the basis reduction rule. One part of that is to compute the net inside attribute amount. In making this computation it appears you are to consider the S1 stock even though it has been transferred. Its basis is $20. However, this basis must be adjusted by the gain recognized on the transfer (i.e., increased to $50). This adjustment is necessary since the gain has increased P s basis in S (i.e., the loss subject to ULR has been increased by $30). Basis Rule for Nontransferred Shares If there is no transfer of shares in more than one subsidiary, the operating rules under Reg (a)(3)(ii) do not apply. However, the basis of stock in lower-tier subsidiaries must be reduced based on a special tentative basis reduction rule in Reg (c)(6). If there are multiple tiers of lower subsidiaries, the basis of stock in each lower-tier subsidiary is tentatively reduced, starting at the lowest tier and successively moving upward to higher tiers. The tentative basis reduction at each tier is moved up to the next tier as a basis reduction to the higher tier. 23 The tentative basis reduction rule tentatively reduces the basis in the share(s) of stock in any lower-tier subsidiary owned by the loss subsidiary that are not transferred in the same transaction that the loss share(s) are transferred. 24 Under this rule, the basis in a lower-tier subsidiary stock is reduced by the lesser of the lower-tier subsidiary s net positive adjustment or its disconformity amount. This tentative reduction amount can be greater than the value of the stock. However, it does not actually reduce the basis in the lower-tier subsidiary s stock under the investment basis adjustment rules of Reg Example 5 looks at the application of this rule where the loss subsidiary is solvent and Example 6 looks at the application of this rule where the loss subsidiary is insolvent. Example 5 Facts: P owns all shares of S stock with uniform stock bases (i.e., no stock basis disparity) totaling $160. S owns two assets: Asset 1 with basis and value of $100 and all S1 shares with uniform bases totaling $60. S1 owns two assets Asset 2 with a $20 basis and a $60 value and Asset 3 with a $20 basis and a $10 value. In year 1, S1 sells Asset 2 to an unrelated person for $60, recognizing a $40 gain. On December 31, year 1, P sells its S stock for $170 to a member of an unrelated consolidated group. Analysis: Under Reg , P s basis in the S share is $200 ($160 of basis increased by $40 gain from S1 which moves upward to S for basis adjustment purposes under Reg ). Under Reg (f)(10), S1 shares are not transferred because both S and S1 are still members in a new consolidated group and S still owns all of S1 s shares following the transaction. There is no basis redetermination under Reg (b) because each S share has the same basis and all S shares are sold. Under the basis reduction rule of Reg (c), P s basis in S stock, $200, is reduced, but not below $170 (i.e., the selling price, which is the sum of $100 of Asset 1 value and $70 of S1 stock value). The basis reduction is the lesser of the net positive adjustment in S stock or the disconformity amount. The net positive adjustment in S stock is $40 gain from S1 s sale of Asset 2. The disconformity amount of S is the excess of stock basis ($200) over the S s net inside attribute amount. The net inside attribute amount is the sum of S s basis in Asset 1 and S s basis in S1 stock. S s basis in S1 share is $100 (original $60 basis increased by $40 gain from sale of Asset 2) under Reg For S s net inside attribute amount in determining the disconformity amount, however, S s basis in S1 share is tentatively reduced by the lesser of the S1 share s net positive adjustment or S1 share s disconformity amount. The S1 share s net positive adjustment is $40, the gain from the sale of Asset 2. The disconformity amount of S1 share is $20, the excess of stock basis ($100) over the share s net inside attribute amount of $80 ($60 cash from the sale of Asset 2 and $20 basis in Asset 3). S s basis in S1 share ($100) is reduced by the lesser of the net positive adjustment ($40) or the disconformity amount ($20), resulting in a reduced basis of $ Taxes The Tax Magazine APRIL 2015

7 S s net inside attribute amount is the sum of S s basis in Asset 1($100) and S s basis in S1 stock ($80 as computed above), totaling $180. The disconformity amount in S s share is the excess of S s stock basis ($200) over the net inside attribute amount ($180), or $20. P s basis reduction in S s share is the lesser of the positive adjustment ($40) or the disconformity amount ($20). Thus, P s basis in S s share ($200) is reduced by $20 to $180. P is allowed a loss of $10 under the ULR on the sale of S share ($180 basis in excess of $170 selling price). It should be noted that the reduction of S1 s stock basis for computing S s net inside attribute amount has no actual effect on S s basis in S1 share, which is $100, under Reg Example 6 Facts: P owns all shares of S stock with uniform stock bases (i.e., no stock basis disparity) totaling $10. P had formed S with $10. S had then borrowed $180 from X, the parent of an unrelated consolidated group. S used the funds to purchase assets and the stock of S1. S owns two assets: Asset 1 with basis and value of $100 and all S1 shares with uniform bases totaling $90. S1 owns two assets Asset 2 with a $20 basis and a $60 value and Asset 3 with a $20 basis and a $10 value. In year 1, S1 sells Asset 2 to an unrelated person for $60, recognizing a $40 gain. On December 31, year 1, P determines S is insolvent (i.e., it has assets worth $170 and third-party debt of $180) and transfers its S stock to X for $1. Analysis: Under Reg , P s basis in the S share is $50 ($10 of basis increased by $40 gain from S1 which moves upward to S for basis adjustment purposes under Reg ). Under Reg (f)(10), S1 shares are not transferred because both S and S1 are still members in a new consolidated group and S still owns all of S1 s shares following the transaction. S1 is also not worthless within the meaning of Reg (f)(10). There is no basis redetermination under Reg (b) because each S share has the same basis and all S shares are sold. Under the basis reduction rule of Reg (c), P s basis in S stock, $50, is reduced, but not below $1 (i.e., the selling price). The basis reduction is the lesser of the net positive adjustment in S stock or the disconformity amount. The net positive adjustment in S stock is $40 gain from S1 s sale of Asset 2. The disconformity amount of S is the excess of stock basis ($50) over the S s net inside attribute amount. The net inside attribute amount is the sum of S s basis in Asset 1 and S s basis in S1 stock. S s basis in S1 share is $130 (original $90 basis increased by $40 gain from sale of Asset 2) under Reg For S s net inside attribute amount in determining the disconformity amount, however, S s basis in S1 share is tentatively reduced by the lesser of the S1 share s net positive adjustment or S1 share s disconformity amount. The S1 share s net positive adjustment is $40, the gain from the sale of Asset 2. The disconformity amount of S1 share is $50, the excess of stock basis ($130) over the share s net inside attribute amount of $80 ($60 cash from the sale of Asset 2 and $20 basis in Asset 3). S s basis in S1 share ($130) is reduced by the lesser of the net positive adjustment ($40) or the disconformity amount ($50), resulting in a reduced basis of $90. S s net inside attribute amount is the sum of S s basis in Asset 1($100) and S s basis in S1 stock ($90 as computed above) less the liability to X of $180, totaling $10. The disconformity amount in S s share is the excess of S s stock basis ($50) over the net inside attribute amount ($10), or $40. P s basis reduction in S s share is the lesser of the positive adjustment ($40) or the disconformity amount ($40). Thus, P s basis in S s share ($50) is reduced by $40 to $10. P is allowed a loss of $9 under the ULR on the sale of S share ($10 basis in excess of $1 selling price). It should be noted that the reduction of S1 s stock basis for computing S s net inside attribute amount has no actual effect on S s basis in S1 share, which is $130, under Reg One Final Observation An unfortunate consequence of this special tentative basis reduction rule is that the basis in the lower-tier subsidiary must be computed even though the stock is not being transferred. This often presents a problem when the loss subsidiary was acquired and the lower-tier subsidiary was owned by the loss subsidiary at the time of such acquisition. This issue was raised in comments to the proposed regulations and a look through rule was suggested. This approach was rejected by the Treasury in T.D based on a fear that inappropriate results could be reached. However, the Treasury did recognize that determining lower-tier subsidiary stock basis may APRIL CCH INCORPORATED. ALL RIGHTS RESERVED. 21

8 TACKLING TAXES be difficult. Although the need to determine lower-tier subsidiary stock basis is not particular to these regulations, the ULR arguably increases both the frequency and significance of these determinations. Accordingly, the IRS and Treasury Department said they are considering various proposals that would mitigate these difficulties on a system-wide basis. Conclusion We have just begun our exploration of the issues in applying Reg and -36 in situations where an insolvent subsidiary has a lower tier subsidiary. In our next column we will continue to look at the application of the basis reduction rule and the attribute reduction rule to this fact pattern. ENDNOTES * This column represents the views of the authors and does not necessarily represent the views or professional advice of Plante Moran and DePaul University. 1 Reg (a)(4). In addition to no reduction to basis of assets, intricate rules apply to the reduction of SRLY attributes. 2 Reg (b)(3)(ii). 3 Reg (b)(3)(iii). 4 Reg (a)(3)(ii). 5 Reg (a)(3)(ii). 6 Note that an excess loss account is not created if the basis in the subsidiary is less than the excluded COD income. Reg (a)(2). 7 See Reg (b)(3)(ii)(C) and (iii)(a). 8 Reg (a)(3)(ii). 9 If more than one member has excluded COD income that has not been applied to reduce its respective tax attributes (the remaining COD income) and the group s remaining tax attributes available for reduction are less than the aggregate remaining COD amount, each member s remaining COD amount is applied to reduce the group s remaining tax attributes on a pro rata basis. Reg (b)(1)(iii). 10 Reg (b). 11 Reg (c). 12 Reg (d). 13 Reg (f)(10) defines a transfer: (i) Definition. Except as provided in paragraph (f)(10)(ii) of this section, for purposes of this section, M transfers a share of S stock on the earliest of (A) The date that M ceases to own the share as a result of a transaction in which, but for the application of this section (and notwithstanding the deferral of any amount recognized on the transfer, other than by reason of ), M would recognize income, gain, loss or deduction with respect to the share (see paragraph (e)(3) of this section in the case of a transfer in an intercompany transaction); (B) The date that M and S cease to be members of the same group; (C) The date that a nonmember acquires the share from M; and (D) The last day of the taxable year during which the share becomes worthless under section 165 (taking into account the provisions of (c)) if the share is treated as a capital asset, or the date the share becomes worthless (taking into account the provisions of (c)) if the share is not treated as a capital asset. (ii) Excluded transactions. Notwithstanding paragraph (f)(10)(i) of this section, M does not transfer a share of S stock if (A) M ceases to own the share as a result of a transaction to which section 381(a) applies and in which either a member acquires assets from S or S acquires assets from M, provided that (1) M recognizes no income, gain, loss, or deduction with respect to the share, and (2) If the transaction is a liquidation to which section 332 applies, M is the only member that owns shares of S stock (if another member owns shares of S stock, see paragraph (e) (4) of this section for a limitation on the application of this section); or (B) M ceases to own the share as a result of a distribution of the share to a nonmember in a transaction to which section 355 applies, and in which the share is treated as qualified property for purposes of section 355(c) or section 361(c). 14 There are two other situations, albeit not common, in which a worthless stock deduction of an insolvent subsidiary can be claimed without a transfer of shares in a lower-tier subsidiary see Reg (c)(1)(iii)(B) and (C). 15 Reg (c)(1)(iii)(A). 16 See our February 2015 column for further discussion. 17 A more detailed discussion of these issues can be found in Dubroff, et al., Federal Income Taxation of Corporations Filing a Consolidated Return, Chapter 73A.03[1][c]. 18 Reg (c)(6)(v), Example. 19 The net inside attribute amount is the sum of the loss subsidiary s money, basis in assets other than money, net operating and capital loss carryovers, and deferred deductions, minus its liabilities. Reg (c)(5). 20 Reg (c)(5), which states that for the net inside attribute amount, S s basis in any share of lower-tier subsidiary stock is generally S s basis in that share, adjusted to reflect any gain or loss recognized in the transaction with respect to the share and any other related or resulting adjustments to the basis of the share. Reg (a)(3)(ii)(A), which provides the operating rules for stock of multiple subsidiaries transferred in the transaction, further states that any basis redetermination and basis reduction adjustments under Reg (b) and (c), any gain or loss recognized on the transferred S2 shares (whether allowed or disallowed), and any related or resulting adjustments then tier-up and apply to adjust member s bases in subsidiary stock under Reg Both of these regulations do not explain the meaning of any other related or resulting adjustments to the stock basis. Based on these regulations, it seems that for purposes of the net inside attribute amount of an insolvent subsidiary, the stock basis in a transferred lower-tier subsidiary share generally can be determined by the basis under Reg , adjusted for any gain or loss determined based on the basis under Reg before any ULR basis redetermination and reduction amount that would apply to the lower-tier share if it is a loss share. 21 If the lower-tier subsidiary s shares are loss shares, the basis redetermination and the basis reduction rules are applied to those loss shares first. 22 Reg (f)(10). 23 Reg (c)(6)(iii). 24 This could occur when the insolvent subsidiary is worthless because an indebtedness of the insolvent subsidiary is discharged, and a part of the amount discharged is not included in gross income and is not treated as tax-exempt income under Reg (b)(3)(ii)(C). See Reg (f)(10)(i)(D) and (c) (1)(iii)(B). 25 Preamble to the proposed ULR: This reduction is made only for the purposes of determining basis reduction to the S share, and has no other effect. REG (Jan. 23, 2007). This article is reprinted with the publisher s permission from the Taxes The Tax Magazine, a monthly journal published by CCH, a part of Wolters Kluwer. Copying or distribution without the publisher s permission is prohibited. To subscribe to the Taxes The Tax Magazine or other CCH Journals please call or visit CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH. 22 Taxes The Tax Magazine APRIL 2015