[Federal Register Volume 67, Number 205 (Wednesday, October 23, 2002)]
[Proposed Rules]
[Pages 65060-65074]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-26835]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-131478-02]
RIN 1545-BB25


Guidance Under Section 1502; Suspension of Losses on Certain 
Stock Dispositions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that redetermine 
the basis of stock of a subsidiary member of a consolidated group 
immediately prior to certain dispositions and deconsolidations of such 
stock. In addition, this document contains proposed regulations that 
suspend certain losses recognized on the disposition of such stock. The 
regulations apply to corporations filing consolidated returns. This 
document also provides notice of a public hearing on these proposed 
regulations.

DATES: Written or electronic comments must be received by January 21, 
2003. Outlines of topics to be discussed at the public hearing 
scheduled for January 15, 2003, at 10 a.m. must be received by December 
27, 2002.

ADDRESSES: Send submissions to CC:ITA:RU (REG-131478-02), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to CC:ITA:RU (REG-131478-02), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit electronic 
comments directly to the IRS Internet site at www.irs.gov/regs. The 
public hearing will be held in room 6718, Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Aimee K. 
Meacham, (202) 622-7530; concerning submissions, the hearing, and/or to 
be placed on the building access list to attend the hearing, Sonya M. 
Cruse, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S, 
Washington, DC 20224. Comments on the collection of information should 
be received by December 23, 2002. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in these proposed regulations is in 
Sec.  1.1502-35(c) and Sec.  1.1502-35(f). This information is required 
by the IRS to verify compliance with section 1502. This information 
will be used to determine whether the amount of tax has been calculated 
correctly. The collection of information is required to properly 
determine the amount permitted to be taken into account as a loss. The 
respondents are corporations filing consolidated returns. The 
collection of information is required to obtain a benefit.
    Estimated total annual reporting and/or recordkeeping burden: 
10,500 hours.
    Estimated average annual burden per respondent: 2 hours.
    Estimated number of respondents: 5,250.
    Estimated annual frequency of responses: on occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 1502 of the Internal Revenue Code (Code) states that--

    [t]he Secretary shall prescribe such regulations as he may deem 
necessary in order that the tax liability of any affiliated group of 
corporations making a consolidated return and of each corporation in 
the group, both during and after the period of affiliation, may be 
returned, determined, computed, assessed, collected, and adjusted, 
in such manner as clearly to reflect the income-tax liability and 
the various factors necessary for the determination of such 
liability, and in order to prevent avoidance of such tax liability.

    The legislative history regarding that grant of authority states 
that ``[a]mong the regulations which it is expected that the 
commissioner will prescribe are [regulations addressing the] extent to 
which gain or loss shall be recognized upon the sale by a member of the 
affiliated group of stock issued by any other member of the affiliated 
group [and] the basis of property * * * acquired, during the period of 
affiliation, by a member of the affiliated group, including the basis 
of such property after such period of affiliation.'' S. Rep. No. 960, 
70th Cong., 1st Sess. 15 (1928).

[[Page 65061]]

    In 1991, the IRS and Treasury Department promulgated Sec.  1.1502-
20, which set forth rules regarding the extent to which a loss 
recognized by a member of a consolidated group on the disposition of 
stock of a subsidiary member of the same group was allowed. Section 
1.1502-20 provided that a loss recognized by a group member on the 
disposition of subsidiary member stock was allowable only to the extent 
it exceeded the sum of ``extraordinary gain dispositions,'' ``positive 
investment adjustments,'' and ``duplicated loss.'' The rule not only 
implemented section 337(d), which directed the Secretary to promulgate 
regulations to prevent the circumvention of corporate tax on 
appreciated property through the filing of a consolidated return, but 
also was intended to further single entity principles by preventing the 
deduction of stock losses that reflected a subsidiary member's loss 
carryforwards, deferred deductions, and unrecognized losses inherent in 
its assets.
    In Rite Aid Corp. v. United States, 255 F.3d 1357 (Fed. Cir. 2001), 
the United States Court of Appeals for the Federal Circuit considered 
the validity of the duplicated loss component of Sec.  1.1502-20. The 
court held that the duplicated loss component of Sec.  1.1502-20 was an 
invalid exercise of regulatory authority.
    In response to the Rite Aid decision, the IRS and Treasury 
Department issued Notice 2002-11 (2002-7 I.R.B. 526), stating that the 
interests of sound tax administration would not be served by the 
continued litigation of the validity of the duplicated loss component 
of Sec.  1.1502-20. Notice 2002-11 announced that, because of the 
interrelationship in the operation of all of the loss disallowance 
factors of Sec.  1.1502-20, the IRS and Treasury Department had decided 
that new rules governing loss disallowance on sales of subsidiary stock 
by members of consolidated groups should be implemented.
    On March 7, 2002, the IRS and Treasury Department filed with the 
Federal Register temporary regulations under sections 337(d) and 1502 
governing the determination of a consolidated group's allowable stock 
loss on a disposition of subsidiary member stock. Those regulations 
included Sec.  1.337(d)-2T, which generally allows a loss on the 
disposition of subsidiary member stock only to the extent that a 
taxpayer can establish that the stock loss is not attributable to the 
recognition of built-in gain. Section 1.337(d)-2T does not disallow 
stock loss that reflects loss carryforwards, deferred deductions, or 
built-in asset losses of the subsidiary member.
    Concurrently with the filing of Sec.  1.337(d)-2T with the Federal 
Register, the IRS and Treasury Department issued Notice 2002-18 (2002-
12 I.R.B. 644), which stated that regulations would be promulgated that 
would defer or otherwise limit the utilization of a loss on stock (or 
another asset that reflects the basis of stock) in transactions that 
facilitate the group's utilization of a single economic loss more than 
once. Notice 2002-18 is based on the principle that a consolidated 
group should not be able to obtain more than one tax benefit from a 
single economic loss. See Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 
(1934) (disallowing a worthless stock deduction recognized on a 
liquidation of a subsidiary member because the group had already 
obtained the tax benefit from the operating losses that gave rise to 
the deduction). The Notice stated that the regulations would apply to 
dispositions occurring on or after March 7, 2002.

Explanation of Provisions

    These proposed regulations reflect the principle set forth in 
Notice 2002-18 that a consolidated group should not be able to obtain 
more than one tax benefit from a single economic loss. The proposed 
regulations consist primarily of two rules: a basis redetermination 
rule and a loss suspension rule. The proposed regulations also include 
a basis reduction rule to address certain cases not within the scope of 
the loss suspension rule. Finally, the proposed regulations include 
certain anti-avoidance rules to address certain transactions designed 
to avoid the application of the basis redetermination and loss 
suspension rules.
    The rules in these proposed regulations are intended to address at 
least two types of transactions that may allow a group to obtain more 
than one tax benefit from a single economic loss. In the first type of 
transaction, a group absorbs an inside loss (e.g., a loss carryforward, 
a deferred deduction, or a loss inherent in an asset) of a subsidiary 
member and then a member of the group recognizes a loss on a 
disposition of stock of that subsidiary member that is duplicative of 
the inside loss. For example, assume that in Year 1, P, a member of a 
group, forms S with a contribution of $80 in exchange for 80 shares of 
common stock of S (representing all of the outstanding stock of S). In 
Year 2, P contributes Asset A with a basis of $70 and a value of $20 to 
S in exchange for an additional 20 shares of S common stock. In Year 3, 
S sells Asset A and recognizes a $50 loss, which offsets income of P on 
the group's return. Under the investment adjustment rules of Sec.  
1.1502-32, P's basis in each share of S common stock it holds is 
reduced by a pro rata share of the $50 loss, with the result that the 
shares acquired in Year 1 have a basis of $40 and the shares acquired 
in Year 2 have a basis of $60. In Year 4, P sells the shares acquired 
in Year 2 for $20 and recognizes a $40 loss, which offsets income of P 
on the group's return. In this transaction, the group has obtained a 
total of $90 tax benefit from the single $50 loss.
    Alternatively, assume that, in Year 1, P forms S with a 
contribution of $100 in exchange for all of the common stock of S. In 
Year 2, P contributes Asset A with a basis of $50 and a value of $20 to 
S in exchange for all of the preferred stock of S. In Year 3, S sells 
Asset A and recognizes a $30 loss, which offsets income of P on the 
group's return. Under the investment adjustment rules of Sec.  1.1502-
32, P's basis in each share of S common stock it holds is reduced by a 
pro rata share of the $30 loss. P's basis in its preferred shares, 
however, is not reduced. In Year 4, P sells the preferred stock of S 
for $20 and recognizes a $30 loss, which offsets income of P on the 
group's return. In this transaction, the group has obtained a $60 tax 
benefit from the single $30 economic loss in Asset A.
    Although, in both cases, a taxable disposition of the S common 
stock acquired in Year 1 would offset the excess tax benefit, the group 
has various non-taxable alternatives by which to ensure that the excess 
tax benefit is not reduced, including retention of the remaining shares 
of S or the liquidation of S in a transaction described in section 332.
    In the second type of transaction, a member of the group recognizes 
a loss on a disposition of subsidiary member stock that is duplicative 
of an inside loss of the subsidiary member, the subsidiary remains a 
member of the group, and the group subsequently recognizes the inside 
loss of that subsidiary member. For example, assume that in Year 1, P 
forms S with a contribution of $80 in exchange for 80 shares of the 
common stock of S. In Year 2, P contributes Asset A with a basis of $50 
and a value of $20 to S in exchange for an additional 20 shares of S 
common stock. In Year 3, P sells the 20 shares of S common stock that 
it acquired in Year 2 for $20 and recognizes a $30 loss, which offsets 
income of P on the group's return. The sale of the 20 shares of S 
common stock does not result in the deconsolidation of S. In Year 4, S 
sells Asset A and recognizes a $30 loss, which also offsets income of P 
on the

[[Page 65062]]

group's return. In this transaction, the group has obtained the use of 
two losses from the single economic loss in Asset A. Again, although a 
taxable disposition by P of its remaining S common stock would offset 
the tax benefit of one of the losses, the group has various non-taxable 
alternatives by which to ensure that the excess tax benefit is not 
reduced, including retention of the remaining shares of S or the 
liquidation of S in a transaction described in section 332.

A. Basis Redetermination Rule

    The investment adjustment rules of Sec.  1.1502-32 are premised on 
certain assumptions regarding the shareholders' interests in the 
subsidiary. One assumption is that the subsidiary's losses are borne by 
the holders of the common stock before the holders of the preferred 
stock. Another assumption is that each share within a class is entitled 
to an equal portion of the subsidiary's items of income and gain, and, 
in the case of common stock, of deduction and loss. The investment 
adjustment rules, therefore, generally allocate basis adjustments 
without regard to differences in members' bases in their shares of the 
stock of the subsidiary member and without regard to whether a basis 
adjustment reflects an item of income, gain, deduction, or loss that 
was built-in with respect to contributed property. These assumptions 
can give rise to the results illustrated in the transactions described 
above.
    The basis redetermination rule attempts to mitigate the effect of 
the assumptions underlying the investment adjustment rules by reversing 
certain investment adjustments to take into account the source of 
certain items of deduction and loss. In addition, where the subsidiary 
member remains a member of the group, the basis redetermination rule 
equalizes members' bases in subsidiary stock such that the loss 
suspension rule, described below, need not include inordinately complex 
rules to address the method by which inside losses reduce stock basis 
under Sec.  1.1502-32.
    The proposed regulations require the redetermination of the basis 
of subsidiary member stock held by members of the group immediately 
before a disposition or deconsolidation of a share of subsidiary member 
stock when the basis of such stock exceeds its value. The rule applies 
differently when the subsidiary remains a member of the group after its 
stock is disposed of or deconsolidated from when the subsidiary does 
not remain a member of the group.
    If a subsidiary remains a member of the group, the basis 
redetermination rule requires that all members of the group aggregate 
their bases in all shares of the subsidiary member. That basis is then 
allocated first to the shares of the subsidiary member's preferred 
stock that are owned by the members of the group in proportion to, but 
not in excess of, their value on the date of the disposition or 
deconsolidation. After the allocation of the aggregated basis to all 
shares of the preferred stock of the subsidiary member held by members 
of the group, any remaining basis is allocated among all common shares 
of subsidiary member stock held by members of the group in proportion 
to their value on the date of the disposition or deconsolidation. This 
rule reallocates past adjustments to reflect an economic allocation of 
the built-in items of deduction and loss with respect to contributed 
property. The rule also reallocates stock basis that arose from capital 
contributions of property and stock basis that arose as a result of 
positive investment adjustments. The reallocation of basis obviates the 
need for complex rules addressing basis adjustments resulting from an 
inside loss that was reflected in a stock loss that is suspended 
pursuant to the loss suspension rule described below.
    If the subsidiary is no longer a member of the group immediately 
after the disposition or deconsolidation of its stock, the basis 
redetermination rule requires a reallocation of a certain amount of the 
basis of the stock of the subsidiary member owned by group members. In 
particular, the amount of basis subject to reallocation is equal to the 
lesser of (1) the loss inherent in the stock disposed of or 
deconsolidated, and (2) the subsidiary member's items of deduction and 
loss that were taken into account in computing the adjustment to the 
basis of any share of stock of the subsidiary member, other than the 
shares disposed of or deconsolidated, during the time such subsidiary 
member was a member of the group. However, only those items of 
deduction and loss that are attributable to formerly unrecognized or 
unabsorbed items reflected in the basis of the subsidiary member stock 
disposed of or deconsolidated are included in the computation of the 
amount of basis subject to reallocation. For example, if a share of 
stock has a basis in excess of value because the stock was acquired in 
exchange for a built-in loss asset, the stock's basis reflects that 
unrecognized loss. If that loss is later recognized, the basis 
adjustment resulting from that recognition is an item of loss 
attributable to a formerly unrecognized item reflected in the basis of 
such stock. The proposed regulations contain a presumption that all 
items of deduction and loss included in the computation of prior 
investment adjustments to the basis of members' shares of the 
subsidiary member are attributable to the recognition and absorption of 
a deduction or loss reflected in the basis of the shares that are 
disposed of or deconsolidated. The regulations do, however, permit 
groups to establish that particular items of deduction and loss are not 
reflected in the basis of the shares disposed of or deconsolidated, 
and, therefore, are not reallocated to other shares.
    If the subsidiary is no longer a member of the group immediately 
after the disposition or deconsolidation of its stock, the basis in the 
shares of subsidiary member stock disposed of or deconsolidated is 
reduced by the amount of basis subject to reallocation. Then, to the 
extent of the amount of basis subject to reallocation, the basis of all 
preferred shares of stock of the subsidiary member that are held by 
members of the group immediately after the disposition or 
deconsolidation is increased such that the basis of each such share 
equals, but does not exceed, its value immediately before the 
disposition or deconsolidation. Finally, to the extent that the amount 
of basis subject to reallocation does not increase the basis of such 
preferred shares of the subsidiary member, such amount increases the 
basis of all common shares of stock of the subsidiary member held by 
members of the group immediately after the disposition or 
deconsolidation in a manner that, to the greatest extent possible, 
causes the ratio of the basis to the value of each such share to be the 
same.
    The basis redetermination rule does not apply if the group disposes 
of all its stock of the subsidiary member within a single taxable year, 
in one or more fully taxable transactions, or is allowed a worthless 
stock deduction with respect to all of the subsidiary member stock 
owned by the members. Under those circumstances, if a second tax 
benefit has been derived from an economic loss, the second tax benefit 
will be recaptured in the taxable year in which it was obtained.
    The proposed regulations also include a look-through rule that 
applies the basis redetermination rule to stock of lower-tier 
subsidiary members when there is a disposition or deconsolidation of 
stock of a higher-tier member. In addition, the proposed regulations 
provide that basis adjustments made pursuant to the basis 
redetermination

[[Page 65063]]

rule result in basis adjustments to higher-tier member stock.
    While the basis redetermination rule may prevent the recognition of 
a current loss on a particular share of subsidiary member stock, it 
does not prevent a group from obtaining a benefit from its investment 
in the subsidiary member. The basis redetermination rule affects only 
the timing of the group's loss and, in so doing, prevents the group 
from inappropriately duplicating a single economic loss.

B. Loss Suspension Rule

    The loss suspension rule prevents duplication of an economic loss 
by effectively disallowing a stock loss if the economic loss giving 
rise to that stock loss is later reflected on the group's return as in 
the second type of transaction described above.
1. Suspension of Stock Loss
    Under the loss suspension rule, if, after application of the basis 
redetermination rule, a member of a consolidated group recognizes a 
loss on the disposition of stock of a subsidiary member of the same 
group, and the subsidiary member is a member of the same group 
immediately after the disposition, then the selling member's stock loss 
is suspended to the extent of the duplicated loss with respect to such 
stock. The proposed regulations also include a special rule that 
applies the loss suspension rule in cases of a disposition of stock of 
a subsidiary member that leaves the group where the subsidiary owns 
stock of another subsidiary that remains a member of the group. In 
addition, the proposed regulations include a substitute asset rule that 
suspends a member's loss recognized on a disposition of an asset other 
than stock of a subsidiary member where such member's basis in the 
asset disposed of was determined, directly or indirectly, in whole or 
in part, by reference to the basis of stock of a subsidiary member with 
respect to which there was a duplicated loss, and immediately after the 
disposition, the subsidiary member is a member of such group.
    The amount of duplicated loss is the excess of (1) the sum of the 
aggregate basis of the subsidiary member's assets (excluding stock in 
other subsidiary members of the group), the subsidiary member's losses 
that are carried to its first taxable year after the disposition, and 
the subsidiary member's deductions that have been recognized but 
deferred under another provision, over (2) the sum of the value of 
stock of the subsidiary member and the subsidiary member's liabilities 
that have been taken into account for tax purposes. Each of these items 
in the computation (except stock value) includes the subsidiary 
member's allocable share of the same items of any lower-tier 
subsidiary. This definition of duplicated loss is substantially 
identical to the one in former Sec.  1.1502-20, except that securities 
of other members of the group are not excluded from the computation of 
the subsidiary's aggregate asset basis.
    The application of the loss suspension rule can be illustrated as 
follows. Assume P, the common parent of a consolidated group, forms S 
in Year 1 by contributing $100 to S in exchange for all 10 shares of 
S's outstanding stock. Immediately after the contribution, S purchases 
a building for $100. In Year 2, the value of the building declines to 
$10. At the end of Year 2, P sells one share of S stock for $1 and 
recognizes a $9 loss. (Because the basis of P's shares of S stock is 
uniform at the time of the disposition, the basis redetermination rule 
does not alter P's basis in the share sold.) Immediately after the 
sale, S is still a member of the P group because P continues to own 90% 
of the S stock. On the date of the stock sale, S's duplicated loss is 
$90, the excess of its asset basis ($100) over the value of the assets 
(deemed to be equal to the aggregate stock value, $10). Of the total 
duplicated loss, 10%, or $9, is allocable to the share sold. Thus, 
under the loss suspension rule the $9 stock loss is suspended.
2. Reduction of Suspended Stock Loss
    Because a suspended stock loss reflects the subsidiary member's 
unrecognized or unabsorbed deductions and losses, the suspended loss is 
reduced, with the result that it will not later be allowed, as the 
subsidiary member's deductions and losses are taken into account (i.e., 
absorbed) in determining the group's consolidated taxable income (or 
loss). The reduction of suspended loss is appropriate because, once the 
group takes the inside loss into account in determining consolidated 
taxable income (or loss), the group should not be able to take such 
loss (in the form of the stock loss or otherwise) into account again in 
determining consolidated taxable income or loss. Using the facts of the 
above example, assume that, in Year 3, S sells its building for $10 and 
recognizes a $90 loss. The P group uses the entire $90 loss to offset 
income of another member of the group. Under these proposed 
regulations, the absorbed loss ($90) reduces the suspended loss amount 
($9), but not below zero. Thus, P will benefit from the economic loss 
once on its return, no suspended stock loss will remain, and P's basis 
in its remaining S stock will be reduced by its allocable share of the 
loss ($81).
    The proposed regulations generally presume that all deductions and 
losses are attributable first to the duplicated loss that gave rise to 
a suspended stock loss. The presumption, however, is rebuttable. If a 
taxpayer can establish that an item of deduction or loss was not part 
of the duplicated loss that gave rise to a suspended stock loss, the 
taxpayer will not be required to reduce its suspended stock loss. To 
illustrate, assume that, instead of selling the building, S retained 
the building and, in Year 3, earned $50 which it then used to purchase 
a truck. In Year 4, S sells the truck, recognizing a $25 loss. That 
loss offsets income of another member of the P group. Assuming that P 
and S have kept adequate records, P should be able to establish that 
the loss on the truck was not reflected in the stock loss (because it 
was attributable to an asset that was acquired after the disposition of 
stock that gave rise to the suspended stock loss). In that case, P 
would not be required to reduce its suspended stock loss. The IRS and 
Treasury Department are concerned about, and specifically request 
comments regarding, the administrability aspects of this exception.
3. Allowance of Suspended Stock Loss
    The proposed regulations provide that any suspended stock loss 
remaining at the time the subsidiary member leaves the group is 
allowed, to the extent otherwise allowable under applicable provisions 
of the Code and regulations thereunder. The loss is allowed on a return 
filed for the taxable year that includes the last day that the 
subsidiary member is a member of the group. Once the subsidiary member 
is no longer a member of the group, the group will not typically be 
able to use the subsidiary member's deductions or losses on the group's 
return. Accordingly, it is appropriate to allow any suspended stock 
loss remaining at the time the subsidiary member leaves the group.
    The proposed regulations also provide that any suspended stock loss 
remaining is allowed at the time the group is allowed a worthless stock 
deduction with respect to all of the subsidiary member stock owned by 
members. In such cases, the basis reduction rule, described below, may 
reduce a worthless stock deduction effectively to prevent any second 
tax benefit that could be derived from the economic loss that gave rise 
to the suspended stock loss.

[[Page 65064]]

    The proposed regulations require that in order for a group to be 
allowed a loss that was recognized on the disposition of a subsidiary 
member and that was suspended, the group must file a statement of 
allowable loss with the consolidated return for the year in which the 
loss is allowable.

C. Application of the Basis Redetermination and Loss Suspension Rules 
Generally

    The IRS and Treasury Department do not expect that the basis 
redetermination and the loss suspension rules will apply frequently. 
This expectation is based on the assumption that, when a group seeks to 
raise capital, the common parent will typically issue stock directly or 
sell all of the stock of a subsidiary member. Alternatively, groups 
sometimes seek to raise capital by creating minority interests in a 
subsidiary member. In such cases, however, the group will typically 
cause the subsidiary member to issue shares directly to the nonmember. 
Thus, the IRS and Treasury Department believe that a member's sale of 
less than all of the stock of a subsidiary member to a nonmember, which 
may trigger application of the basis redetermination and loss 
suspension rules, is not a common transaction in the absence of tax 
incentives.

D. Basis Reduction Rule

    The loss suspension rule apples only if there has been a 
disposition of subsidiary member stock and the subsidiary member is a 
member of the group immediately after the disposition. The IRS and 
Treasury Department, however, are concerned that a group may obtain 
more than one tax benefit from a single economic loss in certain cases 
in which a group member recognizes a loss with respect to subsidiary 
member stock and, in connection with such recognition event, the 
subsidiary member ceases to exist. For example, suppose P owns all of 
the stock of S. P's basis in its S stock is $100 and the value of the S 
stock is $0 because S is insolvent. S liquidates into P. In that case, 
P will recognize a loss of $100 on the disposition of the S stock. 
Because S is not a member of the P group immediately after the 
disposition of S stock, the loss suspension rule will not apply. The 
portion of the group's consolidated net operating and net capital loss 
carryforwards attributable to S, however, may remain with the P group. 
Therefore, to that extent, any loss on the stock of the subsidiary 
duplicates those losses. To address this case, these proposed 
regulations provide that if a member disposes of subsidiary member 
stock and on the following day the subsidiary is not a member of the 
group and does not have a separate return year, then the basis of the 
subsidiary member stock is reduced to the extent of the consolidated 
net operating loss and net capital loss carryforwards attributable to 
such subsidiary member, as though they were absorbed immediately prior 
to the disposition.
    Similarly, where the subsidiary becomes worthless under the 
standards of Sec.  1.1502-80(c), the group may be allowed a worthless 
stock loss while consolidated net operating and net capital loss 
carryforwards attributable to the worthless subsidiary member remain 
unabsorbed. Although the subsidiary may be viewed as remaining in the 
group, rather than rely on existing rules, including the excess loss 
account recapture rules, to prevent the possible duplication of the 
unabsorbed losses, these proposed regulations provide for a negative 
stock basis adjustment similar to that described above in such cases.

E. Anti-avoidance Rules

    The IRS and Treasury Department are concerned that, in certain 
cases, taxpayers may structure transactions to avoid the application of 
the basis redetermination and loss suspension rules in a manner that is 
not consistent with the purpose of the proposed regulations to prevent 
a consolidated group from obtaining more than one tax benefit from a 
single economic loss. In particular, suppose P acquires 80 shares of S 
common stock in exchange for $80. In a later year, P contributes an 
asset with a basis of $50 and a value of $20 to S in exchange for 20 
shares of S preferred stock. The following year, S sells the 
contributed asset, recognizing a loss of $30. As a result of the sale 
of the asset, P's basis in the S common stock is reduced by $30 from 
$80 to $50. In contemplation of the sale of the S preferred stock, P 
contributes the 80 shares of S common stock to PS, a partnership, in a 
transaction described in section 721. Because P's basis in the S common 
stock does not exceed the value of such stock, the deconsolidation of 
the S common stock does not trigger the application of the basis 
redetermination rule. In the same year, but after the contribution of 
the S common stock to PS, P sells the S preferred stock, recognizing 
$30 of loss. Absent the application of an anti-avoidance rule, the P 
group will have obtained more than one tax benefit from the single 
economic loss inherent in the contributed asset. Accordingly, the 
proposed regulations provide that if a share of subsidiary member stock 
is deconsolidated and such deconsolidation is with a view to avoiding 
application of the basis redetermination rule prior to the disposition 
of loss stock of the subsidiary member, then the basis redetermination 
rule will apply immediately prior to the deconsolidation.
    In addition, suppose in Year 1, P forms S with a contribution of 
$100 in exchange for 100 shares of common stock of S which at that time 
represents all of the outstanding stock of S. In Year 2, P contributes 
20 shares of common stock of S to PS, a partnership, in a transaction 
described in section 721. In Year 3, P contributes an asset with a 
basis of $50 and a value of $20 to PS in a transaction described in 
section 721. Also in Year 3, PS contributes the built-in loss asset to 
S and P contributes an additional $80 to S in transfers to which 
section 351 applies. In Year 4, S sells the built-in loss asset for 
$20, recognizing a loss of $30. The P group uses that loss to offset 
income of P. Also in Year 4, P sells its entire interest in PS for $40, 
recognizing a loss of $30, or PS sells its S stock for $20, recognizing 
a loss of $30. In either case, the P group would obtain more than one 
tax benefit from the single economic loss in the contributed asset. 
Accordingly, the proposed regulations provide that where a member of a 
consolidated group contributes a built-in loss asset to a partnership 
or a deconsolidated corporation, that partnership or deconsolidated 
corporation subsequently contributes the built-in loss asset to a 
subsidiary member of the group, and those contributions are with a view 
to avoiding the application of the basis redetermination rule or the 
loss suspension rule, adjustments must be made to prevent the 
consolidated group from obtaining more than one tax benefit from a 
single economic loss in the case.
    The IRS and Treasury Department are also concerned that it may be 
possible to avoid the loss suspension rule by disposing of a sufficient 
amount of subsidiary member stock to cause a deconsolidation of the 
subsidiary member, but then engage in a transaction that has the effect 
of re-importing to the group losses of that subsidiary member. To 
address this concern, the proposed regulations include an anti-
avoidance rule that prevents the group from obtaining the tax benefit 
of the re-imported loss. The rule applies whenever (1) a group 
recognizes and is allowed a loss on the disposition of subsidiary 
member stock with respect to which there is a duplicated loss, (2) as a 
result of that

[[Page 65065]]

disposition or another disposition, the subsidiary member leaves the 
group, and (3) within ten (10) years after the date the subsidiary 
member leaves the group, a loss of the subsidiary member is re-imported 
into the group. A loss of a subsidiary may be re-imported into the 
group when the subsidiary member rejoins the group at a time when it 
has losses or deferred deductions that it had on the date of the 
disposition or has losses or deferred deductions that are attributable 
to built-in loss assets held by the subsidiary member on the date of 
the disposition, or has built-in loss assets that were built-in loss 
assets of the subsidiary member on the date of the disposition. A loss 
of a subsidiary member may also be re-imported into the group when a 
member of the group succeeds to losses or deferred deductions of the 
subsidiary member that were losses or deferred deductions of the 
subsidiary member on the date of the disposition, or losses or deferred 
deductions that are attributable to assets that were built-in loss 
assets of the subsidiary member on the date of the disposition, or 
acquires built-in loss assets that were built-in loss assets of the 
subsidiary member on the date of the disposition. If the anti-avoidance 
rule applies, then these proposed regulations generally prohibit the 
use of the re-imported item of deduction or loss to offset income of 
the group.

F. Application of Anti-Abuse Rules

    Finally, the proposed regulations make clear that the proposed 
rules do not preclude the application of anti-abuse rules of the Code 
and regulations thereunder, including to a transaction entered into to 
invoke the basis redetermination rule to avoid the effect of any other 
provision of the Code or regulations.

G. Request for Comments

    The IRS and Treasury Department are considering alternative 
approaches to the basis redetermination rule that would mitigate basis 
disparities in stock of a subsidiary member. In this regard, the IRS 
and Treasury Department are considering an approach that would adjust 
the bases of all shares of subsidiary member stock held by group 
members upon any acquisition of subsidiary member stock. Comments are 
requested regarding the appropriateness and desirability of such an 
approach as well as suggestions for alternative approaches.
    In addition, under the proposed regulations, the basis 
redetermination and loss suspension rules apply only to certain events 
involving stock that has a basis in excess of value. The IRS and 
Treasury Department, however, are considering the appropriateness and 
feasibility of a rule that applies the principles of the basis 
redetermination and loss suspension rules to certain events involving 
stock that has a value in excess of basis. With respect to the 
application of the principles of the loss suspension rule to 
dispositions of stock that has a value in excess of basis and that 
reflects duplicated gain, a rule might require taking into account the 
stock gain upon the disposition of the stock but would eliminate gain 
recognized on the disposition of assets that had a built-in gain at the 
time of the stock transaction. The IRS and Treasury Department request 
comments on appropriate and administrable applications of the 
principles of the basis redetermination and loss suspension rules to 
dispositions and deconsolidations of stock that has a built-in gain.
    Finally, as an alternative or supplement to the rule providing for 
basis reduction for unabsorbed losses in certain cases where the 
subsidiary member ceases to exist or the group is allowed a worthless 
stock deduction with respect to the stock of such subsidiary member, 
the IRS and Treasury Department are considering whether it would be 
more appropriate to restrict the losses pursuant to the approach set 
forth in section 382(g)(4)(D). Comments are requested regarding whether 
such an approach would be appropriate, desirable and administrable, as 
well as the application of such an approach in the context of 
consolidated attributes.

Proposed Effective Date

    These regulations, other than the anti-avoidance rule that relates 
to the re-importing of losses, are proposed to apply to transactions 
that occur on or after March 7, 2002, but only if such transactions 
occur during a taxable year the original return for which is due 
(without regard to extensions) after the date these regulations are 
published as temporary or final regulations in the Federal Register. 
The anti-avoidance rule that relates to the re-importing of loss is 
proposed to apply to losses re-imported as a result of an event that 
occurs on or after October 18, 2002, that triggers the application of 
such rule, but only if such event occurs during a taxable year the 
original return for which is due (without regard to extensions) after 
the date these regulations are published as temporary or final 
regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that these regulations do not have a significant impact on a 
substantial number of small entities. This certification is based on 
the fact that these regulations will primarily affect affiliated groups 
of corporations, which tend to be larger businesses. Moreover, the 
number of taxpayers affected and the average burden are minimal. It has 
also been determined that section 553(b) of the Administrative 
Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, 
and because these regulations do not impose a collection requirement on 
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
does not apply. Therefore, a Regulatory Flexibility Analysis is not 
required. Pursuant to section 7805(f) of the Internal Revenue Code, 
this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on their impact on small businesses.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed regulations and how they may be made easier to understand. 
All comments will be available for public inspection and copying.
    A public hearing has been scheduled for January 15, 2003, beginning 
at 10 a.m. in room 6718, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Due to building security procedures, 
visitors must enter at the Constitution Avenue entrance. In addition, 
all visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 30 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT portion of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments must submit written or electronic 
comments and an outline of the topics to be discussed and

[[Page 65066]]

the time to be devoted to each topic (a signed original and eight (8) 
copies) by December 27, 2002. A period of 10 minutes will be allotted 
to each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

    The principal author of these regulations is Aimee K. Meacham of 
the Office of the Associate Chief Counsel (Corporate), IRS. However, 
other personnel from the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for part 1 continues to read in part as 
follows:

    Authority: 26 U.S.C. 7805 * * *

    2. Section 1.1502-32 is amended by:
    1. Revising paragraph (a)(2).
    2. Adding paragraphs (b)(3)(iii)(C), (b)(3)(iii)(D), and 
(b)(3)(vi).
    The revision and additions read as follows:


Sec.  1.1502-32  Investment adjustments.

    (a) * * *
    (2) Application of other rules of law. The rules of this section 
are in addition to other rules of law. See, e.g., section 358 (basis 
determinations for distributees), section 1016 (adjustments to basis), 
Sec.  1.1502-11(b) (limitations on the use of losses), Sec.  1.1502-19 
(treatment of excess loss accounts), Sec.  1.1502-31 (basis after a 
group structure change), and Sec.  1.1502-35 (additional rules relating 
to stock loss). P's basis in S's stock must not be adjusted under this 
section and other rules of law in a manner that has the effect of 
duplicating an adjustment. For example, if pursuant to Sec.  1.1502-
35(c)(3) and paragraph (b)(3)(iii)(C) of this section the basis in 
stock is reduced to take into account a loss suspended under Sec.  
1.1502-35(c)(1), such basis shall not be further reduced to take into 
account such loss, or a portion of such loss, if any, that is later 
allowed pursuant to Sec.  1.1502-35(c)(5). See also paragraph (h)(5) of 
this section for basis reductions applicable to certain former 
subsidiaries.
* * * * *
    (b) * * *
    (3) * * *
    (iii) * * *
    (C) Loss suspended under Sec.  1.1502-35(c). Any loss suspended 
pursuant to Sec.  1.1502-35(c) is treated as a noncapital, 
nondeductible expense incurred during the tax year that includes the 
date of the disposition to which such section applies. See Sec.  
1.1502-35(c)(3). Consequently, the basis of a higher-tier member's 
stock of P is reduced by the suspended loss in the year it is 
suspended.
    (D) Loss disallowed under Sec.  1.1502-35(g)(3)(iii). Any loss the 
use of which is disallowed pursuant to Sec.  1.1502-35(g)(3)(iii)(A) or 
(B) is treated as a noncapital, nondeductible expense incurred during 
the taxable year that includes the date on which such loss is 
recognized. Any loss the use of which is disallowed pursuant to Sec.  
1.1502-35(g)(3)(iii)(C) and with respect to which no waiver described 
in paragraph (b)(4) of this section is filed is treated as a 
noncapital, nondeductible expense incurred during the taxable year that 
includes the day after the event described in Sec.  1.1502-
35(g)(3)(iii)(C) that gives rise to the application of Sec.  1.1502-
35(g)(3). See Sec.  1.1502-35(g)(3)(iv).
* * * * *
    (vi) Special rules in the case of certain transactions subject to 
Sec.  1.1502-35. If a member of a group disposes of a share of 
subsidiary member stock or a share of subsidiary member stock is 
deconsolidated, and, at the time of such disposition or 
deconsolidation, the basis of such share exceeds its value, all members 
of the group are subject to the provisions of Sec.  1.1502-35, which 
generally require a redetermination of members' basis in all shares of 
subsidiary stock.
    3. Section 1.1502-35 is added to read as follows:


Sec.  1.1502-35  Disposition or deconsolidation of subsidiary member 
stock.

    (a) Purpose. The purpose of this section is to prevent a group from 
obtaining more than one tax benefit from a single economic loss. The 
provisions of this section shall be construed in a manner consistent 
with that purpose and in a manner that reasonably carries out that 
purpose.
    (b) Redetermination of basis on disposition or deconsolidation of 
subsidiary member stock--(1) Application. Except as provided in 
paragraph (b)(4) of this section, this paragraph (b) applies if a 
member of a consolidated group disposes of stock of a subsidiary member 
or a share of subsidiary member stock is deconsolidated, and such 
disposed of or deconsolidated stock has a basis that exceeds it value 
immediately prior to such disposition or deconsolidation. If, 
immediately after such disposition or deconsolidation, the subsidiary 
member remains a member of the group, then, immediately before such 
disposition or deconsolidation, the basis in each share of subsidiary 
member stock owned by each member of the group shall be redetermined in 
accordance with the provisions of paragraph (b)(2) of this section. If, 
immediately after such disposition or deconsolidation, the subsidiary 
is not a member of the group, then immediately before such disposition 
or deconsolidation, the basis in each share of subsidiary member stock 
owned by each member of the group shall be redetermined in accordance 
with the provisions of paragraph (b)(3) of this section.
    (2) Redetermination of subsidiary member stock basis if subsidiary 
member remains a member of the same group. If the subsidiary member the 
stock of which is disposed of or deconsolidated remains a member of the 
group, all of the members' basis in the shares of subsidiary member 
stock shall be aggregated. Such aggregated basis shall be allocated 
first to the shares of the subsidiary member's preferred stock that are 
owned by the members of the group, in proportion to, but not in excess 
of, the value of those shares on the date of the disposition or 
deconsolidation that gave rise to the application of this paragraph 
(b). After allocation of the aggregated basis to all shares of the 
preferred stock of the subsidiary member held by members of the group, 
any remaining basis shall be allocated among all common shares of 
subsidiary member stock held by members of the group in proportion to 
the value of such shares on the date of the disposition or 
deconsolidation that gave rise to the application of this paragraph 
(b).
    (3) Redetermination of subsidiary member stock basis if subsidiary 
member does not remain a member of the group--(i) Calculation of 
Reallocable Basis Amount. The reallocable basis amount shall equal the 
lesser of--
    (A) The amount by which the basis of the disposed of or 
deconsolidated stock exceeds the value of such stock immediately prior 
to the disposition or deconsolidation that gave rise to the application 
of this paragraph (b); and

[[Page 65067]]

    (B) The total of the subsidiary member's (and any predecessor's) 
items of deduction and loss, and the subsidiary member's (and any 
predecessor's) allocable share of items of deduction and loss of all 
lower-tier subsidiary members, that were taken into account in 
computing the adjustment to the basis of any share of stock of the 
subsidiary member (and any predecessor) under Sec.  1.1502-32 other 
than the stock of the subsidiary member the disposition or 
deconsolidation of which gave rise to the application of this paragraph 
(b), during the time such subsidiary member (or any predecessor) was a 
member of the group, except to the extent the group can establish that 
all or a portion of such items would not have been reflected in a 
computation of the duplicated loss with respect to the disposed of or 
deconsolidated stock of the subsidiary member (or any predecessor) at 
any time prior to such disposition or deconsolidation.
    (ii) Allocation of reallocable basis amount. If the subsidiary 
member the stock of which is disposed of or deconsolidated does not 
remain a member of the group, the basis in the shares of subsidiary 
member stock that were disposed of or deconsolidated shall be reduced 
by the reallocable basis amount. Then, to the extent of the reallocable 
basis amount, the basis of all the preferred shares of stock of the 
subsidiary member that are held by members of the group immediately 
after the disposition or deconsolidation shall be increased such that 
the basis of each such share shall equal, but not exceed, its value 
immediately before the disposition or deconsolidation. If the 
reallocable basis amount is not sufficient to increase the basis of 
each such share of preferred stock to its value immediately before the 
disposition or deconsolidation, the basis of each such share shall be 
increased in a manner that, to the greatest extent possible, causes the 
ratio of the basis to the value of each such share to be the same. 
Then, to the extent the reallocable basis amount does not increase the 
basis of shares of subsidiary member preferred stock pursuant to the 
second sentence of this paragraph (b)(3)(ii), such amount shall 
increase the basis of all common shares of subsidiary member stock held 
by members of the group immediately after the disposition or 
deconsolidation in a manner that, to the greatest extent possible, 
causes the ratio of the basis to the value of each such other share to 
be the same.
    (4) Exception to application of redetermination rules. This 
paragraph (b) shall not apply to a disposition of subsidiary member 
stock if, within the taxable year of such disposition, in one or more 
fully taxable transactions, the group disposes of its entire equity 
interest in the subsidiary member or is allowed a worthless stock loss 
under section 165(g) (taking into account the provisions of Sec.  
1.1502-80(c)) with respect to all of the subsidiary member stock owned 
by members.
    (5) Special rule for lower-tier subsidiaries. If--
    (i) A member of a consolidated group disposes of stock of a 
subsidiary member of the same group or a share of subsidiary member 
stock is deconsolidated, and, immediately before the disposition or 
deconsolidation, the member's basis in the disposed of or 
deconsolidated share of subsidiary member stock exceeds its value;
    (ii) The subsidiary member owns stock of another subsidiary member 
of the same group and, immediately before the disposition or 
deconsolidation, the basis of some or all of such stock exceeds its 
value; and
    (iii) Immediately after the disposition or deconsolidation, another 
member of the same group owns stock of such other subsidiary member, 
then the basis in each share of such other subsidiary member shall be 
redetermined pursuant to this paragraph (b) as if the stock of such 
other subsidiary member owned by the subsidiary member had been 
disposed of or deconsolidated. This paragraph (b)(5) shall not apply in 
the case of a disposition of subsidiary member stock if, within the 
taxable year of the disposition of subsidiary member stock, in one or 
more fully taxable transactions, the group disposes of its remaining 
equity interests in the other subsidiary member or is allowed a 
worthless stock loss under section 165(g) (taking into account the 
provisions of Sec.  1.1502-80(c)) with respect to such other subsidiary 
member. These same principles shall apply to stock of subsidiary 
members of the same group that are owned by such other subsidiary 
member.
    (6) Stock basis adjustments for higher-tier stock. The basis 
adjustments required under this paragraph (b) result in basis 
adjustments to higher-tier member stock. The adjustments are applied in 
the order of the tiers, from the lowest to highest. For example, if a 
common parent owns stock of a subsidiary member that owns stock of a 
lower-tier subsidiary member and the subsidiary member recognizes a 
loss on the disposition of a portion of its shares of the lower-tier 
subsidiary member stock, the common parent must adjust its basis in its 
subsidiary member stock under the principles of Sec.  1.1502-32 to 
reflect the adjustments that the subsidiary member must make to its 
basis in its stock of the lower-tier subsidiary member.
    (7) Ordering rule. The rules of this paragraph (b) apply after the 
rules of Sec.  1.1502-32 are applied. Paragraph (b)(5) of this section 
(and any resulting basis adjustments to higher-tier member stock made 
pursuant to paragraph (b)(6) of this section) applies prior to 
paragraph (b)(2) or (b)(3) of this section (and any resulting basis 
adjustments to higher-tier member stock made pursuant to paragraph 
(b)(6) of this section).
    (c) Loss suspension--(1) General rule. Any loss recognized by a 
member of a consolidated group with respect to the disposition of a 
share of subsidiary member stock shall be suspended to the extent of 
the duplicated loss with respect to such share of stock if, immediately 
after the disposition, the subsidiary is a member of the consolidated 
group of which it was a member immediately prior to the disposition (or 
any successor group).
    (2) Special rule for lower-tier subsidiaries. This paragraph (c)(2) 
applies if neither paragraph (c)(1) nor (f) of this section applies to 
a member's disposition of a share of stock of a subsidiary member (the 
departing member), a loss is recognized on the disposition of such 
share, and the departing member owns stock of one or more other 
subsidiary members (a remaining member) that is a member of such group 
immediately after the disposition. In that case, such loss shall be 
suspended to the extent the duplicated loss with respect to the 
departing member stock disposed of is attributable to the remaining 
member or members.
    (3) Treatment of suspended loss. For purposes of the rules of Sec.  
1.1502-32(b)(3)(iii), any loss suspended pursuant to paragraph (c)(1) 
or (c)(2) of this section is treated as a noncapital, nondeductible 
expense of the member that disposes of subsidiary member stock incurred 
during the taxable year that includes the date of the disposition of 
stock to which paragraph (c)(1) or (c)(2) of this section applies. See 
Sec.  1.1502-32(b)(3)(iii)(C). Consequently, the basis of a higher-tier 
member's stock of the member that disposes of subsidiary member stock 
is reduced by the suspended loss in the year it is suspended.
    (4) Reduction of suspended loss--(i) General rule. The amount of 
any loss suspended pursuant to paragraphs (c)(1) and (c)(2) of this 
section shall be reduced, but not below zero, by the subsidiary 
member's (and any successor's) items of deduction and loss,

[[Page 65068]]

and the subsidiary member's (and any successor's) allocable share of 
items of deduction and loss of all lower-tier subsidiary members, that 
are allocable to the period beginning on the date of the disposition 
that gave rise to the suspended loss and ending on the day before the 
first date on which the subsidiary member (or any successor) is not a 
member of the group of which it was a member immediately prior to the 
disposition (or any successor group), and that are taken into account 
in determining consolidated taxable income (or loss) of such group for 
any taxable year that includes any date on or after the date of the 
disposition and before the first date on which the subsidiary member 
(or any successor) is not a member of such group. The preceding 
sentence shall not apply to items of deduction and loss to the extent 
that the group can establish that all or a portion of such items was 
not reflected in the computation of the duplicated loss with respect to 
the subsidiary member stock on the date of the disposition of such 
stock.
    (ii) Operating rules--(A) Year in which deduction or loss is taken 
into account. For purposes of paragraph (c)(4)(i) of this section, a 
subsidiary member's (or any successor's) deductions and losses are 
treated as taken into account when and to the extent they are absorbed 
by the subsidiary member (or any successor) or any other member. To the 
extent that the subsidiary member's (or any successor's) deduction or 
loss is absorbed in the year it arises or is carried forward and 
absorbed in a subsequent year (e.g., under section 172, 465, or 1212), 
the deduction is treated as taken into account in the year in which it 
is absorbed. To the extent that a subsidiary member's (or any 
successor's) deduction or loss is carried back and absorbed in a prior 
year (whether consolidated or separate), the deduction or loss is 
treated as taken into account in the year in which it arises and not in 
the year in which it is absorbed.
    (B) Determination of items that are allocable to the post-
disposition, pre-deconsolidation period. For purposes of paragraph 
(c)(4)(i) of this section, the determination of whether a subsidiary 
member's (or any successor's) items of deduction and loss and allocable 
share of items of deduction and loss of all lower-tier subsidiary 
members are allocable to the period beginning on the date of the 
disposition of subsidiary stock that gave rise to the suspended loss 
and ending on the day before the first date on which the subsidiary 
member (or any successor) is not a member of the consolidated group of 
which it was a member immediately prior to the disposition (or any 
successor group) is determined pursuant to the rules of Sec.  1.1502-
76(b)(2), without regard to Sec.  1.1502-76(b)(2)(ii)(D), as if the 
subsidiary member ceased to be a member of the group at the end of the 
day before the disposition and filed separate returns for the period 
beginning on the date of the disposition and ending on the day before 
the first date on which it is not a member of such group.
    (5) Allowable loss--(i) General rule. To the extent not reduced 
under paragraph (c)(4) of this section, any loss suspended pursuant to 
paragraph (c)(1) or (c)(2) of this section shall be allowed, to the 
extent otherwise allowable under applicable provisions of the Internal 
Revenue Code and regulations thereunder, on a return filed by the group 
of which the subsidiary was a member on the date of the disposition of 
subsidiary stock that gave rise to the suspended loss (or any successor 
group) for the taxable year that includes the day before the first date 
on which the subsidiary (or any successor) is not a member of such 
group or the date the group is allowed a worthless stock loss under 
section 165(g) (taking into account the provisions of Sec.  1.1502-
80(c)) with respect to all of the subsidiary member stock owned by 
members.
    (ii) No tiering up of certain adjustments. No adjustments shall be 
made to a member's basis of stock of a subsidiary member (or any 
successor) for a suspended loss that is taken into account under 
paragraph (c)(5)(i) of this section. See Sec.  1.1502-32(a)(2).
    (iii) Statement of allowed loss. Paragraph (c)(5)(i) of this 
section applies only if the separate statement required under this 
paragraph (c)(5)(iii) is filed with, or as part of, the taxpayer's 
return for the year in which the loss is allowable. The statement must 
be entitled ``ALLOWED LOSS UNDER Sec.  1.1502-35(c)(5)'' and must 
contain the name and employer identification number of the subsidiary 
the stock of which gave rise to the loss.
    (6) Special rule for dispositions of certain carryover basis 
assets. If--
    (i) A member of a group recognizes a loss on the disposition of an 
asset other than stock of a subsidiary member;
    (ii) Such member's basis in the asset disposed of was determined, 
directly or indirectly, in whole or in part, by reference to the basis 
of stock of a subsidiary member and, at the time of the determination 
of the member's basis in the assets disposed of, there was a duplicated 
loss with respect such stock of the subsidiary member; and
    (iii) Immediately after the disposition, the subsidiary member is a 
member of such group, then such loss shall be suspended pursuant to the 
principles of paragraphs (c)(1) and (c)(2) of this section to the 
extent of the duplicated loss with respect to such stock at the time of 
the determination of basis of the asset disposed of. Principles similar 
to those set forth in paragraphs (c)(3), (4), and (5) of this section 
shall apply to a loss suspended pursuant to this paragraph (c)(6).
    (7) Coordination with loss deferral, loss disallowance, and other 
rules--(i) In general. Loss recognized on the disposition of subsidiary 
member stock or another asset is subject to redetermination, deferral, 
or disallowance under other applicable provisions of the Internal 
Revenue Code and regulations thereunder, including sections 267(f) and 
482. Paragraphs (c)(1), (c)(2), and (c)(6) of this section do not apply 
to a loss that is disallowed under any other provision. If loss is 
deferred under any other provision, paragraphs (c)(1), (c)(2), and 
(c)(6) of this section apply when the loss would otherwise be taken 
into account under such other provision. However, if an overriding 
event described in paragraph (c)(7)(ii) of this section occurs before 
the deferred loss is taken into account, paragraphs (c)(1), (c)(2), and 
(c)(6) of this section apply to the loss immediately before the event 
occurs, even though the loss may not be taken into account until a 
later time.
    (ii) Overriding events. For purposes of paragraph (c)(7)(i) of this 
section, the following are overriding events--
    (A) The stock ceases to be owned by a member of the consolidated 
group;
    (B) The stock is canceled or redeemed (regardless of whether it is 
retired or held as treasury stock); or
    (C) The stock is treated as disposed of under Sec.  1.1502-
19(c)(1)(ii)(B) or (c)(1)(iii).
    (d) Definitions--(1) Disposition. Disposition means any event in 
which gain or loss is recognized, in whole or in part.
    (2) Deconsolidation. Deconsolidation means any event that causes a 
share of stock of a subsidiary member that remains outstanding to be no 
longer owned by a member of any consolidated group of which the 
subsidiary is also a member.
    (3) Value. Value means fair market value.
    (4) Duplicated loss--(i) In general. Duplicated loss is determined 
immediately after a disposition and equals the excess, if any, of--

[[Page 65069]]

    (A) The sum of--
    (1) The aggregate adjusted basis of the subsidiary member's assets 
other than any stock that subsidiary member owns in another subsidiary 
member; and
    (2) Any losses attributable to the subsidiary member and carried to 
the subsidiary member's first taxable year following the disposition; 
and
    (3) Any deductions of the subsidiary member that have been 
recognized but are deferred under a provision of the Internal Revenue 
Code (such as deductions deferred under section 469); over
    (B) The sum of--
    (1) The value of the subsidiary member's stock; and
    (2) Any liabilities of the subsidiary member that have been taken 
account for tax purposes.
    (ii) Special rules. (A) The amounts determined under paragraph 
(d)(4)(i) of this section with respect to a subsidiary member include 
its allocable share of corresponding amounts with respect to all lower-
tier subsidiary members. If 80 percent or more in value of the stock of 
a subsidiary member is acquired by purchase in a single transaction (or 
in a series of related transactions during any 12-month period), the 
value of the subsidiary member's stock may not exceed the purchase 
price of the stock divided by the percentage of the stock (by value) so 
purchased. For this purpose, stock is acquired by purchase if the 
transferee is not related to the transferor within the meaning of 
sections 267(b) and 707(b)(1), using the language ``10 percent'' 
instead of ``50 percent'' each place that it appears, and the 
transferee's basis in the stock is determined wholly by reference to 
the consideration paid for such stock.
    (B) The amounts determined under paragraph (d)(4)(i) of this 
section are not applied more than once to suspend a loss under this 
section.
    (5) Predecessor and Successor. A predecessor is a transferor of 
assets to a transferee (the successor) in a transaction--
    (i) To which section 381(a) applies;
    (ii) In which substantially all of the assets of the transferor are 
transferred to members in a complete liquidation;
    (iii) In which the successor's basis in assets is determined 
(directly or indirectly, in whole or in part) by reference to the 
transferor's basis in such assets, but the transferee is a successor 
only with respect to the assets the basis of which is so determined; or
    (iv) Which is an intercompany transaction, but only with respect to 
assets that are being accounted for by the transferor in a prior 
intercompany transaction.
    (6) Successor group. A surviving group is treated as a successor 
group of a consolidated group (the terminating group) that ceases to 
exist as a result of--
    (i) The acquisition by a member of another consolidated group of 
either the assets of the common parent of the terminating group in a 
reorganization described in section 381(a)(2), or the stock of the 
common parent of the terminating group; or
    (ii) The application of the principles of Sec.  1.1502-75(d)(2) or 
(3).
    (7) Preferred stock, common stock. Preferred stock and common stock 
shall have the meanings set forth in Sec.  1.1502-32(d)(2) and (3), 
respectively.
    (8) Lower-tier. A subsidiary member is lower-tier with respect to a 
member if or to the extent investment basis adjustments under Sec.  
1.1502-32 with respect to the stock of the former member would affect 
investment basis adjustments with respect to the stock of the latter.
    (e) Examples. For purposes of the examples in this section, unless 
otherwise stated, all groups file consolidated returns on a calendar-
year basis, the facts set forth the only corporate activity, all 
transactions are between unrelated persons, and tax liabilities are 
disregarded. The principles of paragraphs (a) through (d) of this 
section are illustrated by the following examples:

    Example 1. (i) P owns 100 percent of the common stock of each of 
S1 and S2. S1 and S2 each have only one class of stock outstanding. 
P's basis in the stock of S1 is $100 and in the stock of S2 is $120. 
P, S1, and S2 are all members of the P group. S1 and S2 form S3. In 
Year 1, in transfers to which section 351 applies, S1 contributes 
$100 to S3 in exchange for all of the common stock of S3 and S2 
contributes an asset with a basis of $50 and a value of $20 to S3 in 
exchange for all of the preferred stock of S3. S3 becomes a member 
of the P group. In Year 3, in a transaction that is not part of the 
plan that includes the formation of S3, S2 sells the preferred stock 
of S3 for $20. Immediately after the sale, S3 is a member of the P 
group.
    (ii) Under paragraph (b)(1) of this section, because S2's basis 
in the preferred stock of S exceeds the value of such shares 
immediately prior to the sale and S is a member of the P group 
immediately after the sale, all of the P group members' bases in the 
stock of S3 is redetermined pursuant to paragraph (b)(2) of this 
section. Of the group members' total basis of $150 in the S3 stock, 
$20 is allocated to the preferred stock, the fair market value of 
the preferred stock on the date of the sale, and $130 is allocated 
to the common stock. S2's sale of the preferred stock results in the 
recognition of $0 of gain/loss. Pursuant to paragraph (b)(6) of this 
section, the redetermination of S1's and S2's bases in the stock of 
S3 results in adjustments to P's basis in the stock of S1 and S2. In 
particular, P's basis in the stock of S1 is increased by $30 to $130 
and its basis in the stock of S2 is decreased by $30 to $90.
    Example 2. (i) P owns 75 shares of common stock of S each with a 
basis and value equal to $1. S is a member of the P group. On 
January 1st of Year 1, in a transfer to which section 351 applies, P 
contributes Asset A, which has a basis of $100 and value of $25, to 
S in exchange for 25 shares of common stock of S. In Year 1, S 
incurs $40 of ordinary operating expenses and takes a depreciation 
deduction in the amount of $10 with respect to Asset A. Those 
deductions offset income of P in Year 1. Pursuant to Sec.  1.1502-
32, the negative investment adjustment of $50 with respect to the 
stock of S reduces the basis of each share of S common stock by 
$0.50. Therefore, P's original 75 shares of S common stock each has 
a basis of $0.50 and each of the 25 shares of S common stock that P 
acquired in Year 1 has a basis of $3.50. In Year 3 in a transaction 
that is not part of a plan that includes the Year 1 contribution, P 
sells the 25 shares of common stock it acquired in Year 1 for 
$12.50. As a result of that sale, S ceases to be a member of the P 
group.
    (ii) Under paragraph (b)(1) of this section, because P's basis 
in the 25 shares of common stock it acquired in Year 1 exceeds its 
value immediately prior to the sale and S is not a member of the P 
group immediately after the disposition, P's basis in its shares of 
S common stock is redetermined pursuant to paragraph (b)(3) of this 
section. Pursuant to paragraph (b)(3)(i) of this section, the 
reallocable basis amount is $37.50 (the lesser of the amount by 
which P's basis in the S common stock sold exceeds the value of such 
stock immediately prior to the sale ($87.50 minus $12.50, or $75) 
and the aggregate amount of S's items of deduction and loss that 
were previously taken into account in the computation of the 
adjustment to the basis of the S common stock other than the stock 
disposed of, under Sec.  1.1502-32, during the time that S was a 
member of the P group ($37.50)). P, however, may be able to 
establish that $30 of the $37.50 of items of deduction and loss 
taken into account in computing the adjustment to the basis of the S 
common stock (other than the S common stock disposed of) in Year 1 
was not attributable to a loss that was already reflected in P's 
basis in its shares of S common stock disposed of. Assuming that P 
can establish this fact, pursuant to paragraph (b)(3)(i) of this 
section, the reallocable basis amount would be $7.50. In that case, 
P's basis in the 25 shares of S common stock sold would be reduced 
from $87.50 to $80 pursuant to paragraph (b)(3)(ii) of this section. 
Accordingly, P would recognize a loss of $67.50 on the sale of the 
25 shares of S common stock for $12.50. In addition, the basis of 
each remaining share of S common stock would be increased in an 
aggregate amount of $7.50 in a manner that, to the greatest extent 
possible, causes the ratio of the basis to the value of each such 
other share to be equal. In this case, the basis of each of the 75 
shares of S common stock retained would be increased by $0.10 to 
$0.60.
    Example 3. (i) In Year 1, P forms S by contributing Asset A with 
a basis of $90 and

[[Page 65070]]

a value of $10 in exchange for one share of S common stock (CS1) in 
a transfer to which section 351 applies. In Years 2 and 3, in 
successive but unrelated transfers to which section 351 applies, P 
transfers $10 to S in exchange for one share of S common stock 
(CS2), Asset B with a basis of $2 and a value of $10 in exchange for 
one share of S common stock (CS3), and Asset C with a basis of $100 
and a value of $10 in exchange for one share of S common stock 
(CS4). In Year 4, S sells Asset A, recognizing $80 of loss that is 
used to offset income of P recognized during Year 4. As a result of 
the sale of Asset C, the basis of each of P's four shares of S 
common stock is reduced by $20. Therefore, the basis of CS1 is $70. 
CS2 has an excess loss account of $10. CS3 has an excess loss 
account of $18. CS4 has a basis of $80. In Year 5 in a transaction 
that is not part of a plan that includes the Year 1 contribution, P 
sells CS1 for $10. Immediately after the sale of CS1, S is not a 
member of the P group.
    (ii) Under paragraph (b)(1) of this section, because P's basis 
in CS1 exceeds its value immediately prior to the sale and S is not 
a member of the P group immediately after the disposition, P's basis 
in its shares of S common stock is redetermined pursuant to 
paragraph (b)(3) of this section. Pursuant to paragraph (b)(3)(i) of 
this section, the reallocable basis amount is $60 (the lesser of the 
amount by which P's basis in the S common stock sold exceeds the 
value of such stock immediately prior to the sale ($60) and the 
aggregate amount of S's items of deduction and loss that were 
previously taken into account in the computation of the adjustment 
to the basis of the S common stock other than the stock disposed of, 
under Sec.  1.1502-32, during the time that S was a member of the P 
group ($60)). Pursuant to paragraph (b)(3)(ii) of this section, P's 
basis in CS1 is reduced from $70 to $10. On the sale of CS1, 
therefore, P recognizes $0 gain/loss. Then, P's basis in the 
remaining S common stock is increased in an aggregate amount of $60 
in a manner that, to the greatest extent possible, causes the ratio 
of the basis to the value of each such share to be same. In this 
case, $20 of the reallocable basis amount is allocated to CS2 and 
$28 of the reallocable basis amount is allocated to CS3 so as to 
increase the basis of such shares to $10, the basis of CS1. The 
remaining $12 of the reallocable basis amount is allocated equally 
to CS2 and CS3 so as to increase the basis of each such share from 
$10 to $16.
    Example 4.  (i) In Year 1, P forms S with a contribution of $80 
in exchange for 80 shares of the common stock of S, which at that 
time represents all of the outstanding stock of S. S becomes a 
member of the P group. In Year 2, P contributes Asset A with a basis 
of $50 and a value of $20 in exchange for 20 shares of the common 
stock of S in a transfer to which section 351 applies. In Year 3, in 
a transaction that is not part of the plan that includes the Year 2 
contribution, P sells the 20 shares of the common stock of S that it 
acquired in Year 2 for $20. At that time, S has $80 and Asset A, the 
basis and value of which have not changed. In Year 4, S sells Asset 
A for $20, recognizing a $30 loss. That $30 loss is used on the P 
group return to offset income of P. In Year 5, P sells its remaining 
S common stock for $80.
    (ii) Under paragraph (b)(1) of this section, because P's basis 
in the common stock sold exceeds its value immediately prior to the 
sale and S is a member of the P group immediately after the sale, 
P's basis in all of the stock of S is redetermined pursuant to 
paragraph (b)(2) of this section. Of P's total basis of $130 in the 
S common stock, a proportionate amount is allocated to each of the 
100 shares of S common stock. Accordingly, $26 is allocated to the 
common stock of S that is sold and $104 is allocated to the common 
stock of S that is retained. On P's sale of the 20 shares of the 
common stock of S for $20, P recognizes a loss of $6. Because the 
sale of the 20 shares of common stock of S does not result in the 
deconsolidation of S, under paragraph (c)(1) of this section, that 
loss is suspended to the extent of the duplicated loss with respect 
to the shares sold. The duplicated loss with respect to the shares 
sold is $6. Therefore, the entire $6 loss is suspended. Pursuant to 
paragraph (c)(4) of this section, the amount of the suspended loss 
is reduced, but not below zero, by S's items of deduction and loss 
that are allocable to the period beginning on the date of the Year 2 
disposition of the S stock and ending on the day before the first 
date on which S is not a member of the P group and that are taken 
into account in determining consolidated taxable income (or loss) of 
the P group for any taxable year that includes any date on or after 
the date of the Year 2 disposition and before the first date on 
which S is not a member of the P group, except to the extent the P 
group can establish that all or a portion of such items was not 
included in the calculation of the duplicated loss with respect to 
the shares of S sold on the date of the Year 2 disposition. Because 
the loss recognized on the sale of Asset A was included in the 
calculation of the duplicated loss with respect to the S common 
stock sold on the date of the sale and is absorbed by the P group, 
the suspended loss is reduced to zero pursuant to paragraph (c)(4) 
of this section. Accordingly, no amount of suspended loss is allowed 
under paragraph (c)(5) of this section. Under Sec.  1.1502-32, P's 
basis in its S stock is reduced by $24. Accordingly, such basis is 
reduced from $104 to $80. P recognizes $0 gain/loss on the Year 5 
sale of its remaining S common stock.
    Example 5. (i) The facts are the same as in Example 4, except 
that instead of selling Asset A for $20, S sells Asset A for $45, 
recognizing a $5 loss. In addition in Year 5, P sells its remaining 
S common stock for $100.
    (ii) As in Example 4, P recognizes a loss of $6 on the sale of 
the 20 shares of the common stock of S and that loss is suspended 
under paragraph (c)(1) of this section. Pursuant to paragraph (c)(4) 
of this section, assuming the P group cannot establish that only a 
portion of the loss recognized on the sale Asset A was reflected in 
the computation of the duplicated loss with respect to the 20 shares 
of S common stock sold, the amount of the suspended loss is reduced 
by the $5 loss recognized on the sale of Asset A to $1. Under Sec.  
1.1502-32, P's basis in its S stock is reduced by $4 from $104 to 
$100. In Year 5, when P sells its remaining S common stock for $100, 
it recognizes $0 gain/loss. Pursuant to paragraph (c)(5) of this 
section, the remaining $1 of the suspended loss is allowed on the P 
group's return for Year 5.
    Example 6. (i) The facts are the same as in Example 4, except 
that S does not sell Asset A prior to the sale of its remaining S 
common stock.
    (ii) As in Example 4, P recognizes a loss of $6 on the sale of 
the 20 shares of the common stock of S and that loss is suspended 
under paragraph (c)(1) of this section. In Year 5 when P sells its 
remaining S common stock for $80, it recognizes a loss of $24. 
Pursuant to paragraph (c)(5) of this section, for the year that 
includes the date of the deconsolidation of S, the suspended loss 
attributable to its Year 2 sale of S common stock is allowed to the 
extent it has not been reduced pursuant to paragraph (c)(4) of this 
section. Because S had no items of loss and deduction that are 
allocable to the period beginning on the date of the Year 2 
disposition of the S stock and ending on the day before the first 
date on which S is not a member of the of the P group, the suspended 
loss is not reduced pursuant to paragraph (c)(4) of this section. 
Accordingly, pursuant to paragraph (c)(5) of this section, the 
entire $6 suspended loss is allowed on the P group's return for Year 
5.
    Example 7. (i) In Year 1, P forms S1 with a contribution of $200 
in exchange for all of the common stock of S1, which represents all 
of the outstanding stock of S1. In the same year, S1 forms S2 with a 
contribution of $80 in exchange for 80 shares of the common stock of 
S2, which at that time represents all of the outstanding stock of 
S2. S1 and S2 become members of the P group. In the same year, S2 
purchases Asset A for $80. In Year 2, S1 contributes Asset B with a 
basis of $50 and a value of $20 in exchange for 20 shares of the 
common stock of S2 in a transfer to which section 351 applies. In 
Year 3, S1 sells the 20 shares of the common stock of S2 that it 
acquired in Year 2 for $20. At that time, the bases and values of 
Asset A and Asset B are unchanged. In Year 4, S2 sells Asset A for 
$50, recognizing a $30 loss. That $30 loss is used on the P group 
return to offset income of P. In Year 5, S1 sells its remaining S2 
common stock for $56.
    (ii) Under paragraph (b)(1) of this section, because S1's basis 
in the S2 common stock sold exceeds its value immediately prior to 
the sale and S2 is a member of the P group immediately after the 
sale, S1's basis in all of the stock of S2 is redetermined pursuant 
to paragraph (b)(2) of this section. Of S1's total basis of $130 in 
the S2 common stock, a proportionate amount is allocated to each of 
the 100 shares of S2 common stock. Accordingly, a total of $26 is 
allocated to the common stock of S2 that is sold and $104 is 
allocated to the common stock of S2 that is retained. On S1's sale 
of the 20 shares of the common stock of S2 for $20, S1 recognizes a 
loss of $6. Because the sale of the 20 shares of common stock of S2 
does not result in the deconsolidation of S2, under paragraph (c)(1) 
of this section, that loss is suspended to the extent of the 
duplicated loss with respect to

[[Page 65071]]

the shares sold. The duplicated loss with respect to the shares sold 
is $6. Therefore, the entire $6 loss is suspended. Pursuant to 
paragraph (c)(3) of this section and Sec.  1.1502-32(b)(3)(iii)(C), 
the suspended loss is treated as a noncapital, nondeductible expense 
incurred by S1 during the tax year that includes the date of the 
disposition of stock to which paragraph (c)(1) of this section 
applies. Accordingly, P's basis in its S1 stock is reduced from $200 
to $194. Pursuant to paragraph (c)(4) of this section, the amount of 
the suspended loss is reduced, but not below zero, by S2's items of 
deduction and loss that are allocable to the period beginning on the 
date of the Year 3 disposition of the S2 stock and ending on the day 
before the first date on which S2 is not a member of the P group, 
and that are taken into account in determining consolidated taxable 
income (or loss) of the P group for any taxable year that includes 
any date on or after the date of the Year 3 disposition and before 
the first date on which S2 is not a member of the P group, except to 
the extent the P group can establish that all or a portion of such 
items was not included in the calculation of the duplicated loss 
with respect to the S2 stock sold on the date of the disposition. 
Assuming the P group can establish that the $30 loss generated by S2 
on the sale of Asset A was not included in the calculation of the 
duplicated loss with respect to the S2 stock sold on the date of the 
disposition, such loss does not reduce the suspended loss. In that 
case, for the taxable year that includes the day before the first 
date in Year 5 on which S is not a member of the P group, the P 
group is allowed to take into account the $6 suspended loss. On the 
other hand, if the P group cannot establish that the $30 loss 
generated by S2 on the sale of Asset A was not included in the 
calculation of the duplicated loss with respect to the S2 stock sold 
on the date of the disposition, pursuant to paragraph (c)(4) of this 
section, such loss reduces the suspended loss to zero, and no amount 
of suspended loss is allowed under paragraph (c)(5) of this section. 
In either case, under Sec.  1.1502-32, S1's basis in its remaining 
S2 stock is reduced by $24 from $80 to $56. S1 recognizes $0 gain/
loss on the sale of its remaining S2 stock.
    Example 8. (i) In Year 1, P forms S1 with a contribution of 
Asset A with a basis of $50 and a value of $20 in exchange for 100 
shares of common stock of S1 in a transfer to which section 351 
applies. Also in Year 1, P and S1 form S2. P contributes $80 to S2 
in exchange for 80 shares of common stock of S2. S1 contributes 
Asset A to S2 in exchange for 20 shares of common stock of S2 in a 
transfer to which section 351 applies. In Year 3, in a transaction 
that is not part of a plan that includes the Year 1 contributions, P 
sells its 100 shares of S1 common stock for $20. At that time, S1 
owns 20 shares of common stock of S2 and S2 has $80 and Asset A, the 
basis and value of which have not changed. In Year 4, S2 sells Asset 
A for $20, recognizing a $30 loss. That $30 loss is used on the P 
group return to offset income of P. In Year 5, P sells its S2 common 
stock for $80.
    (ii) Because the P group disposes of its entire equity interest 
in S1 within a single taxable year, pursuant to paragraph (b)(4) of 
this section, paragraph (b) of this section does not apply 
immediately prior to the disposition to cause a redetermination of 
P's basis in its S1 common stock. Pursuant to paragraph (b)(5) of 
this section, however, because, immediately prior to the disposition 
of the S1 stock, P's basis in such stock exceeds its value, S1 owns 
stock of S2 (another subsidiary member of the same group) and, 
immediately prior to the disposition of the S1 stock, such S2 stock 
has a basis that exceeds its value, and, immediately after the 
disposition of the S1 stock, P owns stock of S2, the basis in each 
share of S2 that is owned by members of the P group must be 
redetermined as provided in paragraph (b) of this section as if S1's 
S2 stock had been disposed of or deconsolidated. Because S2 is a 
member of the group immediately after the disposition of the S1 
stock, the group member's basis in the S2 stock is redetermined 
pursuant to paragraph (b)(2) of this section immediately prior to 
the sale of the S1 stock. Of the group members' total basis of $130 
in the S2 stock, $26 is allocated to S1's 20 shares of S2 common 
stock and $104 is allocated to P's 80 shares of S2 common stock. 
Pursuant to paragraph (b)(6) of this section, the redetermination of 
S1's basis in the stock of S2 results in an adjustment to P's basis 
in the stock of S1. In particular, P's basis in the stock of S1 is 
decreased by $24 to $26. On P's sale of its 100 shares of S1 common 
stock for $20, S1 recognizes a loss of $6. Because S1 is not a 
member of the P group immediately after S1's disposition of the S2 
stock, paragraph (c)(1) of this section does not apply to suspend 
such loss. Pursuant to paragraph (c)(2) of this section, however, 
because P recognizes a loss with respect to the disposition of the 
S1 stock and S1 owns stock of S2 (which is a member of the P group 
immediately after the disposition), such loss is suspended up to $6, 
an amount equal to the amount by which the duplicated loss with 
respect to the stock of S1 sold is attributable to S2's adjusted 
basis in its assets, loss carryforwards and deferred deductions. 
Pursuant to paragraph (c)(4) of this section, the amount of the 
suspended loss is reduced, but not below zero, by S2's items of 
deduction and loss that are allocable to the period beginning on the 
date of the Year 3 disposition of the S1 stock and ending on the day 
before the first date on which S2 is not a member of the P group and 
that are taken into account in determining the consolidated taxable 
income (or loss) of the P group for any taxable year that includes 
any date on or after the date of the Year 3 disposition and before 
the first date on which S2 is not a member of the P group, except to 
the extent the P group can establish all or a portion of such items 
were not included in the calculation of the duplicated loss with 
respect to the S1 stock sold or were not attributable to S2's 
adjusted basis in its assets, loss carryforwards, or deferred 
deductions. Because the loss recognized on the sale of Asset A was 
included in the calculation of the duplicated loss with respect to 
the S1 stock on the date of the sale of the S1 stock and is absorbed 
by the P group, the suspended loss is reduced to zero pursuant to 
paragraph (c)(4) of this section. Accordingly, no amount of 
suspended loss is allowed under paragraph (c)(5) of this section. 
Under Sec.  1.1502-32, P's basis in its S2 stock is reduced by $24 
from $104 to $80. P recognizes $0 gain/loss on the sale of its S2 
common stock.
    Example 9. (i) In Year 1, P forms S with a contribution of $80 
in exchange for 80 shares of common stock of S which at that time 
represents all of the outstanding stock of S. S becomes a member of 
the P group. In Year 2, P contributes Asset A with a basis of $50 
and a value of $20 in exchange for 20 shares of common stock of S in 
a transfer to which section 351 applies. In Year 3, in a transaction 
that is not part of a plan that includes the Year 1 and Year 2 
contributions, P contributes the 20 shares of S common stock it 
acquired in Year 2 to PS, a partnership, in exchange for a 20 
percent capital and profits interest in a transaction described in 
section 721. In Year 4, P sells its interest in PS for $20, 
recognizing a $30 loss.
    (ii) Under paragraph (b)(1) of this section, because P's basis 
in the S common stock contributed to PS exceeds its value 
immediately prior to its deconsolidation and S is a member of the P 
group immediately after the deconsolidation, P's basis in all of the 
S stock is redetermined pursuant to paragraph (b)(2) of this 
section. Of P's total basis of $130 in the common stock of S, a 
proportionate amount is allocated to each share of S common stock. 
Accordingly, $26 is allocated to the S common stock that is 
contributed to PS and, under section 722, P's basis in its interest 
in PS is $26. P recognizes a $6 loss on its disposition of its 
interest in PS. Because P's basis in its interest in PS was 
determined by reference to the basis of S stock and at the time of 
the determination of P's basis in its interest in PS such S stock 
had a duplicated loss of $6, and, immediately after the disposition, 
S is a member of the P group, such loss is suspended to the extent 
of such duplicated loss. Principles similar to those of paragraphs 
(c)(3), (4), and (5) of this section shall apply to such suspended 
loss.

    (f) Basis reduction on worthlessness and certain dispositions not 
followed by separate return years. If a member of a group disposes of 
subsidiary member stock and on the following day the subsidiary is not 
a member of the group and does not have a separate return year, then, 
immediately prior to the recognition of any gain or loss with respect 
thereto, and immediately after all other adjustments under Sec.  
1.1502-32 with respect thereto, the basis of upper-tier members in the 
stock of the subsidiary member shall be reduced to the extent of the 
consolidated net operating losses and net capital losses that would be 
treated as attributable to such subsidiary member (and lower-tier 
members) under the principles of Sec.  1.1502-21(b)(2)(iv), as though 
such losses were absorbed by the group. In addition, if, taking into 
account the provisions of Sec.  1.1502-80(c), stock of a

[[Page 65072]]

subsidiary member is treated as worthless under section 165, then, 
immediately prior to the allowance of any loss or inclusion of an 
excess loss account with respect thereto, and immediately after all 
other adjustments under Sec.  1.1502-32 with respect thereto, the basis 
of upper-tier members in the stock of the worthless member shall be 
reduced to the extent of the consolidated net operating losses and net 
capital losses that would be treated as attributable to such subsidiary 
member (and lower-tier members) under the principles of Sec.  1.1502-
21(b)(2)(iv), as though such losses were absorbed by the group.
    (g) Anti-avoidance rules. (1) Disposition or deconsolidation of 
gain share in avoidance. If a share of subsidiary member stock has a 
basis that does not exceed its value and the share is deconsolidated 
with a view to avoiding application of the rules of paragraph (b) of 
this section prior to the disposition of a share of subsidiary member 
stock that has a basis that does exceed its value, the rules of 
paragraph (b) of this section shall apply immediately prior to the 
deconsolidation.
    (2) Transfers of loss property in avoidance. If a member of a 
consolidated group contributes an asset with a basis that exceeds its 
value to a partnership in a transaction described in section 721 or a 
corporation that is not a member of such group in a transfer described 
in section 351, such partnership or corporation contributes such asset 
to a subsidiary member in a transfer described in section 351, and such 
contributions are undertaken with a view to avoiding the rules of 
paragraph (b) or (c) of this section, adjustments must be made to carry 
out the purposes of this section.
    (3) Anti-loss reimportation--(i) Application. This paragraph (g)(3) 
applies if--
    (A) A member of a group recognizes and is allowed a loss on the 
disposition of a share of stock of a subsidiary member with respect to 
which there is a duplicated loss;
    (B) As a result of that disposition or another disposition, the 
subsidiary member ceases to be a member of such group; and
    (C) Within the 10-year period beginning on the date the subsidiary 
member ceases to be a member of such group--
    (1) The subsidiary member (or any successor) again becomes a member 
of such group (or any successor group) when the subsidiary member (or 
any successor) owns any asset that has a basis in excess of value at 
such time and that was owned by the subsidiary member on the date of 
the disposition and that had a basis in excess of value on such date;
    (2) The subsidiary member (or any successor) again becomes a member 
of such group (or any successor group) when the subsidiary member (or 
any successor) owns any asset that has a basis in excess of value at 
such time and that has a basis that reflects, directly or indirectly, 
in whole or in part, the basis of any asset that was owned by the 
subsidiary member on the date of the disposition and that had a basis 
in excess of value on such date;
    (3) In a transaction described in section 381 or section 351, any 
member of such group (or any successor group) acquires any asset of the 
subsidiary member (or any successor) that was owned by the subsidiary 
member on the date of the disposition and that had a basis in excess of 
its value on such date, or any asset that has a basis that reflects, 
directly or indirectly, in whole or in part, the basis of any asset 
that was owned by the subsidiary member on the date of the disposition 
and that had a basis in excess of its value on such date, and, 
immediately after the acquisition of such asset, such asset has a basis 
in excess of its value;
    (4) The subsidiary member (or any successor) again becomes a member 
of such group (or any successor group) when the subsidiary member (or 
any successor) has any losses or deferred deductions that were losses 
or deferred deductions of the subsidiary member on the date of the 
disposition;
    (5) The subsidiary member (or any successor) again becomes a member 
of such group (or any successor group) when the subsidiary member (or 
any successor) has any losses or deferred deductions that are 
attributable to any asset that was owned by the subsidiary member on 
the date of the disposition and that had a basis in excess of value on 
such date;
    (6) The subsidiary member (or any successor) again becomes a member 
of such group (or any successor group) when the subsidiary member (or 
any successor) has any losses or deferred deductions that are 
attributable to any asset that had a basis that reflected, directly or 
indirectly, in whole or in part, the basis of any asset that was owned 
by the subsidiary member on the date of the disposition and that had a 
basis in excess of value on such date; or
    (7) Any member of such group (or any successor group) succeeds to 
any losses or deferred deductions of the subsidiary member (or any 
successor) that were losses or deferred deductions of the subsidiary 
member on the date of the disposition, that are attributable to any 
asset that was owned by the subsidiary member on the date of the 
disposition and that had a basis in excess of value on such date, or 
that are attributable to any asset that had a basis that reflected, 
directly or indirectly, in whole or in part, the basis of any asset 
that was owned by the subsidiary member on the date of the disposition 
and that had a basis in excess of value on such date.
    (ii) Operating rules--(A) For purposes of paragraph (g)(3)(i)(C) of 
this section, assets shall include stock and securities and the 
subsidiary member (or any successor) shall be treated as having its 
allocable share of losses and deferred deductions of all lower-tier 
subsidiary members and as owning its allocable share of each asset of 
all lower-tier subsidiary members.
    (B) For purposes of paragraphs (g)(3)(i)(C)(4), (5), and (6) of 
this section, unless the group can establish otherwise, if the 
subsidiary member (or any successor) again becomes a member of such 
group (or any successor group) at a time when the subsidiary member (or 
any successor) has any losses or deferred deductions, such losses and 
deferred deductions shall be treated as losses or deferred deductions 
that were losses or deferred deductions of the subsidiary member on the 
date of the disposition, losses or deferred deductions that are 
attributable to assets that were owned by the subsidiary member on the 
date of the disposition and that had bases in excess of value on such 
date, or losses or deferred deductions that are attributable to assets 
that had bases that reflected, directly or indirectly, in whole or in 
part, the bases of assets that were owned by the subsidiary member on 
the date of the disposition and that had bases in excess of value on 
such date.
    (C) For purposes of paragraph (g)(3)(i)(C)(7) of this section, 
unless the group can establish otherwise, if a member of such group (or 
any successor group) succeeds to any losses or deferred deductions of 
the subsidiary member (or any successor), such losses and deferred 
deductions shall be treated as losses or deferred deductions that were 
losses or deferred deductions of the subsidiary member on the date of 
the disposition, losses or deferred deductions that are attributable to 
assets that were owned by the subsidiary member on the date of the 
disposition and that had bases in excess of value on such date, or 
losses or deferred deductions that are attributable to assets that had 
bases that reflected, directly or indirectly, in whole or in part, the 
bases of assets that were owned by the subsidiary member on the date of 
the

[[Page 65073]]

disposition and that had bases in excess of value on such date.
    (iii) Loss disallowance. If paragraph (g)(3) of this section 
applies, then, to the extent that the aggregate amount of loss 
recognized by members of the group (and any successor group) on 
dispositions of the subsidiary member stock was attributable to a 
duplicated loss of such subsidiary member, and such loss was allowed, 
such group (or any successor group) will be denied the use of--
    (A) Any loss recognized that is attributable to, directly or 
indirectly, an asset that was owned by the subsidiary member on the 
date of the disposition and that had a basis in excess of value on such 
date, to the extent of the lesser of the loss inherent in such asset on 
the date of the disposition of the subsidiary member stock and the loss 
inherent in such asset on the date of the event described in paragraph 
(g)(3)(i)(C) of this section that gives rise to the application of this 
paragraph (g)(3); and
    (B) Any loss recognized that is attributable to, directly or 
indirectly, an asset that has a basis that reflects, directly or 
indirectly, in whole or in part, the basis of any asset that was owned 
by the subsidiary on the date of the disposition and that had a basis 
in excess of its value on such date, to the extent of the lesser of the 
loss inherent in the asset that was owned by the subsidiary on the date 
of the disposition the basis of which is reflected, directly or 
indirectly, in whole or in part, in the basis of such asset on the date 
of the disposition and the loss inherent in such asset on the date of 
the event described in paragraph (g)(3)(i)(C) of this section that 
gives rise to the application of this paragraph (g)(3); and
    (C) Any loss or deferred deduction described in paragraph 
(g)(3)(i)(C)(4), (5), (6), or (7) of this section.
    (iv) Treatment of disallowed loss. For purposes of Sec.  1.1502-
32(b)(3)(iii), any loss the use of which is disallowed pursuant to 
paragraph (g)(3)(iii)(A) or (B) of this section is treated as a 
noncapital, nondeductible expense incurred during the taxable year that 
includes the date on which such loss is recognized. See Sec.  1.1502-
32(b)(3)(iii)(D). In addition, any loss or deferred deduction the use 
of which is disallowed pursuant to paragraph (g)(3)(iii)(C) of this 
section and with respect to which no waiver described in Sec.  1.1502-
32(b)(4) is filed is treated as a noncapital, nondeductible expense 
incurred during the taxable year that includes the day after the event 
described in paragraph (g)(3)(iii) of this section that gives rise to 
the application of this paragraph (g)(3).
    (4) Examples. The principles of this paragraph (g) are illustrated 
by the following examples.

    Example 1. (i) In Year 1, P forms S with a contribution of $80 
in exchange for 80 shares of common stock of S which at that time 
represents all of the outstanding stock of S. S becomes a member of 
the P group. In Year 2, P contributes Asset A with a basis of $50 
and a value of $20 in exchange for 20 shares of preferred stock of S 
in a transfer to which section 351 applies. In Year 3, S sells Asset 
A for $20, recognizing a loss of $30. Under Sec.  1.1502-32, P's 
basis in its common stock of S is reduced from $80 to $50. With a 
view to avoiding the application of the basis redetermination rule 
prior to a sale of the S preferred stock, in Year 4, P contributes 
the 80 shares of S common stock it acquired in Year 1 to PS, a 
partnership, in exchange for a 20 percent capital and profits 
interest in a transaction described in section 721. Also in Year 4, 
P sells its preferred stock of S for $20, recognizing a $30 loss.
    (ii) Under paragraph (g)(1) of this section, the rules of 
paragraph (b) of this section shall apply immediately prior to the 
deconsolidation of the S common stock.
    Example 2. (i) In Year 1, P forms S with a contribution of $100 
in exchange for 100 shares of common stock of S which at that time 
represents all of the outstanding stock of S. S becomes a member of 
the P group. In Year 2, P contributes 20 shares of common stock of S 
to PS, a partnership, in exchange for a 20 percent capital and 
profits interest in a transaction described in section 721. In Year 
3, P contributes Asset A with a basis of $50 and a value of $20 to 
PS in exchange for an additional capital and profits interest in PS 
in a transaction described in section 721. Also in Year 3, PS 
contributes Asset A to S and P contributes an additional $80 to S in 
transfers to which section 351 applies. In Year 4, S sells Asset A 
for $20, recognizing a loss of $30. The P group uses that loss to 
offset income of P. Also in Year 4, P sells its entire interest in 
PS for $40, recognizing a loss of $30.
    (ii) Pursuant to paragraph (g)(2) of this section, if P's 
contributions of S stock and Asset A to PS were undertaken with a 
view to avoiding the basis redetermination or the loss suspension 
rule, adjustments must be made such that the group does not obtain 
more than one tax benefit from the $30 loss inherent in Asset A.
    Example 3. (i) In Year 1, P forms S with a contribution of Asset 
A with a value of $100 and a basis of $120, Asset B with a value of 
$50 and a basis of $70, Asset C with a value of $90 and a basis of 
$100 in exchange for all of the common stock of S and S becomes a 
member of the P group. In Year 2, in a transaction that is not part 
of a plan that includes the contribution, P sells the stock of S for 
$240, recognizing a loss of $50. At such time, the bases and values 
of Assets A, B, and C have not changed since their contribution to 
S. In Year 3, S sells Asset A, recognizing a $20 loss. In Year 3, S 
merges into M in a reorganization described in section 368(a)(1)(A). 
In Year 4, P purchases all of the stock of M for $300. At that time, 
M has a $10 net operating loss. In addition, M owns Asset D, which 
was acquired in an exchange described in section 1031 in connection 
with the surrender of Asset B. Asset C has a value of $80 and a 
basis of $100. Asset D has a value of $60 and a basis of $70. In 
Year 5, P has operating income of $100 and M recognizes $20 of loss 
on the sale of Asset C. In Year 6, P has operating income of $50 and 
M recognizes $50 of loss on the sale of Asset D.
    (ii) P's $50 loss on the sale of S stock is entirely 
attributable to duplicated loss. Therefore, pursuant to this 
paragraph (g)(3), assuming the P group cannot establish otherwise, 
M's $10 net operating loss is treated as attributable to assets that 
were owned by S on the date of the disposition and that had bases in 
excess of value on such date. Without regard to any other 
limitations on the group's use of M's net operating loss, the P 
group cannot use M's $10 net operating loss pursuant to paragraph 
(g)(3)(iii)(C) of this section. Pursuant to paragraph (g)(3)(iv) of 
this section and Sec.  1.1502-32(b)(3)(iii)(D), such loss is treated 
as a noncapital, nondeductible expense of M incurred during the 
taxable year that includes the day after the reorganization. In 
addition, the P group is denied the use of $10 of the loss 
recognized on the sale of Asset C. Finally, the P group is denied 
the use of $10 of the loss recognized on the sale of Asset D. 
Pursuant to paragraph (g)(3)(iv) of this section and Sec.  1.1502-
32(b)(3)(iii)(D), each such disallowed loss is treated as a 
noncapital, nondeductible expense of M incurred during the taxable 
year that includes the date of the disposition of the asset with 
respect to which such loss was recognized.

    (h) Application of anti-abuse rules. The rules of this section do 
not preclude the application of anti-abuse rules under other provisions 
of the Internal Revenue Code and regulations thereunder, including to a 
transaction that is entered into to invoke the basis redetermination 
rule to avoid the effect of any provision of the Internal Revenue Code 
or regulations thereunder.
    (i) [Reserved].
    (j) Effective date. This section, except for paragraph (g)(3) of 
this section, applies with respect to dispositions and deconsolidations 
occurring on or after March 7, 2002, but only if such transactions 
occur during a taxable year the original return for which is due 
(without regard to extensions) after the date these regulations are 
published as temporary or final regulations in the Federal Register. 
Paragraph (g)(3) of this section applies to events described in 
paragraph (g)(3)(iii) of this section occurring on or after October 18, 
2002, but only if such events occur during a taxable year the original 
return for which is due (without regard to extensions) after the date 
these regulations are published as temporary

[[Page 65074]]

or final regulations in the Federal Register.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 02-26835 Filed 10-18-02; 8:45 am]
BILLING CODE 4830-01-P