Consolidated Attribute Reduction Regulations

In early 2005, the Treasury Department issued final regulations that employ a hybrid single member, group-wide entity approach to reduce consolidated group members' tax attributes when a member excludes cancellation of debt income ("COD") under the bankruptcy or insolvency exceptions to COD (together with the prior temporary regulations, the "Consolidated 108 Regulations").1 This outline briefly summarizes the general section 108 cancellation of debt rules and the application of these rules to consolidated groups prior to the new regulations, and analyzes the new consolidated attribute reduction regulations. The regulations generally do not apply to transactions on or before August 29, 2003, although the IRS is maintaining its pre-regulation litigating position of group-wide consolidated attribute reduction with respect to those transactions.2

I. SECTION 108 CANCELLATION OF DEBT RULES

1. General Rule. Generally, COD is included in a taxpayer's gross income.3 However, a taxpayer does not recognize COD if it is in bankruptcy or to the extent it is insolvent.4 COD is recognized only to the extent it exceeds a debtor's insolvency,5 although a debtor in a Title 11 proceeding generally will not recognize any COD.6

2. Exclusion of COD. A taxpayer that excludes COD from gross income because of its insolvency or bankruptcy must reduce its tax attributes after the determination of its tax for the year of cancellation or, in the case of tax basis, as of the beginning of its next taxable year.7 A taxpayer may elect to reduce the basis of its depreciable property prior to the reduction of other tax attributes (a "depreciable property election").8

   Subject to the depreciable property election, a taxpayer must reduce its tax attributes in the following order:

   net operating losses ("NOLs") created in the taxable year of discharge, and then NOL carryovers in the order in which they arose;9 general business credits, in the order they would be used against taxable income;10 alternative minimum tax credits; capital loss carryovers, first from the year of discharge and then in the order created;11 basis of both depreciable and nondepreciable assets (in the order provided in regulations), but in general such aggregate basis is not required to be reduced below the aggregate amount of the debtor's liabilities outstanding immediately after the discharge;12 carryovers of passive activity loss deductions and credits that have been suspended under the passive activity loss rules; and foreign tax credit carryovers to or from the taxable year of discharge.13 All credits are reduced $1 for every $3 of excluded COD.14

3. Prior Law Regarding Consolidated Group Attribute Reduction. Whether consolidated groups could isolate attribution reduction to the attributes of solely the debtor member that incurred the excluded COD had been a hotly debated issue for some time before the Consolidated 108 Regulations were issued. At one time, the IRS took the position that a debtor member's COD would reduce only those attributes attributable to that member,15 but eventually reversed its position and argued that a debtor member's COD would reduce the group's consolidated NOL ("CNOL"), even if no portion of the CNOL was attributable to the debtor member.16 The IRS viewed the Supreme Court's holding in United Dominion17 as support for its view that separate-entity attribute reduction did not apply,18 and still maintains that position.19 Bills introduced during 2003 in both the House and the Senate also mandated attribute reduction on a consolidated group basis,20 but were not pursued following the issuance of the Consolidated 108 Regulations.

   II. NEW CONSOLIDATED 108 REGULATIONS

1. Determination of Insolvency. The Consolidated 108 Regulations determine the insolvency of a debtor that realizes COD on a separate entity basis, taking into account only the assets and liabilities of the member whose debt is cancelled.21 Applying this rule to the question of whether an insolvent or bankrupt single member LLC (an "SMLLC") could exclude COD, an IRS official stated that an SMLLC would only be treated as bankrupt or insolvent if its member is also bankrupt or insolvent.22 The IRS's position notwithstanding, compelling arguments can be made that an SMLLC's bankruptcy is sufficient to qualify for exclusion.

2. Depreciable Property Election. Another separate entity rule retained by the Consolidated 108 Regulations provides that a consolidated group may elect to first reduce the basis of the depreciable property of the debtor member that realizes excluded COD (but not below zero) before applying the normal ordering rules for attribute reduction.23 By contrast, within the context of the normal ordering rules, the basis of a debtor member's depreciable and nondepreciable assets generally cannot be reduced below the aggregate amount of liabilities immediately after the debt cancellation.24 This limitation is applied by reference to the aggregate basis of property held by the member (reduced by any depreciable basis as to which a depreciable property election was made), rather than the aggregate basis of property held by all the group members, and by reference to the debtor member's liabilities, rather than the aggregate liabilities of all group members.25

3. Hybrid Approach to Consolidated Attribute Reduction: Ordering Rules. The Consolidated 108 Regulations provide a three-part rule for the reduction of tax attributes. Separate member attributes are reduced first, followed by the "push down" of any reduction in the stock basis of a subsidiary member to the tax attributes of the subsidiary member (under the so-called "lookthrough" rule, discussed in Section II.E. below). Finally, consolidated attributes of all members are reduced.

   The Consolidated 108 Regulations reduce all attributes of the debtor member before reducing any attributes of other group members.26 Notably, this approach differs from the pure consolidated approach adopted by the IRS prior to the regulations, based in part on the Supreme Court's single asset CNOL approach in United Dominion. Had the regulations adopted a pure consolidated approach, the entire CNOL would be reduced to zero before any other attributes of the debtor or any other member are reduced. Instead, the regulations preserve the location of tax items within a consolidated group to the greatest extent possible by reducing all tax attributes of, or attributed to, the debtor member first.

   Attributes of the debtor member include the debtor member's allocable portion of consolidated attributes and the debtor's own separate company attributes, e.g., any loss carryforwards of the debtor member arising in separate return limitation years ("SRLYs"), and the basis of the debtor member's property (including stock basis in subsidiaries).27 Under the look-through rule discussed below, any reduction in the stock basis of a subsidiary requires a corresponding reduction in the tax attributes of the subsidiary member.

   If the excluded COD exceeds the attributes of the debtor member, then consolidated attributes attributable to other group members are reduced.28 "Consolidated attributes" are not specifically defined in the regulations, but apparently include consolidated losses and credits of any type.29 In addition, they expressly include SRLY subgroup losses attributable to a subgroup of which the debtor is a member, and SRLY losses to which the section 382/SRLY "overlap" rule applies.30 Consolidated attributes do not include tax basis.31

   The regulations' approach limits the chance that a debtor member's tax attributes will survive.32 The preamble to the temporary regulations explains that this reduces the ability to "shift" the cost of the attribute reduction to other members, such that if and when the debtor member leaves the group, the debtor member will bear the cost of increased future tax liability, rather than the other members of the group. In effect, the regulations attempt to balance the principles of section 108 with the single entity principles of the consolidated return regulations.

4. Limited Asset Basis Reduction Rules. The regulations provide that a debtor member's excluded COD may only reduce asset basis of a debtor member (and, under the "look-through" rule or by reason of the depreciable property election, its direct and indirect subsidiaries). Asset basis of other consolidated group members may not be reduced. The general treatment of tax basis as a separate company attribute seems to us to be the correct result given the fact that the basis of assets held by such other members is not directly available to offset income of the debtor member, and in fact may never give rise to a tax attribute that could be directly available to offset a group member's income in a consolidated return year.33

5. "Look-Through" Basis Reduction Rule. A mandatory look-through rule applies to preserve the "single taxpayer" fiction of consolidated groups when a debtor member reduces its basis in subsidiary stock.34 This rule operates in a top-down fashion, such that the reduction of the stock basis of a subsidiary member cascades down from a top-tier debtor member through the attributes of its direct and indirect subsidiary debtors. More specifically, the look-through rule treats a subsidiary member as a "debtor" with an amount of excluded COD equal to the reduction in its stock basis, and thus requires the subsidiary member to reduce its tax attributes, i.e., both the consolidated attributes attributable to that subsidiary as well as that subsidiary's own attributes.35

   The final regulations provide that the look through rule applies if the subsidiary whose stock basis is reduced is either (i) a member of the debtor's consolidated group on the last day of the debtor's taxable year of discharge or (ii) the first day of the debtor's next taxable year.36

   All of the subsidiary's separate attributes are available for reduction, including its SRLY attributes and...