Daily Tax Update - March 21, 2005

THE DAILY TAX UPDATE WILL BE PUBLISHED ON A PERIODIC BASIS UNTIL CONGRESS RETURNS FROM ITS RECESS ON APRIL 4TH.

IRS ISSUES FINAL CONSOLIDATED ATTRIBUTE REDUCTION REGULATIONS:
The Service today issued final regulations governing the application of section 108 when a member of a consolidated group realizes discharge of indebtedness income. The final regulations address the required attribute reduction under section 108(b) that applies upon the exclusion from income of discharged indebtedness under section 108(a).

Background. On September 4, 2003, the Service issued temporary and proposed regulations relating to the application of section 108 to members of a consolidated group (the "September 4 regulations"). In general, the September 4 regulations concluded that consolidated affiliates must reduce consolidated tax attributes but, except in special circumstances, need not reduce other tax attributes, such as tax basis. The September 4 regulations apply to discharges of indebtedness that occurred after August 29, 2003.

On December 11, 2003, the Service issued a second set of temporary and proposed regulations to clarify that certain attributes that arise (or are treated as arising) in a separate return year are subject to reduction when no SRLY limitation applies to the use of such attributes (the "December 11 regulations"). The December 11 regulations apply to discharges of indebtedness that occur after August 29, 2003 if the discharge occurs during a taxable year the original return for which is due (without regard to extensions) after December 10, 2003.

On March 15, 2004, the Service issued a third set of temporary and proposed regulations to address certain issues under section 1245 and the matching rule of Treas. Reg. § 1.1502-13, and the inclusion of excess loss accounts in cases in which excluded discharge of indebtedness income is not fully applied to reduce attributes (the "March 15 regulations"). In addition, the Service issued as proposed (but not temporary) regulations certain rules addressing the computation of gain or loss on the disposition of member stock and the computation of the portion of an excess loss account that must be taken into account when excluded discharge of indebtedness income is not fully applied to reduce attributes.

The Final Regulations. The final regulations adopt the proposed and temporary regulations discussed above, with certain modifications. The modifications addressed by the final regulations include the following:

  • Apportionment of Net Operating Losses. The final regulations clarify the timing of the recomputation of the percentage of a consolidated net operating loss attributable to a member in cases in which a portion of a consolidated net operating loss is carried back to a separate return year or a portion is reduced in respect of excluded discharge of indebtedness income.
  • Timing of Asset Basis Reduction. The final regulations clarify that basis of property is subject to reduction pursuant to the rules of sections 108 and 1017 and Treas. Reg. § 1.1502-28 after the determination of tax for the year during which the member realizes excluded discharge of indebtedness income (and any prior years) and coincident with the reduction of other attributes pursuant to section 108 and Treas. Reg. § 1.1502-28. However, only the basis of property held as of the beginning of the taxable year following the taxable year during which the excluded discharge of indebtedness income is realized is available for reduction.
  • Application of the Look-Through Rule. The September 4 regulations included a look-through rule that applies if the attribute of the debtor member reduced is the basis of stock of another member of the group. In these cases, corresponding reductions must be made to the attributes attributable to the lower-tier member. Questions arose regarding whether the look-through rule applies when there is a reduction in the basis of stock of a corporation that is a member of the group on the last day of the debtor’s taxable year during which the excluded discharge of indebtedness income is realized, but is not a member of the group on the first day of the debtor’s following taxable year. The final regulations provide that, if the basis of stock of a corporation (the lower-tier member) that is owned by another corporation (the higher-tier member) is reduced and both of such corporations are members of the same consolidated group on either the last day of the higher-tier member’s taxable year that includes the date on which the excluded discharge of indebtedness income is realized or the first day of the higher-tier member’s taxable year that follows the taxable year that includes the date on which such excluded income is realized, the look-through rule will apply to reduce the attributes of the lower-tier member.
  • Intragroup Reorganizations and Group Structure Changes. Questions arose regarding the application of the attribute reduction rules when a consolidated group member realizes excluded discharge of indebtedness income during the same consolidated return year during which such member transfers assets in a section 381(a) transaction to another corporation that is a member of the group immediately after the transaction. The final regulations provide that if the taxable year of a member during which such member realizes excluded discharge of indebtedness income ends prior to the last day of the consolidated return year and, on the first day of such member’s next taxable year such member has a successor member (determined by reference to section 381(a)), the successor member is treated as if it had realized the excluded income. Accordingly, all attributes of the successor member listed in section 108(b)(2) (including attributes that were attributable to the successor member prior to the date such member became a successor member) are subject to reduction prior to the attributes attributable to other members of the group.
  • Application of the Next Day Rule. Questions arose whether the next day rule can be applied when the debt of a subsidiary is discharged in exchange for stock of the subsidiary and, as a result of the issuance of the subsidiary’s stock to the creditor, the subsidiary ceases to be a member of the group. As a result of the application of the "next day rule" of Treas. Reg. § 1.1502-76, the excluded discharge of indebtedness income would be treated as realized at the beginning of the day following the day the subsidiary ceases to be a member of the group, rather than on the day it ceases to be a member of the group. According to the preamble to the final regulations, the Service believes that, because the excluded income accrued in the group, it is not appropriate to apply the next day rule in these cases. Accordingly, the final regulations provide that the next day rule cannot be applied to treat excluded discharge of indebtedness income as realized at the beginning of the day following the day on which it is realized.
  • Timing of Investment Adjustments. Questions arose regarding when basis adjustments under Treas. Reg. § 1.1502-32 are effective in cases in which a subsidiary ceases to be a member of the group on or prior to the end of the consolidated return year during which a member realizes excluded discharge of indebtedness income. The final regulations clarify that, in those cases, basis adjustments resulting from the realization of excluded discharge of indebtedness income and from the reduction of attributes in respect thereof are made immediately after the determination of tax for the group for the consolidated return year during which the excluded income is realized (and any prior years) and are effective immediately before the beginning of the day following the day the member departs from the group. Thus, if the departing member becomes a member of another group, the adjustments to the basis of the departing member’s stock in respect of such excluded income will not cause stock basis adjustments in the new group.
  • Elimination of Circular Stock Basis on Disposition of Member Stock. The final regulations modify the method under Treas. Reg. § 1.1502-11 for computing the limitation on attribute reduction in connection with transactions involving the disposition of stock of a member of the group.
  • Transactions Designed to Avoid the Application of the Attribute Reduction Rules. The Service stated in the preamble to the final regulations that it believes that general principles (including step transaction doctrine) could be applied to disregard certain transactions that have the effect of changing the result of the application of the attribute reduction rules. Accordingly, the final regulations do not include any additional anti-avoidance rules.

Effective Date. In general, the final regulations apply to discharges of indebtedness that occur after March 21, 2005. However, consolidated groups generally may apply the final regulations in whole, but not in part, to discharges of indebtedness that occur on or before March 21, 2005 and after August 29, 2003. Special effective date rules permit retroactive application of a rule included in the March 15, 2004 regulations that prevents the potential duplication of ordinary income recapture under section 1245.

IRS ISSUES TECHNICAL ADVICE REGARDING CERTAIN TRUST INVESTMENTS IN LIFE INSURANCE:
Today, the IRS made public a National Office technical advice memorandum ("TAM"), TAM 200511015 (Dec. 8, 2004), which allows a corporation to deduct contributions to a Voluntary Employees’ Beneficiary Association ("VEBA") trust established to fund certain post-retirement benefits, although contributions to the VEBA are used to fund variable life insurance contracts held as assets in the VEBA.

  • The taxpayer, a corporation, contributed cash to a VEBA trust to fund postretirement welfare benefits, including medical and death benefits. The trustee of the trust was a bank. The corporation’s Board of Directors appointed the corporation’s Vice-President and Treasurer as a fiduciary for the VEBA plan, and resolved that the corporation’s Administrative Committee would direct the trustee in all matters pertaining to the investment of the funds held in the VEBA trust.
  • The trust invested in individual variable life insurance contracts insuring the lives of certain key employees, with the consent of those employees.
  • In each of the five years at issue, the cash contribution made by the corporation to the VEBA was equal to the amount of the annual premium on the life insurance policies. Subject to the account limit rules of section 419A(c), which were not at issue in the TAM, the taxpayer deducted its cash contributions to the VEBA trust.
  • The IRS examining agent argued that the taxpayer’s deductions for contributions to the VEBA trust were disallowed under section 264(a)(1) as amounts paid in connection with life insurance contracts. In support of this argument, the agent asserted that (1) the contributions made to the VEBA trust were part of the taxpayer’s "overall plan" to purchase life insurance through the VEBA, (2) the taxpayer controlled the VEBA, and (3) the VEBA trust served as a "conduit" for the corporation to purchase life insurance. In sum, the agent argued that the VEBA trust should be disregarded as a separate entity and the corporation should be treated as the entity making the life insurance investments. The revenue agent cited three cases in support of his position -- Glassner v. Commissioner, Neonatology Associates v. Commissioner, and General Signal Corp. v. Commissioner.
  • The National Office rejected the revenue agent’s position and refused to ignore the VEBA trust, concluding that the corporation could deduct its contributions to the VEBA trust. The TAM states that fiduciary obligations under ERISA are not disregarded for tax purposes, and acknowledges that ERISA permits financial institutions to serve as "directed trustees" and permits individuals to "wear more than one hat." Given this context, the National Office concluded that, absent "some showing of violation of the fiduciary principles" there is "no agency, conduit, or other relationship that would equate [t]axpayer’s contributing amounts to the VEBA to the payment of premiums."
  • The TAM distinguishes the three cases cited by the agent. Also, in light of the National Office’s decision regarding the section 264(a)(1) issue, the TAM does not address the two additional issues raised by the agent, i.e., whether the taxpayer was "directly or indirectly" a beneficiary of the life insurance policies, and whether the deductions would otherwise be disallowed under section 419(a)(2) if the deductions were precluded by section 264(a)(1).
  • For additional information, contact J. Walker Johnson at mailto:wjohnson@steptoe.com.

INTERNAL REVENUE SERVICE - CIRCULAR 230 DISCLOSURE:
As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

STEPTOE & JOHNSON LLP - TAX PRACTICE
Steptoe & Johnson LLP has one of the largest and most diverse law firm tax practices in the country. The practice covers the entire spectrum of federal taxation, including representation of businesses before the Congress, Treasury and the national office of the IRS; transactional planning for domestic and multinational corporations; complex audit and controversy work for corporations and other business interests contesting IRS adjustments; litigation before the Tax Court, Court of Federal Claims, district courts, courts of appeals and the Supreme Court. The firm's tax practice also encompasses all aspects of employee benefits (ERISA), executive compensation, tax-exempt organizations and charitable giving.  Steptoe has an extensive state and local tax practice, representing an array of business clients on complex sales and use tax, corporate income tax and property tax matters, both advising those clients and handling audits, administrative appeals, and litigation for them.  Read  more information on Steptoe's tax practice