What Does Loss Disallowance Rule Mean?
The loss disallowance rule is a rule created by the IRS that prevents a consolidated group or business conglomerate from filing a single tax return on behalf of its subsidiaries in order to claim a tax deduction for losses on the value of the subsidiary's stock.
The IRS created this rule in the 1990s to make sure corporations paid taxes on their capital gains while preventing the loss from being claimed twice as a tax deduction. This practice was known as a duplicated loss.
For example, a corporation may earn a net profit of $1 million per year. If that corporation acquires a smaller company as a subsidiary, and that subsidiary operates at a $200,000 loss that year, according to the loss disallowance rule, the corporation at the top cannot file a tax return that includes that subsidiary and its loss as a way to bring down the corporation’s net profit to $800,000.
Understanding Loss Disallowance Rule (LDR)
The loss disallowance rule was changed in 1995 in an overhaul by the IRS. The new version of the rule eliminated a number of technical provisions and examples related to the stock basis effects of loss allowance.
An important court case in the history of the loss disallowance rule was Rite Aid Corp v. United States. In this case, the Federal Circuit Court of Appeals rejected the IRS's duplicated loss component of the loss disallowance rule. This set an important precedent for corporations going forward.
Rite Aid Corporation v. United States
Rite Aid, a large pharmacy chain, acquired 80 percent of Penn Encore, a bookstore chain in 1984. In 1988, Rite Aid purchased the balance of Penn Encore’s stock. From 1984 until 1994, Rite Aid included Penn Encore in its group of affiliated corporations when it filed consolidated tax returns.
During these years, Penn Encore experienced growth, but only earned a marginal level of profit. The company’s net income decreased over time, ultimately leading to a $5.2 million loss. In 1994, Rite Aid sold Penn Encore to another, unrelated company. This company was CMI Holding Corp. For tax purposes, CMI then refused to acknowledge the transaction as a purchase of assets, since Penn Encore had operated at a loss.
Rite Aid reported a loss on its sale of Penn Encore. Under the rules at the time, Rite Aid was allowed to deduct its loss on the sale of Penn Encore. However, another regulation stipulated a limit to the reported loss based on the subsidiary’s duplicated loss factor. Essentially, the rules disallowed both parties from reporting a loss that would exceed the actual loss calculated through the transaction.