Loss Disallowance Rule (LDR)

What Does Loss Disallowance Rule Mean?

The loss disallowance rule is a rule made by the IRS that forestalls a consolidated group or business conglomerate from filing a single tax return for its subsidiaries to claim a tax deduction for losses on the value of the subsidiary's stock.

The IRS made this rule during the 1990s to ensure corporations paid taxes on their capital gains while keeping the loss from being claimed two times as a tax deduction. This practice was known as a copied loss.

For instance, a corporation might earn a net profit of $1 million every year. Assuming that that corporation obtains a more modest company as a subsidiary, and that subsidiary works at a $200,000 loss that year, as indicated by the loss disallowance rule, the corporation at the top can't file a tax return that incorporates that subsidiary and its loss as a method for cutting down the corporation's net profit to $800,000.

Understanding Loss Disallowance Rule (LDR)

The loss disallowance rule was changed in 1995 in an update by the IRS. The new form of the rule dispensed with a number of technical provisions and models connected with 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 dismissed the IRS's copied loss part of the loss disallowance rule. This set an important precedent for corporations going ahead.

Ritual Aid Corporation v. United States

Ritual Aid, a large drug store chain, acquired 80 percent of Penn Encore, a book shop 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, yet just earned a marginal level of profit. The company's net income diminished after some time, at last 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 wouldn't recognize the transaction as a purchase of assets, since Penn Encore had lost money.

Ceremony Aid reported a loss on its sale of Penn Encore. Under the rules at that point, Rite Aid was permitted to deduct its loss on the sale of Penn Encore. Nonetheless, one more regulation stipulated a limit to the reported loss in light of the subsidiary's copied loss factor. Basically, the rules prohibited the two players from reporting a loss that would surpass the genuine loss calculated through the transaction.