IRS Gives Up Fight On Breaks for Sell-Offs

The Internal Revenue Service (IRS) has quietly dropped its long battle to prevent many divesting companies from claiming federal tax deductions when they sell businesses at a loss, a move that could involve billions in refunds and future revenues. The agency decided not to appeal to the U.S. Supreme Court a setback it suffered on the issue in the District of Columbia Court of Appeals last year. As a result, it is rewriting its so-called “loss disallowance rule (LDR)” to eliminate the offending portion, which is known as the “duplicated loss factor.” Accountants expect the new rule to retain taboos against using accounting gimmicks to manufacture losses but allow restructuring companies to get deductions for legitimate economic losses, such as taking fire-sale prices on distressed or underperforming divisions. Robert Willens, a managing director and corporate tax expert at Lehman Brothers, says that while it is historically uncharacteristic for the IRS to give up a fight against tax breaks, it has softened its positions during the Bush administration. “This has been a very taxpayer-friendly administration,” he states. With the concession, the agency may have opened the way for a spate of tax-refund requests by companies denied deductions for sell-off losses since the rule was issued in 1991. As much as $10 billion in refunds may be sought, according to estimates. At the margin, the end of the fight may spark a few divestitures of distressed businesses that had been on hold. But it is not likely to have a heavy impact on the flow of divestitures because of depressed pricing in the m&a market. Under the “duplicated loss factor,” the IRS ruled that only one party in a divestiture could claim a deduction. In the case that was the centerpiece for the battle, it was the seller, drugstore chain Rite Aid Corp., that was denied the deduction. Rite Aid sought the deduction because it suffered a $22 million loss on the sale of its Encore book chain in 1994, and sued in the U.S. Court of Claims when the IRS balked at granting it. While the agency won the first round, Rite Aid succeeded in getting the D.C. appeals court to reverse the lower court. The appeals court found that the loss was legitimate and that Rite Aid was unfairly denied the deduction because the rule disallowed losses only for companies that filed consolidated tax returns. The court said that had Rite Aid not filed a consolidated return, it would have easily qualified for the tax deduction.