Loss Disallowance Rule (LDR): What it is, How it Works

Lea Uradu, J.D. is a Maryland State Registered Tax Preparer, State Certified Notary Public, Certified VITA Tax Preparer, IRS Annual Filing Season Program Participant, and Tax Writer.

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 for its subsidiaries and claiming a tax deduction for losses on the value of the subsidiary’s stock.

The IRS created this rule in the 1990s to ensure corporations pay taxes on their capital gains and prevent the duplication of loss as a tax deduction.

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 cannot include that subsidiary’s loss in its tax return to reduce its net profit to $800,000.

Understanding Loss Disallowance Rule (LDR)

The loss disallowance rule was changed in 1995 in an IRS overhaul. The new version of the rule eliminated technical provisions and examples related to the stock basis effects of the 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 rule, setting an important precedent.

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 remaining stock of Penn Encore.

From 1984 to 1994, Rite Aid included Penn Encore in its group of affiliated corporations when filing consolidated tax returns.

During these years, Penn Encore experienced growth but only earned a marginal level of profit. The company’s net income gradually decreased, resulting in a $5.2 million loss. In 1994, Rite Aid sold Penn Encore to another unrelated company, CMI Holding Corp.

For tax purposes, CMI refused to acknowledge the transaction as a purchase of assets due to Penn Encore’s operating loss.

Rite Aid reported a loss on the sale of Penn Encore, but regulations limited the reported loss based on the subsidiary’s duplicated loss factor. Essentially, the rules disallowed both parties from reporting a loss that exceeded the actual loss calculated through the transaction.