Consolidated Tax Return Fundamentals

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CONSOLIDATED TAX RETURNS

Although most corporations are required to file their own separate tax returns, certain related

corporations (e.g., a parent corporation and its 80% owned subsidiary) are entitled to file a consolidated tax return. The consolidated tax return is essentially a method by which to determine the tax liability of a group of affiliated corporations. The tax computation is based on the view that the businesses of the related corporations represent but a single enterprise. Accordingly, it is appropriate to tax the aggregate income of the group rather than the separate income of each corporation. This is not to say, however, that a consolidated return simply reports the sum of each member corporation's taxable income as if the group were one enlarged single corporation. The applicable Treasury Regulations1 modify the aggregate results by providing special rules requiring the statement of certain items on a consolidated basis (e.g., capital gains) and adjustments for intercompany transactions. The intricacies of these consolidated rules are the subject of this book.

THE HISTORY OF THE CONSOLIDATED RETURN

The origin of the consolidated tax return can be found in the early Regulations concerning the

tax imposed on excess profits during World War I. These Regulations authorized the Commissioner of the Internal Revenue Service to prescribe rules necessary to prevent corporations from avoiding the tax by eliminating their “excess profits” by arbitrarily shifting income to another corporation where it would not be considered excessive. As early as 1917, the

1 See generally Reg. §§ 1.1502-11, 12, and 13.

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Commissioner used this power to require the filing of consolidated tax returns by affiliated corporations to limit the benefits of multiple corporations. By 1918, Congress had made the filing of consolidated returns mandatory for affiliated groups for purposes of not only the excess profits tax but also the income tax. In addition, the Commissioner’s authority to issue Regulations governing consolidated returns was codified.

The end of the war produced several changes affecting consolidated returns. The war's end eliminated the need for the excess profits tax and consequently it was repealed. At the same time, the forerunner of § 482 was enacted. This provision permitted the IRS to apportion income, expenses, or credits between two or more organizations that are under common control in order to prevent tax avoidance and clearly reflect income. The repeal of the excess profits tax and the extension of the Commissioner's authority to reallocate income reduced the opportunity for distorting income and thus the need for mandatory consolidated returns for affiliated groups. As a result, in 1921 Congress made the filing of a consolidated return optional.

For the next 14 years, consolidated returns remained optional, although an additional 1 percent tax was imposed on the privilege of filing a consolidated return in 1932. In 1934, influenced by the effects of the Great Depression and the ability of a loss corporation to offset the income of a profitable one, Congress abolished the use of the consolidated tax return2. The consolidated tax return soon reappeared with the beginning of World War II as Congress extended corporations the privilege of filing a consolidated return in 1942. This time, however, the cost for filing a consolidated return was increased. Congress imposed a 2 percent penalty on consolidated taxable income–a penalty that was to remain until its repeal in 1964. Since 1942, the filing of a consolidated return has been elective.

Although certain benefits could be gained through filing consolidated returns, for many years affiliated groups often opted to file separate returns to obtain the benefits accorded multiple corporations.

Example 1 P, S, and T are an affiliated group of corporations. Each corporation had taxable income of $50,000 for the year. The group's major competitor, Z, a separate corporation, had taxable income of $150,000. If P, S, and T file their own separate returns reporting $50,000 of taxable income on each return, their combined tax liability will be $22,500 ($7,500 x 3). In contrast, Z’s tax liability for its $150,000 of taxable income is $41,750, which is $19,250 greater than the combined liability of P, S, and T. Note that the taxes saved are attributable to the fact that the group's taxable incomes are never taxed at the higher rate (i.e., 34%) or subject to the additional 5% surtax.

In 1969 the benefits of multiple corporations illustrated above were severely curtailed. Under the Tax Reform Act of 1969,3 affiliated corporations were effectively treated as a single corporation (e.g., in the example above, P, S, and T would be treated like Z) not withstanding the fact that each corporation filed a separate return. With the elimination of these benefits, there has been increasing interest in the filing of consolidated returns.

2 This election still remained available for certain railroad corporations. 3 §§ 1561 and 1563

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THE CONSOLIDATED RETURN REGULATIONS

As previously mentioned, Congress granted the Commissioner (IRS) the authority to

promulgate regulations for filing a consolidated tax return. Specifically, Code § 1502 states:

The Secretary shall prescribe such regulations as he may deem necessary in order that the tax liability of any affiliated group of corporations making a consolidated return and of each corporation in the group, both during and after the period of affiliation, may be returned, determined, computed, assessed, collected, and adjusted, in such manner as clearly to reflect the income tax liability and the various factors necessary for the determination of such liability, and in order to prevent avoidance of such tax liability.4

It takes little imagination to see that Congress has granted the IRS broad authority to write regulations governing the filing of a consolidated tax return. These Regulations, referred to as legislative regulations,5 grant a nearly absolute power to the Secretary of the Treasury to prescribe the rules for consolidated tax returns. Although not statutory in form, these regulations have the force and effect of law and remain effective unless overturned by the courts or restricted by Congress.

As early as 19286 and then again in 1954,7 Congress contemplated codifying the consolidated return regulations. In 1954 the House Ways and Means Committee wanted the regulations written into the statutes on the grounds that the Regulations had become generally accepted and should be formalized. The Senate Finance Committee, however, rejected this notion.8 The Senate felt that the detailed consolidated return rules should remain in regulation format. By leaving the Regulations in that form, any rule or tax law change could be readily addressed by the IRS without requiring further action by Congress.9

In 1966 the IRS completely overhauled the existing system governing consolidated returns by replacing the old Regulations with a lengthy and intricate set of new Regulations. These "new" Regulations rejected the accounting principles that had served as the basis of the old Regulations and adopted a different approach. The new Regulations remain in effect today and provide the rules for consolidated tax returns, having gone relatively unchanged since their adoption. In fact, the majority of the changes made to the Regulations since 1965 primarily reflect changes passed by Congress that were applicable to all corporations, not just affiliated groups.

4 § 1502. 5 Legislative regulations as contrasted with interpretive regulations. 6 S. Report No. 960, 70th Cong., 1st Session. 7 H. Report No. 1337, 83rd Cong., 2nd Session. 8 S. Report No. 1622, 70th Cong., 2nd Session. 9 Whether this logic still applies today (due to frequent tax law changes) may be a subject for debate. It often

takes years to get Regulations proposed and finalized.

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ADVANTAGES AND DISADVANTAGES OF THE CONSOLIDATED TAX RETURN

Although filing a consolidated tax return has advantages, numerous disadvantages exist as

well. A review of the various advantages and disadvantages that must be considered before filing a consolidated return is presented below.

ADVANTAGES OF CONSOLIDATED RETURNS

A partial list of the advantages of filing a consolidated income tax return includes the following:

1. Unused losses (both ordinary and capital) and credits of an affiliate may be used to offset the income and tax liability of other affiliated group members in the current year. By utilizing these losses and credits in the current year, the group receives immediate tax benefits and thereby avoids the need for carryovers to recover the benefits. In addition, any excess losses or credits can also be carried back or carried over to subsequent consolidated return years.

2. Intercompany profits on the sale of property and services may be deferred until later years. This deferral has the added benefits of postponing depreciation recapture as well as investment tax credit recapture.

3. Intercompany dividends between group members are eliminated from income and are not subject to tax.

4. Deductions and credits that are subject to percentage limitations can be determined on a consolidated rather than on a separate company basis. This permits a single corporation subject to such limitations to effectively avoid them.

5. The basis in the stock of a subsidiary is increased by earnings and profits accumulated during consolidated return years. Thus, when a parent corporation disposes of a subsidiary any resulting gains are reduced or losses increased.

DISADVANTAGES OF CONSOLIDATED RETURNS

Some of the more important disadvantages of filing a consolidated return include the following:

1. Electing to file consolidated returns requires compliance with the consolidated return Regulations. This could create additional costs and administrative burdens.

2. The consolidated return election is binding for future years. This election can only be terminated by disbanding the affiliated group or by obtaining permission from the IRS to file separate returns.

3. In the initial consolidated return year, a double counting of inventory profit can occur if any of the group members had intercompany transactions in an affiliated separate return year.

4. Separate return credits and capital losses can be limited by operating losses and capital losses from other members of the group. Thus, the credit and loss carryovers may expire

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unused due to heavy losses by an affiliated member.

5. A subsidiary member is required to change its tax year to the same year as that of the common parent corporation. This can create a short tax year that is considered a complete tax year for purposes of carrybacks or carryovers in the case of unused losses and credits.

6. Losses of a subsidiary that reduce the tax liability of the group also decrease the parent's tax basis in the subsidiary. This serves to increase a gain or decrease a loss by the parent corporation on the sale of its subsidiary.

7. Under controversial loss disallowance rules, losses on the sale of a subsidiary's stock are not allowed to be recognized for tax purposes.

8. The rights of minority shareholders must be respected both legally and ethically. As a result, the presence of minority shareholders may create situations that may have adverse effects for the affiliated group.

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ELIGIBILITY FOR FILING THE CONSOLIDATED RETURN

Code § 1501 grants an affiliated group the privilege of filing a consolidated tax return on the

condition that all eligible members elect to do so. If a corporation is a member for a fractional part of a year, the consolidated return must include the income for the short period that the affiliate is a member of the group. As may be expected, these rules are precise and complex.

AFFILIATED GROUPS

The term affiliated group refers to one or more chains of includible corporations connected through stock ownership with a common parent corporation.10 This definition contains two requirements that must be satisfied before the related corporations are treated as an affiliated group. First, the corporation must be an includible corporation, and second, the group must pass a stock ownership test. If a corporation fails either test, it is not eligible to file a consolidated return with the remaining qualifying corporations. Includible Corporations

The term includible corporation is defined by exception.11 In other words, an includible corporation is any corporation other than one of the following entities:

1. A corporation exempt from taxation under § 501 (e.g., a nonprofit organization)

2. A corporation electing a U.S. Possession tax credit under § 936

3. Certain life or mutual insurance companies not covered by a separate election12

4. A foreign corporation13

5. A regulated investment company or real estate investment trust

6. A Domestic International Sales Corporation (DISC)

7. An S corporation14

10 § 1504. 11 § 1504(b). 12 Two or more domestic insurance companies cm be treated as includible corporations for purposes of filing a consolidated return for the insurance companies alone. See § 1504(c)(1) and Rev. Rul. 77-210, 1977-1 C,B. For years beginning in 1981, insurance companies taxed under §§ 802 or 821 may elect to file consolidated returns with non-life insurance companies, subject to limitations under § 1504(c)(2). 13 A limited exception exists for wholly owned Canadian or Mexican Corporations. 14 Although S corporations are not specifically excluded under § 1504(b), a provision under § 1361(b)(2)(A) prevents the corporation from becoming a member. A limited exception applies to the affiliated group prohibition where the affiliated corporations do not engage in business or produce gross income. § 1361(c)(6).

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Stock Ownership Test

The stock ownership requirements are satisfied when the following tests are met:

1. An includible parent corporation owns directly at least 80 percent of the total voting power and 80 percent of the fair market value of the stock of at least one of the other includible corporations.

2. An includible corporation (other than the parent) has at least 80 percent of its voting stock and 80 percent of the fair market value of its nonvoting stock owned directly by one or more of the other includible corporations in the group.

The stock ownership test requires that a group must have a common parent [defined in 1.

above] and at least one includible subsidiary [defined in 2. above]. If either test is not met, the group is ineligible for filing a consolidated return. When applying the stock ownership tests, nonvoting preferred stock that is not convertible into another class of stock or stock that does not significantly participate in corporate growth is generally ignored.

Example 2 Individual A owns 100% of both J and K Corporations. J owns 60% of T Corporation, the remaining 40% is owned by K (Diagram 1). Neither J nor K qualifies as a parent corporation and consequently the group cannot file a consolidated tax return.15 It should be noted that neither corporation is owned 80% or more by other corporations, so the second test is failed as well. Had J owned 80% of T, then both tests would have been met for the affiliated group composed of J and T.

Example 3 P Corporation owns 100% of the stock of both E and F Corporations. E and F each own 50% of the G Corporation stock (Diagram 2). If all corporations are includible corporations, then P, E, F, and G are considered affiliated corporations with P as the parent. G is included in the affiliated group because it is more than 80% owned by other members of the group (E and F). The affiliated group composed of P, E, F, and G is eligible for filing a consolidated tax return.

15 These corporations would, however, fall within the controlled group provisions of §§ 1561 through 1564.

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Diagram 1

Diagram 2

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Example 4 P Corporation owns 80% of both L and Q Corporations. L owns 100% of M Corporation and Q owns 80% of both R and S Corporations. R and S own 80% and 20% of T Corporation, respectively (Diagram 3). If L is a newly formed life insurance company L-1 a second life insurance company, and S a regulated investment company, two affiliated groups exist L and L-1 make up an affiliated insurance group with L as the parent. P, Q, R, and T make up a second affiliated group with P as the parent, L and L-1 are not includible corporations within the exception of § 1504(c)(2) and S is not includible by definition. Although T is owned 20% by S (not an includible corporation), T is owned 80% by R, an includible corporation, so it is included within the affiliated group. Under a special rule, L and L-1 are eligible to file their own consolidated return.

Diagram 3Diagram 3

Example 5 X Corporation owns 70% of both Y and Z Corporations. The remaining 30% of Z is owned by Y and the remaining 30% of Y is owned by Z (Diagram 4). Under the provisions defining a controlled group, identical ownership is ignored so that X indirectly owns 100% of both Y and Z.16 For purposes of an affiliated group, the 8O% direct ownership test is not met and thus X, Y, and Z cannot file a consolidated tax return.

16 See Reg. § 1. 1563- l(a)(2) Example 4 for a more detailed explanation.

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Diagram 3Diagram 3

THE ELECTION

If an affiliated group wishes to file a consolidated tax return, Form 1122 (Consent Form) must be executed by each subsidiary indicating its consent to file on a consolidated basis. These consent forms must be attached to the initial consolidated tax return, Form 1120 along with a Form 851 (Affiliations Schedule) which indicates ownership of the members of the affiliated group. See Diagram 5 for an illustration. The initial return (with the election) must be filed on or before the common parent's due date (including extensions) for filing its tax return. The group can, at any time prior to the extended due date, change its decision and revoke its election to file a consolidated return. Once the extended due date passes, however, the election cannot be withdrawn,17 and consolidated returns must be filed until the group terminates.

If any member of the group falls to file a consent form or does not join in the filing of a

consolidated return, the tax liability of each member is determined as if separate returns were filed.18 If the common parent can establish to the satisfaction of the Commissioner that the failure of the member to join in the filing was an inadvertent error, the election to file a consolidated tax return remains valid.

DISCONTINUING THE ELECTION

The advantages of filing consolidated returns often lose their utility. When this occurs, the group may desire to discontinue its election. However, once a group has elected to file a consolidated return, it is bound by that decision as long as the group remains in existence. A

17 Reg. § 1.1502-75(a)(1) 18 Reg. § 1.1502-75(b)(3).

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Diagram 5Diagram 5

First Consolidated Tax Return

851

AffiliationsSchedule

Consentby

members

1122

1120

Common Parent

Insert Form 1122 Here

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group is generally considered to remain in existence if the common parent has at all times during the tax year at least one subsidiary that was a member of the group at any time during the year.19

Example 6 On January 2, 1998 P, a calendar year corporation, forms a wholly owned subsidiary, S. P and S file a consolidated tax return for 1998 and 1999. If P purchases all the stock of T Corporation on July 1, 2000 and sells all the stock of S on August 1, 2000, P Corporation is still required to file a consolidated return for 2000. In this case, P had at least one subsidiary (either S or T) at all times during the year. If, however, P had sold S and then one month later purchased T, two consolidated tax returns may be filed if P makes a new election with T. The first consolidated return would begin on January 1 and end the day P purchases T. The second return would begin the day P purchases T and continue through the year end.20

The election may be discontinued either by disbanding the group or by securing permission of

the IRS. Permission is granted only if the group can establish good cause. An application must be filed with the IRS at least 90 days before the due date of the tax return (including extensions). An example of a good cause would be a change in the law or regulations that has an adverse effect on the consolidated tax liability.21 The Regulations also grant the Commissioner discretionary authority to issue blanket permission for all taxpayers to discontinue filing consolidated returns. This authority is generally exercised only when an amendment to the Code or Regulations has an adverse effect on a group or class of corporate taxpayers.22

If a corporation is included in a consolidated return and then ceases to be a member of the affiliated group, that corporation (or its successor) cannot return to be re-included as a member of the affiliated group for a specified period. That period generally ends on the 61st month beginning after the corporation's first taxable year in which it ceased being a member of the group. The Commissioner, however, is authorized to waive application of this rule under conditions it deems appropriate.

19 Although a group normally terminates when a parent corporation ceases to exist, certain exceptions apply relating to reverse acquisitions, F reorganizations, and downstream mergers. 20 Reg. § 1.1502-76(b)(3) Example 3. 21 Reg. § 1.1502-75(c)(1). 22 Reg. § 1.1502-75(a)(2). For example, in 1995 the IRS issued blanket permission to disaffiliate due intercompany transaction regulations that were newly issued. This permission expired in 1996.