Pearsons Federal Taxation 2017 Corporations Partnerships Estates and Trusts 30th Edition Pop

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 Chapter C:8

Consolidated Tax Returns

Learning Objectives

After studying this chapter, the student should be able to:

1. Determine whether a group of corporations is an affiliated group.

2. Describe how an affiliated group makes a consolidated return election and how it
discontinues the election.

3. Calculate consolidated taxable income for a consolidated group.

4. Apply the rules for reporting intercompany transactions.

5. Compute on a consolidated basis deductions and credits subject to limitations.

6. Determine a consolidated group’s NOL, calculate the carryback or carryover of a

consolidated NOL, and apply the SRLY restrictions on NOL usage.

7. Adjust the parent’s basis in stock of a consolidated subsidiary.

8. Compare the advantages and disadvantages of filing a consolidated tax return.

9. Comply with the procedures for making a consolidated return election.

10. Explain the financial statement implications of various consolidated transactions.

Areas of Greater Significance

The instructor should emphasize the definition of an affiliated group, the reporting of
intercompany transactions and dividends by the group members, and the calculation of taxable
income on a consolidated basis.

Areas of Lesser Significance

In the interest of time, the instructor may determine that the following areas are best covered
by student reading, rather than class discussion:

1. Special loss limitations (SRLY and Sec. 382 loss limitations).

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 2. Tax planning considerations (advantages and disadvantages of filing a consolidated
tax return).

3. Compliance and procedural considerations (the basic election, parent corporation as

agent for the affiliated group, and liability for taxes).

Problem Areas for Students

The following areas may prove especially difficult for students:

1. Inclusion in consolidated taxable income of income, gains, deductions, and losses

related to intercompany transactions.

2. Special loss limitations (SRLY and Sec. 382 loss limitations).

3. Carryback and carryforward of consolidated NOLs.

Highlights of Recent Tax Law Changes

Qualifying for the dividends-received deduction are dividends from a corporation that would
be a member of the distributee’s consolidated group but is excluded because it is a life insurance
company.

Teaching Tips

1. The sample consolidated tax return contained in Appendix B can be a helpful teaching
device. The Form 1120 corporate tax return includes a completed worksheet that can
be used to illustrate the conversion of separate taxable income into consolidated
taxable income. The worksheet illustrates two different intercompany transactions,
the exclusion of dividends, and the netting of gains and losses.

Lecture Outline

I. Definition of an Affiliated Group.

A. Requirements.

1. Stock Ownership Requirement. Only an affiliated group of corporations

can elect to file a consolidated return. The stock ownership requirements that
must be satisfied are: (1) a parent corporation must directly own stock
having at least 80% of the total voting power of all classes of stock entitled to
vote and at least 80% of the total value of all outstanding stock in at least one
includible corporation; (2) for each other corporation eligible to be included
in the affiliated group, stock having at least 80% of the total voting power of

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 all classes of stock entitled to vote and at least 80% of the total value of all
outstanding stock must be owned directly by the parent corporation and the
other group members. (See Examples C:8-1, C:8-2, C:8-3, and C:8-4.)

The definition of stock excludes most nonvoting preferred stock. Special

rules are provided regarding the treatment of warrants, convertible
obligations, and options as stock, inadvertent failure of the 80% of value test,
and transfers of stock within the affiliated group to bring about
deconsolidation.

2. Includible Corporation Requirement. As few as two corporations may

satisfy the definition of an affiliated group. In the United States, some
affiliated groups are composed of hundreds of corporations. Not all
subsidiaries are able to participate in the consolidated tax return because they
are not includible corporations. A list of corporations that are not includible
is found on p. C:8-3. If both the stock ownership and includible corporation
requirements are satisfied, the subsidiary corporation must be included in the
consolidated return election made by the parent. (See Example C:8-5.)

B. Comparison with Controlled Group Definition. There are three types of

controlled groups: brother-sister groups, parent-subsidiary groups, and combined
groups. (See Chapter C:3.) Brother-sister groups cannot file a consolidated tax
return. Parent-subsidiary groups and the parent-subsidiary portion of combined
controlled group can elect to file a consolidated tax return.

1. Difference Between Definitions. Only affiliated groups can elect to file

consolidated tax returns. Four differences between the definitions of Sec.
1504 and Sec. 1563 (parent-subsidiary controlled group) do exist. These
differences cause some members of a controlled group to be excluded from
the affiliated group. The differences are listed on p. C:8-4.

II. Consolidated Tax Return Election.

A. Consolidated Return Regulations. Code Secs. 1501 through 1504 are the primary
statutory provisions governing the filing of consolidated tax returns. The statute is
very general and primarily defines the composition of affiliated groups that are
eligible to file a consolidated tax return. Regulations provide much of the guidance
needed to file consolidated tax returns.

B. Termination of the Affiliated Group. An affiliated group “remains in existence for

a tax year if the common parent remains as the common parent and at least one
subsidiary that was affiliated with it at the end of the prior year remains affiliated
with it at the beginning of the year.” The parent corporation need not own the same
subsidiary throughout the entire tax year nor own any subsidiary throughout the tax
year. (See Examples C:8-6 and C:8-7.)

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 1. Good Cause Request to Discontinue Status. The IRS sometimes grants
permission to discontinue filing a consolidated tax return. For example, this
permission may be granted in response to a taxpayer’s “good cause” request.
In new intercompany transaction regulations issued in the mid-1990s, the
IRS gave blanket permission to all affiliated groups to discontinue their
consolidated tax return election.

2. Effects on Former Members. The termination of an affiliated group affects

its former members in several ways. Some of these ways are listed on p. C:8-6.
In addition, disaffiliation of a corporation from an affiliated group prevents the
corporation from being included in a consolidated return with the same
affiliated group, or any other affiliated group having the same common parent,
until five years after the end of the tax year in which it ceased to be a member
of the group.

III. Consolidated Taxable Income.

The five steps to use in calculating consolidated taxable income are found on p. C:8-9. An
overview of these steps is found in Table C:8-1. Table C:8-1 may be used at this point as
you cover the steps necessary to calculate consolidated taxable income. The tax due is
calculated using the tax rates found in Sec. 11. The corporate alternative minimum tax, or
one of the other special tax levies, may increase this amount.

A sample consolidated tax return worksheet is included in Appendix B that illustrates the
consolidated taxable income calculation.

A. Affiliated Group Elections.

1. Tax Years. An affiliated group must file its consolidated tax return using the
parent corporation’s tax year. Beginning with the initial consolidated return
year, each subsidiary must adopt the parent corporation’s tax year.

2. Methods of Accounting. Each consolidated group member uses the same

accounting method that it would have used if it were filing a separate tax
return.

The possibility of finding a mixture of cash and accrual method corporations

in a consolidated group is restricted because of the Sec. 448 restrictions on
the use of the cash method of accounting by a C corporation.

B. Income Included in the Consolidated Tax Return. A consolidated tax return

includes the parent corporation’s income for its entire tax year, except for any portion
of the year that it was a member of another affiliated group that filed a consolidated tax
return. A subsidiary corporation’s income is included in the consolidated tax return
only for the portion of the affiliated group’s tax year for which it was a group member.

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 When a member of the affiliated group is a member for only part of the year, the
member’s income for the remainder of the year is included in a separate tax return or
the consolidated tax return of another affiliated group. The short period return is a full
tax year for purposes of NOL and other carryovers. (See Example C:8-8.)

A corporation that becomes or ceases to be a group member during a consolidated

return year changes its status at the end of the day on which such change occurs (i.e.,
the change date). Its tax year ends for federal income tax purposes at the end of the
change date. Transactions that occur on the change date that are allocable to the
portion of the day after the event resulting in the change (e.g., a stock sale or merger)
are accounted for by the group member (and all related parties) as having occurred
on the next day.

Tax returns for the years that end and begin with a corporation becoming, or ceasing
to be, a member of a consolidated group are separate return years. The returns are, in
general, short period returns (i.e., for applying the MACRS rules), but do not require
annualization of the tax liability or estimated tax calculations when a corporation
joins a consolidated group. Allocation of income between the consolidated tax return
and a member’s separate return year takes place according to the accounting methods
employed by the individual corporation. If this allocation cannot be readily
determined, the allocation of items included in each tax return (other than ones
considered to be extraordinary) can be based upon the relative number of days of the
original tax year included in each tax year.

IV. Intercompany Transactions.

An intercompany transaction is a transaction between corporations that are members of the

same consolidated group immediately after the transaction. The Regulations specify two
general rules for including the income, gains, deductions, or losses related to intercompany
transactions: the matching rule and the acceleration rule. The intent of these rules is to
determine consolidated taxable income on a single entity basis. The Regulations denote the
two corporations involved in the intercompany transaction as S (the corporation selling
goods or services) and B (the corporation buying goods or services).

A. Terminology. There are three important terms related to the matching and
acceleration rules.

1. Intercompany item. S’s income, gain, deduction, and loss from an

intercompany transaction.

2. Corresponding item. B’s income, gain, deduction, and loss from an

intercompany transaction or from property acquired in an intercompany
transaction.

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 3. Recomputed corresponding item. The corresponding item B would have if
S and B were divisions of a single corporation and the transaction were
between those divisions.

B. Matching rule. S’s intercompany item is included in consolidated taxable income

such that, when it is combined (i.e., matched) with B’s corresponding item, the result
is the same as the recomputed corresponding item (i.e., the same result as if the
consolidated group were a single corporation). The amount of S’s intercompany
item that is included in consolidated taxable income can be calculated as follows:

Amount of recomputed corresponding item

- Amount of B’s corresponding item
= Amount of S’s intercompany item taken into account for consolidated taxable
income.

C. Acceleration rule. If it becomes impossible to match B’s corresponding item to S’s

intercompany item (e.g., S or B departs the consolidated group before B’s
corresponding item occurs), the acceleration rule requires that S’s intercompany item
be included in consolidated taxable income immediately before the time it first
becomes impossible to apply the matching rule.

D. The matching and acceleration rules are more conceptual, rather than mechanical, in
nature. They require someone applying them to think about the reporting of the
transaction by the two corporations involved on a separate entity basis (i.e., how
S and B would each report the transaction if their affiliation with each other were
ignored) and about the reporting of the transaction on a single entity basis (i.e., how a
single corporation with S and B as two divisions would report the transaction).
Students may find it easier to understand the matching and acceleration rules by
applying them to specific sets of facts and circumstances. The application of the two
rules to several situations is illustrated on pp. C:8-12 through C:8-17.

Intercompany sale of stock. Application of the matching rule often results in S’s
gain or loss on the sale of stock to B to be included in consolidated taxable income
when B sells the stock to a third party. However, if B’s sale to a third party is an
installment sale, the inclusion of S’s gain or loss in consolidated taxable income
could be spread over several years. (See Examples C:8-19 and C:8-20.)

Performance of services. If B expenses the services obtained from S, S’s income

will be included in consolidated taxable income under the matching rule at the same
time as B’s expenses are included. The two items offset in consolidated taxable
income. If B capitalizes the amounts paid to obtain services from S, S’s income will
be included in consolidated taxable income under the matching rule as B reports
deductions for the capitalized costs (e.g., depreciation, amortization) or reports a gain
or loss on its disposition.

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 Intercompany sale of inventory. Many consolidated groups have sales of inventory
within the group. The matching rule applies in this situation and allows the
consolidated group to defer taxation of profit from the intercompany transaction until
B sells the inventory to a third party. (See Examples C:8-25 and C:8-26.)

V. Items Computed On A Consolidated Basis.

A consolidated group calculates deductions and credits that are subject to limitations on a
consolidated basis rather than separately for each corporation in the group. The calculations
are very similar to those for unaffiliated corporations except that consolidated tax return
amounts are used. Calculating a deduction or credit on a consolidated basis rather than a
separate basis could lead to a larger or smaller amount of deduction or credit.

A. Charitable contributions. The 10%-of-adjusted-taxable-income limitation is based

on consolidated adjusted taxable income.

B. Net Section 1231 gain or loss. All of the group members’ Section 1231 gains and
losses are netted rather than netting the gains and losses for each member separately.

C. Capital gains and losses. All of the group members’ capital gains and losses are
netted rather than netting the gains and losses for each member separately.

D. Dividend-received deduction. The limitation on the dividends-received deduction

is calculated on a consolidated basis for dividends received from corporations outside
of the consolidated group. Dividends received by one consolidated group member
from another group member are eliminated in calculating consolidated taxable
income, so no dividends-received deduction is allowed for them.

E. U.S. production activities deduction. Section 199 requires that the U.S. production
activities deduction for an affiliated group be computed on a consolidated basis,
whether the group files a consolidated tax return or separate tax returns. (See
Example C:8-31.)

F. Regular tax liability. The consolidated group applies the Sec. 11 corporate tax rates
to determine its consolidated tax liability. Since the group also qualifies as a
controlled group, it would be limited to an aggregate of $50,000 being taxed at 15%
and $25,000 being taxed at 25% if it were to file separate tax returns.

G. Corporate alternative minimum tax. The consolidated group determines its

alternative minimum tax on a consolidated basis.

H. Tax credits. The limitations on the general business credit and foreign tax credit are
determined on a consolidated basis.

I. Estimated tax payments. A consolidated group generally determines its estimated

tax payments on a consolidated basis. However, in the first two years of its

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 consolidated status, it may elect to make estimated tax payments on a consolidated
basis or a separate basis.

VI. Net Operating Losses (NOL).

One advantage of filing a consolidated tax return is that one member’s NOL can offset
another member’s taxable income. The rules governing the use of NOLs incurred in separate
return years are more complex.

A. Current Year NOLs. Each member’s separate taxable income is combined to

determine combined taxable income before any adjustment is made for NOL
carryovers. (See Table C:8-1.) A group member cannot elect separately to carry
back its own losses from a consolidated return year to one of its earlier profitable
separate return years. Only the consolidated NOL of the group may be carried back
or forward. (See Example C:8-36.)

B. Carrybacks and Carryforwards of Consolidated NOLs. A consolidated NOL

can be carried back to the preceding consolidated return years or carried over to the
20 succeeding consolidated return years. When members of the consolidated group
are not the same in the carryback or carryforward period, an apportionment must be
made. The consolidated NOL is apportioned to each corporation that was both a
member of the consolidated group and incurred a separate NOL during the loss year.

C. Carryback of Consolidated NOL to Separate Return Year. A consolidated NOL

may be carried back and absorbed against a member’s taxable income from a
preceding separate return year. To effect this, part or all of the consolidated NOL must
be apportioned to the member. See the formula on p. C:8-28 and Example C:8-37.

A special carryback rule applies to new members that are “offspring” of other
corporations that were members of the affiliated group in a carryback year. (See
Examples C:8-40 and C:8-41.)

D. Carryforward of Consolidated NOL to Separate Return Year. If a corporation

ceases to be a member of the consolidated group during the current year, the portion
of the consolidated NOL that is allocable to the departing member becomes the
member’s separate carryforward. This calculation is made after the available
carryover is absorbed to the extent permitted in the current consolidated return year.
(See Example C:8-41.)

E. Special Loss Limitations. Two loss limitations, the separate return limitation year
(SRLY), and the Sec. 382 loss limitation rules are imposed on affiliated groups.

1. Separate Return Limitation Year Rules. A member incurring an NOL in a

separate return year, that is available to be used in a consolidated return year,
is subject to a limit on the use of the NOL when the loss year is designated a
separate return limitation year (SRLY).

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 Under the SRLY rules, an NOL incurred in a SRLY may be used as a carry
forward in a consolidated return year equal to the lesser of (1) the aggregate
of the consolidated taxable income amounts for all consolidated return years
of the group determined by taking into account only the loss member’s items
of income, gain, deduction, and loss, (2) consolidated taxable income, or
(3) the NOL carryover. (See Examples C:8-42 and C:8-43.)

2. Section 382 Loss Limitations. Section 382 prevents the purchasing of the
assets or stock of a corporation having loss carryovers (known as the loss
corporation) primarily to acquire the corporation’s tax attributes. The
consolidated Sec. 382 rules generally provide that the ownership change and
Sec. 382 limitation are determined with respect to the entire consolidated
group, or a subgroup that is acquired and that has an NOL carryover, and not
for the separate corporations. Following an ownership change for a loss
group, the consolidated taxable income for a post-change taxable year that
may be offset by a pre-change NOL cannot exceed the consolidated Sec. 382
limitation.

At this point you may wish to introduce Topic Review C:8-2 in order to review the rules
governing consolidated group NOL carrybacks and carryforwards.

VII. Stock Basis Adjustments.

A. General Basis Rules. The basis for an investment in a subsidiary corporation is

adjusted annually for the subsidiary’s profits and losses as well as for its distributions
to higher-tier subsidiaries, or to its parent corporation. These rules parallel those
used in the equity method of accounting, but use tax numbers instead of book income
numbers. The making of the stock basis adjustment reduces the gain (increases the
loss) recognized when the stock investment in the subsidiary corporation is sold.

B. Basis Adjustments.

1. The starting point for the basis calculation is the original basis for the stock
investment (e.g., cost basis, carryover basis for Sec. 351 transaction, etc.).

2. The initial basis amount is then increased or decreased for the basis
adjustments. Some common basis adjustments are listed on p. C:8-35.

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VIII. Tax Planning Considerations.

A. Advantages of Filing a Consolidated Return. Filing a consolidated return offers a

number of advantages and disadvantages. Some of the more important advantages
are found on p. C:8-36.

B. Disadvantages of Filing a Consolidated Return. Some of the more important

disadvantages of filing a consolidated corporate return are found on p. C:8-37.

IX. Compliance and Procedural Considerations.

A. The Basic Election. An affiliated group makes an election to file tax returns on a
consolidated basis by filing a tax return that includes the income, expenses, etc., of
all of its members. See Appendix B. The election must be made no later than the
due date of the parent’s return including extensions. See p. C:8-38 for due date and
filing deadlines. Each corporation that is a member of the affiliated group must
consent to the election. The parent consents by filing the consolidated return. Other
members of the group consent by filing a Form 1122 (Authorization and Consent of
Subsidiary to Be Included in a Consolidated Income Tax Return). This form is
submitted with the original Form 1120. Although not displayed in Appendix B, the
consolidated return should include the Schedule M-3 if applicable. (See Chapter
C:3.) See Example C:8-50.

Each consolidated tax return must include an Affiliations Schedule (Form 851). This
form includes the name, address, and identification number of the corporations
included in the affiliated group, the corporation’s tax prepayments, the stock
holdings at the beginning of the tax year, and all stock ownership changes occurring
during the tax year.

The due date for the consolidated tax return is the 15th day of the third month after the
end of the affiliated group’s tax year. A six-month extension is permitted if the parent
corporation files Form 7004 (Application for Automatic Extension of Time to File
Corporation Income Tax Return) and pays the estimated tax liability for the group.

B. Parent Corporation as Agent for the Affiliated Group. The parent corporation
acts as agent for each subsidiary corporation and for the affiliated group. No
subsidiary corporation can act in its own behalf, except in cases where the parent
corporation is prohibited from acting.

C. Liability for Taxes Due. The parent corporation and every other member of the
affiliated group are severally liable for the consolidated taxes.

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X. Financial Statement Implications.

A. Intercompany Transactions. Intercompany transactions can raise deferred tax

issues depending on the type of transaction and whether the affiliated group files
consolidated tax returns or separate tax returns. The discussion assumes a 100%-
owned subsidiary and addresses just two types of intercompany transactions:
(1) distributed and undistributed subsidiary profits and (2) intercompany sales of
property.

For a parent with a 100%-owned subsidiary, intercompany dividends and

undistributed subsidiary earnings cause no temporary differences. If the group files a
consolidated tax return, the intercompany dividend is eliminated for both tax and
consolidated financial statement purposes. If the group files separate returns, the
parent takes a 100% dividends-received deduction because it owns at least 80% of
the subsidiary’s stock. Undistributed subsidiary earnings are included in
consolidated financial statements, but a parent filing separate tax returns would not
include these earnings in its income until the subsidiary distributed them as
dividends.

If a consolidated return is filed for the group, the group defers income on
intercompany sales for both tax and consolidated financial statement purposes. If
separate returns are filed, the selling member recognizes income for tax purposes but
not for consolidated financial statement purposes, thereby creating a temporary
difference. Instead, the group recognizes a deferred tax asset on the difference
between the seller’s profit deferred in the consolidated financial statements and the
taxes paid on the seller’s separate tax return. ASC 810, formerly ARB No. 51,
Consolidated Financial Statements, requires the group to defer recognizing income
taxes on intercompany profits on assets remaining within the group, but ASC 740
Income Taxes prohibits recognition of a deferred tax asset for the difference between
the tax basis of the assets in the buyer’s jurisdiction and their cost as reported in the
consolidated financial statements. Thus, even though the buyer’s tax basis may
exceed the financial statement basis, the group does not recognize a deferred tax
asset. Instead, the group recognizes a prepaid asset. The text provides an example
illustrating these rules.

It is important to note that the FASB is currently considering a change to its

accounting standards that would require the recognition of deferred tax consequences
of intra-company asset transfers.

B. SRLY Losses. A net operating loss (NOL) from a separate return limitation year
(SRLY) will create a deferred tax asset possibly subject to a valuation allowance. An
example is provided in the text illustrating this rule. See Example C:8-52.

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Pearsons Federal Taxation 2017 Corporations Partnerships Estates and Trusts 30th Edition Pop

Court Case Briefs

U.S. v. Manor Care, Inc., 490 F.Supp 355 (DC MD, 1980).

Manor Care, Inc. owned various subsidiary corporations, including corporations involved in the
nursing home business. Certain pre-opening expenses of these subsidiaries were paid for by the
parent corporation and were deducted by the subsidiaries in the consolidated income tax return filed
for the affiliated group. The activities of the separate corporate entities were operated together as if
they were a single business unit.

The court ruled that the deductibility of these expenses must be determined on the basis of the facts
of each case. This depends on whether the particular subsidiary may deduct the expenses and not on
the basis of whether items could be deducted by an affiliated group. Therefore, each company must
be treated as a separate tax entity for claiming deductions on a consolidated return.

Georgia-Pacific Corp. v. U.S., 648 F.2d 653 (9th Cir., 1981) aff’g. 43 AFTR 2d 79-337 (DC OR,
1978).

Georgia Pacific Corp. (GP) was the parent corporation of an affiliated group which included two
wholly owned subsidiaries, Rex Timber Corp. and Timber, Inc. The group filed consolidated income
tax returns. GP owned timber lands and timber cutting rights. GP entered into a timber contract with
Timber whereby Timber could buy and cut timber on GP land. GP also transferred timber and timber
cutting rights to Rex as a contribution to capital and then entered into a timber cutting contract to buy
and cut timber on the land transferred to Rex. Capital gains treatment for the sales by GP and Rex
were claimed on the consolidated return. The IRS contended and the court upheld that because the
sales were deferred intercompany transactions the gain must be treated as ordinary income. The
buyers had acquired economic interests in the standing timber and were therefore entitled to depletion
deductions. Therefore the gain on the sales of the timber was to be treated as ordinary income in
accordance with the consolidated return regulations related to such transactions.

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