Consolidated Corporate Tax Returns
IRC §1501 allows, but does not require, an affiliated group of corporations to file a consolidated income tax return for the group. Consolidated corporate returns have been allowed since 1918, in recognition of the fact that although many businesses achieve some of their objectives with multiple legal entities, the tax code recognizes that the business entity is singular.
There are several advantages to filing a consolidated tax return, such as being able to centralize the planning, reporting, and paying of the tax, but once the choice is made to file consolidated returns, then the group must continue to do so thereafter.
Although a group that has chosen the consolidated filing option can ask the IRS to discontinue the consolidated filing, the IRS rarely grants such permission, although at times it may grant blanket permission to numerous taxpayers within a certain industry where changes in the tax code may adversely affect their consolidated returns.
Controlled corporate groups are subject to special tax sharing rules, but they only apply if each corporation of the group files its own separate Form 1120, U.S. Corporation Income Tax Return. However, if the business entities file a consolidated Form 1120, then the controlled corporate group tax rules do not apply.
The tax code defines an affiliated group as one in which there is a parent corporation that owns at least 80% of both the voting power and the value of the stock of another corporation and the affiliated group includes all other corporations in which 80% of both the voting power and the value of their stock is owned collectively by other members of the group.
The affiliated group can only consist of includable corporations, which the tax code defines negatively as being corporations that are not tax-exempt or foreign, and are not life insurance companies, regulated investment companies, real estate investment trusts, or S corporations.
Generally accepted accounting principles (GAAP) requires corporations and their controlled subsidiaries to file consolidated financial statements, since consolidated statements give a better financial status of the companies. However, the GAAP requirement is that the controlling corporation must own only at least 50% of the voting power of a subsidiary's stock rather than the 80% required by the tax code. So even if a corporate group must file a consolidated financial accounting report does not necessarily qualify it for filing a consolidated tax return.
Filing a Consolidated Return
When a consolidated return for a group is 1st filed, consent by all of the corporations within the group is required, which subsidiaries do by filing Form 1122, Authorization and Consent of Subsidiary Corporation To Be Included in a Consolidated Income Tax Return and attaching it to their group's Form 1120. Thereafter, the affiliated group is referred to as a consolidated group.
The consolidated group exists as long as the parent corporation satisfies the 80% rule for at least 1 subsidiary. Other members of the group can leave the group without terminating the group's status. Other companies can join the group later, without having to file Form 1122.
As long as the parent satisfies the 80% rule, then the parent defines the group. Even if the original subsidiary that defined the group leaves the group, the group can still maintain its existence if the parent satisfies the 80% rule for another corporation within the group.
A consolidated tax return reports the income or loss of the parent for the entire year but only a portion of the year for which any affiliate belonged to the group is reported on the consolidated return. If any affiliate had an existence apart from the group during a portion of the tax year, then that portion must be reported separately on the company's own Form 1120. Treasury regulations provide an "end-of-the-day rule" which defines the corporation as either entering or leaving the group at the end of the day.
Consolidated Taxable Income
The consolidated Form 1120 must be filed by the parent of the consolidated group and each affiliate must adopt the parent's tax year. Although each entity can adopt its own methods of accounting, the information must be aggregated and consolidated to determine taxable income, which requires 4 steps:
- Step 1: Each entity must determine its taxable income, gains, deductions, and losses.
- Step 2: Each affiliate must account for intercompany transactions, which are those transactions between 2 members of the group.
- Step 3: Each affiliate must then determine its net income or loss by excluding those items that have to be consolidated, and this net income or loss is referred to as the separate taxable income. The items that are generally calculated on a consolidated basis include: capital gains, §1231 net losses, charitable contributions deduction, net operating loss deductions, and the dividend-received deduction.
- Step 4: The separate taxable incomes of all affiliates are totaled and then the consolidated items are netted among the group to arrive at the group's consolidated taxable income (CTI).
The parent then reports the CTI on Form 1120, where each item on the form is either the sum of the line items of each affiliate or the group's consolidated item. The parent corporation must also attach Form 851, Affiliations Schedule, when filing a consolidated return.
An intercompany transaction is one between corporations of the same consolidated group, including:
- the rental or licensing of property;
- the performance of services for compensation;
- sale or exchange of property.
There are many tax rules to prevent the use of intercompany transactions to reduce or avoid tax, but the net effect of these rules is that if CTI changes because of the intercompany transaction, then there must be an accounting adjustment to eliminate the change; otherwise, no accounting adjustment will be necessary if the transaction, as a transaction between 2 separate entities, would have no different effect than if it had occurred within the divisions of a single corporation.
So if Affiliate A provides $25,000 worth of services for Affiliate B, then Affiliate A records the income while Affiliate B records the $25,000 payment as a deduction. Hence, the taxable income of the group is unchanged.
However, if an intercompany transaction affects CTI, then there is a matching rule that requires one of the members to adjust its income, deduction, gain, or loss in such a way that there is no effect on CTI.
Generally, the matching rule requires spreading out gains and losses or deductions over a period of years so that the income and deductions cancel out. Thus, in any intercompany transaction, the separate-entity tax treatment must be compared to the single-entity tax treatment. If they are different, then there must be a matching rule adjustment such that the separate-entity tax treatment yields the same results as the single-entity treatment.
However, an affiliate does not recognize an intercompany dividend in gross income, since it is generally treated as a return of investment, which decreases the basis of stock held by the affiliate of the dividend-paying corporation.
The consolidation of the tax returns of an affiliated group includes consolidating the group's regular income tax, the alternative minimum tax, the accumulated earnings tax, and any tax credits, including the foreign tax credit.
Even though the corporate parent acts as the group's agent in regards to filing the consolidated Form 1120 and paying the federal tax liability, each company that was an affiliate during any part of the year maintains liability for the entire federal income tax of the group.
Excess Loss Account
The use of consolidated returns also necessitates that each company adjust its basis of held stock of the other affiliates, so that gains or losses are not recognized more than once.
In a consolidated filing, losses can exceed the basis of the subsidiary's stock owned by the other affiliates, whereby the negative stock basis adjustment creates an excess loss account in regard to the stock. When the stock is disposed of, then the negative portion of the tax basis must be added to any positive gain on the stock, so if a stock has an excess loss account of $25,000, and the stock is subsequently sold to an outside group for $50,000, then the affiliate group must recognize a $75,000 gain.
Advantages and Disadvantages of Consolidated Tax Returns
The advantages in filing consolidated returns include:
- offsetting the profits of one company against losses of another;
- netting out capital gains and losses;
- no tax on intercompany distributions;
- the recognition of income is deferred on intercompany transactions;
- any unused foreign tax credit by one company can be used by the other affiliates within the group; and
- the parent company serves as the agent in all tax matters.
The disadvantages include:
- the accumulated earnings and profits of the entire group is considered when calculating the accumulated earnings tax liability, since only a single minimum credit amount can be used;
- intercompany transactions where matching rules apply must be tracked over a period of years;
- and just as the recognition of income resulting from intercompany transactions is deferred, so are any losses.
Alternatives to Consolidated Corporate Groups for S Corporations
Up until 1997, the shareholders of S corporations had to be individuals — not partnerships or corporations, or even other S corporations. Since 1997, tax law has allowed a new type of business entity, referred to as a Qualified Subchapter S Subsidiary (QSub), which is basically an S corporation in every way except that it is wholly owned by an S corporation parent. Thus, the QSub is not treated as a separate entity but as an operating division of its parent, where income, deductions, gains and losses are included in the parent corporation's tax return, which subsequently is reported on the tax returns of the shareholders of the parent.
Another recently permitted type of shareholder of an S corporation is a single-member LLC, which is a limited liability company with only a single owner. Most states now allow the formation of single-member LLCs and their use is mainly to limit financial and legal risk.