Section 1504: Consolidated Group Membership Issues ALI-ABA Course of Study Consolidated Tax Return Regulations Section 1504: Consolidated Group Membership Issues Steven B. Teplinsky Steptoe & Johnson LLP Washington, DC October 4-5, 2007 Copyright © 2007, Steven B. Teplinsky All Rights Reserved

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

§1504: Required Consolidation of a Nonmember?

CCA 200729035 (Apr. 11, 2007) P 7 Regional Cooperatives Several Foreign OpCos Less than 80% vote More than 20% vote National Cooperative Query: Did the IRS conclude that National Cooperative must be treated as a member of P’s consolidated group for all purposes? See §1501 (“An affiliated group of corporations shall, subject to the provisions of this chapter, have the privilege of making a consolidated return ….”); Treas. Reg. §1.1502-13(h) (“If a transaction is engaged in or structured with a principal purpose to avoid the purposes of this section (including, for example, by avoiding treatment as an intercompany transaction), adjustments must be made to carry out the purposes of this section.”).

§1504(a)(3): Required Five-Year Lapse Before Reconsolidation

§1504(a)(3)(A) §1504(a)(3)(A): “If-- (i) a corporation is included … in a consolidated return filed by an affiliated group …, and (ii) such corporation ceases to be a member of such [affiliated] group …, … such corporation (and any successor of such corporation) may not be included in any consolidated return filed by the affiliated group (or by another affiliated group with the same common parent or a successor of such common parent) before the 61st month beginning after its first taxable year in which it ceased to be a member of such affiliated group.” Note: §1504(a)(3) limits the inclusion of a corporation in a consolidated return filed by a consolidated group. §1504(a)(3) does not affect the inclusion of the corporation in the affiliated group itself. There is no definition of “successor” for purposes of §1504(a)(3).

§1504(a)(3)(B): Waiver of Five-Year Reconsolidation Waiting Period §1504(a)(3)(B): “The Secretary may waive the application of subparagraph (A) to any corporation for any period subject to such conditions as the Secretary may prescribe.” Rev. Proc. 2002-32, 2002-1 C.B. 959, and Rev. Proc. 2006-21, 2006-24 I.R.B. 1050 (modifying Rev. Proc. 2002-32), provide rules regarding waivers.

§1504(a)(3): Legislative History §1504(a)(3) was enacted in 1984. Conference Committee Report states that “[t]he rule is an anti-abuse rule, and the conferees expect the Treasury to so apply it.” Conference Committee Report does not identify the targeted abuse. Presumably, Congress was attempting to prevent taxpayers from electively deconsolidating the group or deconsolidating certain group members for a desired period of time.

§1504(a)(3)(A): Base Case P P P S X S X S X T T T Year 1 Year 4 Result P P P $ $ S X S X S X 100% T Stock 100% T Stock T T T T is barred from joining the P group’s consolidated return until Year 7.

Base Case – Parent Variation Year 1 Year 4 Result $ Shareholders $ X X A X A 100% P Stock 100% P Stock P P P S S S T T T The new P affiliated group is barred from filing a consolidated return until Year 7 (absent a waiver). See PLRs 200607012, 200517024, 200539007. What if P acquired a new subsidiary in Year 3 (while P was a member of X’s group)? Would P and the new subsidiary be permitted to file a consolidated return in Year 5 without a waiver? What if P acquired a new subsidiary in Year 5 (while P was the parent of a new P group)?

The Successor Case PS PS PS A A P P P S W S W V S W/V A T T T V Year 1 Result PS PS PS A A 90% 10% P P P 10% P Stock S W S W V S W/V Merge $ A T T T 100% V Stock V Although there are numerous definitions of “successor” for particular consolidated return regulations, there is no definition of “successor” for purposes of §1504(a)(3). Nevertheless, W presumably is V’s successor. Query whether the respective pre-merger values of W and V are relevant. If W is V’s successor, W is subject to §1504(a)(3). If P has an excess loss account (an “ELA”) in W’s stock, it appears that the ELA is triggered. See Treas. Reg. §1.1502-19(c)(1)(ii) & (c)(2). If W was a buyer or seller in an intercompany transaction, it appears that the intercompany item should be taken into account immediately before the merger under Treas. Reg. §1.1502-13(d) (subject to other applicable Code sections, such as §267).

The Successor Parent Case Year 1 Year 2 Year 3 Result A A Old P Shareholders 40% P Stock P A P A 60% 40% P P/T $ Merge T Stock V S V S T V S T V S X T X X X If T had merged into a P subsidiary, the surviving corporation presumably would have been a successor of T and thus would have been precluded from joining in the P group’s consolidated return under §1504(a)(3)(A). Because T instead merges into P, it appears that P is T’s successor and that P is precluded from joining in the P group’s consolidated return. Cf. the Base Case - Parent Variation. If P is precluded from joining in the P group’s consolidated return, is the P group completely deconsolidated, or is P the only affiliated group member excluded from the consolidated return? If S, X, and V can file a consolidated return without P, must they do so? If S, X, and V file a consolidated return without P, how would the consolidated return regulations work?

The Interposed Successor Case Year 1 Year 3 Result PS PS PS A P A P 90% 10% 10% P Stock P S S V $ Merge A S/V T T 100% V Stock T V Presumably, S is V’s successor, and thus is excluded from the P consolidated group under §1504(a)(3). The treatment of T is unclear. If S is not a member of P’s consolidated group, it is unclear how to make appropriate adjustments under the consolidated return regulations. Should S’s basis in its T stock be adjusted under Treas. Reg. §1.1502-32? If yes, should P’s basis in its S stock be adjusted under the tier-up rules of Treas. Reg. §1.1502-32(a)(3)(iii)? What of adjustments to earnings and profits (“e&p”) under Treas. Reg. §1.1502-33? Should appropriate stock basis and e&p adjustments be “suspended” until S is included in P’s consolidated return? Should transactions between P and T be intercompany transactions under Treas. Reg. §1.1502-13 if the investment adjustment provisions do not operate in a manner that preserves single entity treatment? If S sells the T stock, should the loss disallowance regulations of Temp. Treas. Reg. §1.337(d)-2T apply? If S is not included in the P consolidated group, can S and T elect to consolidate? See §1501 (stating that “[a]n affiliated group of corporations shall, subject to the provisions of this chapter, have the privilege of making a consolidated return…”); Treas. Reg. §1.1502-75(a) (generally requiring that all eligible members join in the consolidated return).

Parent Liquidation Case Year 1 Result A B A B (2) P liquidates P (1) P contributes some assets S1 S1 S2 S2 Can the S1 affiliated group elect to consolidate? Or is S1 a successor to P, causing §1503(a)(3)(A) to apply? Or should the S1 affiliated group be required to consolidate? Does it matter what portion of P’s assets are contributed to S1? Does it matter when P contributes assets to S1? In connection with the liquidation transaction, In a separate transaction more than two years before P liquidates, or In a separate transaction more than five years before P liquidates.

Parent Termination Case #1 (PLR 200438015) Year 1 Year 1 Result S Corp Merger S Corp/P (1) Stock of Other Subs S Corp/P S Sub S Sub S Sub/S P S T Other Subs T (2) Merger S T Other Subs Other Subs The merger of P into S Corp deconsolidates the P group and disaffiliates T and the Other Subs. S Corp’s contribution of Other Subs to T reaffiliates T and the Other Subs, with T as the common parent of a new affiliated group. Can the T affiliated group elect to consolidate? Or is T a successor to P, in which case §1503(a)(3)(A) applies? Does it matter what portion of P’s assets were contributed to T? Would it matter if P contributed assets to T before the merger, of if S Corp contributed P assets to T one or two years after the merger? In PLR 200438015, the Service concluded that the T group had the privilege of filing a consolidated return beginning in the first year after the transaction. In light of taxpayer’s representations, the Service may have viewed T as P’s successor and granted a waiver under §1504(a)(3)(B), although the ruling doesn’t refer to a waiver or the waiver provision. The taxpayer represented that “[t]he transfers of assets from [P] to [T] will represent less than X of [P].” Should the percentage of P’s assets or S’s assets transferred to T be relevant?

Parent Termination Case #2 (PLR 200604017) Effective Date A Date B Result Old P Old P Old P Converts to S Corp Sub Sub Sub Convert to QSubs Sub 1 Sub 1 Sub 1 Subs 2, 3, & 4 New P Sub 2 Sub 3 Sub 4 Sub 2 Sub 3 Sub 4 New P Sub 2 Sub 3 Sub 4 The conversion of Old P to an S Corp terminates the Old P group effective Date A. The Conversion of Sub 1 to a QSub disaffiliates Subs 2-4 effective Date A. The contribution of Subs 2-4 to New P creates a new affiliated group with New P as the parent. Can the New P group elect to consolidate (without a waiver)? Or is New P a successor to Old P, causing §1503(a)(3)(A) to apply? Does it matter what portion of Old P’s assets were contributed to New P? In PLR 200604017, the Service concluded that New P “will not be considered a successor” under §1504(a)(3)(A) and that the New P group may elect to file a consolidated return. The taxpayer represented that “[t]he stock of Sub 2, Sub 3, and Sub 4 accounted for approximately x% (less than 5%) of the total fair market value of Old Parent.” This 5% threshold is unrelated to the “substantially all” standard contained in Rev. Proc. 77-37, 1977-2 C.B. 568 (90% net value/70% gross value).

Section 355 – New Affiliated Group Case #1 (PLR 200023040) Year 1 Year 1 Year 1 Result (1) P contributes some D stock to F P P P P D F D F F D F Controlled Controlled Newco Newco Newco (2) F forms Newco with some D stock and other assets Other Subs Other Subs (3) D distributes the Controlled stock in return for D stock D Controlled Controlled Other Subs Other Subs P and D continue to be an affiliated and consolidated group, with P as the common parent. Newco, Controlled and the Other Subsidiaries are a new affiliated group, with Newco as the common parent. Can the Newco affiliated group elect to consolidate? Or is Newco a successor to P, causing §1504(a)(3)(A) to apply? In PLR 200023040, the Service expressly granted a waiver of §1504(a)(3)(A), thus apparently concluding that Newco was a successor of P.

Section 355 – New Affiliated Group Case #2 (PLR 200626011) Public Public Public Controlled Stock Distributing Distributing Contributed Subs Distributing Controlled Retained Subs Contributed Subs Controlled Retained Subs Controlled Retained Subs Contributed Subs Contributed Subs Distributing and the Retained Subs continue to be a consolidated group. Can Controlled and the Contributed Subs file a consolidated return? Or is Controlled a successor to Distributing, causing §1504(a)(3)(A) to apply? In PLR 200626011, the Service held that Controlled will not be considered a successor to Distributing for purposes of §1504(a)(3), and that Controlled and the Contributed Subs could elect to file a consolidated return. The ruling does not refer to any taxpayer representation regarding the relative values of Distributing and the Contributed Subs transferred to Controlled.

Taxable Asset Acquisition Case $ B P 85% of T Stock (1) 85% 15% (2) T checks the box to be treated as a partnership (§332 as to B, §331 as to P) S T T Can the P group continue? Or is P the successor of deconsolidated T because P has acquired 15% of T’s assets in a taxable transaction? What if P retained 25% of T’s stock (so that (i) P acquired 25% of T’s assets and (ii) T’s liquidation was a §331 liquidation for both P and B)? What if, instead, P purchased a significant portion of T’s assets prior to selling the stock of T?