1. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporations, Partnerships, Estates & Trusts 1 Chapter 8 Consolidated Tax Returns

2. The Big Picture (slide 1 of 2) Alexander Corporation has had a long-term association with one of its suppliers, Hamilton Corporation. –In the past, Hamilton was a highly profitable operation and was even able to make loans to Alexander to cover short-term working capital needs. –Recently, however, Hamilton has been less reliable, but Alexander feels confident that Hamilton’s fortunes will improve. If this financial turnaround occurs, Alexander will continue dealing with Hamilton. Alexander’s tax advisers have suggested that Alexander consider acquiring Hamilton in a merger or other takeover that qualifies as a tax-favored reorganization (see Chapter 7).

3. The Big Picture (slide 2 of 2) Acquisition of Hamilton offers several advantages. –Hamilton has large net operating losses that Alexander could use on future joint tax returns. –Hamilton’s name, reputation, and location still have value in the marketplace. It could continue as a separate division or subsidiary of Alexander. Furthermore, the takeover would give other businesses greater assurance of Hamilton’s financial viability. –Lastly, there could be other tax advantages to Alexander, the new parent of a two-corporation group. Evaluate this and other viable alternatives for Alexander taking into account various possible outcomes (e.g., the success or failure of Hamilton’s business). Read the chapter and formulate your response.

4. Reasons for Using Multiple Entities (slide 1 of 3) Isolate assets of certain ventures from liabilities of other ventures (i.e., obtain limited liability) Carry out estate planning objectives

5. Reasons for Using Multiple Entities (slide 2 of 3) Define upper limit on losses in joint venture with outside party by establishing minimally funded subsidiary to participate in venture Shield identities of true owners of venture

6. Reasons for Using Multiple Entities (slide 3 of 3) Enhance market value of entity assets by taking advantage of goodwill or trade names of certain members

7. Consolidated Return Advantages (slide 1 of 3) Current losses can offset income of other members and reduce current regular tax or AMT Operating and capital loss carryovers of one member may be used to offset income of other members

8. Consolidated Return Advantages (slide 2 of 3) Taxation of intercompany dividends may be eliminated Income on certain intercompany transactions can be deferred

9. Consolidated Return Advantages (slide 3 of 3) Certain deductions and tax credits can be better utilized when subject to limitations of overall group rather than individual members Basis in stock owned in lower tier entities is increased as income is reported

10. Consolidated Return Disadvantages (slide 1 of 3) Election is binding on all members for current and all subsequent years’ returns Election may be terminated if: –IRS consents to revocation, or –If membership in group changes and new member is not included in election

11. Consolidated Return Disadvantages (slide 2 of 3) Losses on intercompany transactions are deferred Certain deductions and tax credits may be reduced if limitations are determined based on activities of entire group

12. Consolidated Return Disadvantages (slide 3 of 3) Basis in stock owned in lower tier entities is reduced if losses from the subsidiary are reported Additional reporting requirements exist, and additional administrative procedures are necessary

13. The Consolidated Return Election

14. Electing Consolidated Return Status A corporation can elect to join in a consolidated return if: –It is a member of an affiliated group –It is not ineligible to file on a consolidated basis –It meets initial and ongoing requirements

15. Affiliated Group (slide 1 of 3) Exists when one corporation owns at least 80% of voting power and stock value of another corporation –Ownership test must be met every day of tax year –Multiple tiers and chains of corporations are allowed –Must have an identifiable parent corporation At least 80% of one corporation must be owned by another

16. Affiliated Group (slide 2 of 3) Affiliated group members can file tax returns in two ways: –Each member files a separate return Claim a 100% dividends received deduction for payments passing among them –Elect to file consolidated tax returns No 100% dividends received deduction is allowed for payments among group members Election may not be binding for state purposes

17. Affiliated Group (slide 3 of 3)

18. Affiliated Versus Controlled Group An affiliated group is similar but not identical to a parent-subsidiary controlled group Members of a controlled group are –Required to share a number of tax benefits, including: Discounted marginal tax rates on the first $75,000 of taxable income The $150,000 or $250,000 accumulated earnings credit The $40,000 exemption in computing AMT liability –Must defer recognition of realized loss on intercompany sales until sale is made at a gain to a nongroup member –Must recognize as ordinary income gain on the sale of depreciable property between controlled group members

19. Parent-subsidiary Controlled Group Exists when one corporation owns at least 80% of voting power or stock value of another corporation on the last day of the year –Can have multiple tiers of subsidiaries and chains of ownership –Must have an identifiable parent

20. Entities Not Eligible for Consolidation Election Entity type: –Corporations established outside the US or in a US possession –Tax-exempt (charitable) corporations –Insurance companies –Partnerships, trusts, estates, limited liability entities, or other noncorporate entities These corporations cannot be used to meet the stock ownership tests and their incomes cannot be included in the consolidated return

21. Are these Eligible Groups?

22. Compliance Requirements (slide 1 of 5) Initial consolidated return must meet the following requirements: –Form 1120 should include income of all members of consolidated group –Form 1122 is filed with first consolidated tax return Represents consent by all entities to be included in consolidated group –Election must be made no later than the extended due date of parent’s return

23. Compliance Requirements (slide 2 of 5) Subsequent consolidated returns: –Form 851 is included, which identifies all group members and shareholdings among the members –Form 851 also lists estimated tax payments made by any member during year

24. Compliance Requirements (slide 3 of 5) Liability for taxes: –Each member is jointly and severally liable for entire consolidated tax liability, penalties and interest –Starting with third consolidated tax year, estimated tax payments must be made on consolidated basis

25. Compliance Requirements (slide 4 of 5) Tax liability calculation –Regular tax is determined using graduated tax rates on consolidated income –Lower tax brackets are allocated equally to all members unless an election is made to allocate such benefits differently –Alternative minimum tax liability is based on consolidated AMTI of group Group gets only one $40,000 exemption ACE adjustment is computed using consolidated amounts

26. Compliance Requirements (slide 5 of 5) Accounting periods and methods: –Tax year of parent must be used by all members Short-year return may be required for the first year a subsidiary is included in the consolidated return –Accounting methods in place at the date of the election continue to be used

27. The Big Picture – Example 13 Compliance Requirements (slide 1 of 2) Return to the facts of The Big Picture on p. 8-2. Assume that both Alexander and Hamilton use calendar tax years, and that they wish to file their Federal income tax returns on a consolidated basis starting with the 2011 tax year. – Alexander does not elect an extended due date for its 2011 return.

28. The Big Picture – Example 13 Compliance Requirements (slide 2 of 2) For the consolidation election is to be effective –Alexander must file a Form 1120 that includes the taxable income/(loss) for both corporations by March 15, 2012. –Hamilton must execute a Form 1122 and attach it to the consolidated Form 1120. If Alexander and Hamilton convert their separate tax returns to the consolidated format in this manner –The election in force for all future tax years, or –Until the IRS approves Alexander’s application to revoke it.

29. Stock Basis of Subsidiary (slide 1 of 7) Parent corporation’s basis in the subsidiary’s stock is: –Initially, the acquisition price –Adjusted at end of each tax year Prevents double taxation of gain or loss on ultimate disposal of subsidiary’s shares

30. Stock Basis of Subsidiary (slide 2 of 7) Positive adjustments: Basis in subsidiary is increased by: –Allocable share of consolidated taxable income for year –Allocable share of consolidated operating or capital loss of subsidiary that could not use the loss through carryback to a prior year –Contributions to capital of subsidiary

31. Stock Basis of Subsidiary (slide 3 of 7) Negative adjustments: Basis in subsidiary is reduced by: –Allocable share of consolidated taxable loss for year –Allocable share of operating or capital loss carryover deducted on consolidated return which did not previously reduce basis in subsidiary’s stock –Dividends paid by subsidiary to the parent out of E & P

32. Stock Basis of Subsidiary (slide 4 of 7) When postacquisition taxable losses of subsidiary exceed acquisition price, an excess loss account is established –Allows consolidated return to recognize losses of subsidiary in current year –Enables group to avoid reflecting a negative stock basis in subsidiary

33. Stock Basis of Subsidiary (slide 5 of 7) If stock of subsidiary is redeemed or sold to third party, any balance in excess loss account is recognized as capital gain

34. Stock Basis of Subsidiary (slide 6 of 7) In a chain of more than one tier of subsidiaries, begin computation of stock basis in lowest- level subsidiary – Proceed up the ownership structure to parent

35. Stock Basis of Subsidiary (slide 7 of 7) There is no such concept as consolidated E & P –Each entity accounts for its share of consolidated taxable income –Immediately recognizes within E & P any deferred gain or loss on intercompany transactions –Reduces E & P by allocable share of consolidated tax liability

36. The Big Picture – Example 18 Stock Basis Of Subsidiary (slide 1 of 2) Return to the facts of The Big Picture on p. 8-2. Assume that Alexander acquired all of the outstanding Hamilton stock on January 1, 2010, for $1 million. The parties immediately elected to file consolidated Federal income tax returns.

37. The Big Picture – Example 18 Stock Basis Of Subsidiary (slide 2 of 2) Hamilton reported a 2010 taxable loss of $100,000, but it generated $40,000 taxable income in 2011 and $65,000 in 2012. Hamilton paid a $10,000 dividend to Alexander in mid-2012. Alexander holds the following stock bases in Hamilton on the last day of each of the indicated tax years. 2010 $900,000 2011 $940,000 2012 $995,000

38. Computing Consolidated Taxable Income (slide 1 of 3) Sequential Approach: –Compute taxable income separately for each member of group –“Group items” and “intercompany items” are isolated and receive special treatment –Remaining separate incomes are combined with group and intercompany items, resulting in consolidated taxable income

39. Computing Consolidated Taxable Income (slide 2 of 3) This computational procedure allows several transactions to be accounted for on a consolidated basis –e.g., charitable contributions, capital gains and losses

40. Computing Consolidated Taxable Income (slide 3 of 3)

41. Intercompany Transactions (slide 1 of 4) Most intercompany transactions remain in the members’ separate taxable income –Effectively cancel each other out on a consolidated basis

42. Intercompany Transactions (slide 2 of 4) Most intercompany transactions remain in the members’ separate taxable income (cont’d) –e.g., Services provided by one member to another member Services provider recognizes income Service purchaser recognizes deductible expense Net result is a zero addition to consolidated taxable income

43. Intercompany Transactions (slide 3 of 4) When members involved in the intercompany transaction use different accounting methods –Payor’s deduction for intercompany expenditure is deferred until year in which recipient recognizes the related gross income

44. Intercompany Transactions (slide 4 of 4) Dividends received from other group members –Eliminated from recipient’s separate taxable income –No dividends received deduction allowed –If dividend is noncash asset Payor member realizes gain but defers recognition until asset leaves the group The (eliminated) dividend amount = FMV of asset received

45. Member’s NOLs (slide 1 of 6) Usual corporate provisions for NOLs are available for consolidated losses –Carryback 2 years –Then forward 20 years –Election to forgo carryback for all members is available

46. Member’s NOLs (slide 2 of 6) In computing consolidated NOL –Remove consolidated charitable contributions and capital gain or loss from taxable income These items have their own carryover periods and rules –The consolidated dividends received deduction remains a part of the consolidated NOL

47. Member’s NOLs (slide 3 of 6) Complications arise when group members enter or depart from the consolidated group –Members’ NOLs are either incurred in a “separate return year” and deducted in a “consolidated return year” or vice versa Several restrictions limit the availability of such NOL deductions

48. Member’s NOLs (slide 4 of 6) Where members of consolidated group change over time, consolidated NOL must be apportioned to group members using the following formula: Member’s separate NOL × Consolidated NOL Members’ aggregate NOL = Member’s apportioned NOL

49. Member’s NOLs (slide 5 of 6) In years when group member files a separate return, only the apportioned NOL may be carried over When member leaves the group, any apportioned share of unused loss carryforwards can be used on its subsequent separate returns

50. Member’s NOLs (slide 6 of 6) Separate return limitation year (SRLY) rules apply when NOLs are carried forward from a separate return year onto a consolidated return Consolidated return can include loss from member’s SRLY period only to lesser of its: Current year income, or Cumulative positive contribution to current year consolidated income

51. Computation of Group Items (slide 1 of 2) Several items are computed on a consolidated basis including: –Net capital gain/loss –§ 1231 gain/loss –§ 199 domestic production activities deduction –Casualty/theft gain/loss –Charitable contributions –Dividends received deduction –Net operating loss –AMT adjustments and preferences

52. Computation of Group Items (slide 2 of 2) Several items are computed on a consolidated basis (cont’d) –All of these items are removed from members’ separate taxable income Then use consolidated taxable income to that point to determine statutory limitations for group-basis gains, losses, income, and deductions

53. The Matching Rule (slide 1 of 3) Certain intercompany transactions receive deferral treatment –Gain or loss realized is removed from taxable income until the sold asset leaves the group –Prevents accelerating loss deductions on sales of assets within the group

54. The Matching Rule (slide 2 of 3) Certain intercompany transactions receive deferral treatment (cont’d) –Applies to the following transactions among group members: Sale of assets Performance of services

55. The Matching Rule (slide 3 of 3) The entire deferred gain or loss is included in consolidated taxable income when: –The asset is transferred outside the group –The transferor of property leaves the group –Consolidation election is terminated

56. Refocus On The Big Picture (slide 1 of 3) If Alexander and Hamilton qualify, and both corps. continue to exist as separate entities, they should consider filing their Federal income tax returns on a consolidated basis. –If Hamilton begins to generate positive taxable income, the NOLs and other attractive tax attributes that Hamilton brings to the group will be of great benefit to both corporations.

57. Refocus On The Big Picture (slide 2 of 3) The group also may benefit from other aspects of Hamilton’s tax situation, including its accumulated capital and passive losses and credits that have been carried forward due to a lack of tax liability. –In all likelihood, Alexander and Hamilton are a ‘‘good match’’ as potential consolidated return partners.

58. Refocus On The Big Picture (slide 3 of 3) What If? But what if Alexander’s expectations for a turnaround in Hamilton’s business fortunes prove to be incorrect and the subsidiary continues to generate NOLs? –The SRLY rules will prevent the deductions and credits acquired from Hamilton from being of immediate use to the affiliated group. –A consolidation election will be beneficial only if the Hamilton subsidiary generates positive postacquisition taxable income.

59. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 59 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta