Chapter 7 LIMITATIONS AND ADJUSTMENTS DUE TO CONSOLIDATION. Example 29. Consolidated Tax Return Fundamentals -45-

Transcription

1 Consolidated Tax Return Fundamentals -45- Chapter 7 LIMITATIONS AND ADJUSTMENTS DUE TO CONSOLIDATION One of the attractions of filing a consolidated tax return is the ability of a profitable entity to use the losses and credits of an unprofitable entity. One can only imagine the abuses that would result if some form of limitation were not imposed to maintain the integrity of a single-entity concept while preventing certain abuses. As a result, the consolidated return Regulations impose certain restrictions. These involve the following: 1. Separate return limitation years. 2. Built-in deductions. 3. Carryovers and carrybacks to separate return years. 4. Consolidated 382. SEPARATE RETURN LIMITATION YEAR When a corporation incurs a net operating loss in a separate return year and subsequently carries that loss to a consolidated return year, the Regulations limit the deductible amount of the loss carryover. 1 The limitation is imposed only if the loss year is considered a separate return limitation year (SRLY). Generally, this means any loss year for which a separate return was filed, except where the corporation was a member of the group for the entire year or the corporation is the parent in the year to which the loss is being carried. The amount of loss incurred in a SRLY that may be deducted in a consolidated year is limited to the excess of consolidated taxable income (computed without regard to the net operating loss deduction) over consolidated taxable income as reduced by the loss member's income and deductions. 2 In essence, the group's deduction for any member's SRLY losses cannot exceed the member's contribution to consolidated taxable income. 3 Example 29 P and S are members of an affiliated group for Year 1 and file a consolidated tax return. T Corporation, owned by an individual, incurs a $15,000 net operating loss for Year 1. On January 1, Year 2, P acquires all the stock of T. In Year 2 P, S, and T file a consolidated tax return showing consolidated taxable income of $40,000, of which $6,000 is 1 Reg A. 2 Reg A(c)(2) 3 If there are carryovers from more than one year, they are absorbed in chronological order.

2 attributable to the efforts of T. Because of the SRLY rules, only $6,000 of the $15,000 loss is considered a consolidated net operating loss carryover to Year 2. The carryover is limited to $6,000 [$40,000 (consolidated taxable income) minus the $34,000 (consolidated taxable income of $40,000 - the loss member s income and deductions of $6,000)]. The remaining $9,000 ($15,000 - $6,000) may be carried over to Year 3 and is subject to the SRLY rules and NOL carryover limitations. According to the definition of a SRLY noted above, the corporation designated as the common parent for an affiliated group is generally not subject to the SRLY rules since its years are not considered SRLY years. Under this so-called lonely parent rule, the parent's losses from a "pre" or "post" affiliation year may be used to offset the earnings of other members in a consolidated return year. 4 This exception does not apply if there has been a reverse acquisition or similar merger of a parent into a subsidiary. Example 30 Example 31 In Year 1, P, a first-year corporation, files a separate return with an operating loss of $12,000. On January 1, Year 2, P acquires all the stock of S Corporation. For Year 2, P and S file a consolidated tax return reflecting P s taxable income of $5,000 for Year 2 and S s taxable income of $24,000. In this case, the SRLY rules are not applicable since P is the common parent. Consequently, all $12,000 of the loss carryover is utilized in Year 2. Assume the same facts as in Example 30, except that P sells all the S stock on January 1, Year 3. If P incurs a $14,000 loss for Year 3, the SRLY rules do not restrict P from carrying back the loss from this postaffiliation year to a consolidated return year since P was the parent in the year to which the loss is carried. Therefore, the full amount of the loss can be carried back to Year 2 to offset consolidated taxable income without limitation. (Note that the SRLY rules apply to carrybacks as well as carryovers.) The SRLY rules are also inapplicable for a corporation's separate return year (SRY) if that corporation was a member of the group for each day of such year. 5 This would occur when the corporation was a member of a group that elected not to file on a consolidated basis. 6 Example 32 4 F.C. Donovan, Inc. v. U.S., 261 F.2d 470 (CA- 1, 1958). 5 Reg (f). See Braswell Motor Freight Line, Inc. v. U.S., 477 F.2d 594 (CA-5, 1973), where a corporation was formed in 1955 and became a member of the group in July of Although the corporation had no assets or taxable income prior to July 1957, the loss generated in the latter half of the year was subject to the SRLY rules because the corporation was not a member for each day of the year (1957). 6 Reg (f). The same rule applies to a predecessor of any group member that was a member of the group on each day of the year. A predecessor is a transferor or distributor of assets to the member in a transaction to which 381(a) applies.

3 Consolidated Tax Return Fundamentals Assume P forms S in Year 2 and each corporation files a separate tax return for 2 years. In Year 4 P and S elect to join in the filing of a consolidated tax return. Any loss carryforwards that S incurred during Year 2 or Year 3 will not be subject to the SRLY rules because S was a member of the group for each day of those years. Related Provisions The SRLY rules are not restricted to net operating losses. The rules also apply to net capital losses, the investment tax credit, and foreign tax credits. Note, however, that charitable contribution carryovers do not fall within these restrictions. MODIFIED SRLY RULES The history of the final regulations dates back to the beginning of the 1990 s. Proposed regulations were first issued on January 29, The 1991 proposed regulations set forth amendments to the rules regarding NOLs, built-in losses, capital losses, and the application of 382 and 383(b) for consolidated groups, and introduced two new concepts related to the SRLY rules -- subgrouping and the cumulative register. On June 26, 1996, the 1991 proposed regulations were withdrawn, and Treasury issued temporary and re-proposed regulations. The only significant change in the 1996 temporary regulations dealt with the effective date of the rules. The 1996 temporary regulations applied to all SRLY losses that are used in consolidated return years beginning after 1996, regardless of the date that the subsidiary (or subgroup) joined the consolidated group. In addition to establishing an effective date, two important transition changes for years between 1991 and 1997 were made beyond what was originally proposed. 7 After painstakingly soliciting comments on the temporary amendments, final regulations were issued on June 25, The tough issue for Treasury was whether to retain or abandon the SRLY. Commentators suggested that due to the harsh and restrictive nature of 382, SRLY rules were not necessary to prevent the trafficking in net operating losses. After much deliberation, Treasury took the middle ground in the final regulations with a new overlap rule. Under the overlap rule, SRLY limitations generally will not apply to NOL carryovers when it overlaps with the application of 382. Each of these topics will be addressed in more depth as they are discussed throughout this chapter A Member's Contribution to Taxable Income Recall that the amount of net operating loss being carried into a consolidated return from a SRLY year is limited to the income contributed by the member carrying over the loss. Under the old (pre-1991) regulations, a member's contribution to the taxable income of the group was measured on a "with and without" basis. Under the new temporary regulations, a member's contribution to consolidated taxable income is based upon the member's own items of income, gain, deduction, and loss. 8 Thus, the amount of SRLY that may be absorbed in any given consolidated return year is established solely by reference to that member's contribution to consolidated taxable income. Under this method, a member's contribution to taxable income cannot be diminished by another member's net operating loss or capital loss unless it is a member 7 Reg (g)(3). 8 Reg (c)(1).

4 of a subgroup (discussed later). Cumulative Contribution to Consolidated Taxable Income The Cumulative Register Under the modified regulations, the ability to use a SRLY loss is based not only upon the member's contribution to consolidated taxable income but also upon the member s cumulative contribution to taxable income since it became a member of the group. 9 As a result, if a subsidiary with SRLY losses becomes a member of an affiliated group and continues to generate losses after affiliation, the new member must first contribute income toward consolidated taxable income in the amount of its post-affiliation losses before it has the opportunity to utilize its SRLY losses. Example 33 P and S, both calendar year corporations, become affiliated on January 1, Year 1, when S has a NOL carryover of $40,000. During Year 1, P and S have consolidated taxable income of $100,000, of which $16,000 is attributable to S. In Year 2, P and S experience a consolidated loss of $85,000, of which $50,000 is attributable to S. In Year 3, P and S have $120,000 of consolidated taxable income, of which $31,000 is attributable to S. Under the new cumulative contribution rules, in Year 1 S can utilize up to $16,000 of its NOL carryforward and the remaining $24,000 ($40,000 - $16,000) will continue to carry forward. In Year 2, because S has made no contribution to taxable income, none of the NOL carryforward can be utilized. In Year 3, even when S contributes taxable income of $31,000, none of the NOL carryforward can be used because S has made a negative contribution to consolidated taxable income on a cumulative basis since it became a member of the affiliated group ($16,000 - $50,000 + $31,000 = -$3,000). Until S can recover to a positive contribution on a cumulative basis, none of its SRLY loss can ever be utilized. Under the pre-1991 rules, S could have utilized the remaining $24,000 of its NOL in Year 3 because it made a positive contribution to taxable income for that year. A favorable result of this cumulative approach, however, is that SRLY losses can now be absorbed in a year in which the member has no taxable income, provided the member has contributed positively to consolidated taxable income on a cumulative basis since it became a member of the group. SRLY Subgroups A second facet of the new regulations promulgate the extent to which a group can absorb a SRLY loss must be determined on a sub-group basis. 10 In other words, all corporations within that subgroup are treated as a single entity for purposes of determining a cumulative contribution to consolidated income. A SRLY subgroup is a group composed of all members that have been 9 Ibid. 10 Reg (c)(2).

5 Consolidated Tax Return Fundamentals continuously affiliated with the member since the loss arose. A separate SRLY subgroup is formed for each SRLY loss that is carried into a consolidated return. Once a SRLY subgroup is established, no other corporations can become a member of that subgroup unless they become classified as "successor" corporations. Example 34 On December 31, Year 1 P and S, affiliated calendar year corporations, have a NOL carry forward of $40,000, which is not a SRLY and all of the loss is attributable to S. On January 1, Year 2 M purchases all the stock of P and S and the NOL now becomes a SRLY loss to the M-P-S group. Because P and S now become a subgroup, their $40,000 SRLY NOL can be used to the extent that the subgroup (and not just S) can contribute to the M-P-S affiliated group s income for the year. Because more than one SRLY loss may be carried forward, a corporation may be considered to be a member of more than one SRLY subgroup. When this is the case, the regulations provide "anti-duplication" rules to ensure that items of income and deductions are not taken more than once in determining the SRLY absorption. 11 In addition, losses utilized by the consolidated group are absorbed on a FIFO basis using the principles of 172. Example 35 Assume the same facts as Example 34, and for Year 3 the M P S affiliated group experiences a consolidated taxable loss of $55,000. Accordingly, none of the $40,000 SRLY subgroup loss can be utilized. If on January 1, Year 4, L corporation buys all the stock of M corporation, two SRLY subgroups are formed: P S, with a SRLY loss of $40,000, and M P S, with a SRLY loss of $55,000. Because P and S are in both subgroups, special anti-duplication rules will prevent any positive taxable income generated by these corporations in the future from being used more than once in absorbing SRLY carryovers to the L M P S affiliated group OVERLAP RULE Included in the final 1999 SRLY regulations was a concept referred to as the overlap rule. In general, if an NOL carryover is subject to both the SRLY rules and 382, the overlap rule eliminates the application of the SRLY rules. To qualify for the NOL overlap rule, a corporation must become a member of a consolidated group (a SRLY event) within six months of the change date of an ownership change that gives rise to a 382(a) limitation with respect to that carryover (a 382 event). 12 Accordingly, the overlap rule applies to preclude a SRLY limitation whenever a SRLY event precedes or follows a 382 event by six months. 11 Reg (c)(2)(iv). 12 Reg (g)(2)(ii).

6 Example 36 Individual A owns all of the stock of P, which in turn owns all of the stock of S. P and S file a consolidated return. In Year 2, B, an individual unrelated to Individual A, forms T which incurs a $100 net operating loss for that year. At the beginning of Year 3, S acquires T. S s acquisition of T results in T becoming a member of the P group (the SRLY event) and also results in an ownership change of T (the 382 event) with respect to the T NOL carryover. Because the SRLY event and the change date of the 382 event occur on the same date, there is an overlap of the application of the SRLY rules and the application of 382. Consequently, in Year 3 the SRLY limitation does not apply to the Year 2 $100 net operating loss. If the 382 event precedes the SRLY event, the overlap rule, and therefore the elimination of SRLY, is applicable to the tax year that includes the SRLY event. If the SRLY event precedes the 382 event, the elimination of SRLY is delayed until the first tax year that begins after the 382 event. Without this delay it would be possible to acquire an NOL carryover and have a period of time when neither SRLY nor 382 would apply. While Treasury wants to eliminate the unnecessary duplication of loss limitation rules, Treasury does not want these acquired NOL carryovers to have a period of time where they are not subject to any loss limitation rule. Example 37 Example 38 Individual A owns all of the stock of P, which in turn owns all of the stock of S. P and S file a consolidated return. In Year 1, B, an individual unrelated to Individual A, forms T which incurs a $100 net operating loss for that year. On February 28 of Year 2, S purchases 55% of T from Individual B. On June 30, of Year 2, S purchases an additional 35% of T from Individual B. The February 28 purchase of 55% of T is a 382 event because it results in an ownership change of T with respect to the T NOL carryover. The June 30 purchase of 35% of T results in T becoming a member of the P group and is therefore a SRLY event. Because the SRLY event occurred within six months of the change date of the 382 event, there is an overlap of the application of the SRLY rules and the application of 382. Consequently, in Year 2 the SRLY limitation does not apply to the Year 1 $100 net operating loss carryover. However, if Individual B does not sell the additional 35% of T to S until September 30, Year 2, the SRLY event does not occur until that time. Because the SRLY event did not occur within six months of the change date of the 382 event, there is no overlap of the application of the SRLY rules and the application of 382. Consequently, the Year 1 net operating loss is subject to a SRLY limitation and a 382 limitation. P and S file a consolidated return. S has owned 40% of T for 6 years. For Year 6, T has an net operating loss of $500 that is carried forward. On October 31, Year 7, S acquires an additional 40% of T, and on November 30, Year 7, S acquires the remaining 20% of T. The October 31 purchase of 40% of T results in T becoming a member of the P group and is therefore a SRLY event. The November 30 purchase of 20% of T is a 382

7 Consolidated Tax Return Fundamentals event because it results in an ownership change of T with respect to the T carryover. Because the SRLY event occurred within six months of the change date of the 382 event, there is an overlap of the application of the SRLY rules and the application of 382. The SRLY rules will apply to the Year 7 tax year. Beginning in Year 8 (the year after the 382 event), any unabsorbed portion of the Year 6 net operating loss will not be subject to a SRLY limitation. If the final 20% of T was acquired on February 28, Year 8, instead of November 30, Year 7, since the February 28 purchase is still within 6 months of the SRLY event (October 31, Year 7), the overlap rule is still applicable. However, under these facts, the SRLY limitations would apply to T s NOL carryforward in Year 7 and Year 8. Beginning in Year 9 (the year after the 382 event), any unabsorbed portion of the Year 6 net operating loss will not be subject to a SRLY limitation. Overlap Subgroup Rules In general, the overlap rule applies to the subgroup and not separately to the members of the subgroup. However, the overlap rule does not apply unless the SRLY subgroup is coextensive with the 382 loss subgroup. The Treasury s believes that the coextensive requirement is necessary because a 382 subgroup limitation that is computed with respect to the expected income generation of a group of corporations does not reasonably approximate a limitation that would be based on the actual contribution to consolidated taxable income by a smaller number of corporations. Example 39 Individual A owns all of the stock of S, which in turn owns all of the stock of T. S and T file a consolidated return beginning in Year 1. B, an individual unrelated to A, owns all of the stock of P, the common parent of a consolidated group. In Year 2, the S group has a $200 consolidated NOL which is carried forward, of which $100 is attributable to S, and $100 is attributable to T. At the beginning of Year 3, the P group acquires all of the stock of S from Individual A. P s acquisition of S results in S and T becoming members of the P group (the SRLY event). With respect to the Year 2 NOL carryover, S and T compose a SRLY subgroup. S and T also compose a loss subgroup under Reg (d)(1) with respect to the Year 2 NOL carryover. P s acquisition also results in an ownership change of S, the subgroup parent, (the 382 event) with respect to the Year 2 carryover. Because the SRLY event and the change date of the 382 event occur on the same date, there is an overlap of the application of the SRLY rules and the application of 382. Because the SRLY subgroup and the loss subgroup are coextensive, the SRLY limitation does not apply to the Year 2 $200 NOL carryover. In those situations in which a SRLY subgroup would be larger than the corresponding 382 subgroup (or single new loss member), the final regulations provide for an election effectively to expand a newly-formed 382 subgroup to conform with a SRLY subgroup Reg (d)(4). The election must be timely made by the common parent with its income tax return for the consolidated return year in which the members with respect to which the election is made become members of the group. This election is described in more detail later in this chapter and also in Reg

8 Example 40 Individual B owns all of the stock of P, the common parent of a consolidated group. P owns all of the stock of S and all of the stock of T. Individual A owns all of the stock of X, the common parent of another consolidated group. In Year 1, the P group has a $200 consolidated NOL, of which $100 is attributable to S and $100 is attributable to T. At the beginning of Year 3, the X group acquires all of the stock of S and T from P and does not make an election under Reg (d)(4). X s acquisition of S and T results in S and T becoming members of the X group (the SRLY event). With respect to the Year 1 NOL, S and T compose a SRLY subgroup. S and T do not bear (and are not treated as bearing) a 1504(a)(1) relationship. Therefore, S and T do not qualify as a loss subgroup under (d)(1). X s acquisition of S and T results in separate ownership changes of S and T, that give rise to separate limitations under 382(a) (the 382 events) with respect to each of S and T s Year 1 NOL carryovers. The SRLY event and the change dates of the 382 events occur on the same date. However, the overlap rule does not apply because the SRLY subgroup (composed of S and T) is not coextensive with a loss subgroup with respect to the Year 1 carryovers. Consequently, the Year 1 NOL is subject to both a SRLY subgroup limitation and also separate 382 limitations for both S and T. To illustrate the complexity of trying to apply a single SRLY subgroup limitation and multiple 382 limitations to the same NOL carryover, make the following assumptions relative to Year 3 in Example 40: (1) S and T contribute $40 as a subgroup to the consolidated taxable income of the X group (i.e., the SRLY subgroup limitation is $40), (2) S s separate 382 limitation is $20, and (3) T s separate 382 limitation is $30. Since the SRLY limitation ($40) is less than the combined 382 limitations ($50), only $40 of the S-T NOL carryovers can be used in Year 3. The regulations do not provide any guidance as to how these two limitations should be integrated. The approach suggested here is to allocate the $40 SRLY limitation to the two 382 limitations on a pro-rata basis. If this approach were taken, the maximum amount of S s $100 of NOL carryovers that could be utilized in Year 3 is $16 ($20/$50 x $40) and the maximum amount of T s $100 of NOL carryovers that could be utilized in Year 3 is $24 ($30/$50 x $40). For Year 3, S and T would have unused 382 limitation amounts of $4 ($20 - $16) and $6 ($30 - $24), respectively. Also, S and T would have NOL carryovers to Year 4 of $84 ($100 - $$16) and $76 ($100 - $24), respectively. To preserve the effect of the elimination of SRLY under the overlap rule as corporations move from group to group, the final regulations also provide a special rule expanding the 96(e).

9 Consolidated Tax Return Fundamentals definition of SRLY subgroups. 14 Under this rule, a SRLY subgroup includes a member carrying over a loss that was subject to the overlap rule in a former group, and all members of that former group who become a member of the current group at the same time as the loss member. Example 41 Individual A owns all of the stock of R and M, each the common parent of a consolidated group. B, an individual unrelated to Individual A, owns all of the stock of D. In Year 1, D incurs a $100 NOL that is carried forward. At the beginning of Year 3, R acquires all of the stock of D. In Year 5, M acquires all of the stock of R in a transaction that did not result in an ownership change of R. R s Year 3 acquisition of D results in D becoming a member of the R group (the SRLY event) and also results in an ownership change of D (the 382 event) with respect to D s NOL carryover. Because the SRLY event and the change date of the 382 event occur on the same date, there is an overlap. Consequently, D s Year 1 $100 NOL is not subject to a SRLY limitation in the R group. M s Year 5 acquisition of R results in R and D becoming members of the M group (the SRLY event), but does not result in an ownership change of R or D under 382(a). Because there is no 382 event, the application of the SRLY rules and 382 do not overlap. Consequently, D s Year 1 $100 NOL is subject to a SRLY limitation in the M group. Because D s Year 1 NOL carryover was subject to the overlap rule when it joined the R group and there was no SRLY application, a new SRLY subgroup with respect to the carryover of D s NOL includes all of the members of the R group that joined the M group at the same time as D. BUILT-IN LOSSES The concept of built-in losses (formerly referred to in the regulations as built-in deductions) has long been part of the consolidated return regulations which impose certain restrictions on their use. 15 A built-in loss is a deduction or loss that economically accrues in a separate return year but is recognized in a consolidated return year for tax purposes. Example 42 S Corporation purchased an investment three years ago for $22,000. On January 1, Year 4, P Corporation purchased all of the stock of S. At that time, S s investment was worth $13,000. If P and S sell the investment in Year 4 and file a consolidated tax return for the year, $9,000 ($22,000 - $13,000) is considered a built-in loss because it economically accrued in years before Year 4. Under the regulations, 16 a built-in loss can be deducted in determining consolidated taxable income only to the extent of the acquired member's contribution toward consolidated taxable 14 Reg (g)(2) 15 Reg Reg (a)

10 income. The effect of this limitation is the same as if the loss had occurred in pre-affiliation years subject to the SRLY rules for net operating losses. Deductions and losses not currently used are carried forward indefinitely to succeeding years. 17 Exceptions There are two exceptions to the built-in loss rule. First, the limitation does not apply to the assets that a group acquires prior to 1997 (either directly or by acquiring a new member) if the acquisition occurred more than 10 years before the first day of the taxable year in which the sale occurs. 18 Second, the limitation does not apply if immediately before the acquisition of the assets, the aggregate adjusted basis of all assets acquired (excluding cash and marketable securities) did not exceed the fair market value of such assets by more than 15 percent. 19 Cash and marketable securities are excluded from the computation in order to prevent avoidance of this rule by making additional cash and security contributions immediately before acquisition. For years beginning after 1996, the regulations make certain conforming adjustments to the rules of 382(h), and the ten year holding period requirement of has been reduced to 5 years. Example 43 Example 44 On May 24, Year 1, P acquires all the stock of S Corporation. At the time of the acquisition S s only assets are land (fair market value of $12,000; basis of $7,000) and machinery (fair market value of $8,000; basis of $15,000). If in Year 4 the group sells the machinery for $8,000, the built-in loss rules will not apply since at the time of the original acquisition the aggregate basis of S's assets ($7,000 + $15,000 = $22,000) did not exceed their fair market value ($12,000 + $8,000 = $20,000) by more than 15% ($20,000 x 115% = $23,000). Assume the same facts as Example 43, except that the only asset of S was the machinery. In this case the basis exceeds the fair market value by 87.5% (($15,000 - $8,000) $8,000)) and the built-in deduction limitation would apply. However, if the group had waited until Year 6 to sell the machinery, the limitation would not apply because the acquisition took place more than 5 years before the year of the sale (assuming the sale took place after 1996). Built-in Loss Subgroups For corporations that become members of a consolidated group after January 29, 1991, new regulations apply the rules of 382(h) in determining the presence of built-in losses. 20 The presence of a built-in loss must be determined on a subgroup basis at the time of affiliation. A built-in loss subgroup is composed of the member recognizing the loss and all members of the consolidated group that have been continuously affiliated with that member for 60 consecutive 17 Reg (a)(1). 18 Reg (a)(4)(i)(a). 19 Reg (a)(4)(I)(b). 20 Reg

11 Consolidated Tax Return Fundamentals months prior to subgroup status. The final regulations do not adopt the restrictions of 382(h)(1)(B)(ii) which limits the amount of recognized built-in loss to the amount of the net unrealized built-in loss of the subgroup. 21 Example 45 Corporations X and Y are owned by the same individual in Year 1 when X acquires all of the stock of Y. No ownership change occurs because X and Y are commonly controlled. Y is the sole owner of Z Corporation which has been filing a consolidated tax return with Y for the past 7 years. Y and Z become a subgroup. At the time of the acquisition Y has a single asset with a built-in loss and Z has two assets; one with a loss and one with a gain as illustrated below: Z Asset 1 Z Asset 2 Y s Asset Net Unrealized Loss FMV Total FMV Basis Total Basis gain/<loss> 50 <60> <70> <80> The acquisition of the Y subgroup becomes subject to the built-in loss rules because the subgroup exceeds the 15% threshold of 382(h)(3)(B) and Y and Z have been affiliated for more than 60 months. If in Year 2, Z sells Asset 2 for $80, only $60 of the loss (instead of the $70 realized loss) will be subject to the SRLY limitation because only $60 was built-in at the time of the acquisition. If in Year 3, Y sells its asset for $10, it might appear similar to meaning only $20 would be subject to the SRLY limitation ($80 Net unrealized loss $60 subject to SRLY in Year 2). But because of the inconsistency between 382 and Regs , the entire $70 loss is subject to the SRLY limitation. Built-in Loss Overlap Rule The overlap rule, described earlier, also exists for built-in losses and is very similar to the overlap rule for net operating losses. 22 Generally, to qualify for the built-in loss overlap rule, a SRLY event must occur within six months of the change date of an ownership change that gives rise to a 382(a) limitation that would apply to recognized built-in losses (a 382 event). However, the overlap rule does not apply (even with respect to assets held on the date of the 382 event) if assets are transferred to a corporation after the 382 event and before the SRLY event that exceed the de minimis threshold of 382(h). 23 In that case, both the SRLY rules and the 382 rules will apply. Furthermore, the overlap rule does not apply if a corporation that would otherwise be subject to the overlap rule acquires assets from a person (other than a 21 Reg (b)(2)(iii). 22 Reg (g). 23 Reg (g)(3)(ii).

12 member of the group) with a NUBIL in excess of the threshold requirement of 382(h)(3)(B) after the 382 event, but before the SRLY event. 24 The final regulations also provide that after a corporation joins a group in an overlap transaction, it is deemed to have been affiliated with the common parent of the acquiring group for 60 consecutive months in the event the new common parent becomes a member of a new consolidated group. Those corporations that join the group in the same transaction, but that were not part of a subgroup eligible for the overlap rule, begin measuring the period of their affiliation immediately after joining the group, notwithstanding their actual affiliation history. 25 Even after the application of the overlap rule, the SRLY rules for built-in losses apply to asset acquisitions by an acquired corporation that occur after the latter of the SRLY event or 382 event. 26 Example 46 In Year 1 Corporation P, owned 100 percent by individual A, acquires from an unrelated party all of the stock of Corporation S and its includable subsidiary of the past 7 years, T. S and T have a net unrealized built-in loss of $50 and $10 respectively, but because of an overlap situation, are only subject to 382. If, however, over the course of the next 60 months, A for example, should make a transfer under 351 to T of property with a built-in loss, and that built-in loss exceeds the threshold amount, any sale of that property during the 60 month period would be subject to the built-in loss SRLY application. CONSOLIDATED SECTION 382 A General Overview of Section Enacted in 1986, 382 embraces a neutrality principle which imposes an annual limitation on the use of net operating losses (NOLs) and other tax attributes following any ownership change with respect to a loss corporation. Under this principle, the new owners of a loss corporation should not achieve a greater utilization of the loss corporation s tax benefits than its former owners. Thus, the losses and other benefits deemed available to the seller of the stock (and available for use by the purchaser) are represented by the income that would be generated if the assets were sold for cash and the proceeds invested in long-term tax-exempt bonds. An ownership change occurs when one or more 5 percent shareholders of a loss corporation have a more than 50 percentage-point increase in the value in such corporation s stock over the least amount owned by such shareholders at any time during a testing period. The testing period normally begins 3 years before the testing date under consideration. In addition, 382(g)(4)(D) provides special rules for 50% or greater shareholders that treat their loss corporation stock as becoming worthless during a taxable year. Corporations experiencing more than one ownership change must compute a separate 382 limitation for each ownership change. 24 Reg (g)(3)(i). 25 Reg (g)(6), Example Reg (g)(6), Example This overview is by no means a comprehensive analysis of 382. Its purpose is to serve as a very general review of the 382 concepts for the purposes of discussing consolidated 382.

13 Consolidated Tax Return Fundamentals In making the computation of the 382 limitation, Congress imposed additional restrictions in determining the value of the loss corporation. 28 Thus, the value of the loss corporation s stock generally must be reduced by (1) the amount of capital contributions made during the 2-year period ending on the date of the ownership change, (2) the amount of capital contributions made prior to the 2-year period for the principal purpose of avoiding or enhancing the 382 limitation, (3) redemptions or other corporate contractions in connection with the ownership change, and (4) if nonbusiness assets exceed one-third of the total assets at the time of the ownership change, the net value of the nonbusiness assets on the change date. The 382 limitation is reduced to zero if the loss corporation fails to satisfy a continuity of business enterprise test for two years following the ownership change date. In addition to the above restrictions, if a loss corporation has a net unrealized built-in loss on the change date that exceeds the de minimis threshold (which is the lesser of $10 million or 15% of the value of the loss corporation s assets), then the 382 limitation will apply to any built-in loss recognized by the loss corporation within 5 years after the change date as if the built-in loss was a net operating loss arising prior to the change date. Conversely, the limitation will be enhanced by (1) any built-in gain recognized by the loss corporation within 5 years after the change date, provided the loss corporation has a net unrealized built-in gain on the change date that exceeds the de minimis threshold established above and (2) any deemed sale gain recognized that results from a 338(g) election made in connection with the ownership change. 29 Example 47 On June 1, Year 5, P Corporation purchases 40 percent of the outstanding stock of S corporation. On December 31, Year 6 when S has a value of $1,000 and an NOL of $300, P purchases an additional 42 percent of S. Assume that the long-term tax exempt rate for Year 6 is 7 percent. Because a more than 50 percent-point change (40% + 42%) has taken place within the past three years, 382 will apply. Thus, the maximum amount of the $300 NOL that can be taken by S in any given year will be limited to $70 (the $1,000 value of the company multiplied by the long-term tax-exempt rate of 7 percent). Note that the $1,000 value must be reduced for any capital contributions made in anticipation of the 382 ownership change including any contributions made within the last two years. Furthermore, if S fails to continue its historic business for the next two years, the value of S is deemed to be $0 on December 31, Year 6 and none of the $300 NOL can be utilized in the future. Consolidated Section 382 Rules Historically, the consolidated tax return regulations applied a separate company basis in determining an affiliated group s taxable income but embraced a single entity theory when examining the group as a whole. In 1986, when new 382 rules were legislated, no regulatory 28 See 382(l). 29 See 382(h).

14 guidance was provided as to how these rules should be applied in a consolidated context. As a practical matter, 382 could be applied on a separate entity basis, on a single entity basis, or on some hybrid basis such as an equity method. In 1991, at the same time that the SRLY rules were being introduced, the IRS issued proposed consolidated return regulations under 382 to provide guidance on these issues. 30 Unfortunately, the 1991 regulations only offered tutelage in a proposed format and confusion resulted for the next five and one-half years from the failure to finalize these rules. As a result of this confusion, the Internal Revenue Service replaced in 1996 substantially all of the former 1991 proposed regulations. These temporary regulations became effective for tax years (or testing dates) beginning on or after January 1, 1997 and became finalized in The new 382 regulations, somewhat by necessity, offer a dual approach in their application of 382 to an affiliated group. Under both sets of regulations, a loss group or loss subgroup is treated as a single entity and rules were written to embody this approach known as the parent change method. In order to avert potential abuses of the parent change method by having shareholders sell interests in the underlying subsidiaries, the government also applied an equity method approach known as the supplemental method. Each of these rules will be discussed in further detail. Parent Change Method The determination of whether a consolidated group has encountered an ownership change is made using a single entity approach. Under the single entity approach, the members of a consolidated group are treated as divisions of a single taxpayer with the common parent acting as the sole agent for each member of the group. Accordingly, a consolidated group has an ownership change only if the common parent has an ownership change as described by 382(g) and Regs T thus the name the parent change method. 31 Note that the determination as to whether a loss group has an ownership change is not affected by transfers of ownership interests in a subsidiary of the group. Example 48 P Corporation has been filing consolidated returns for the past several years with its 100% owned subsidiary L (a corporation with an NOL). Assume 40% of P s stock is sold in January of the current year and six months later, 20% of L s stock is sold to an unrelated party. Because P and L file a consolidated return, an examination of these transactions is made using the parent change method. Thus, the sale of S is ignored and no ownership change occurs because P s ownership only changed by 40%. The Supplemental Method If in the above example P and L do not file a consolidated tax return, the sale of L s stock results in an ownership change (a 60 percentage point increase) under a strict application of 30 Reg through -99, CO ( ). 31 Reg (b)(1).

15 Consolidated Tax Return Fundamentals Therefore, to avert an end run around the single entity application of the parent change method, a supplemental method rule was developed. Under the supplemental method, the Regulations apply an equity method approach in determining whether a more than 50 percentage-point change in a shareholder s value has been made. The supplemental method applies if a person who is a five-percent shareholder of the common parent increases its percentage ownership within a three-year period both in the common parent and in any subsidiary of the group. In such an event, the group must determine whether an ownership change has occurred under the parent change method. However, in addition to actual common parent stock received by 5 percent shareholders, any subsidiary stock received by a 5 percent shareholder is treated as if the shareholder received an issuance of common parent stock equal to the value of the subsidiary stock that was actually received. 32 Example 49 Individual A owns 100% of P corporation s outstanding stock with a fair market value of $1,000. P owns 100% of L, a corporation with an NOL that has been filing a consolidated return with P for the past 10 years. Assume that L s outstanding stock has a value of $600. Within a threeyear period, individual B purchases 49% of P s stock and 20% of L s stock. Because a 5 percent shareholder increased ownership in both the common parent and a subsidiary, the supplemental rule comes into play. B is treated as having acquired P stock worth $610 ($490 of actual P stock + $120 (20% of $600) of deemed P stock). P s outstanding stock is deemed to be valued at $1,120 ($1,000 actually issued + $120 deemed issued). Because B has increased his ownership value in P s by 54.5% ($610 $1,120), an ownership change has occurred. Loss Groups and Loss Subgroups In General The single entity approach of 382 is applied in determining ownership changes that occur in a loss group (or loss subgroup). Under the Regulations, a loss group is defined as any consolidated group that: (1) is entitled to use an NOL that did not arise (nor is treated as arising) in a SRLY; (2) has a consolidated net operating loss for a taxable year in which a testing date of the common parent occurs (treating the common parent as a loss corporation); or (3) has a net unrealized built-in loss on the testing date. 33 A loss subgroup is composed of members of one group that become members of another consolidated group. Example 50 Assume that P and L file separate tax returns and P has a NOL carryover arising in Year 1 that is carried over to Year 2. Assume that P owns 60 shares of the 100 outstanding shares of L stock. At the close of business on December 31, Year 1, P buys the remaining 40 shares of L and both corporations file a consolidated tax return for Year 2. Because the P 32 Regs (c). 33 See Regs (c)(1). Note that Regs (a) treats certain net operating loss carryovers (or net unrealized built-in gains and losses) as satisfying the definition of loss group in Reg (c)(1).

16 group (including L) is entitled to use the Year 1 NOL of P (the common parent of the group which did not arise in a SRLY), P and L become designated a loss group for the consolidated return year ending December 31, Year 2. Section 382 Subgroup defined. The regulations under 382 also extend the single entity approach to loss subgroups within a consolidated group. A loss subgroup generally consists of two or more corporations that are continuously affiliated after ceasing to be members of the first group and at least one of the corporations carries over losses from the first group to the second group. A major concern about the subgroup concept is that the SRLY, consolidated 382, and built-in loss rules each provide a different definition of what constitutes a subgroup. For purposes of 382 a loss subgroup exists if: (1) corporations were affiliated with each other in another group, (2) these corporations bear a relationship to each other described in 1504(a)(1) immediately after they become members of the new group, and (3) at least one of the members carries over an NOL that did not arise in a SRLY with respect to the former group. 34 This is in contrast to the SRLY subgroup rules that are composed of the member carrying over the loss (loss member) and each other member that was a member of the former group at the same time as the loss member. The following example illustrates the complexity introduced by not having identical 382 and SRLY subgroup definitions. Example 51 P corporation is the common parent of the P-S-T-U consolidated group (P group). P owns 100% of the stock of S and T. T owns 100% of the stock of U. The P group has a consolidated NOL (CNOL). A portion of this CNOL is attributable to each of the member corporations. Z corporation simultaneously acquires 100% of the S stock for $1,000 and 100% of the T stock for $600. The long-term tax-exempt rate is 6%. The new consolidated group, Z-S-T-U (Z group), files its first consolidated return with the following income and loss amounts: CTI Z $100 S 50 T 50 U (20) Total $180 The acquisition of S and T constitute ownership changes. T and U comprise a 382 loss subgroup. However, S is not included in the same 382 subgroup because S does not bear a relationship described in 1504(a)(1) to either T or U immediately after becoming a member of the 34 Temp. Regs T(d)(1).

17 Consolidated Tax Return Fundamentals Z group. Therefore, two 382 limitations must be computed: (1) $60 ($1,000 X 0.06) for the T-U subgroup and (2) $36 ($600 X 0.06) for S. S-T-U comprise a SRLY subgroup because they need only be continuously affiliated in the Z group to satisfy the SRLY subgroup requirements. Therefore, the S-T-U subgroup is subject to a single SRLY limitation of $80 (S s $50 + T s $50 + U s $(20)). When one provision ( 382) results in multiple limitations and another provision (SRLY) provides a single overall limitation, it is not clear how these limitations should be integrated. Since the SRLY limitation of $80 is smaller than the sum of the two 382 limitations of $96 ($60 + $36); $80 represents the maximum amount of NOL carryovers than can be utilized by the Z group in its first consolidated return year (CRY). It seems logical that principles similar to those of Temp. Regs (T)(b)(1) (i.e., pro rata allocation) should be applied to determine which loss corporation s NOLs are included in the $80 utilized in Z's first CRY. If this is the case, $50 ($60/$96 X $80) of the losses absorbed are attributable to T-U and $30 ($36/$96 X $80) of the losses absorbed are attributable to S. For the next CRY, T-U and S will have unused 382 limitation amounts of $10 ($60 - $50) and $6 ($36 - $30) respectively. The Consolidated Section 382 Limit Once a loss group has been identified and it is determined that an ownership change has occurred, a consolidated 382 limitation must be calculated. This limitation is also computed by treating the loss group as a single entity. Thus, for any post-change year, the consolidated 382 limitation is an amount equal to the value of the loss group multiplied by the long-term taxexempt rate that applies with respect to the ownership change. The value of the loss group (or loss subgroup) is the value of the stock of the common parent (including 1504(a)(4) preferred stock) increased by any minority interests in the subsidiary members. 35 Value is determined immediately before the ownership change takes place. Example 52 P, L, and S compose a loss group (P group). P has outstanding common stock, valued at $1,000. L has outstanding common stock worth $300 and preferred stock (described in 1504(a)(4)) worth $40. S has outstanding common stock worth $400. P owns 90% of L s common stock. Individual A owns 10% of L s common stock and 100% of L s preferred stock. P owns 50%, L owns 30% and individual B owns 20% of S's common stock. If P undergoes an ownership change, the value of the P group is $1,150 calculated as follows: (1) the P stock valued at $1,000 plus (2) 10% of the L common stock owned by A valued at $30 (10% of $300) plus (3) all the L preferred stock owned by A valued at $40 plus (4) 20% of the S common stock owned by B valued at $80 (20% of $400). 35 Regs (a) and (b).

18 It is important to note that in certain circumstances the value of the loss group might be further adjusted pursuant to 382 and the regulations thereunder. 36 Thus, the consolidated 382 limitation would be zero, for example, if the loss group does not satisfy the continuity of business enterprise requirement for the two-year period beginning on the change date. This determination is also made by looking at the loss group as a single entity. 37 CONSOLIDATED BUILT-IN GAINS AND LOSSES UNDER SECTION 382. Recent changes have been made to the consolidated return regulations to conform the built-in loss rules of 382 and Regs to the consolidated 382 rules. These changes will be discussed after a brief overview of the relationship between built-in gains and losses and 382 in general. Built-in Losses And The 382 Relationship: An Overview. The annual 382 limitation can be increased or decreased to the extent that there are any postacquisition gains or losses recognized which were also built-in gains or losses as of the date of acquisition. A built-in gain occurs when the fair value of an asset exceeds its tax basis. Conversely, a built-in loss occurs when the fair market value of an asset is less than its tax basis. The determination of whether a net built-in gain or loss situation arises is made on the date of acquisition for each of the assets held in the target corporation. In computing the annual 382 limitation during a year when a built-in loss is realized, the available NOL and the realized built-in loss or losses are combined. To the extent this combined sum exceeds the annual 382 limit, the realized built-in losses for the year are utilized before application of the NOL carryback or carryforward. This limitation on built-in losses expires 5 years after the date of acquisition. Thus, in the sixth year, any realized built-in losses are deductible in full and are not subject to the annual 382 limitation. If specific conditions are met, a de minimis transition rule under 382(h)(3)(B) will allow any built-in gains or losses of the target corporation to escape the clutches of 382. More specifically, when at the date of acquisition the amount of the net unrealized built-in gain or loss of the target corporation is not greater than the lesser of: 1. 15% of the gross assets, or 2. $10 million the net unrealized loss or gain will be deemed to be zero. For purposes of calculating the de minimis threshold, all assets of the target corporation except cash and marketable securities are considered in the computation. 38 Example Regs (b)(2) (c)(1) and Regs (d). The example in Regs (d)(2), in illustrating the application of this rule, appears to indicate that a discontinuance of two-thirds (in value) of an historic business will not violate the continuity of business requirement where the other one-third (in value) of the business is continued. 38 Securities are excluded provided the value does not substantially differ from the adjusted basis.