NEW PROPOSED REGULATIONS FROM THE IRS PROVIDE TAXPAYER-FRIENDLY SOLUTIONS TO ISSUES WITH TAX RETURN DUE DATES AND CIRCULAR ADJUSTMENT TO BASIS.
In the last six months, the U.S. Department of the Treasury has issued two sets of proposed regulations that provide needed guidance in the area of consolidated returns. Two of these provisions are highlighted below.
Tax Return Due Dates
A corporation’s year ends when it becomes a member of a consolidated group. Joining a group may create a shortened tax year if the corporation joins before the end of its taxable year. The due date for the return of a domestic corporation (without an extension) is the 15th day of the third month following the close of the corporation’s tax year. See Treas. Reg. § 1.6072-2.
Treasury Regulations section 1.1502-76(b)(4), however, provides an exception to the general due date rule for a short-period return. That exception changes the deadline for a short-period return to the earlier of the due date had the corporation not joined the consolidated group (including extensions) or the due date of the consolidated group’s return (including extensions). If a corporation ceases to exist during the same consolidated return year in which it becomes a member, the due date for the corporation’s tax return for the short period that ends as a result of becoming a member could be accelerated and cause the corporation to file a late return.
For example, a corporation that is acquired in a forward triangular merger ceases to exist, and the return is due (without regard to extensions) on the 15th day of the third month from the end of the month it ceases to exist. If the merger is midyear, the tax return would be due earlier than if the corporation had not ceased to exist.
A short-period return that is not timely filed may trigger a penalty for late filing and for late payment of tax. If certain international information returns are required to be filed with the corporate return, those returns could also be late, causing additional penalties. A final short-period return that the Internal Revenue Service (IRS) treats as not timely filed may also result in the IRS treating an election made on the return as not timely.
On March 23, the IRS issued proposed regulations under section 1.1502-76 that would amend paragraph (b)(4) to prevent a taxpayer from inadvertently missing a filing date for a short-period return. The proposed regulations provide that, if a corporation goes out of existence in the same consolidated return year in which it becomes a member of a consolidated group, the due date for filing the separate return is determined without regard to the corporation’s ceasing to exist. A return that has an accelerated due date will not be considered late under the proposed regulations if filed by the original return date or by the consolidated return due date. Thus, companies that are merged out of existence or liquidated following a merger will no longer have an accelerated due date for filing the final stub return. The proposed regulations will be prospectively effective when finalized.
Circular Adjustments to Basis
To prevent the income, gain, deduction or loss of a subsidiary from being reflected more than once in a consolidated group’s income, the consolidated return regulations adjust an owning member’s basis in a subsidiary’s stock to reflect those items. When a consolidated group takes into account a member’s items of income or gain, the owning member’s stock basis in the subsidiary increases. Conversely, when the group absorbs that member’s deductions or losses, the owning member’s basis in the subsidiary’s stock decreases under Treasury Regulations section 1.1502-32.
If a group absorbs a portion of a subsidiary’s loss in the same consolidated return year in which an owning member disposes of that subsidiary’s stock, the owning member’s basis in the subsidiary’s stock is reduced immediately before the disposition by the amount of the loss. Any reduction in the stock basis from the disposition may, in turn, affect the amount of the subsidiary’s loss that the group absorbs. This would require additional absorption of the member’s losses that would then result in further adjustments to the member’s stock basis. Due to the circularity in the reduction in stock basis and absorption of loss, taxpayers sometimes were left with no ability to claim the entire loss after multiple iterations.
To illustrate the issue, P has a $500 basis in S’s stock. In year one, P has ordinary income of $30 of its own, and S has a $100 ordinary loss. P sells the S stock for $520 at the close of year one. Before determining the amount of the gain from the sale of S, the consolidated net income for the group is a net $50 loss. Because $30 of S’s loss is absorbed by P to offset its income, P’s basis in S’s stock is reduced to $470. Since the gain is now $50 due to the basis adjustment, $50 of S’s remaining carryover loss is used to offset the $50 of gain. Because an additional $50 of loss is absorbed by P, P’s basis in S’s stock would drop by $50, causing additional gain and additional loss to be absorbed.
Treasury Regulations section 1.1502-11 was intended to coordinate and limit the effect of the stock basis adjustments in the year of a subsidiary’s disposition. These rules prevent the circular basis problem in certain situations. However, the current rules do not prevent iterative computations in all situations. This has led taxpayers to take a broad range of approaches to ameliorate circular basis problems.
On June 10, the IRS released proposed regulations that would provide relief and certainty to this problem. The proposed regulations "turn off" the normal ordering rules under Treasury Regulations section 1.1502-32 and require a group first to determine the amount of each disposed-of subsidiary’s loss that will be absorbed by computing consolidated taxable income (CTI) without regard to gain or loss on the disposition.
Determining each disposed-of subsidiary’s absorbed amount establishes an immutable number that will also be the amount of reduction to the basis of the owning member’s stock taken into account in computing the owning member’s gain or loss on the disposition of the disposed-of member’s stock.
As noted in the preamble, in some instances, applying the generally applicable rules would result in less than all of a disposed-of subsidiary’s absorbed amount being used. The proposed regulations aim to prevent such a result by providing for an alternative four-step computation of CTI if, by applying the general ordering rules, less than all of a disposed-of subsidiary’s absorbed amount would be used. Under the four step process:
- Any income, gain or loss on any share of subsidiary stock would be excluded from the computation of consolidated taxable income, and the group would use losses of each disposed-of subsidiary equal in both amount and character and from the same tax years as those used in the computation of its absorbed amount.
- A disposing member would offset its gain on the disposition of subsidiary stock with its losses on subsidiary stock. If the disposing member has net income or gain on the subsidiary stock, and if the disposing member also has a loss of the same character (determined without regard to the stock net income or gain), the disposing member’s loss would be used to offset the net income or gain on the subsidiary stock to the extent of such income or gain. Any remaining net income or gain would be added to the group’s remaining income or gain as determined under point one above.
- If, after the application of the second step of the alternative computation, the group has remaining income or gain and a disposing member has a net loss on subsidiary stock, that income or gain would then be offset by the loss on the disposition of subsidiary stock, subject to generally applicable tax rules. The amount of the offset, however, would be limited to the lesser of the total remaining ordinary income or capital gain of the group (determined after the application of the second step) or the amount of the disposing member’s ordinary income or capital gain (determined without regard to the stock loss).
- If the group has remaining income or gain, the unused losses of all members would be applied on a pro rata basis.
The proposed regulations will be prospectively effective when finalized.
Both of these sets of proposed regulations are very taxpayer friendly and will alleviate issues taxpayers may currently be facing. The revised circular basis rules, in particular, provide a simple, reasonable approach to situations where a company could be losing significant losses from the unintended consequences of Treasury Regulations section 1.1502.32.