National Tax Director Rojas & Associates
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How CPAs Should Address Consolidated Returns for Middle Market Businesses

The author has known auditors to perform a “search for unrecorded companies” prior to opining on the financials. He has also seen footnotes hedging on just how many companies are in the group’s financial statements. These big group scenarios usually embrace consolidated return tax reporting (IRC Section 1501).

Jul 22nd 2020
National Tax Director Rojas & Associates
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corporate taxes
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There is also a place for consolidated tax reporting within the privately-held business group, particularly if non-tax concerns suggest multiple entities.

In this article, the focus will be on your midsized client’s business income and does not encompass international aspects, or the matter of state-federal differences.

Going Corporate

Whether to file consolidated is a subset of going corporate, so let’s begin with some of the basic math of whether to incorporate.

The 20 percent deduction may not be available depending on the level of income and type of business or businesses (IRC Section 199A). However, the C corporation foregoes the 20 perent of business income deduction that might otherwise be available. The 20 percent deduction is, however, scheduled for eventual repeal.

On the other hand, the current corporate level tax rates are considerably less than the rates that apply to higher levels of business income taxed in the Form 1040 (See “Incorporating Your Business – A Planning Opportunity and a Puzzle,” Robert L. Rojas and J. Michael Pusey, Practical Tax Strategies, May, 2020, Thompson Reuters, reproduced at Rojascpa.com). There are seven individual tax brackets, two of which are lower than the corporate rate. However, the third and fourth brackets, with rates of 22 percent and 24 percent, are relatively close to the 21 percent corporate rate.

In a closely-held context, tax planners generally have a sense of the tax that would be incurred without the C corporation. There are issues of self-employment tax via sole proprietorship businesses or partnerships, but the basic math may focus on the relatively lower initial rates for individuals compared to the corporate rates. 

There is a point at which the successful private company will incur less tax under the individual rates, then there’s a crossover point where the 21 percent current corporate rate is less. Having some income within a C corporation and some income outside of the corporation may be a planning consideration. But also consider that loses of a C corporation don’t flow through to the returns of the owners.

Then there is the issue of double taxation. Consolidated groups maintain earnings and profits accounts, the source of taxable dividends, albeit on a consolidated basis (Regs. 1.1552-1, 1.1502-33). Double taxation doesn’t go away when the group files consolidated returns, although there is generally relief from double taxation within the consolidated group.  

Double taxation as a result of incorporating is mitigated to the extent there is deductible compensation to the owner/owners versus distributions that are merely nondeductible dividends. Deductible corporate expenses also save taxes at the corporate tax rate. Historically, in terms of recent history, the corporate tax rate is relatively low.

Going Consolidated

If a midsized business goes corporate, there are often reasons to have multiple corporations. The incentive for multiple C corporations often has to do with sheltering assets from creditor claims.

At the forefront of consolidated tax reporting is the ability to offset the losses of some members against the income of the profitable members. It is not uncommon to find closely-held groups with pockets of unused C corporation losses that go unused despite profitable businesses within the group.   

The basic idea of a consolidated return is single-return reporting for all the consolidated members, despite the existence of the myriad different entities. The very first box to check on the top left of the Form 1120 is whether the group is filing a consolidated return.  

In general, an “affiliated group” can elect to file a consolidated return for the year if all of the members consent. The group then ends up reporting on a single corporate return, Form 1120.

The common parent makes the election to file consolidated, and attaches a Form 851, Affiliation Schedule, of information on members of the group. It also files a Form 1122, Authorization and Consent of Subsidiary Corporation to Be Included in a Consolidated Tax Return (Regs. 1.1502-75), whereby each member has to consent to consolidated reporting. 

The parent company must own at least 80 percent of the voting power and value of the stock of at least one other member of the group, but the basic concept of 80 percent control can arise within the group from other than the common parent (See Section 1504). Consolidated reporting would be available as individual A who directly owns multiple corporations – the typical brother-sister which often opts for S corporation status reporting.

The consolidated reporting concept involves separate taxable income of the members with certain adjustments that may arise from such items as intercompany transactions, inventory and depreciation adjustments. Certain items in the return are computed on a consolidated basis, whereby the net operating loss deduction as an example (Regs. 1.1502-12).

There are understandably a number of special rules affecting the consolidated reporting. One is known as the “SRLY rule” (separate return limitation year). This rule prevents the group from just buying a member with an NOL carryover and using pre-acquisition losses to offset the post-acquisition income of other members (Regs. 1.1502-21).

But in general, the consolidated reporting concept can be used to facilitate offsetting gains and losses, and deferring gains (and losses) on intercompany sales. The common parent can request permission for an exception to the general rule of deferring intercompany gains and losses (Regs. 1.1502-13).

The ability to offset gains and losses encompasses operating income and loss, but also capital gains and losses. Another advantage is that it may avoid any tax on corporate dividends within the group.

In general, the consolidated reporting concept does not reach S corporations, exempts, foreign corporations (with some exceptions for Canada and Mexico) and such special groups as REITs and mutual funds. It may be possible for multiple exempts to file their own consolidated return.

Keep in mind the consolidated reporting concept is one for “regular” corporations, not S corporations. Also, know that there is still the double taxation problem as to dividends. 

In general, there are basis adjustments for the stock aimed at reflecting the lower tier subsidiary’s earnings in the consolidated return. Earnings of the subsidiary basically get reflected in the stock basis of the parent to mitigate duplicate taxation.  

In the simplest scenario, assume top parent invests $1,000 in tier 1 subsidiary then reports $1,000 of income of the subsidiary in the consolidated return. If the subsidiary’s stock were then sold for $2,000, the parent corporation selling such stock would break even given these assumptions.

Final Thoughts

The consolidated reporting rules embrace basis adjustments to avoid unfair duplication of income reporting. The consolidated return reporting then basically continues until such time as the common parent makes a timely application showing good cause for discontinuing consolidated filing. The time limit here is generally not more than 90 days before the consolidated return due date, including extensions.

If one opts for subjecting income to C corporation taxation and the context is multiple C corporations, it is important for tax planners to keep in mind the potential advantages of consolidated reporting. This is true of middle market companies as well as large, public groups.

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