Disregarded, Consolidated And Surly

 

I was reading a consolidated group tax case recently.

It made me think: it has been a moment since I have worked with a consolidated return. It did however remind me a of a favorite tax term.

I consider consolidated groups more the realm of Fortune 500 companies. The reason is that these companies have publicly-traded stock, and publicly-traded stock is a cousin (if not a sibling) to cash. If I am a Fortune 500 and want to buy your company, I am motivated to use my stock to pay for some/all of the purchase price. Why? Because I am not depleting my cash reserves. Since my stock is publicly-traded, however, you are likely to consider it as similar to cash, but being stock there may be tax strategies available to avoid the heavy hand of immediate taxation. It is about as close to a win:win as you can find in the Code.

Let’s take a brief look at this part of the Code.

What is a Consolidated Tax Return?

First of all, we are now talking about corporations. These corporations have sufficient common ownership (that is, are “affiliated”) to combine their separate tax returns into one (“consolidated”) tax return which will be treated as a single unit for tax purposes.

        Code § 1501 - Privilege to file consolidated returns

An affiliated group of corporations shall, subject to the provisions of this chapter, have the privilege of making a consolidated return with respect to the income tax imposed by chapter 1 for the taxable year in lieu of separate returns. The making of a consolidated return shall be upon the condition that all corporations which at any time during the taxable year have been members of the affiliated group consent to all the consolidated return regulations prescribed under section 1502 prior to the last day prescribed by law for the filing of such return. The making of a consolidated return shall be considered as such consent. In the case of a corporation which is a member of the affiliated group for a fractional part of the year, the consolidated return shall include the income of such corporation for such part of the year as it is a member of the affiliated group.

As shorthand, we will refer to the area of the tax Code that deals with consolidated returns as the “15XX Regulations.”

Who Can File a Consolidated Return?

The affiliated group will have at least two corporations connected through a common parent. The corporations (other than the parent) must be at least 80% owned by another corporation (it does not have to be the parent) in the group.

In general, S corporations and foreign corporations cannot be members of an affiliated group. 

BTW you can remain an affiliated group indefinitely and not elect to file a consolidated return.

Like Hotel California, however, once you elect it is not so easy to leave.

Why Would I File a Consolidated Return?

One key advantage is being able to offset the losses from one member of the group against the income of another member.

If one were to file separately, then the profitable member would have taxable income (and pay tax) while the loss member would have a net operating loss that carries over to some future profitable year. It is not the end of the world, but one would probably prefer to use those NOLs now.

How Do Affiliated Corporations Come into Existence?

The first way is organic: the parent creates a subsidiary. In a later year, perhaps the parent creates another subsidiary, or an existing subsidiary creates a new subsidiary.

A second way is to acquire other corporations via mergers and acquisitions.

As shorthand, we will refer to the area of the tax Code that deals with corporate formations, mergers, acquisitions and divisions as the “3XX Regulations.”

Are the Rules Complicated?

You bet.

The 15XX Regulations are some of the most difficult and byzantine rules you will ever work through.

And the 15XX Regulations - just to make it sporting - like to cross-reference the 3XX Regulations.

You will spend time flipping pages, at least until you memorize the citations.

Let’s Look at One Rule: The SRLY

This is pronounced “surly.”

The idea is that a corporation enters the consolidated group with net operating losses. One’s first thought is that the group can immediately use those losses to offset income from other members.

No, it can’t. Congress thought of this, which is how SRLY came into existence.

In general, the SRLY rules will limit the use of net operating losses to future income from the same corporation that brought the losses into the group.

There is a cousin to this rule in 3XX Regulations upon ownership changes, but it does not require an affiliated group. SRLY, on the other hand, is found in the 15XX Regulations and applies to consolidated groups.

Let’s Look at a Recent Case Involving a SRLY

As we have sometimes done before, we will change the names to make this more readable.

Scooby was created pursuant to a reorganization in 2012. Scooby was an S corporation, and it had a subsidiary called Shaggy, itself another S corporation. An S corporation generally cannot have a corporation as a shareholder, so Scooby elected to treat Shaggy as a Qualified Subchapter S Subsidiary (QSSS).

Shaggy in turn acquired a C corporation we will call Daphne. A C corporation (as contrasted to an S corporation) can have a corporation as a shareholder. Daphne was dragging net operating losses behind it.

Shaggy distributed Daphne to Scooby.

At this point we have an S corporation (Scooby) owning a C corporation (Daphne) and an S corporation subsidiary (Shaggy).

COMMENT: We are not there yet, but you see a key piece to a potential SRLY: a C corporation with NOL carryovers. To provoke SRLY, we next need a consolidated group.

In 2018 Scooby revoked its S election.

Scooby elected to treat Daphne as a disregarded entity. For federal tax purposes, Daphne liquidated into Scooby and ceased to exist as a separate entity.

Scooby then formed a consolidated group (which we will call Super Scooby).

Super Scooby was knocking it out of the park. It had group taxable income of $13 million for 2018, $46 million for 2020, and $89 million for 2021, even though Scooby/Daphne had zero (-0-) profit of its own. All the profit was coming from the subsidiaries.

Super Scooby – of course – wanted to use the corporation-previously-known-as-Daphne NOLs. The amount was significant - $108 million.

The IRS said No. Why? Because of SRLY, that’s why.

Off to Tax Court they went.

Super Scooby had a straightforward argument: there was no SRLY because Daphne was disregarded. What was Daphne’s was now Scooby’s, and there is no SRLY rule on the parent of an affiliated group.

True, but there is a “predecessor and successor” rule in the thicket of the 15XX Regulations.

The IRS saw Daphne as a predecessor. Super Scooby did not. Super Scooby argued that Scooby once owned Daphne as a separate corporation. After the S revocation, Daphne ceased to exist, and there remained only Scooby.  Super Scooby was then created upon election to file a consolidated return.

Why the pedantism?

Super Scooby wanted the “lonely parent” exception found in the 15XX Regulations.

COMMENT: I love this term. The idea is that the parent can always drag its NOLs behind it without SRLY restrictions. The idea makes sense if the parent remains the same. It makes less sense if the tax planners restructure the group to result in a new parent, or – as in this case – when a previously existing corporation goes “poof” into the parent.

Do you test the lonely parent before or after the poof?

Super Scooby argued that the test was after the poof.

The IRS of course argued that the test was before.

The Court approached the issue by looking at the predecessor-successor rules in the 3XX Regulations:

In general, a predecessor is any transferor in a Section 381 transaction.”

COMMENT: Section 381 addresses carryovers when corporations acquire corporations.

                

Scooby “acquired” Daphne when it revoked its S election and Daphne liquidated under Section 332. The liquidation triggered Section 381 for any Daphne carryovers, which in turn triggered the “transferor in a Section 381 transaction” requirement for a predecessor-successor.

Daphne was a predecessor.

On to the lonely parent:

Where a member of the group is the successor in a 381 transaction, any net operating loss of the predecessor corporation are considered to have occurred in a SRLY if the predecessor was not a member of the group for each day of such year. The lonely parent rule does not apply in these situations, and the loss carryovers are subject to the SRLY restrictions, despite the fact that the common parent may be the successor corporation in the 381 transaction.”

In recap, the Court reasoned that:

• Daphne was a predecessor.

• Daphne was never a member of the Super Scooby consolidated group.

• The lonely parent rule cannot be extended to predecessors not members of the (consolidated) group.

• Daphne’s SRLYs remained SRLYs.

Super Scooby struck out trying to claim Daphne’s NOLs.

Why was Super Scooby swinging so hard? There was consolidated taxable income of – what? - $13 million, $46 million, $89 million. There appeared plenty of income to go around.

But there wasn’t.

All the consolidated income came from the subsidiaries.

The Daphne SRLY looked only at the income that Daphne (now liquidated into Scooby) brought into the consolidated group.

Scooby/Daphne itself had zero (-0-) income.

Meaning the SRLY was also limited to zero (-0-).

NOTE: The solution to Super Scooby’s problem seems straightforward: why not check-the-box to disregard one (or more) subsidiaries as separate from Scooby? Scooby would then have income to absorb the Scooby/Daphne NOLs. Yes, we still have a SRLY, but we are putting (as much) income (as necessary) into Scooby/Daphne to release some/all of the NOL. Maybe we burn the NOL over several years rather than just one, but that is still a better result than the above.

Our case this time was HBM Holdings Co v Commissioner, 167 T.C. No. 6 (July 27, 2026).

The IRS Goes Rounds With Cohan

 

The decision begins with the IRS seeking taxes of $805,149, $1,145,104, $1,161,864, and $831,771 for years 2013 through 2016. The penalties were unsurprisingly also enormous.

I want to know what happened here.

The taxpayer was Mohammad Nasser Aboui, and he was the sole shareholder of an S corporation called HPPO. He owned several used vehicle lots, and in 2009 he put them into HPPO as its initial corporate capitalization.

It sounds like a tough business:

·       Most of HPPO customers had bad credit.

·       Many did not have a checking account and instead paid HPPO in cash.

·       HPPO financed between 90% and 95% of its sales.

·       Customers repaid their loans less than 10% of the time.

·       HPPO repossessed approximately 25% of the cars it sold within 3 or 4 months.

·       HPPO had quite the barter system going with its mechanics: the mechanic would work on HPPO cars in exchange for rent of HPPO’s garage space.

Around 2014 Aboui decided to close the business. There were serious family health issues and HPPO was not making any money.

The IRS started its audit in September 2015.

HPPO’s accountant was ill at the time and later died.

To its credit, the IRS waited.

More than 3 years later HPPO engaged another accountant to represent the audit.

The second accountant made immediate mistakes, such as getting HPPO’s accounting method wrong when dealing with the IRS Revenue Agent (RA).

COMMENT: More specifically, the accountant told the RA that HPPO used the overall cash basis of accounting. HPPO did not. In fact, it could not because inventory was a material income-producing factor.

The RA wanted HPPO’s books and records, including access to its accounting software. HPPO could provide much but not the software. Its software license expired when it left the vehicle business in 2018.

This is a nightmare.

HPPO did eventually reactivate the software, but it was too late to help with the RA.

The RA – being told by the second accountant that HPPO used the cash basis of accounting – decided to use bank statements to reconstruct gross income.

BTW HPPO wound up dismissing the second accountant.

The results were odd: HPPO had reported more sales for 2013 through 2015 – nearly $3.25 million - than was deposited at the bank.

The pattern reversed in 2016 when HPPO deposited approximately $539 grand more than it reported in sales.

COMMENT: I have an idea what happened.

The RA also saw following bad debt expense:

          2013             $1,069,739

          2014             $ 668,537

          2015             $ 902,967

          2016             $ 436,738    

Here is something about the cash basis of accounting: you cannot have bad debt expense. It makes sense when you remember that gross income is reported as monies are deposited. Bad debts are receivables that are never collected, meaning there is nothing to deposit. One never leaves home plate.

So, the RA disallowed the bad debt expense entirely.

I am pretty sure about my earlier hunch.

The RA also determined that HPPO had distributed the following monies to Aboui, one way or another:

          2013             $2,476,301

          2014             $1,704,329

          2015             $1,406,893

2016             $1,934,033

There were other issues too.

Off they went to Tax Court.

Remember what I said about reactivating the accounting software license? Aboui now presented thousands of pages to document cost of sales and other expenses. The Court encouraged the IRS to accept and review the new records.

The IRS said, “nah, we’re good.”

COMMENT: Strike one.

The Court started its opinion with HPPO’s sales.

The RA stated to the Court that HPPO used the overall cash basis of accounting.

Don’t think so, said the Court. The Court saw HPPO using the accrual basis of accounting for sales and the cash basis of accounting for everything else.

COMMENT: This is referred to as a hybrid method: a pinch of this, a sprinkle of that. If one is consistent – and the results are not misleading – a hybrid is an acceptable method of accounting.

The Court asked Treasury why it thought that HPPO used the cash basis of accounting.

Treasury replied that it had never said that.

The Court pointed out that the RA had said that she understood HPPO to be a cash basis taxpayer. To be fair, that is what the second accountant had told her.

Nope, never used the cash method insisted Treasury.

COMMENT: An explanation is in order here. Treasury Department attorneys take over when the matter goes to Court. Perhaps the attorneys meant “direct” Treasury. The RA – while working for the IRS which itself is part of the Treasury – would then be “indirect” Treasury. I am only speculating, as this unforced error makes no sense. Clearly it bothered the Court.

Strike two.

The Court then reasoned why HPPO was reporting more sales than it deposited in the bank: it was reporting the total vehicle sale price in revenues at the time of sale. That also explained the bad debt expense: HPPO financed most of its sales and most of those loans went sour.

But why the reversal in 2016?

Aboui explained to the Court that by 2016 he was closing the vehicle business. He would have slowed and eventually stopped selling cars, with the result that he would be depositing more in the bank than he currently sold.

The Court decided that HPPO had correctly recorded its sales for the years at issue.

Next came the cost of vehicles sold.

This accounting was complicated because so much cash was running through the business. Sometimes cash was used to immediately pay expenses without first being deposited into a bank account – NOT a recommended accounting practice.

The RA had also identified certain debits to HPPO’s bank account that were either distributions or otherwise nondeductible.

The Court could find no evidence that those identified debits had been deducted on the tax returns.

The RA – and by extension, the … Treasury – was losing credibility.

Aboui meanwhile provided extensive documentation of HPPO’s expenses at trial. Some of these were records the Court had asked the IRS to accept and review – and which the IRS passed on.

Here is the Court:

Petitioners provided extensive documentation at trial to substantiate the COGS and business expenses. Mr. Aboui testified that HPPO was unprofitable. Given the record in its entirety, we find that petitioners have substantiated HPPO’s COGS and business expenses as reported on HPPO’s returns for each year at issue, except for meal and entertainment expenses of …..”

COMMENT: Strike three.

The Court went to the bad debts.

Mr. Aboui credibly testified that he was unable to repossess approximately 250 cars during the years at issue. The loss of these cars adequately substantiates the amount of HPPO’s bad debt deductions for the years at issue under the Cohan rule.”

The Court went to the distributions.

Respondent determined that petitioners failed to report approximately $7.5 million in taxable distributions from HPPO during the years at issue.”

COMMENT: Remember that HPPO is an S corporation, and Aboui would be able to withdraw his invested capital – plus any business income he had paid taxes on personally but left in the business – without further tax. This amount is Aboui’s “basis” in his S corporation stock.

Here is the Court:

Respondent argues that petitioners have not established Mr. Aboui’s basis in HPPO during the years at issue. We disagree and that the record and Mr. Aboui’s credible testimony provides sufficient evidence for us to reasonably estimate his basis under the Cohan rule.”

The IRS won a partial victory with the distributions. The Court thought Aboui’s basis in HPPO was approximately $5.1 million.

The IRS had wanted zero basis.

The effect was to reduce the excess distributions to $$2.4 million ($7.5 minus $5.1).

Still, it was a rare win for the IRS.

Excess distributions are taxable. Aboui had taxable distributions of $2.4 million. Yes, it is a lot, but it is also a lot less than the IRS wanted.

COMMENT: The nerd part of me wonders how the Court arrived at an estimate of $5.1 million for Aboui’s basis. Unfortunately, there is no further explanation on this point.

Oh, one more thing from the Court:

… we hold that petitioners are not liable for any penalties.”

While not contained within the four corners of this decision, I am curious why the Court repetitively went to the Cohan rule. I have followed this literature for years, and this result is not normal. Courts generally expect a business to maintain an accounting system that produces reliable numbers. Yes, every now and then there may be a leak in the numbers, and the court may use Cohan to plug said leak. That is not what we have here, though. This boat was sinking.

Perhaps Aboui presented his case well.

Mr. Aboui was incredibly forthright in his testimony.”

And perhaps the IRS should not have argued that an RA – an IRS employee – is not the IRS.

Our case this time was Aboui and Mizani v Commissioner, T.C. Memo 2024-106.

An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.