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).
