A consolidated tax return is a single tax return filed by a group of affiliated corporations as if it were a single entity. Consolidated filing offers a strategic way for corporate groups to manage their tax liabilities by offsetting the income of profitable members with the losses of others.
Getting the most out of this strategic move while staying compliant with consolidated return rules is complex. Most groups filing a single return turn to professionals to guide them through the process successfully.
Consolidated Tax Returns Explained
Section 1501 of the Internal Revenue Code allows a parent company to file a single tax return to include all its subsidiaries rather than file separate returns for each entity. This collection of entities, known as an “affiliated group,” is defined as one or more chains of corporations connected through stock ownership with a common parent corporation (page 3 of the PDF).
The main motivation behind choosing a consolidated tax return is strategic tax planning. This is because filing a consolidated tax return is a way to offset capital gains with business losses, as capital gains from the parent company or a subsidiary can be canceled out (wholly or partially) by losses from another subsidiary (or the other way round).
Corporations often use this strategy to reduce their ordinary income tax or capital gains tax liability. However, the process and rules surrounding filing as an affiliated group are considerably more complex than regular business tax returns. Consult an expert in corporate tax planning services to see how filing a consolidated tax return could lower your tax liability. They will then help you ensure full compliance throughout the process.
Who Qualifies to File a Consolidated Tax Return?
Most corporations qualify to file a consolidated tax return. Corporations that aren’t considered “includible companies”—and therefore can’t file as a group—include insurance companies, tax-exempt corporations, foreign corporations, real estate investment trusts, S corporations, and regulated investment companies.
Other requirements include that the parent corporation must own 80 percent or more of the voting power and 80 percent of the value of the stock of one or more of the subsidiary corporations. All members of the group must also formally consent to consolidated filing. File Form 1120 and attach Form 1122 for each subsidiary to formally elect group filing.
Consolidated Filing Step-by-Step
Filing a consolidated tax return is a process with various steps. It’s essential to file correctly to avoid any mistakes that put your transactions or IRS compliance at risk. Follow these instructions to file a consolidated tax return:
Step 1: Align Fiscal Years
Firstly, all subsidiary corporations must align their fiscal years with the parent company’s.
Step 2: Gather Tax Information
Each subsidiary must provide its own tax information to the parent company. This includes standard income, deductions, and credits.
Step 3: Show Intercompany Transactions
Affiliates must also report and then eliminate transactions between companies. These could include transactions like money lending, renting property, or buying or selling goods and services. Skipping this step could lead to double-counting or artificial income or loss.
Be aware that the IRS has strict rules surrounding tracking basis and gains or losses from intercompany transactions under Section 1.1502-13. These transactions could trigger basis adjustments or deferred gain recognition that complicate tax planning in the future. This is something your CPA will be able to manage for the most favorable outcome for your group.
Step 4: Calculate Separate Taxable Income
Each affiliate calculates its own net profit or loss to create a separate taxable net income or loss for each entity.
Step 5: Consolidate
It’s time to sum up the taxable income from all affiliates. The consolidated items are then netted across companies to calculate the total consolidated taxable income for the group.
Advantages of Filing Consolidated Tax Returns
Consolidating tax returns offers several advantages. Ask your CPA if any of the following apply to your business:
- Potential to Reduce Tax Liability: The main motivation behind consolidating tax returns is to reduce the group’s overall tax liability by offsetting one company’s profit with another’s losses.
- Possibility to Defer Intercompany Taxable Gains: Sales (like asset sales) between affiliated companies aren’t immediately taxable. No tax is due until a final sale to an outside party. This ensures you don’t pay tax prematurely.
- Shared Tax Attributes: Capital gains and losses, plus other benefits like tax credits, are typically netted across affiliates. Foreign tax credits can also be shared among the consolidated group.
- Simplified Accounting: Though consolidated filing serves up some administrative challenges, transactions like intercompany dividends are eliminated. This reduces duplication and simplifies tax reporting. Reducing the number of separate returns also streamlines compliance and reduces preparation costs.
Potential Limitations of Filing Consolidated Tax Returns
A consolidated status also comes with significant limitations that groups must be aware of:
- Binding status: The IRS must grant permission to a group that’s elected to file a consolidated return to file separate returns at a later date. This may limit your flexibility for future tax planning.
- Complex administration: Groups must meticulously track all intercompany transactions, basis adjustments, and any other transactions that could cause filing errors or compliance issues.
- Restrictions on how to use losses: Losses from one member may be limited by separate return limitation year (SRLY) rules if losses were generated before joining the group. SRLY rules determine whether losses, credits, or other tax attributes can be carried over from a tax year before a corporation joined the group. Consult an expert to see if your group is eligible to fully offset taxable income across all members.
- Limitations on tax benefits: Filing a consolidated return could limit your access to some tax credits or deductions, like the foreign tax credit.
- State and local tax challenges: Not all states follow federal consolidation rules. Your state may require separate or combined filings. Differences between federal and state rules will increase your group’s administrative burden and compliance costs.
- Complications when the group’s status changes: Changes like one member leaving, transfers of ownership, or the affiliate group dissolving could trigger different recognition rules or limitations.
Reporting Requirements and Forms
The key reporting requirements and forms you need to file a consolidated return are:
- Form 1120: U.S. Corporation Income Tax Return. Only the parent corporation needs to file this form on behalf of the whole group.
- Form 851: Affiliations Schedule. Attach this to Form 1120 to list each member of the affiliated group and detail the parent’s ownership.
- Form 1122: Authorization and Consent of Subsidiary Corporation. Each new member must file Form 1122 to give their consent to be included in the consolidated group. Include this with the group’s first consolidated return.
Consolidated Income Tax Return: Example Scenario
Let’s imagine two companies: XCorp and SubX. XCorp is a successful tech company that designs and sells software. It created a subsidiary, SubX, to develop an innovative mobile telephone app.
This tax year, XCorp was highly profitable, with a taxable income of $10 million. However, SubX is a new venture and recorded a taxable loss of $3 million due to high R&D costs.
If both companies do separate filings:
- XCorp would owe taxes on the entirety of its $10 million profit.
- SubX would carry forward its $3 million loss to offset future profits. It isn’t liable to pay any income tax this year.
If they file a consolidated tax return:
- SubX’s loss can be used to offset XCorps $10 million profits. This reduces the parent company’s taxable income to $7 million.
Plan Strategically for Your Group’s Financial Future
A consolidated tax return is a powerful tool for corporate groups that may lead to lower tax bills. However, this tax planning strategy requires careful consideration due to its complex rules and the added administrative burden it places on the group (especially at first).
The decision to file a consolidated tax return is only recommended after a thorough analysis of the benefits and possible drawbacks. Consult a professional corporate tax planning professional to ensure this strategy will be advantageous for your company and that all of the requirements are met once it’s time to file.
