Effect of consolidated return investment adjustment principles on E&P determinations.

• Author: Blair, David W.

Consolidated groups that have member subsidiaries with net operating losses (NOLs) and that are anticipating making, or have made, distributions must consider the impact of Regs. Secs. 1.1502-32 and -33 on the calculation of earnings and profits (E&P). Affiliated groups filing consolidated returns must apply these provisions in determining the E&P of group members. In practice, operation of these rules often results in E&P determinations that may be counterintuitive to many taxpayers, since the detailed principles of Regs. Secs. 1.1502-32 and -33 for calculating E&P are not well-known by nontax financial professionals and lesser experienced tax personnel. Additionally, because of these rules, radically different E&P results can occur depending on whether a business is operated as a branch or a subsidiary.

Basic investment adjustment rules

In general, Regs. Sec. 1.1502-33(c)(4)(ii) provides that investment adjustments made to the basis of subsidiary stock must also be reflected in E&P. More specifically, a group member's E&P must reflect that member's net negative adjustment (under Regs. Sec. 1.1502-32(e)(1)) or net positive adjustment (under Regs. Sec. 1.1502-32(e)(2)) made with respect to a subsidiary of that member. A negative adjustment includes an allocable part of the deficit in the subsidiary's E&P for the year (Regs. Sec. 1.1502-32(b)(2)(i)). A negative adjustment also includes an allocable part of any NOL or capital loss incurred by the subsidiary in a separate return year, or incurred in a prior consolidated return year and attributable to the subsidiary, if that NOL or capital loss is carried over and used in the current year (Regs. Sec. 1.1502-32 (b)(2)(ii)). A positive adjustment includes an allocable part of the undistributed E&P of a subsidiary for the year (Regs. Sec. 1.1502-32 (b)(1)(i)). A positive adjustment also includes an allocable part of any consolidated NOL or capital loss attributable to the subsidiary that cannot be carried back and used in a prior year (Regs. Sec. 1.1502-32(b)(1)(ii)).

Consolidated loss year--member's current year NOLs

When the negative adjustment for a subsidiary is less than the positive adjustment (e.g., because of slower recovery of depreciable property (Sec. 312(k))), the parent company may have current year E&P even though the group has a consolidated NOL for the year. This may surprise an individual shareholder of the parent who may be expecting that a distribution will be treated as a...