Reconsolidation of subsidiary corporations; waiver of the 60-month waiting period.

• Author: Kramer, John L.

An affiliated group of corporations that elects to file on a consolidated basis does so because of the tax benefits that are available. Various events can cause an affiliated group to be restructured so that one or more subsidiary corporations are no longer affiliated; that is, they no longer meet the stock ownership or includible corporation requirements for affiliation and cannot participate in the consolidated return election. When disaffiliation occurs, both the tax benefits and the tax problems of consolidation disappear.(1)

The choice to disaffiliate is often driven by business rather than tax considerations. A need for working capital may cause part or all of an investment in a subsidiary corporation to be sold or may lead to additional stock being issued by the subsidiary. The acquisition of the assets or stock of a target corporation may be paid for with additional stock issued by the subsidiary. These transactions result in disaffiliation if the subsidiary fails the stock ownership requirement.(2) The subsidiary's acquisition of a special tax status (e.g., as a Sec. 936 possessions credit corporation, Sec. 801 insurance company, regulated investment company, or real estate investment trust) also can result in disaffiliation.

Results of Disaffiliation

Some unfavorable tax results may occur from disaffiliation. Separate tax returns are required of the disaffiliated corporations. Net operating losses (NOLs) of the disaffiliated member can no longer be used to offset the taxable income of other group members. The disaffiliated member's NOL, credit and other carryovers are subject to the separate return limitation year (SRLY) rules. Deferred intercompany gains may need to be restored. An excess loss account balance for the parent corporation's investment in the subsidiary corporation may require the recognition of income or gain. Allocation of tax attributes between the remaining group members and the departing member also may be needed.

However, there clearly are some situations in which disaffiliation of a subsidiary can generate significant tax benefits. For example, disaffiliation may permit the recognition of some or all of the realized loss on the sale of the investment in the subsidiary's stock under Regs. Sec. 1.1502-20. Loss, credit and other carryforwards that are allocable to the departing group member can be used on a separate company basis when such amounts might not be usable on a consolidated basis because of a limitation based on the group's consolidated taxable income or tax liability.(3) Specifically, a profitable subsidiary may be able to use loss or credit carryovers on a separate return basis that would not be available to a consolidated group reporting a smaller consolidated taxable income amount (or even a consolidated NOL) arising from other subsidiaries reporting substantial losses. The use of a consolidated tax attribute in a separate return year that is about to expire may be another reason for disaffiliating.

Disaffiliation also can involve a profitable corporation becoming part of an affiliated group that has substantial loss carryforwards. The profits of the new group member can be used to offset the group's current losses and loss carryovers. After such losses have been fully used, the profitable corporation, subject to certain restrictions, can rejoin its original affiliated group.

Congress became aware that corporations were abusing the consolidated return rules in two ways. First, firms were complying with the literal requirement of Sec. 1504(a) and were acquiring 80% or more of the voting power of a subsidiary so that the two firms could be consolidated. However, some firms were acquiring necessary voting power while much, if not most, of the value of the stock was in the hands of individuals or entities that were not part of the affiliated group.

A second perceived abuse grew out of the potential for disaffiliating from a consolidated group in order to achieve some specific tax benefit and then reaffiliating with the original group at a later date. This article will examine this problem, the statutory solution and the IRS's willingness to waive the five-year waiting period for reconsolidation that is mandated by statute.

Legislative Remedies

Congress added two provisions to Sec. 1504 in the Deficit Reduction Act of 1984 (DRA) to deal with abuses it perceived occurring with consolidated tax returns.

* Stock ownership requirement

The first change requires ownership of 80% of the total voting power and 80% of the total value (excluding certain nonvoting preferred stock issues) of a subsidiary's stock for affiliation to occur in tax years beginning after Dec. 31, 1984.(4) In addition to changing the minimum ownership requirement, Congress granted the Treasury the ability to draft regulations to cover the following situations. 1. Treat warrants, obligations convertible into stock and other similar interests as stock and to exclude certain stock issues (e.g., puttable stock) from the "stock" definition. 2. Treat options to acquire or sell stock as having been exercised. 3. Treat the 80%-of-value requirement as having been met if the affiliated group, in reliance on a good faith (but erroneous) determination of value, treated such requirement as having been met. 4. Disregard a failure to meet the 80%-of-value requirement resulting from inadvertent, small changes in the relative values of different classes of stock. 5. Disregard transfers of stock within the affiliated group for purposes of determining whether a corporation ceases to be a group member. 6. Disregard changes in voting power that are disproportionate to related changes in value.(5)

To date, regulations implementing these changes have not been issued. This lack of guidance has created uncertainty regarding whether disaffiliation has, in fact, taken place.(6)

* Reconsolidation waiting period

The second change to the consolidated return rules added by the DRA was a five-year waiting period between a corporation's disaffiliation and reconsolidation with the same affiliated group.(7) The Code prevents a corporation from being consolidated with the original affiliated group (or another affiliated group with the same common parent or a successor to that common parent)(8) before the sixty-first month after the first tax year in which the disaffiliated corporation was not included in the consolidated return.(9) Sec. 1504(a)(3)(B) permits the five-year waiting period to be waived by the IRS. The DRA Conference Report provided an example of a situation in which the waiver should be granted.

For example, assume that operating corporation A owns all the stock of operating corporation X and that the two file a consolidated return. On July 1, 1986, A merges into unrelated operating corporation B in a transaction qualifying under section 368(a)(1)(A). Assume that the transaction is not a reverse acquisition. Absent other factors, X should be able to join in filing a consolidated return with the group of which B is the common parent for the period beginning July 1, 1986, and regulations should so provide.(10)

The five-year waiting period would generally apply in this situation (unless a waiver were granted) because X Corporation, which was a member of the A-X group (old group) before the merger, would become a member of the B-X group (new group) following the merger and the new group's parent corporation (B) is a successor to the old group's parent corporation (A).

Letter Rulings

Disaffiliated firms that wished to reconsolidate before the end of the five-year waiting period are required to request a waiver from the IRS. The IRS National Office has issued approximately 100 letter rulings authorizing a waiver of the five-year waiting period. These rulings have permitted reconsolidation when the taxpayer established that the disaffiliation and reconsolidation did not secure for any of the affiliated groups or corporations involved the benefit of any deduction, credit or other allowance that would not otherwise have been available if...