SRLY loss temp. regs. offer significant planning opportunities.

• Author: Thompson, Steven C.
• Position: Separate return limitation year

Taxable income of a consolidated group is determined by aggregating the income and losses of each group member, an approach that reflects the single-entity concept. An exception to this approach applies to losses incurred by nongroup members that are carried into a consolidated return year. The separate return limitation year (SRLY) rules limit the group's use of such losses on the theory that net operating losses (NOLs) generated outside of the group should be permitted only to the extent that the loss member contributes income to the group.

In January 1991, the IRS issued proposed regulations(1) (1991 PRs) that would have profoundly changed the treatment of NOLs, built-in deductions and capital losses of consolidated groups, including rules on the carry-over and carryback of losses to consolidated and separate return years. Many of the proposed changes would have been effective for tax years ending after Jan. 28, 1991, or for corporations joining consolidated groups after that date. Because of the extreme delay in finalizing these rules, consolidated groups have been uncertain whether the existing regulations(2) or the 1991 PRs(3) govern the use of SRLY losses on a consolidated return.

To address the uncertainty, the IRS recently issued temporary amendments to the consolidated dated return regulations regarding losses of affiliated group members.(4) These amendments effectively withdrew the 1991 PRs and issued new rules as both temporary and proposed regulations (1996 TRs). The 1996 TRs are substantially identical to the 1991 PRs and primarily address the uncertainty created by the latter's effective dates; they are generally effective for consolidated return years beginning after 1996, with transition rules for certain groups.

One such transition rule offers consolidated groups an opportunity for significant tax planning for SRLY losses. This article will address this planning opportunity after discussing the 1996 TRs' changes to the SRLY loss rules.

The 1996 TRs

Temp. Regs. Secs. 1.1502-21T(c) and -22T(c) amend the existing SRLY rules on the use of NOL and capital loss carrybacks and carryovers, and differ from those rules in three significant ways.(5) First, the method of determining a member's contribution to consolidated taxable income (CTI) has changed. Second, rather than applying the SRLY limit on a year-by-year basis, the 1996 TRs use a member's cumulative contribution to CTI (or consolidated net capital gain). Third, the computation of the SRLY limit is made on a subgroup, rather than a member, basis.

A Members Contribution to Taxable Income

Under Regs. Sec. 1.1502-21A(c)(2), a SRLY loss member's contribution to the groups taxable income is determined on a "with and without" basis. Specifically, the group's CTI is calculated "with" the SRLY loss member's income and deductions, then without; the difference between the two computations is the income the loss member contributes to CTI. Under this method, anomalies may exist; for example, an unexpected SRLY limit may result whenever a loss member makes a positive contribution to CTI consisting of capital gains that are offset by another member's capital losses.

The group's CTI is $200. The CTI without T is $175 (the capital loss cannot be used in the "without" computation). Using the "with and without" methodology of Regs. Sec. 1.1502-21A(c)(2), the group can use only $25 of T's SRLY NOL, because S's capital loss cannot be offset against T's capital gain in the "without" computation.

Under Temp. Regs. Sec. 1.1502-21T(c)(1)(i)B, a member's contribution to CTI is based on its items of income, gain, deduction and loss; thus, the SRLY loss that may be absorbed in any given consolidated return year is established solely by reference to that member's contribution to CTI. Under this method, a member's contribution to CTI cannot be diminished by another member's NOL or capital loss unless it is a member of a related subgroup. Applying this rule to Example 1 provides a more reasonable SRLY limit of $100 to use T's $75 NOLCO.

Example 1: P, S and T file a consolidated return. T has a $75 SRLY NOL carryover (NOLCO). Income and losses for the year are:

P S T CTI Ordinary income $125 $50 $25 $200 Capital gain/loss 0 (75) 75 0 Total $125 $(25) $100 $200

Cumulative Contribution to CTI

Under Regs. Sec. 1.1502-21A(c)(2), SRLY limits are calculated on a year-by-year basis. However, under Temp. Regs. Sec. 1.1502-21T (c)(1)(i)(B), the ability to use a SRLY loss is based on the member's cumulative contribution to taxable income since it became a group member. While the new rule offers a radical departure from the underlying operation of the existing regulations, it conforms more closely to the IRS's application of the Sec. 382 regulations. For example, under the new rule, a member's SRLY loss may be absorbed in a consolidated return year in which the member does not currently contribute to CTI to the extent its cumulative net contribution to CTI in prior consolidated return years is positive; alternatively, a member's SRLY losses may not be absorbed in a consolidated return year in which the member currently contributes to CTI if its cumulative contribution since it became a group member is negative. Consequently, a member's SRLY loss that can be absorbed by the group in any given year cannot exceed that member's aggregate positive contribution to group CTI, less any NOLCO previously absorbed.

Example 2: P and S, calendar-year corporations, become affiliated on Jan. 1, 19x3, when S has a $40 NOLCO. The income and losses for the group are:

19x3 19x4 19x5 19x6 P $ 84 $(15) $(33) $50 S 16 (20) 35 (10) CTI $100 $(35) $ 2 $40

Under Regs. Sec. 1.1502-21A(c)(2), the group could use $16 of S's SRLY NOL in 19x3 and $2 in 19x5 (because the group's CTI is only $2 in 19x5)(6); the remaining $22 of NOLs are carried over to 19x7. The fact that S contributed $35 to CTI in 19x5 has no effect on the 19x6 SRLY computation.

Under Temp. Regs. Sec. 1.1502-21T(c)(1)(i)(B), S can use $16 of its NOLCO in 19x3. In 19x4, because S has made no contribution to taxable income, none of the NOLCO can be used. In 19x5, when S contributes taxable income of $35, only $2 of the NOLCO can be used; $22 ($ 40 - $16 - $2) of the SRLY NOL carries over to 19x6. This is because the groups CTI is only $2 - even though S's cumulative contribution to taxable income from 19x5 is $15 ($16 in 19x3 - $16 used in 19x3 - $20 in 19x4 + $35 in 19x5). In 19x6, S makes no contribution to CTI for the year, but can still use $3 of its NOLCO, because its cumulative contribution to the group is $3 ($16 in 19x3 -...