December 1999


By Randy A. Schwartzman and Donald A. Barnes

On June 25, 1999, the IRS issued three sets of final regulations that affect the use of corporate losses by consolidated groups. These rules eliminate some of the anomalies, complexities, and overlap that existed under temporary regulations. The most prominent feature of the final regulations is the elimination of the separate return limitation year (SRLY) rules in certain circumstances where IRC section 382 also applies. In addition, the new regulations contain rules for applying IRC section 382 to affiliated groups of companies that join or leave a consolidated group.

Because the regulations are extensive and address a wide variety of complex situations, a discussion of this nature is limited to providing only a basic overview of the new rules. A brief overview of each limitation is provided below to facilitate an understanding of the interaction of the various loss utilization rules under the new regulations.

SRLY Losses

A SRLY loss is a loss incurred by a member of a consolidated group in a year in which the corporation filed a separate tax return or was included in a consolidated return with another affiliated group. An affiliated group that files a consolidated tax return can use a SRLY loss only to the extent that the loss corporation generates its own taxable income while a member of the consolidated group.

SRLY losses can be used to the extent of the member's cumulative contribution to consolidated taxable income since joining the group, not just the new member's contribution to current-year consolidated taxable income. This could occur when consolidated group members that are not subject to the SRLY rules have losses in excess of the income generated by the SRLY members in consolidated return years. This rule was retained from the temporary regulations.

For example, a calendar-year corporation, A, acquires an unrelated loss corporation, B, on January 1, 1998, and an election to file a consolidated tax return is made in 1998. B enters the AB group with SRLY net operating losses (NOL) of $1 million. In 1998, B had taxable income equal to $500,000 and A had a tax loss equal to $500,000. Since taxable income was zero, none of B's SRLY losses were utilized in 1998. In 1999, A and B had taxable income equal to $500,000 each. Under these circumstances, subject to the change in ownership rules discussed below, B's entire SRLY loss of $1 million could be used to offset the AB group's taxable income of $1 million in 1999. The entire loss is allowed based on B's cumulative contribution to taxable income of $1 million through 1999--$500,000 in 1998 and $500,000 in 1999.

Section 382 Limitation

IRC section 382 imposes an annual limitation on the use of NOLs and other tax attributes following a change of ownership in the loss corporation of more than 50 percentage points by one or more five-percent shareholders within a three-year period. Under IRC section 382, the corporation's NOLs incurred prior to the change of ownership can be utilized each year in an amount equal to the "IRC section 382 limitation." The IRC section 382 limitation is equal to the fair market value of the loss corporation's stock immediately before the ownership change multiplied by the Federal long-term tax-exempt rate.

Thus, for example, if the fair market value of a loss corporation is $10 million and the Federal long-term tax-exempt rate is five percent, the IRC section 382 limitation is $500,000 per year. This would permit $500,000 of the loss corporation's NOLs to be utilized each year, subject to the general rules regarding carryovers (i.e., the losses are limited to taxable income, utilized in chronological order, and subject to the applicable 15- or 20-year carryforward periods). If less than $500,000 of the loss corporation's losses were utilized in any year, the unused portion of the IRC section 382 limitation amount would carry over and increase the IRC section 382 limitation amount in a subsequent year. This rule provides for the fairness and similarity offered by the cumulative contribution rule related to the utilization of SRLY losses discussed above.

It should be noted that the annual limitation on use of NOLs and other attributes is reduced to zero (and therefore none of the NOLs can be utilized in the future) in certain situations. This could occur, for example, if the loss corporation fails to continue its business, or sells its historic business assets, within a two-year period subsequent to the ownership change. In addition, special rules apply when a loss corporation has built-in gains and losses.

New Overlap Rule

In many cases, the date on which a corporation becomes a member of a consolidated group (and thus subject to the SRLY rules) is also the date on which there is a more than 50 percentage point change in ownership of the corporation for purposes of IRC section 382. Prior to issuance of the new regulations, loss corporations that joined a consolidated group and experienced a more than 50% change in ownership were subject to two separate limitations on their loss carryovers: the SRLY limitation and the annual IRC section 382 limitation. These rules apply to NOLs, tax credits, and certain built-in losses.

The new regulations generally eliminate application of the SRLY rules where a new member joins a consolidated group and the new member experiences an ownership change under IRC section 382 simultaneously with, or within six months of, joining the consolidated group. This is referred to in the new regulations as the overlap rule.

Under the overlap rule, when an ownership change precedes the SRLY event, the SRLY restrictions are eliminated as of the date of the ownership change. Moreover, limitations are not imposed on NOLs incurred between the ownership change date (post­ownership change losses) and the date the acquired subsidiary enters the consolidated return. This limitation is common for the so-called creeping acquisition.

The following example illustrates application of the overlap rule in situations where an ownership change precedes a SRLY event: Parent Company, P, acquires 50% of Target Company, T, on April 1, 1999, and then acquires an additional 30% of T on September 1, 1999, at which time T becomes a member of the PT consolidated group. Since T experiences an IRC section 382 change of ownership on April 1, 1999, and becomes a member of the acquirer's consolidated group on September 1, 1999 (creeping acquisition), losses incurred by T prior to September 1, 1999 would not be subject to the SRLY rules under the new regulations. This occurs because an IRC section 382 ownership change occurred within six months before the SRLY event.

The IRC section 382 limitation only applies to losses incurred prior to a change in ownership, with certain exceptions for built-in gains and losses. Losses incurred by T prior to April 1, 1999, would be subject to IRC section 382. Any losses incurred by T between April 1 and September 1, 1999, would not be subject to the SRLY rules or IRC section 382 because those losses arose subsequent to the change in ownership.

When a SRLY event precedes an ownership change, the elimination of the SRLY limitation is delayed until the first consolidated return year that includes the ownership change. The purpose of this rule is to ensure that an adequate limitation remains on the NOLs at all times.

The following example illustrates application of the overlap rule in situations where a SRLY event precedes an ownership change: Parent, P, has a pre-existing ownership of 45% of a target subsidiary, T, that was acquired more than three years ago. After one year, P acquires an additional 40%, and after two years, P acquires the balance.

Under these circumstances, a SRLY event would occur after the first year (when T joined the consolidated group) and an ownership change would occur after the second year (when a 55% change in control occurred). In this instance, while the SRLY rules would impose limitations in the first year, the SRLY rules would no longer be applicable in the second year.

The new overlap rule does not apply, and therefore the SRLY rules continue to apply in addition to the section 382 rules, where a corporation joins a consolidated group in a transaction that does not involve a more than 50% change of stock ownership of either party. Furthermore, the SRLY rules continue to apply if a change of ownership under IRC section 382 and a SRLY event are separated by more than six months.

Prior to issuance of the new regulations, acquired companies were frequently liquidated (or converted into LLCs), or income-producing assets were transferred to them, in order to avoid the application of the SRLY rules. These steps are no longer necessary where the transaction qualifies for the new overlap rule.


Under the new regulations, the IRC section 382 limitation and the SRLY rules continue to apply on a group or subgroup basis, rather than on a company by company basis, where two or more affiliated companies experience an IRC section 382 change of ownership at the same time or join a consolidated group at the same time.

However, the rules for determining a subgroup for IRC section 382 purposes are not identical to the rules for determining a subgroup for SRLY purposes. This is an important point because the new overlap rule--which eliminates SRLY restrictions where an IRC section 382 ownership change occurs within six months before or after a SRLY event--applies only if the IRC section 382 loss subgroup is identical to the SRLY subgroup.

A SRLY subgroup consists of affiliated companies that become members of a new consolidated group at the same time. Similarly, affiliated companies that experience a change of ownership at the same time comprise an IRC section 382 subgroup.

However, an IRC section 382 subgroup, unlike a SRLY subgroup, must have a parent-subsidiary relationship under IRC section 1504(a)(1) immediately after the change of ownership. Therefore, if a consolidated group acquires the stock of a company that owns one or more subsidiaries, the SRLY subgroup and the IRC section 382 subgroup should have identical membership. However, if a consolidated group acquires two companies that are in a brother-sister relationship, the companies will be included in the same SRLY subgroup but will not be part of the same IRC section 382 subgroup unless their parent corporation is also included in the subgroup.

The following example illustrates this point: P, the common parent of a consolidated group, directly owns all the stock of S and T. T owns all the stock of U. S, T, and U have loss carryovers. Z purchases from P the stock of S and T. Thereafter, S, T, and U join in Z's consolidated return. S, T, and U comprise a single SRLY subgroup because they were affiliated with each other and became members of the Z consolidated group at the same time. However, because S and T are brother-sister corporations, there are two IRC section 382 subgroups--T and U are one IRC section 382 subgroup, and S is another IRC section 382 subgroup. Accordingly, the SRLY rules will apply to the losses of S, T, and U as a subgroup, and IRC section 382 will apply separately to the T-U and S subgroups.

Election. In this situation, however, the new regulations permit the common parent of the acquiring group, Z, to make an election to treat S and T as satisfying the subgroup parent requirement for purposes of IRC section 382. Therefore, if Z wants to take advantage of the new overlap rule and avoid application of the SRLY rules with respect to its acquisition of S and T, Z should file an election to treat S and T as part of the same subgroup.

Fold-in Rule Exception. Even where the companies in an acquired group are in a parent-subsidiary relationship, there can be nonidentical SRLY and IRC section 382 subgroups where the acquired companies have not been affiliated with each other for all prior years. If the acquired parent company acquired subsidiaries more than five years earlier, the new regulations treat the acquired parent company and those previously acquired subsidiaries as a single IRC section 382 subgroup. In effect, the acquired parent company is "folded into" the subgroup it had previously acquired for purposes of tracking future ownership changes. This fold-in rule does not apply for SRLY purposes, however, so application of the fold-in rule can create nonidentical SRLY and IRC section 382 subgroups.

Split Carryback Election

The final regulations contain an important election relating to losses incurred by otherwise profitable corporations subsequent to entering a consolidated group. Pursuant to IRC section 172(b)(3), a taxpayer may elect to relinquish its right to carry back an NOL to an earlier year. Under previous guidance, an election by the group to waive the carryback period could be made only for the entire group, and not for separate corporate taxpayers.

The final regulations now permit the group to waive the carryback period of a single member for the time it was in another consolidated group. This rule is important in drafting agreements relating to acquisitions of target companies that have carryback potential.

Effective Date

The new regulations are effective for consolidated returns with due dates (without regard to extensions) after June 25, 1999. Therefore, the new overlap rule applies to losses carried to consolidated tax returns for the 1999 calendar year and for fiscal years ending on or after April 30, 1999.

The new rules are also applicable to loss carryforwards from years prior to the effective date of the new regulations. Therefore, practitioners should examine clients that have subsidiaries with NOLs previously subject to both the SRLY and IRC section 382 limitations to determine if the SRLY limitation is no longer applicable.

A Word of Caution

The rules provide less onerous restrictions on the use of target losses by acquiring corporations in overlap situations. However, these rules are very complex and contain various traps for the unwary (i.e., the failure to make proper elections). Therefore, a detailed review of the final regulations is necessary prior to making determinations as to the utilization of NOLs in connection with acquisitions of loss companies by consolidated group members. *

Randy A. Schwartzman, CPA, of BDO Seidman LLP (New York) is a member of the NYSSCPA Corporate Distributions, Liquidations, and Reorganizations Committee.
Donald A. Barnes, JD, is with BDO Seidman LLP's national tax department in Washington, D.C.

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editors:
Joel Rothstein, CPA
Cohen Hacker Rothstein & Pearl, LLC
Richard M. Barth, CPA

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