How Tax Consolidation Rules for Corporate Groups Work

Tax consolidation is a system that allows a group of related corporations to file a single federal income tax return, treating the entire group as one taxpayer for reporting purposes. This approach can simplify tax reporting for businesses with multiple legal entities. It is an optional election where an affiliated group combines its financial results, reporting collective income, losses, and credits on one return.

The common parent corporation files the return and acts as the agent for all members in tax matters. Once made, the election is binding for future years.

Eligibility Requirements for Forming a Consolidated Group

To file a consolidated tax return, a corporate group must qualify as an “affiliated group.” This status requires a common parent corporation that directly owns stock in at least one other corporation in the group. The ownership must meet both an 80% voting power test and an 80% value test, meaning the parent must own at least 80% of the total voting power and 80% of the total value of the subsidiary’s stock.

For other subsidiaries to be included, their stock must be owned directly by one or more members of the group, meeting the same 80% thresholds. This creates an unbroken chain of ownership from the parent to the lowest-tier subsidiary.

Each corporation must also be an “includible corporation.” The Internal Revenue Code excludes certain entities from this definition, such as S corporations, foreign corporations, and most Real Estate Investment Trusts (REITs). Certain insurance companies and tax-exempt corporations are also barred from inclusion. While a partnership cannot be a member of a consolidated group, any income or loss that flows from it to a corporate member is included in the group’s taxable income calculation.

The Process of Electing Consolidation

A group that meets the eligibility requirements makes the election by filing a consolidated Form 1120, U.S. Corporation Income Tax Return, by its due date. The act of filing the consolidated return itself signifies the group’s consent to the election. The initial filing must also include two other forms.

The first is Form 851, Affiliations Schedule, which details the group’s stock ownership structure. The second is Form 1122, Authorization and Consent of Subsidiary Corporation to be Included in a Consolidated Income Tax Return, which must be completed by each subsidiary.

Once a group elects to file a consolidated return, it must continue to do so in subsequent tax years. The group cannot return to separate filings without first obtaining permission from the IRS, which requires showing good cause for the change.

Calculating Consolidated Taxable Income

The group’s tax liability is based on consolidated taxable income, not the sum of each member’s separate tax bills. The calculation begins with each member determining its own taxable income or loss as if filing a standalone return. These individual amounts are then aggregated.

This combined figure is adjusted for certain items that must be computed on a group-wide basis. These items include the net operating loss (NOL) deduction, capital gains and losses, and deductions for charitable contributions.

A key part of the calculation is the treatment of intercompany transactions, such as when one member sells an asset to another. The gain or loss on such a transaction is not recognized immediately but is instead deferred. This deferred amount is tracked and only recognized when a “triggering event” occurs.

A common triggering event is when the asset is sold to an entity outside the consolidated group. For instance, if a subsidiary sells equipment to another subsidiary at a gain, that gain is deferred. If the second subsidiary later sells the equipment to an unrelated company, the original deferred gain is recognized and included in the group’s consolidated taxable income for that year. This prevents the group from recognizing artificial gains or losses from simply moving assets internally.

Adjustments When a Member Joins or Leaves the Group

When a corporation becomes a member of a consolidated group during a tax year, its financial results are split. The corporation must file a separate, short-period tax return to report its income and deductions for the portion of the year before it joined the group. From the date of acquisition forward, the new member’s income and deductions are included in the consolidated return. All members must adopt the same tax year as the common parent, which may require a new member to change its accounting period and file another short-period return.

A similar process occurs when a subsidiary leaves a consolidated group. The departing member’s income and deductions are included in the group’s consolidated return only up to the date it ceases to be a member. For the remainder of the tax year, the corporation must file its own separate, short-period return.

When a parent corporation sells the stock of a subsidiary, adjustments to the basis of that stock are required. These rules prevent the parent from recognizing a loss on the sale that is related to losses the subsidiary generated while in the group. Because the group already benefited from using those losses to offset consolidated income, the parent’s basis in the subsidiary’s stock is reduced to prevent a second tax benefit.

Ceasing to be a Consolidated Group

A group’s requirement to file a consolidated return ends when the group terminates. Termination occurs if the common parent corporation ceases to exist, is acquired by another company, or no longer has at least one subsidiary that meets the 80% ownership test. The final consolidated return for the group is filed for the tax year in which the termination event occurs. After that point, the former members must file separate corporate income tax returns, assuming they continue to exist as separate legal entities.

A group can also request to stop filing on a consolidated basis by obtaining permission from the IRS. This is generally granted only if a significant change in law or circumstances creates a substantial adverse effect on the group’s consolidated tax liability compared to separate filings.

If a group deconsolidates for any reason, the corporations that were part of it are generally prohibited from joining another consolidated return for five years. This rule prevents companies from switching between filing methods to gain short-term tax advantages.