Tax Sharing Agreements, Part II

During the past academic year, several questions were raised about tax sharing agreements that I thought worthy of addressing here.

Q1.  Can a corporation elect to stop filing a consolidated tax return? 

I will have to admit this has never come up in my years of practice. Generally, a consolidated tax return provides tax benefits to the consolidated group as the losses of one member of the group offset income to another.  For instance, think of a holding company.  It may provide common services such as payroll and marketing for each member of the consolidated group but it may not have any revenue of its own other than perhaps intercompany charges. The holding company usually  generates a tax loss that would offset taxable income from other members of the group in a consolidated return. 

 Nevertheless, Section 1502 does provide for a corporate parent  to discontinue filing a corporate return. The Commissioner of Internal Revenue (“ the Commissioner”) must give permission for such a change. The application  must be filed 90 days before the due date of the return, including extensions.f  The Commissioner may grant permission upon showing of good cause by the corporate group as to why it no longer wishes to file a consolidated return.  Additionally, the Commissioner may grant blanket permission to corporations or classes of corporations to cease filing a consolidated return if changes in the tax law result in a disadvantageous tax position for these corporations. 

Q2. What forms must be filed to elect a consolidated return?

The IRS website provides the following information for a parent corporation about how to prepare a consolidated tax return when it is filing its Form 1120:

“Corporations filing a consolidated return must check Item A, box 1a, and attach Form 851, Affiliations Schedule, and other supporting statements to the return. Also, for the first year a subsidiary corporation is being included in a consolidated return, attach Form 1122, Authorization and Consent of Subsidiary Corporation To Be Included in a Consolidated Income Tax Return, to the parent’s consolidated return. Attach a separate Form 1122 for each new subsidiary being included in the consolidated return.

File supporting statements for each corporation included in the consolidated return. Do not use Form 1120 as a supporting statement. On the supporting statement, use columns to show the following, both before and after adjustments.

1. Items of gross income and deductions.
2. A computation of taxable income.
3. Balance sheets, as of the beginning and end of the tax year.
4. A reconciliation of income per books with income per return.
5. A reconciliation of retained earnings.

Enter on Form 1120 the totals for each item of income, gain, loss, expense, or deduction, net of eliminating entries for intercompany transactions between corporations within the consolidated group. Attach consolidated balance sheets and a reconciliation of consolidated retained earnings.”

Q3. Have there been any Supreme Court cases that have recently affected the filing of consolidated tax returns? 

The Supreme Court decided Rodriquez v. FDIC in February, 2020. This was a fascinating decision because of its public policy implications, the brevity of the Court’s opinion and perhaps some open questions.  A bank holding company filed a consolidated income tax return that included the tax losses generated by its bank subsidiary. This resulted in a $4 million refund. The refund is directed to the common parent that serves as an agent for the group. Neither IRC Section 1501 and its accompanying regulations or the tax sharing agreement in place between the bank and the bank holding company specified which member of the consolidated group would retain the refund. Should the holding company, as agent for the consolidated group retain the refund, or should the entity generating the taxable loss be entitled to the refund?  Both the bank and the bank holding company subsequently filed for bankruptcy.   The FDIC as the receiver for the bank wanted to claim the tax refund to help defray losses to the deposit insurance fund.  The creditors of the bank holding company saw it differently.  They of course wanted the  bank holding company to retain the refund.  

In its decision, the Supreme Court held that state law should determine which company would get the refund. The Court unanimously decided there simply wasn’t enough of a federal question involved to warrant the creation of a new federal common law to cover this situation.   I find the reasoning of the Court to be more than perplexing.  First, what could be more of a federal issue than the maintenance and preservation of the deposit insurance fund?  In such an ambiguous situation shouldn’t this factor come into play? Secondly, is this decision a universal one across all such situations in the United States?  I suspect maybe not.  Both the bank holding company and the bank were state-chartered entities. The application of state common law is arguably proper in such a situation.  Suppose the bank was a nationally chartered bank?  Would the Supreme Court’s decision then still be applicable?  Would the national charter and the FDIC’s interest in the refund be sufficient to overcome the lack of specificity in the tax sharing agreement?  The opinion of the court did not cover this possibility and could be construed to be a narrow decision. Future litigation may be needed to resolve this. . 

In the meantime, all tax sharing agreements need to be reviewed and amended as necessary to provide the parent company, as the agent for the consolidated group, should receive and retain any refund. Obviously, all proper corporate niceties should be followed in order to make sure the tax sharing agreement is not set aside by a “piercing the corporate veil” argument. 

Citation for the Supreme Court case referenced above:

RODRIGUEZ, AS CHAPTER 7 TRUSTEE FOR THE BANKRUPTCY ESTATE OF UNITED WESTERN BANCORP, INC. v. FEDERAL DEPOSIT INSURANCE CORPORATION, AS RECEIVER FOR UNITED WESTERN BANK