 Hello and welcome to the session. This is Professor Farhat and this session would look at consolidated tax return. This topic is typically covered in a corporate accounting course, definitely on the CPA reg section and in the enrolled agent exam. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1600 plus accounting, auditing, finance and tax lectures. This is a list of all the courses that I cover including CPA questions, hundreds of them. On my website, you will find additional resources such as the PowerPoint slides, true, false, multiple choice, problems, exercises. If you're studying for your CPA 2000 plus CPA questions, I strongly suggest you check out my website. So we're going to be talking about the consolidated return. What does it mean to file a consolidated return? Well, this is very similar to consolidation in financial accounting under GAP, similar but not the same. If you remember under GAP, maybe you do, maybe you don't. To consolidate, you have to own 50% plus. Under tax, you have to own 80%. So notice it's more. So if we have a parent and this is a subsidiary, if the parent owns more than 80% of the subsidiary, they can consolidate. If this subsidiary owns this subsidiary, then all these are in the same group. Then if this subsidiary owns this subsidiary, then these are all in the same group. So they consolidate. However, if the parent owns this subsidiary and the parent owns the yellow subsidiary, those they have a common parent, but they are not connected. Those are brother and sister. So the yellow and the blue are brother and sister. Under those circumstances, they don't consolidate. But if the blue own the green, here we're talking about more than 80%, then the green own the sub, then they will consolidate. The election to file a consolidated return is only available to an affiliated group. What is an affiliated group? It exists when a corporation owns at least 80% of the voting power and the stock value of another corporation either directly or in die directly. So what happened when you consolidate the privilege of filing consolidated return is based on the concept that an affiliated group of a corporation constitute a single taxable entity despite the existence of technically separate businesses parent and the subsidiary, they're technically one group. So by filing a return, the corporation can eliminate intercompany profit and losses on the principle that the tax liability should be based on the transaction with the outsider rather than the intra group affair. So what you can do, you could eliminate intercompany profit case. You don't have to pay taxes on that and you could eliminate the losses as well. So what are the advantages of consolidation? One is you losses from one group can be used to shelter the income of another group. So what happened is a, if they have income, if they own 80% of V, if we have losses, they can offset the gain and pay less taxes. Taxation of intercompany dividend might be eliminated. And we talked about this in another session deduction may be optimized due to a percentage limitation being modified as a result of the consolidated process. We will see what does that mean in a moment. Simply put, when you consolidate, your, your, your, your percentages will go higher. Like for example, for a charitable contribution, so you can take more deduction recognition of income from certain intercompany transaction might be deferred. Sometimes you'd receive income intercompany, you can defer it, you can pay it later basically. And consolidation also eliminate any intercompany pricing problems, which is basically transfer pricing among related corporation that might arise under section 428-36. And what does that mean? Let's take a look at specifically this example. So we get it out of the way. Let's assume Rust Corporation leases a building to Cramson Corporation for 6,000. Now here's what happened. The IRS says, guess what? The real market value is 9,000, not 6,000. Well, a section 482 allocation would increase Rust Corporation monthly income by 3,000. So the IRS said, guess what? You need to increase your income by 3,000 because the fair market value is nine, not six. Not a problem. Okay. If Rust and Cramson are a member of the affiliated group that finally consolidated return, the 482 adjustment would not be made. And if it's made, it's not a big deal. Increase in Rust, corporate rent income by 3,000 is meaningless because it's offset by 3,000 increase and the deduction rent expense of Cramson. So if one company increased their income, or if Rust increased their income, they're supposed to increase income to 9,000? Well, guess what? Cramson will increase their expenses to 9,000, so it will offset each other because it's an affiliated group. So basically, there is no benefit to do so. So it avoid problems like this when you file a consolidated return. Some of these advantages of consolidation is the election is binding upon subsequent year and can be only avoided of the makeup of the affiliate group changes or the IRS consent to revocation of the consolidated return status. Now, when you select to do an affiliate group, all the parties involved will have to agree. If that's not the case, then you cannot have it. So in case you need to change, sometime you need the IRS consent to basically stop preparing your tax return for the whole group. Okay? Also, recognition of losses from certain intercompany transaction might be deferred and that's not good. If you have losses for taxes, you want to take them, you don't want to defer them. If you are an affiliated group, they might be deferred for later until they are transferred to an outside party and we would look at an example. The requirement that all group members use the parent tax year could create a short tax year for the subsidiaries. So you have to follow, all the subsidiaries will have to follow the parent tax year, which in some situation could be bunching income and you have a full year for carryover purposes. Sometime it mess up the income and the taxes. Also, administrative compliance does create complication because, believe me, consolidated tax return are not easy. They're complex and I did few of the moroids in practice, so they're not easy. A further negative consideration is that the tax rules for filing a consolidated return may not mesh with the applicable for those four financial accounting purposes. So for financial accounting purposes, you can do consolidation. Certain rules for consolidation are different. One prime example is if you have a foreign corporation and a foreign corporation, you can include your foreign with your local for financial accounting. For tax purposes, foreign corporation cannot be included and that's what's going to do. That's going to create additional complication and you're going to have to explain the reconciliation between financial accounting numbers of the consolidation and the tax return, which is basically what we're talking about is additional administrative burden because the numbers will not match up because if you're showing your financial statements and you're showing your tax return, one is consolidated and showing that foreign subsidiary, the other one is not, then you have to do more work to show the reconciliation the difference. So those are some of the disadvantages. Let's take a look at how we compute taxable income. So there are several categories that do not enter under determination of the taxable income. For example, intercompany transaction are disregarded, profit and loss are disregarded, dividend paid by one group to another that's basically eliminated, gain and losses from certain intercompany, sales are not recognized until the asset is sold to a third party. And we would look at an example shortly. So what do we consolidate? So on computing the taxable income for any consolidated return, several items are computed on a group basis. And typically, typically on a CPA exam, they ask you questions about what's included and what's not. I mean, the consolidated is tested on the exam, not that heavily, like for example, as partnership, as corporation, but you just have to need to be aware of it. So what are those items? Well, you could net capital gains and capital losses section 1231, you could net casualty gain or losses, you can combine charitable contribution, dividend to receive deduction and net operating losses to believe it or not, that's a lot of benefit. Okay, for the consolidated return. And the best way to illustrate this is to actually look at an example to show you the effect of a consolidated return. So let's take a look at Maze owns 100% of ecru corporation and both have a calendar year for tax purposes. For 2018, they had the following transaction and they file a separate return. So now they're filing separately. Maze income from operation 300,000 capital gain 50. They have a capital loss. Well, that's capital, they don't have a capital loss. They have a charitable contribution of 40,000, of which they can only take 35. Why can they only take 35? Because there is a 10% limit on the taxable income. So basically, if we take 300,000 plus 50 is 350 times 10%, they can only take 35,000 of deduction. Therefore, what they did Maze, they have a 5,000 carry over of a charitable contribution. Okay. So their taxable income is 315. Ecru, they have income from operation for 170. They have no deduction is allowed. They have a 45,000 of capital loss, not allowed, which is zero because you cannot, you can only deduct it up to the extent of income. And they have taxable income of 170. That's good income of 170. Now, simply put, I just want to look at this. If we can combine 315 plus 170 together, I just want to show you their taxable income is 485,000 together if they filed separately. Let's take a look, see what happened if they file a joint return. If they file a joint return, they will combine their income 300 plus 170. Their consolidated income is 470. They have capital gain. So M have a capital gain of 50. E have a capital loss of 45. Now, we can use this capital loss. So now we were able to utilize this capital loss. So we have a net capital gain of 5,000. Now, the charitable contribution, we can deduct all the 40,000. Why? Because 475, okay, now 475, which is those two, 475,000 times, 475 times 10%, we can take up to 47,500 in charitable contribution because we are limited to 10%. Well, that's 40,000 is below. So we were able to do two things. We were able to take advantage of the capital loss. We were able to take advantage fully of the charitable contribution. So all in all, our taxable income is 435. Notice 435 versus 485, there's a difference and we saved money by consolidating, okay? So notice the consolidated return allow one group to use the losses to offset the group of the other company's group, which is, that's really good. Now, bear in mind, this is really good. Congress is aware of this, okay? This possibility could lead to major tax avoidance because what happened is companies will buy up other companies that they have losses and they will take their income to offset their losses. So what happened? What happened? The Congress created some safeguards to stop to limit those potential abuses. So one safeguard against the use of losses and deduction arose in a separate return year. So simply put, if you buy an asset that have losses from other years, you cannot use them for this year. Another safeguard is the use of losses and deduction when ownership changes, when the affiliated group has taken place, when there's changes, some of the, you might lose some of the losses because now you have new owners, okay? And the best way to illustrate this is to look at an example. For the calendar year 2018, K Corporation and S Corporation first elected to file a consolidated joint return. As of January 1st, Starling owned a land held as an investment with a basis of 300,000. They have a basis of 300,000 and a fair market value of 280. So they have a loss, technically, they have a loss of 20,000 on this asset. It's unrealized, nevertheless, it's a loss that they have. During 2018, the land is sold for 270. On a consolidated return, you can only take 10,000. Why? Because when you bought this, when they started to consolidate, the value was 280. When you sold it, the value is 270. So you cannot compare 270 to 300. That's the point. The other 20,000 loss comes from a separate return in and related to Starling. It cannot be used by an affiliated group. Now, when we sell this asset to an outside party, then we can take the losses. We can consider this 300,000. Also remember the deferral of certain intercompany sales can be advantageous. So if we have a deferral of gains, that's good. But remember, if we have losses and we have to defer the losses, that's not good because in taxes, we want to take the losses. We like losses, we like expenses. But if we're filing an affiliated return, we cannot take advantage of those losses. So the realized gain or loss from the intercompany sale is not recognized by the third. And let's assume in 2018, Peach Corporation sells a land basis of 100,000 to be for a fair market value of 180. So they have a gain. Both Peach and Beige are members of the same affiliated group and file tax return. Although they have 80,000 realized gain, none of it is recognized. Why? Because it's an affiliated group. So the third gain or loss may be recognized in later year when the property is sold to an outsider. Let's assume we sell this property to an outsider in year 2020. Let's assume we sold it to a developer for 210,000. Well, guess what now? We sold it for 210. We're going to subtract 100,000 as the basis. And now we have to pay taxes on the 100 and 10,000. So notice, although we did not pay taxes on the 80,000 in 2018, all what happened is this gain was the third. So when we sold it for 210, we would still have to use the $100,000 basis because we deferred the gain. And basically, we saved money for three years. We saved, let's assume the tax rate is 20%. So for 80,000 times 20%, we end up not paying 16,000 for three years until we sold it to a third party. So it's not bad at all. Now, all what I want to remind you is this. I'm always here to help you. 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