 Hello and welcome to this session in which we would look at consolidated tax return. Now this term consolidated should be familiar to us in case we took advanced accounting when we talked about consolidated financial statement. And if you remember in consolidated financial statement if company A owns more than 50 percent of company B then company A can consolidate company B. It means if they are more than 50 percent they are in control. What does that mean? They are in control. It means they can elect the board of directors. The board of directors run the company. If you can run the company if you can select the people to run the company then you are in control. Matter of fact you can select yourself if you own more than 50 percent of the stock of the other company then you own the company. Now when it comes to taxes in order to consolidate tax return you have to own 80 percent plus. It's more than 80 percent. So this is the big idea. This is what we are discussing here. It's an option to file. You don't have to file a consolidated return. The option to file the consolidated return is limited to the group of companies that are affiliated. It means they are connected. They are related to each other. How so? Affiliation is established when one corporation has a minimum of 80 percent of the voting power and stock value of another corporation. Well so let's assume Red Company owns 85 percent of Blue Company. Well now they can consolidate if they chose to. Now let's assume they own 80 percent of Yellow Company. Well Red can consolidate with Yellow as well. They consolidate Yellow but Blue and Yellow they are not connected. Now let's assume Blue owns 83 percent of Green. Now Red owns Blue and owns Green as well. So the ability, the idea to file a consolidation return is rooted in the basic idea that an affiliated group of a corporation is treated as a single taxable entity. So rather than having one, two, three for taxable purposes we can combine all three together. Although they might be operating as separate companies but for the tax return we can combine all the revenues, all the expenses, all the assets, all the liabilities together as one company. Now for the CPA exam you have to learn about advantages and disadvantages of consolidated return and this is exactly what we will do in this session. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today. Starting with advantages of consolidated tax return so why would companies consolidate their tax return, file a consolidated tax return? Well one thing is the losses incurred by one member of the group can be utilized to offset the income earned by another member providing a means to protect earnings from taxation. What does that mean? A good example will be let's assume we have company A and company B. Company A they have capital gains, they have capital gains of 10,000. Company B they have capital losses of 7,000. Now if they file separately company A would report the gain of 10,000 company B cannot use the losses because those are access losses you can't use access losses for tax purposes. If they combine together then the net will be 3,000 of a gain because now company A the losses from company B can offset the gains from company A. So this is one of the advantage of this is one example of it but this is one of the advantage of consolidation. The taxation of dividend between affiliated companies can be completely waived because again one company is paying the other once they consolidate they eliminate that. You could also maximize your deduction. Why? Because once you consolidate a result in adjustment to percentage limitation that's usually higher. What does that mean? You remember when we talked about as an example charitable contribution and that's limited to 10 percent of taxable income. So if the taxable income for company A alone is let's assume 100,000 times 10 percent that's 10,000. That means the company can contribute 10,000 and deduct 10,000 and charitable contribution. If company A and company B are combined their taxable income could be it's going to be more let's say 250,000. Now once we multiply this by 10 percent together they can contribute and deduct 25,000 and charitable contribution. An income recognition from specific and their company transaction can be postponed. So when you have profit from intercompany transaction well they will be postponed. You don't have to pay taxes on them yet. Also consolidation results any concern regarding what we call transfer pricing intercompany pricing issue that may arise among related companies as stipulated by section 482.36. What does that mean? Well let's look at an example to see how this work. Let's assume Adam Corporation leases a facility to NOAA for 8,500 per month. That's the monthly lease. If the tax authority determines that the fair market value is actually 12,500 so they're saying this intercompany pricing because Adam and NOAA are related well guess what you are you are only reporting you are only getting 8,500 you are giving a special price for NOAA because NOAA is an affiliated company it should be 12,500 add 4,000 to your income. Well that's fine if Adam and NOAA are part of a consolidated group that files a joint return then this section 482 would not be necessary even if it's necessary you will add 4,000 to Adam company in revenue in rental revenue or lease revenue then you'll have a deduction on NOAA's return 4,000 of lease deduction or rent rent deduction in effect there is no effect on the bottom line so this is some of the advantages some of the disadvantages of filing a consolidated tax return is an election remain in effect for future years unless there are changes to the affiliated group or the IRS grant the consent to revoke the consolidated return so once you are a consolidated you can no longer back out that easily unless there are the changes to the affiliated group or the IRS you ask the IRS to consent to revoke in this consolidation status now losses arising from specific intercompany transactions are postponed remember we are happy that the gain are deferred or postponed that was an advantage that was an advantage well losses now we don't like losses to be deferred why because we like losses for tax perspective we like losses we like deduction now when the two companies combine and they have losses they cannot take the losses if they are allowed by the tax law they have to defer them because they are intercompany losses also all the group members what they have to do they have to adopt the parent tax year will this could result in shorter tax year for some subsidiaries why is that not good because sometime when you bunch income or exhaust certain carryover if you have a half a year or three fourth of a year or a partial year you may not be able to take advantage of those bunching those deductions also as you consolidate it's more complex and it's the complex and extensive provision of consolidated tax return may result in additional costs administrative compliance costs it costs you more money the tax rules filing is a consolidated return may not be aligned with those used with financial accounting so you have to kind of basically either hire an accountant or hire a CPA firm that can reconcile the two and oftentimes not often it's not as easy and it's costly also if you have a foreign corporation you cannot include in the consolidated tax return certain income that you show for financial statement preparation and we'll work an example in other words if you have a company in Mexico that's generating revenue for you you would report this for financial statement purposes but it's not consolidated for tax purposes it's going to create this discrepancy and this discrepancy will necessitate explanatory reconciliation so eventually you'll have to explain this on schedule m3 the point is when you consolidate you're going to have some complications this is a disadvantage of consolidation now how do you compute taxable income for consolidated groups simply put what's included and what's not included well certain types of transaction are executed from the cal from the calculation of taxable income what are they well intercompany transactions are not taken into account why because the sale of one company is a cost of another company they they cancel each other also dividend distributed from one member of the group to another group are disregarded it's like taking money from one pocket putting the money into the other pocket also any gains and losses resulting from intercompany sales are not realized are I'm sorry are not recognized they are realized recognize means recorded until the asset is sold or transferred to an outside group other than the affiliated group such as when it's disposed of an external party so those losses and gains they don't they don't factor into the consolidated group now what is included when calculating taxable income for the consolidated return what do we include we include net capital gains and losses which is section 1231 as well casualty gains and loss or loss charitable contribution dividend received deduction and net operating loss those we will account for when we are doing a consolidated return the best way to illustrate this concept the benefit of a consolidated return is to look at a quick example just to show you the difference between the two here let's look at adam first adam have income from operation 295 000 capital gains of 55 000 no capital loss and adam made a charitable contribution of 40 000 that's what this is adam's section now let's compute the taxable income for adam we'll take 295 plus 55 000 let's do that 295 plus 55 that's going to give us 350 000 and based on that we can determine the charitable contribution adam made a 40 000 charitable contribution adam can only deduct 35 therefore if we take income from operation for adam plus capital gains minus the charitable contribution 315 000 21 tax 21 tax percent for corporation adam tax bill 66 150 let's look at no one income from operation 175 77 i'm sorry no has a capital loss of 45 000 well no i cannot use it because that's that's an excess capital loss we cannot deduct it for tax purposes we can carry it over therefore noa's taxable income is 177 times 21 noa's tax bill is 37 110 together they paid each one separately but together they paid 103 320 let's see when they consolidate what would happen when they consolidate the total income is 472 000 combining noa and adam capital gains now here's what we do since we are consolidating adam has a capital gain noa has a capital loss well 55 minus 45 now we can use the capital loss of 45 000 and only report is a consolidated capital gains of a 10 000 now 472 plus 10 000 that's 482 now if we multiply this by 10 percent that's going to give us 48 200 this is how much we can contribute to charities you remember adam contributed 40 000 now we can deduct the whole thing so notice by consolidating we were able to use the the capital loss to offset the capital gain and we're able to use the full charitable contribution therefore taxable income is 4 22 multiplied by 21 percent the tax bill is 92 820 notice the difference is 10 500 and savings in case they consolidate so this is just an illustration of the benefit now do government knows about this of course they know so what they'll try to do they want to make sure you don't abuse this type of consolidation therefore they put limitation the rules for consolidated return permit the group to utilize the losses incurred by one member or more of its members to offset gains however because there's a potential of tax abuse or tax avoidance due to that potential you know profitable companies acquiring a loss making a company to utilize its loss carryover so what profitable companies would do they will buy companies that incurring losses and they combine them and they basically wipe out their taxes congress has implemented multiple safeguards to permit to prevent or restrict such potential abuse so the congress they know about this congress people there were business people before there were congress people right so they know exactly what needs to be done so one safeguard is to prevent the utilization of losses and deductions that originated in a separate tax year simply put losses from other years cannot be used in the year of consolidation don't worry we'll look at an example to show you what we mean by this also another safeguard is to restrict the use of losses and deduction when there have been changes in ownership with an affiliated group simply put we have company a company b and company c and what they do they keep buying each other to do what to offset the losses well that that's also cannot be done it's limited let's look at an example that illustrates losses from other years cannot be used in the year of consolidation in the calendar year 2023 adam corporation and noah corporation made their initial decision to file a consolidated return great on january 1st noah had the land as an investment with a basis of 300 000 and a fair market value of 280 well what does that mean means we have a loss right now of 20 000 because the fair market value is less the land is subsequently sold for 270 during 2023 okay now when finally get consolidated returned the affiliated group can only claim 10 000 of losses so the remaining 20 000 stems from a separate return year and pretends exclusively to noah corporation not the consolidated group now let's discuss the third and realized gain and losses the third means pushing things down into the into the future or realized means you are how much you computed an actual realization of gains and losses remember in taxes we like losses in taxes we like losses we don't like gains why because losses reduce our taxable income so the third thing certain intercompany sales can bring either advantages in the case of gains because you want to defer the gain or disadvantages in case of losses because you want to take the losses now and because they can give you a tax benefit okay so the actual gain or loss resulting from intercompany sale is not recognized but instead it's postponed so when we have those type of transaction we have to postpone when they have intercompany gain or loss they are postponed during 2023 farhat corporation a member of the affiliated group that files a consolidated return sells land to add them corporation for its fair market value of 180 000 the land has a basis of 100 000 well everything else is equal there's a realized gain a realized gain of what 80 000 which is 180 this is the consideration received minus the adjusted basis of 100 000 we have a gain of 80 000 okay on the consolidated return on the consolidated return none of this gain is recognized which is we like this we don't want to recognize any gain we don't want to recognize the gain you might be saying but it's a gain yes it's a gain but i don't want to pay taxes on it now in the year 2027 Adam corporation sold the land to an external developer for 210 well according to the consolidation tax return a recognized gain of 110 should be reported now we recognize again of 110 which is 210 minus the basis of 100 000 will give you a return of 110 and now it's sold to an outside party we recognize the gain we recognize the gain what should you do now go to farhat lectures and look at additional resources lectures multiple choice true false additional exercises that's going to help you understand this concept whether you are a CPA candidate an enrolled agent or an accounting student invest in yourself invest in your accounting career good luck study hard and of course stay safe