 Hello and welcome to this session in which we will discuss the filing of a separate tax return when we have a consolidation. What is a consolidation? Consolidation is when we have a parent company and that parent company might own other subs maybe one, two, three subs. It doesn't really matter. They might own them directly or indirectly. For financial accounting purposes, all these subs, they consolidate with the parent and they issue one financial statement. That's fine. However, when it comes to filing a tax return, well, there are certain rules whether these subs can file their own separate tax return or if they have to file or if they can file with the parent company. This is what we'll be discussing. Specifically, we're going to be discussing the separate tax return because we need to know what are the consequences or what are the benefits, what are the pros and what are the cons. Now, in the prior session, we discussed when to file a consolidated return. When can you file a consolidated return for that matter? Well, you have to own between 80 to 100 percent. The company that you own has to be domestic. So you have to own 80 to 100 percent of their stock voting and non-voting to have a consolidated tax return or although you might own this percentage, the company might file separately. And this is what we'll be discussing today. Well, you can file, but you choose to file separately. Remember, if you own less than 80 percent, forget about consolidation. You must file separately. If the corporation is a foreign subsidiary, if the corporation that you own is a foreign subsidiary, forget about consolidation. You must file separately. So consolidation applies to only, let's assume a minority number of subs because you have to own 80 to 100 percent and they have to be domestic. So notice it's a very niche group if you want to call it that. Now, why to file separate return? So why if you have the option to file a consolidated or you may file separately? Why do you file separately? This is what we're going to be discussing 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, Myles. 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. No obligation, no credit card required. So why file a separate return? Well, the affiliates are profitable. Remember, we have many subs, sub one, sub two, sub three. And we have the parent company that own all of those. Now, one reason to consolidate, if this has earnings, this has losses, this has losses, what they would do, they will offset each other. This is one reason to consolidate if you can. Well, if all the affiliates are profitable, there is no motivation because you cannot offset the profit from one sub with the losses of another one because they're all profitable. So that eliminates the incentive for the subsidiary to consolidate, to file their tax return with the parent company and other subsidiaries as well. So you cannot use the losses to offset each other. Also, there might be few intra-entity transactions. What does that mean? It means those subs, sub one, sub two, sub three, they don't buy and sell from each other. They're not related, they're owned by the parent company that they're not related. There's no inter-entity transaction. There is no incentive to consolidate to remove those inter-entity transaction. Now, also there are benefits for filing a separate return. Well, your accounting choices, you have flexibility in accounting choices and flexibility more like, more importantly was fiscal year selection because when you have a consolidated return, they all have to be basically followed a parent company. Now, if your business is seasonal and you would like to choose a fiscal year ending rather than calendar year rather than January to December, well, if you file a separate return, you do have that option because you are filing a separate return. Now, bear in mind, you cannot switch back and forth between filing a separate return and be consolidated. Well, you have to decide what you want to do. You need IRS approval in case you need to change. What do we need to know about filing a separate return? There's immediate taxation on intra-entity profit. Well, what does that mean? It means when you pay taxes on that intra-entity profit and we talked about this in the prior session, you create a deferred tax asset. Because why? Because you paid for the taxes now, although the profit is intra-entity, but if you're filing a separate return, you have to pay it because you are, quote, independent from the other party as far as taxes are concerned. So when you pay your taxes, it's considered prepayment, prepayment of taxes. And as a result, you have a deferred tax asset. So that's one thing we need to be aware of. Also, now bear in mind, if the parent company recognized the profit for financial reporting purposes, so if you have a parent company and they are recognizing the profit for gap purposes, what do they have to do for gap purposes? Because they are recognizing the profit for now. It creates a future taxable liability because they have to do what in the future, pay taxes on that. One topic that we have to be aware of is the third taxes on undistributed earnings. What is distributed earnings? Well, distributed earnings is dividend. So when the company makes earnings and they distribute the earnings, that's the equivalent word of dividend. What happened if the company makes a profit, which is the sub makes a profit, the subsidiary makes a profit, and they don't distribute this dividend? Simply put, that is your earnings. How do we have to deal with this? Well, let's talk about dividend in general, then we'll deal with this undistributed earnings or undistributed in quote dividend. Well, we have to know under gap, dividend are eliminated, they represent inter-entity cash transfer. Also, the tax law state that if you own 80% or more of that company, dividend are also removed from income through the dividend received deduction. Simply put, if you own more than 80% of a company, and obviously you're consolidating, it doesn't matter, there are no differences at that level because in both situations, dividend is not reported. If you own less than 80% of a subsidiary, well, tax recognition becomes necessary because if you own less than 80%, any dividend you receive, 35% of it is taxable. And don't worry, we'll work an example on illustrating this concept, and 65% of it is tax-free. So you still get a dividend received deduction, but not a 100% dividend received deduction. The dividend received deduction goes down to 65%. It's a different percentage. And that sometimes changes, but the point is you'll get some deduction. Now, how about if the sub did not distribute 100% of its earning? So you own shares in another company, you own the majority, you own 70%. For consolidation purposes, you own the whole thing. Now, that subsidiary made a profit, but they only distributed a part of the profit. Well, what happened is they have undistributed profit, undistributed earning. What do we have to do with that undistributed earning? Well, guess what? Income tax liability is immediately created for the recipient, for the future potential recipient because the point is, well, this is your profit, eventually it's gonna be distributed. Once it's distributed, it's going to create a tax liability. Therefore, you have to be ready to book that income tax, the third income tax. Let's take a look at this example to illustrate this concept. Assume parent company owns 70% of the sub. Parents' current earnings before taxes and investment is 400,000, the tax rate is 21%. The sub-current earnings, 200,000, the sub paid 20% of the earnings. So the sub's going to pay 20% of this. This is before taken into account taxes, and we have no intercompany profit or loss to keep it simple. So what is the sub taxes? Well, the sub earned 200,000, the tax rate is 21%, they will pay in taxes 42,000. Now, of the earnings 200,000, they will deduct the taxes. They will come up with net income or earnings after taxes. Well, now you're gonna pay the dividend out of this amount. So they pay $40,000 in dividend, which will keep them with 118,000 in distributed dividend or from a company perspective from a retained earnings perspective. Now, this 40,000, remember, this 40,000 paid in dividend, 70% of that goes to the parent. So let's take a look now at the parent taxes. The parent made a profit of 400,000, that's their current earnings. Then they received 70% of 40,000. 70% of 40,000 is 28,000. Of this amount, on this amount, of this amount, not on this amount, of this amount, 35% is taxable. Why? Because 65% is tax free. Why it's tax free? Because the government gives you something called the dividend receive deduction because the parent company owns 70% of the sub. Guess what? You would receive this deduction. Therefore, the remainder is 35%. And 35% times 28,000 should be 9,800. So of the full amount of the 40,000, all what's left is 9,800, that is taxable, which will give us in total taxable income of 409,800. Now the parent company will have to pay taxes. They will pay 21% and their tax bill for this year will be 86,000, 86,000, 86,058 dollars. Simply put, if you want from a journal entry perspective, debit income, tax, expense, 86,058, credit income, taxes, payable, 86,058. Now, we have undistributed earnings from the sub. And let's focus on this, this amount here, 118. Now, of that 118, 70% belongs to the parent. 70% of that is 82,600. Now, if that income is distributed or if you assume it's distributed, well, it's gonna be 82,600 going to the parent. The parent will have to pay taxes on 35% of it, assuming they keep their interest at 70%. That's gonna make 28,910 dollars of taxable dividend for the future anticipated. Well, guess what? Based on 21%, we're gonna have a future tax bill of 6,071 dollars. Well, guess what? We call this the third taxes payable. Now, also what we have to do, we have to debit income, tax, expense, which is the same amount as this of 6,071 dollars and credit the third taxes liability or the third taxes payable of 6,071 dollars. So let's do the journal entry, combine those two journal entries. We're gonna credit income taxes payable 86,058 for this amount here that we have to pay currently for the taxes. We have a third taxes payable of 6,041 and the combination of those two is 92,191. And this is why I debited income, tax, expense 86,058. I debited income, tax, expense 6,071. And if we add them up 86,058 plus 6,071, they should equal to 92,129. Of this amount, this is the current portion, which is what, 82,600 and this is the third portion. And this is the journal entry that captures this example. What should you do now? Go to Farhat Lectures and look at additional MCQs, exercises, explanation that's gonna help you understand the different tax consequences and a consolidation scenario. This important, this topic is important. Even on the CPA exam, you may not have to go this far, but you have to have a good understanding of this topic for your advanced accounting, for sure you have to know this. Invest in your career, invest in yourself. Visit Farhat Lectures, good luck, study hard and stay safe.