Overview

On March 6, 2015, the IRS issued REG-100400-14, proposing amendments to Treas. Reg. Section 1.1502-76(b), and related provisions, to revise how tax items are reported by a corporation that joins or leaves a consolidated group. The regulations generally apply to corporations joining or leaving a consolidated group on or after the date final regulations are published in the federal register. The proposed rules have several features, and this Alert primarily focuses on the "proposed next-day rule."

A consolidated return generally must include the common parent's items for the entire consolidated return year, and each subsidiary's items for the portion of the year for which it is a member of the consolidated group.¹ Under current law, if a corporation joins or leaves the group, the "end-of-the-day rule" provides that the corporation must close its year as of the end of the day of its change in status, and items arising on the change date are generally reported in the tax return for the period ending on the change date.²

Current law provides an exception to the end-of-the-day rule. If, on the day of a corporation's change in status, a transaction occurs that is "properly allocable" to the portion of the corporation's day after the event resulting in the change in status, the "next-day rule" requires the corporation and its related parties to treat the transaction as occurring at the beginning of the following day. ³ In determining the period to which a transaction is "properly allocable", a taxpayer's determination will be respected if it is "reasonable" and "consistently applied" by all affected persons. The regulations identify several factors to weigh in determining whether an allocation is reasonable.

The preamble to the proposed regulations expresses concern with how taxpayers are interpreting the next-day rule, and explains the proposed next-day rule as "more narrowly tailored to clearly reflect taxable income and prevent certain post-closing actions from adversely impacting [the corporation's] tax return for the period ending on the day of [its] change in status."⁴ The proposed regulations would eliminate electivity and narrow next-day treatment by providing that a corporation generally reports all of its items for the change date under the end-of-the-day rule, but that "extraordinary items" (defined in the regulations) resulting from transactions occurring on the change date and after the event causing the change in status must be treated as occurring and reported at the beginning of the following day. The proposed next-day rule clarifies that next-day treatment is inapplicable to items that arise simultaneously with the event causing the member's change in status.

Generally, when a corporation's S election terminates, it ceases to be an S corporation on the date of termination and it must file its last return as an S corporation for the period ending the day before the terminating event (the "S short period"). To prevent the corporation from having to file a one-day C corporation return, current law provides a separate exception to the end-of-the-day rule for an S corporation. Under this rule, if a corporation's S election terminates as a result of it becoming a member of a consolidated group, the corporation becomes a member of the group at the beginning of the day on which it joins the group. ⁵ The proposed regulations retain this rule and adopt a new "proposed previous-day rule". The proposed previous-day rule provides that if an extraordinary item results from a transaction occurring on the termination date and before or simultaneously with the event causing the termination of the corporation's S election, and the item would be taken into account by the corporation on that day, the item is treated as occurring at the end of the previous day (i.e., at the end the S short period) for purposes of determining the period in which the corporation must report the item. The proposed regulations also provide that an S corporation's items of recognized built-in gain or loss for purposes of Section 1374 will include only the amounts reported on the S short year return (including items reported on that return under the previous-day rule).

In addition to allocating items on the day of a change in status, current law provides rules for allocating items between the two short years that can result from a mid-year change in status.⁶ The IRS requests comments on whether corporations no longer should be permitted to elect to ratably allocate tax items between the two short periods⁷ and whether the list of extraordinary items that are ineligible for proration should be modified to include items not currently listed or to exclude items currently listed.⁸

Current law includes an anti-avoidance rule providing that, if any person acts with a principal purpose contrary to the purposes of the allocation rules under Treas. Reg. Section 1.1502-76(b), adjustments must be made as necessary to carry out the purposes of the regulations. To backstop the mechanical approach of the proposed next-day rule, the proposed regulations would add a parenthetical explaining that the anti-avoidance rule applies where an existing agreement is modified in anticipation of a corporation's change in status. The IRS requests comments regarding this proposed amendment.

The proposed regulations also would address additional issues, including under Sections 382, 1374, 6072, and 381. For example, the proposed regulations would provide that, with regard to an intercompany Section 381(a) transaction, the resulting short year of the target member is not counted as a separate year for purposes of determining the years to which any tax attribute may be carried, thereby expanding the current relief that is limited to net operating loss and net capital loss carryovers, but the preamble indicates that no inference regarding current law should be drawn from the proposal.⁹ In addition, the proposed regulations would eliminate a trap under current law regarding the due date of the final separate return of a corporation whose stock is acquired by a consolidated group in mid year, not accelerating the due date simply because the corporation ceases to exist in the consolidated return year of its acquisition.¹⁰

Implications and observations

The proposed amendment to the anti-avoidance rule creates uncertainty because the referenced agreement modifications presumably are accompanied by economic consequences in order to successfully shift the allocation of items, and if the IRS can adjust an allocation notwithstanding it matching the underlying economics, is the only limit on IRS adjustments the ability of the IRS to establish that the parties acted with prohibited subjective intent? For example, if an agreement is modified to delay accrual of an item by introducing new economic contingencies, can the IRS make adjustments so long as the parties acted with prohibited intent? What if they acted with prohibited intent when undertaking a new agreement, or delaying the disposition of an asset, or engaging in any other activity having a corresponding economic impact?

The proposed next-day rule only permits next-day treatment for extraordinary items resulting from transactions occurring after the event causing the change in a member's status. But the proposed regulations do not define a "transaction" for this purpose. For example, is a transaction limited to the provision of new property or services, or does it include a tax accrual that results from an economic event such as the satisfaction of a condition precedent? Presumably, in light of the goal to protect unsuspecting sellers from post-change in status events, the IRS envisions requiring new property or services.

The proposed next-day rule is inapplicable to items arising simultaneously with the event causing the member's change in status. Proposed Treas. Reg. Section 1.1502-76(b)(5), Ex. 9(c), addresses a Section 302(d) redemption and concludes that "the end-of-the-day rule does not apply" for purposes of determining whether the distributor is a group member, and therefore whether the redemption is an intercompany transaction subject to Treas. Reg. Section 1.1502-13. However, the example might have disregarded the "entitlement rule", which provides that an intercompany distribution is treated as taken into account when the shareholding member becomes entitled to it, not when the distribution is made.¹¹

The mechanical approach of the proposed next-day rule introduces new issues in addition to the uncertainty noted above regarding the anti-avoidance rule. For example, rules elsewhere under the Code and regulations are explicitly or implicitly inconsistent with end-of-the-day or next-day treatment (e.g., Treas. Reg. Section 1.1502-28(b)(11)), and it is unclear how the mechanical approach of the proposed next-day rule will apply if it conflicts with another rule. In addition, there is no requirement for related or other affected parties to report consistently with the corporation whose status as a member has changed, and it is unclear whether or how resulting inconsistencies are to be reconciled.

The narrow, mechanical approach of the proposed next-day rule is a significant change from the flexible approach under current law. Taxpayers will have to adapt to the new approach by considering how to draft agreements related to a corporation joining or leaving a consolidated group, and the extent to which agreement provisions, in lieu of the former regulatory flexibility, can achieve the desired allocation of items.

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ENDNOTES

¹ Treas. Reg. Section 1.1502-76(b)(1)(i).

² Treas. Reg. Section 1.1502-76(b)(1)(ii)(A)(1).

³ Treas. Reg. Section 1.1502-76(b)(1)(ii)(B).

⁴ The IRS issued GLAM 2012-010 to explain its views under current law. See Tax Alert 2013-289 (2/7/2013).

⁵ Treas. Reg. Section 1.1502-76(b)(1)(ii)(A)(2).

⁶ See Treas. Reg. Section 1.1502-76(b)(2).

⁷ See Treas. Reg. Section 1.1502-76(b)(2)(ii).

⁸ See Treas. Reg. Section 1.1502-76(b)(2)(ii)(C).

⁹ See Treas. Reg. Sections 1.1502-21(b)(3)(iii) and 1.1502-22(b)(4)(i).

¹⁰ See Treas. Reg. Section 1.1502-76(b)(4) and (c).

¹¹ Treas. Reg. Section 1.1502-13(f)(2)(iv).