Carryback of Post-Acquisition Consolidated NOL Attributable to Acquired Corporation

The final consolidated return regulations released July 2, 1999 (TD 8823) are well known among corporate tax practitioners for eliminating the separate return limitation year (SRLY) limit on pre-acquisition net operating losses (NOLs) of an acquired member when it overlaps with Sec. 382. However, these regulations may not be so well known for the change they made to the carryback of post-acquisition consolidated NOLs attributable to an acquired member.

Example: P, a profitable company, intends to acquire T in a tax-free corporate reorganization. T is a start-up company, believed to have high growth potential, but expected to continue to have substantial losses for the next several years. Because (for nontax reasons) P needs T to remain in a separate corporation, P can either acquire T's stock in a stock-for-stock B reorganization or a "reverse triangular" merger, or form a subsidiary to acquire T's assets in a "forward triangular" merger. In either event, P will file a consolidated return with T or the new subsidiary after the acquisition.

Because Sec. 382 will apply to P's acquisition of T, T's pre-acquisition NOLs will not be subject to the SRLY rules, regardless of whether T's stock or assets are acquired. However, if after the acquisition T's losses create a consolidated NOL (CNOL), the current benefit of the CNOL attributable to T will depend on whether P acquires T's stock or forms a new company to acquire T's assets.

Acquisition of T's stock: If P acquires T's stock, Sec. 381 is not applicable and the CNOL attributable to T is carried back to T's two preceding tax years (Regs. Sec. 1.1502-21(b)(2)(i)). However, this carryback will result in no tax benefit, as T had NOLs in those years.

Acquisition of T's assets: If a new corporation formed by P acquires T's assets, Sec. 381 applies and the CNOL attributable to the new subsidiary cannot be carried back to T (Sec. 381(b)(3)). However, under the final regulations, as a result of the revised "offspring rule," the CNOL attributable to the new subsidiary can be carried back to the two preceding tax years of P (the common parent) (Regs. Sec. 1.1502-21(b)(2)(ii)(B)). If P was the common parent of an affiliated group filing a consolidated return prior to the T acquisition, the CNOL attributable to the new subsidiary could be carried back to the P group's two preceding tax years. Accordingly, by structuring the T acquisition in the example as an asset acquisition into a newly formed P subsidiary (or any subsidiary "that has been a member continuously since its organization (determined without regard to whether the member is a successor to any other corporation)"), the CNOL attributable to the new subsidiary results in a current tax benefit.

An obvious question is why Treasury and the Service should promulgate a rule by which the type of transaction used to reach the same result should determine to which corporation a post-acquisition CNOL attributable to an acquired corporation can be carried back. As explained in the preamble to the final regulations and in an informal conversation with an attorney from the IRS Office of the Associate Chief Counsel (Corporate), because of Sec. 381(b)(3), any other regulatory rule would preclude the ability to carry back a post-acquisition CNOL attributable to an acquired corporation when the acquisition is accomplished via an asset acquisition. This result also conforms to the single-entity model of consolidated returns, and the same result would occur if, in the example, T had merged into P in a transaction qualifying as a reorganization.

From Lorin Luchs, CPA, J.D., LL.M., Washington, DC