Single-Entity Approach Approved for Affiliated Group Product Liability Losses

In an 8-to-1 decision, the Supreme Court, in United Dominion Industries, Inc., 6/4/01, held that the product liability expenses of a member of an affiliated group of corporations that files a consolidated return are eligible for the 10-year carryback period under Sec. 172(b)(1)(c), if the group as a whole were to have a net operating loss (NOL). The 10-year carryback period applies even if the member that generates the product liability expenses were to have a positive separate taxable income. This issue has previously been addressed by the Tax Court, a district court and the Fourth and Sixth Circuits.

Sec. 172(b)(1)(C) provides an exception to the general carryback period of two years for specified liability losses (SLLs). Under the exception, the normal carryback period is replaced with a 10-year carryback period. An SLL is the sum of certain product liability losses (PLLs) and certain deferred losses to the extent that these amounts are used in computing the net operating loss (NOL) for the tax year. The SLL eligible for a 10-year carryback cannot exceed the taxpayer's NOL for that tax year. Under Sec. 172(f)(1)(A), a SLL includes any amount allowable as a deduction under Sec. 162 or 165, attributable to PLLs or expenses incurred in the investigation or settlement of (or opposition to) claims against a taxpayer on account of product liability.

Sec. 172(f)(1)(B) describes the second category of SLLs, which includes certain deferred losses. For tax years beginning before Oct. 22, 1998, SLLs include any amount (other than PLLs) allowable as a deduction for (1) liabilities under Federal or state law, if the act or failure to act gives rise to the liability of the tax year; or (2) a liability arising out of a tort of the taxpayer.

For tax years beginning after Oct. 21, 1998, Sec. 172(f)(1)(B) limits the types of deferred losses included as SLLs. Deferred liability losses allowed a 10-year carryback period are amounts allowable as a deduction, other than those under Sec. 468(a)(1) or 468A(a) in satisfaction of a liability under Federal or state law requiring (1) the reclamation of land; (2) the decommission of a nuclear power plant; (3) the dismantling of a drilling platform; (4) remediation of environmental contamination; or (5) a payment under any workers' compensation act if the act or failure to act, giving to rise to such liability, occurs at least three years before the beginning of the tax year and the taxpayer used an accrual method throughout such period.

In United Dominion, the AMCA International Corporation (AMCA), the predecessor of the taxpayer corporation, was the common parent of an affiliated group of corporations that filed a consolidated tax return. During 1983 and 1986, the affiliated group reported a consolidated NOL (CNOL) between $85 and $140 million. During the years at issue, several of AMCA's subsidiaries reported PLLs, but these companies had positive separate-company taxable income.

The district court held that the consolidated group could claim NOL carrybacks for PLLs incurred by members of the affiliated group for tax years that preceded their membership in the affiliated group. The Fourth Circuit reversed the district court and held that a parent corporation's carryback of a group member's PLL was limited by the member's separate NOL. The court concluded that the expenses did not qualify for the 10-year carryback provided in Sec. 172(b)(1)(c), because the expenses do not qualify as SLLs under Sec. 172(f).

The Supreme Court reversed the Fourth Circuit and held that the product liability expenses of a member of an affiliated group are eligible to be carried back 10 years if the group as a whole has an NOL. Siding with the taxpayer, the Supreme Court favored the "single entity approach" over the IRS's separate-member approach. The Court indicated that the statute and the regulations governing affiliated groups that file a consolidated return provide for a definition of a CNOL, and not a definition of a separate NOL for members of an affiliated group. As the consolidated return regulations only define a NOL at the consolidated level, the Court determined that there is no NOL below the consolidated level, and there is nothing to compare the product liability expenses to that which would produce a PLL before the calculation of the CNOL. Therefore, the Court rejected the Service's separate-member approach and allowed the taxpayer's 10-year carryback.

From Joseph Quinn, CPA, Oak Brook, IL