What Is a Consolidated Tax Return?

A consolidated tax return is a corporate income tax return of an affiliated group of corporations, who elect to report their combined tax liability on a single return. The purpose of the tax return allows for corporations that run their business through many legal affiliates to be viewed as one single entity. Common items that are consolidated include capital gains, net losses, and certain deductions, such as from charitable contributions or net operating losses.

Key Takeaways

  • A consolidated tax return allows affiliated entities to report their taxes jointly on one return.
  • This benefits a corporation that operates through many legal entities and can thus be seen as one entity.
  • Items that are consolidated typically include capital gains, net losses, and certain deductions.
  • The IRS has laid out many rules and definitions as to how affiliate companies are legally allowed to consolidate and file.
  • Companies not allowed to consolidate include certain insurance companies, foreign corporations, tax-exempt corporations, regulated investment companies, real estate investment trusts, and S corporations.

Understanding a Consolidated Tax Return

A consolidated tax return combines the tax liability of all includible corporations in an affiliated group. The companies legally permitted to partake in the consolidated group must be includible companies. An includible company, defined by tax law, is any corporation except for certain insurance companies, foreign corporations, tax-exempt corporations, regulated investment companies, real estate investment trusts, and S corporations.

An affiliated group is legally defined as "one or more chains of includible corporations, connected through stock ownership, with a common parent corporation." The specific tax law defines this as where the parent corporation owns 80% or more of the voting power and 80% or more of the value of the stock of at least one of the other includible corporations in the group. Corporations in the group must then also have their voting power and value of their stock 80% owned by one or more of the other corporations.

Electing to File a Consolidated Tax Return

Each affiliated corporation must consent to file a consolidated tax return by filing Form 1122 and returning it along with Form 1120, the tax form for U.S. corporations. After that point, any new member of the associated group must join in the consolidated tax return. Single affiliates may leave the consolidated group without the group's status being terminated. The election to file consolidated returns can be difficult to revoke for the group. Once made, the choice remains binding on all subsequent tax years until the affiliated group terminates. The Internal Revenue Service (IRS) may grant permission to discontinue the election.

Process of Filing a Consolidated Tax Return

The parent company files the consolidated tax return and all subsidiaries must begin to follow the tax year of the parent company. The affiliates are also responsible for providing certain information for the consolidated tax return. They must list their own tax information, such as taxable income and deductions. The affiliates must also then determine any transactions between companies. These transactions can include any lending, renting of property, or any goods or services bought or sold. Next, an affiliate has to report its net income or loss, disregarding any items that will be consolidated, to arrive at their separate taxable income.

Once the separate taxable income of all the affiliates is summed, the consolidated items are netted across the member companies, determining the consolidated taxable income.

Advantages and Disadvantages of Filing a Consolidated Tax Return

Advantages

An affiliated group electing to file a consolidated tax return may substantially alter its combined overall tax liability. For example, a consolidated return ignores sales between connected corporations and therefore no tax is marked. Deferment of taxable gains or losses become realized with the ultimate sale to an outside third party. The income of one affiliated corporation can be used to offset losses of another. Capital gains and losses can also be netted across affiliates and foreign tax credit can be shared amongst affiliates.

Disadvantages

When calculating the accumulated earnings tax, the profit and loss of all affiliates are included, which can be detrimental as only a single minimum credit amount is allowed to be used. And not only is intercompany income deferred but so are losses.

Accordingly, the effect of filing a consolidated return on each member, and the affiliated group as a whole, are complicated and should be carefully considered before making the election. The associated group should consider its eligibility, its overall tax liability relative to separate filings, and the election’s effect on future years.