What Is a Consolidated Tax Return? Filing Process, Pros, and Cons

What Is a Consolidated Tax Return?

A consolidated tax return is a corporate income tax return of an affiliated group of corporations that elect to report their combined tax liability on a single return. This 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.

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 (REITs), 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 the parent corporation owning 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 typically begin to follow the tax year of the parent company. This means that the fiscal year of all entities must be aligned. Note that for financial reporting, this is not required. The reporting dates of the parent and subsidiary entities can be different, provided the difference is no more than three months.

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 credits 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. Plus, 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, is 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.

Consolidated Tax Returns and Agents

Under IRS regulations, the agent for a consolidated group is the sole entity authorized to handle all matters related to the federal income tax liability for the consolidated return year for each group member. This agent remains the same for that tax year regardless of subsequent changes in the group's structure or membership. All communications and procedural actions involving the group's tax matters are conducted by or with the agent, as prescribed by the IRS.

The term "agent" typically refers to the common parent of the consolidated group at the end of the tax year, unless specified otherwise by the IRS. Successors to the common parent or designated agents by the IRS or the group follow specific rules to continue handling tax matters. A default successor, often emerging from mergers or restructurings, can step into the agent's role without invalidating prior actions taken by the predecessor agent.

In certain circumstances, the IRS may interact directly with individual group members regarding their separate liabilities, especially if the group's agent terminates or fails to perform its duties. Individual members also retain the right to handle non-income tax matters independently and can be directly addressed by the IRS for information requests or specific actions under partnership tax regulations. Communication and procedural notifications must be made in accordance with established IRS guidelines to ensure proper handling of the group's tax affairs.

The Bottom Line

Section 1501 of the Internal Revenue Code permits companies to report the taxable income for all of their qualifying subsidiaries and affiliates on a single return. All connected entities can combine their incomes, net operating losses, credits, and other items, barring certain insurance companies, foreign corporations, tax-exempt corporations, regulated investment companies, real estate investment trusts, and S corporations.

Joint tax returns are common and help present a corporation that operates through many legal entities as one entity.  But they can be complex, difficult to get out of, and aren’t for everyone.