Consolidated Income of Affiliated Group Subject to Graduated Rates

By James A. Beavers, J.D., LL.M., CPA, CGMA

Consolidated Returns

The Tax Court held that all the consolidated income of an affiliated group that consisted of a corporation that was a qualified personal service corporation and another corporation that was not a qualified personal service corporation should be taxed using the graduated tax rates of Sec. 11(b)(1).

Background

Applied Research Associates Inc. (Applied Research) is a corporation organized under the laws of Tennessee owned by Kenneth and Beth Heathington. It provides, through Mr. Heathington, professional engineering and consulting services and is a qualified personal service corporation as defined in Sec. 448(d)(2). During the years involved (2006 and 2007) Applied Research owned all the outstanding stock of Oak Crest Land & Cattle Co. (Oak Crest), a Texas corporation. Oak Crest owned and operated a 400-acre ranch in Texas that owned between 200 and 300 head of cattle. Mr. Heathington was president of Oak Crest, and Mrs. Heathington was vice president; both spent significant time working on Oak Crest activities. Oak Crest is not a qualified personal service corporation.

Applied Research and Oak Crest constituted an affiliated group as defined in Sec. 1504(a) during 2006 and 2007. The affiliated group timely filed consolidated federal income tax returns for those years, as allowed by Sec. 1501. Applied Research generated taxable income, and Oak Crest generated a loss, for each year, and the consolidated return reported taxable income for each year. The affiliated group paid tax on its consolidated taxable income in 2006 and 2007 at the graduated rates in Sec. 11(b)(1).

In 2011, the IRS issued Applied Research a notice of deficiency covering 2006 and 2007. It determined that the consolidated taxable income reported on both consolidated returns was subject to the Sec. 11(b)(2) flat 35% rate that is applicable to qualified personal service corporation income. Applied Research challenged the IRS's determination in Tax Court.

Statutory and Regulatory Framework

Sec. 1503(a) provides that in any case in which a consolidated return is made, the tax is determined in accordance with the regulations under Sec. 1502. Sec. 1502 allows the IRS to issue regulations to ensure that the tax liability of an affiliated group, and of each of its members, can be computed, assessed, and collected in a way that clearly reflects its income tax liability and to prevent avoidance of tax liability. Under Regs. Sec. 1.1502-2, an affiliated group's tax liability is computed by adding the tax imposed by Sec. 11 on the consolidated taxable income and taxes imposed by a number of other Code sections.

Once the affiliated group calculates its consolidated taxable income, Regs. Sec. 1.1502-2(a) directs the affiliated group to apply "[t]he tax imposed by section 11" on that consolidated taxable income. Sec. 11(b)(1) provides for graduated corporate tax rates, but Sec. 11(b)(2) imposes a flat 35% tax on the taxable income of a qualified personal service corporation, as defined in Sec. 448(d)(2). Sec. 11(b)(2) was added to the Code in 1987; however, Regs. Sec. 1.1502-2(a), which dates to 1966, was not amended to reflect the addition of Sec. 11(b)(2). Therefore, Regs. Sec. 1.1502-2(a) retains the rule that consolidated taxable income is a singular item and does not provide different tax rates for qualified personal service corporations.

The Arguments

The IRS asserted that where an affiliated group that consists of a qualified personal service corporation and another type of corporation files a consolidated return, each member corporation must be examined separately to determine whether it is a qualified personal service corporation. If at least one member of the affiliated group is determined to be a qualified personal service corporation, the consolidated taxable income of the group must be split or broken up into separate baskets, one for the income of the qualified personal service corporation and another for the income of the other type of corporation. After breaking out the income, a flat 35% rate is applied to the qualified personal service corporation income, and graduated rates are applied to the income of the corporation that is not a qualified personal service corporation.

Applied Research argued that because the consolidated return regulations do not provide for the splitting of an affiliated group's consolidated taxable income after the affiliated group's consolidated taxable income has been calculated, the entire amount of consolidated taxable income of the affiliated group is taxed at the graduated rates.

The Tax Court's Decision

The Tax Court held that graduated rates set forth in Sec. 11(b)(1) should be applied to the affiliated group's consolidated taxable income. It found that there is no guidance in the Code, the regulations, or other authority to justify any method other than treating an affiliated group as a single unitary entity for purposes of determining the proper tax rate to be applied to the affiliated group's consolidated taxable income.

The Tax Court found Applied Research's situation to be similar to that of the taxpayer in Woods Inv. Co., 85 T.C. 274 (1985). In Woods, the taxpayer filed a consolidated return for itself and its four wholly owned subsidiaries. The subsidiaries used accelerated depreciation per Regs. Sec. 1.1502-32. However, when the taxpayer parent sold the subsidiaries, it determined its basis in the subsidiaries' stock using straight-line depreciation under Sec. 312(k). The IRS determined that the taxpayer's use of straight-line depreciation gave it a "double deduction" and reduced the taxpayer's basis in the subsidiaries' stock.

However, the Tax Court disagreed and allowed the taxpayer's basis adjustments. The court noted that Congress enacted Sec. 312(k) after the IRS promulgated Regs. Sec. 1.1502-32; that the IRS was aware of the interplay between the Code and the regulations; and that nonetheless, the IRS had failed to amend the regulations to reflect its litigating position. The court concluded that if the IRS wanted to prevent the double deduction, it should amend the regulations. The court stated:

Since [the IRS commissioner] has not taken steps to amend his regulations, we believe his apparent reluctance to use his broad power in this area does not justify judicial interference in what [is] essentially a legislative and administrative matter. [Woods, 85 T.C. at 282]

In the case of affiliated groups consisting of qualified personal service corporations and other types of corporations, the Tax Court found that Regs. Sec. 1.1502-2 did not distinguish between taxable income under Secs. 11(b)(1) and (2), and that there was no authority to permit the breakup of an affiliated group's consolidated taxable income into separate baskets. As it had in Woods, the court refused to expand the regulations where the IRS could have but had failed to do so. Accordingly, it looked at the affiliated group as a whole to determine the characterization of its income. The IRS and Applied Research had stipulated that when viewed as a whole, Applied Research's affiliated group was not a qualified personal service corporation. Thus, the court held that the graduated rates in Sec. 11(b)(1) should be used to determine the tax on the income.

Reflections

As the Tax Court made clear in its opinion, its decision in this case leaves the door open for taxpayers to circumvent Congress's clearly expressed intent that qualified personal service corporations be denied the benefit of the regular corporate graduated tax rates. However, as the court observed, the ability to circumvent this intent is due to the IRS's failure to amend its regulations to reflect statutory changes. The proper way to solve the problem is for the IRS to fix the regulations.

Applied Research Associates, Inc., 143 T.C. No. 17 (2014)

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