Complying with the SRLY rules

Under the single-entity principles applicable to the filing of consolidated returns, consolidated taxable income is computed by aggregating the income and losses of all members of the consolidated group.  However, the separate-return-limitation-year (SRLY) rules prevent a group member from carrying back or forward losses to offset the income of other members if those losses were generated in a tax year in which the member did not join in the filing of a consolidated return with the other members.  Absent this rule (and ignoring the effect of any Sec.  382 limitation), a consolidated group would be free to acquire a corporation with existing losses and use those losses immediately against its members’ income, even though those losses were sustained before any affiliation with the acquired corporation existed.

The SRLY rules provide that certain losses or credits of a member that arose in a separate return year, a year in which it was not a member of its current group for the entire tax year, can be used only to offset that member’s contribution to the group’s consolidated taxable income. The effect of these rules is that losses or credits from a separate return year can only be used to the extent that those losses would have been used if the member continued to file a separate return.

Identifying SRLYs

A SRLY is any separate return year of a member or its predecessor (a corporation from which the member received assets in a transaction to which Sec. 381(a) applies (Regs.  Secs.  1.1502-1(f) (1) and 1.1502-1(f)(4)). A separate return year is any tax year in which a corporation filed a separate federal income tax return or joined in the filing of a consolidated income tax return of another affiliated group (Regs.  Sec. 1. 1502-1(e)). Losses generated in separate return years are subject to the SRLY limitation rules.

The following are excluded from the definition of a SRLY (Regs.  Sec. 1. 1502-1(f)(2)):

• A separate return year of the common parent corporation;
• A separate return year of a subsidiary that was a member of the affiliated group for each day of that year; and
• A separate return year of a predecessor corporation of any group member if the predecessor was a member of the group for each day of that year.

Limiting SRLY NOLs

The amount of a subsidiary’s SRLY net operating loss (NOL) that may be utilized in the group’s consolidated return is limited to the aggregate of the subsidiaryfs income, gain, deduction, and loss included in consolidated return years of the group (Regs.  Sec. 1. 1502-21(c)(1)). Thus, a subsidiary’s SRLY losses can be used by the group in a consolidated return year to the extent of the subsidiary’s cumulative taxable income included in consolidated income for the current year and earlier consolidated return years.

To determine the amount of a subsidiary’s taxable income included in consolidated income, consolidated taxable income is computed as if the subsidiary is the only group member.  In addition, the consolidated income is reduced to the extent the member’s loss and deductions (including capital losses) are actually absorbed during a year by a member of the group (including the subsidiary itself) (Regs.  Sec.  1.1502-21(c)(1)(i)(B)).

Example 1.  Limiting the use of SRLY NOLs: A Corp. joins an affiliated group on Feb. 1, year 1. It has a SRLY NOL carryover of $100,000.  A’s taxable income for January was zero, and for the 11 months ended Dec. 31, year 1 (computed as if it were the only member of the group), it generated a $40,000 loss (fully absorbed by the group in year 1) .  Regs.  Sec.  1.1502-21 disallows the use of a subsidiary’s SRLY NOL in a consolidated tax year when the subsidiary’s cumulative taxable income as a member of the consolidated group is negative.

For year 2, consolidated taxable income before NOLs is $120,000, and taxable income for A (computed as if it were the only member of the group) is $30,000.  A’s cumulative amount of income and deductions included within the group’s consolidated returns is still negative (($40,000) + $30,000 = ($10,000)).  Thus, none of the SRLY NOL is allowed in year 2.

If A’s taxable income in year 2 is $55,000 rather than $30,000, the cumulative amount of A’s income and deductions included in consolidated returns is $15,000 (($40,000) + $55,000).  Thus, $15,000 of the SRLY NOL could offset consolidated taxable income in year 2.

In certain circumstances, the cumulative contribution to consolidated income is calculated on a subgroup basis (Regs. Sec.  1.1502-21(c)(2)). A SRLY loss subgroup is a group in which (1) two or more corporations were members of one affiliated group before they became members of another affiliated group, and (2) one of the members has a loss carryback or loss carryover that is not a SRLY loss with respect to the former group but is a SRLY loss carryover with respect to the new group, or one of the members has a loss carryover that was subject to the overlap rule described in Regs.  Sec.  1.1502-15(g) or 1.1502-21(g) with respect to the former group.

Planning tip: Subject to the anti-avoidance rules (Regs.  Sec. 1. 1502-21(c)(2)(iv) and Sec.  269), there is no prohibition against merging an income-producing group into a SRLY loss subgroup.

Limiting SRLY capital losses

The use of a subsidiary’s capital loss carryover that originated in a preacquisition or preconsolidation year (i.e., a SRLY) is limited in the same manner as SRLY NOLs.  The use of a SRLY capital loss is limited to the subsidiary’s cumulative net capital gains included in the group’s consolidated return (Regs.  Sec. 1. 1502-22(c)). Under this same regulation, the capital loss limitations are also applied on a subgroup basis, if applicable.

Limiting SRLY built-in losses

If the aggregate tax basis of a corporation’s assets exceeds their aggregate fair market value when the corporation becomes a member of a consolidated group, the difference is a built-in loss and is also subject to an annual limitation when a loss is realized from the sale of any of those assets (Regs.  Sec.  1.1502-15). Without the built-in loss provisions, a corporation could acquire another corporation and use the built-in losses of the acquired member to offset income generated by the other group members.

Overlap of SRLY limitations with ownership change limitations

Sec.  382 limits NOL carryforwards and certain built-in losses following an ownership change.  When a member of a consolidated group acquires a subsidiary, the SRLY limitations will not apply if the SRLY event (i.e., the corporation’s joining a consolidated group) occurred on or within six months of the ownership change date under Sec. 382 (Regs.  Sec.  1.1502-21(g)(2)(ii)). Only the Sec.  382 limitation applies to the loss carryforwards of the acquired corporation (Regs.  Sec.  1.1502-21(g)).

When the ownership change date precedes or is the same as the date of the SRLY event, the Sec.  382 limitation applies to the tax year that includes the SRLY event.  When the SRLY event precedes the Sec.  382 change date, the elimination of the SRLY limitation Is effective in the tax year that begins after the ownership change date (Regs. Sec.  1.1502-21(g)(3)). The SRLY rules continue to apply when the ownership change rules do not apply.

Example 2.  Overlap rule applied: On March 31, year 1, D Inc., a member of a consolidated group, acquires 55% of the outstanding stock of T Corp. from J, an individual.  T has a $100,000 NOL carryforward on the date of the transaction.  On June 30, year 1, D Inc. purchases the remaining 45% of the stock from J.

The purchase of 55% of T stock on March 31 qualifies as an ownership change under Sec.  382. 
The June 30 purchase of the remaining stock is a SRLY event since T becomes a member of the consolidated group on that date. Since the SRLY event occurred within six months of the change date under Sec. 382, the SRLY limitation does not apply to T’s NOL beginning in year 1.

If the stock was acquired on Oct. 31, the SRLY event did not occur within six months of the Sec.  382 change date. Therefore, T’s NOL would be subject to both the SRLY and Sec.  382 limitations.

The overlap rule is applied on a subgroup basis rather than a separate-entity basis if the SRLY subgroup is the same as the Sec.  382 subgroup (Regs.  Sec. 1. 1502-21(g)(4)).

The overlap rule for built-in losses is similar to the rules for NOLs.  However, the overlap rule will not apply for assets that exceed the de minimis threshold of Sec.  382(h) transferred to a corporation after the Sec.  382 change date but before the SRLY event.  If a transfer is made in that time frame, both the SRLY and Sec.  382 limitations will apply.

The SRLY limitations will also apply to built-in losses attributable to asset acquisitions by an acquired corporation occurring after the later of the SRLY event or the Sec.  382 change date (Regs. Sec.  1.1502-15(g)(5)). The rules are also applied on a subgroup basis rather than a separate-entity basis when applicable (Regs.  Sec.  1.1502-15(g)(4)).

Contributor 

Shannon Christensen, J.D., MBT, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Closely Held C Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2024 (800-431-9025; tax.thomsonreuters.com).