Computation of Consolidated Accumulated Earnings Tax Explained

2. Whether the operating expenses, inventory and receivables of the PHC members of an affiliated group filing a consolidated return should be eliminated for purposes of computing the consolidated group's reasonable business needs.

3. Whether, for purposes of the consolidated accumulated earnings tax under Treas. Reg. section 1.1502-43, (a) authority exists for using retained earnings in lieu of accumulated earnings and profits ("E&P") or (b) accumulated E&P can be computed by making adjustments to retained earnings.

4. Whether the accumulated E&P of a consolidated group should be computed on a consolidated basis.

5. Whether the accumulated E&P of PHC members of a consolidated group should be excluded from the computation of the group's accumulated E&P.

6. If the accumulated E&P of PHC members of a consolidated group should be excluded from the computation of the group's accumulated E&P, whether pre-merger accumulated E&P of non-PHC entities which have been merged into a PHC should be carved out.

7. Whether the accumulated E&P of a PHC member should be carved out where the earnings constituting the accumulated E&P were earned prior to the entity's becoming a PHC (or prior to the corporation's acquiring PHC status).

2. Pursuant to Treas. Reg. section 1.1502-43(a)(4), the reasonable business needs of a PHC member should not be considered in determining the group's reasonable business needs.

3. If the taxpayer's accumulated E&P is not available, its retained earnings, taking into account any known adjustments, may be used. We note, however, that the taxpayer may be required under Treas. Reg. section 1.533-2 to furnish a statement of its accumulated E&P and, further, that the Service's use of retained earnings would be subject to any valid adjustments presented by the taxpayer.

4. For purposes of determining the extent to which the group's E&P may be accumulated in the current taxable year for its reasonable business needs, the group's accumulated E&P should be computed on a consolidated basis.

5. Because the accumulated E&P of a PHC member are generally available to the group for its business needs and are not a factor in the PHC member's liability for the PHC tax under I.R.C. section 541, we believe that the accumulated E&P of a PHC member should be included in the group's consolidated accumulated E&P.

6. In light of our position with respect to Issue 5 that the PHC member's accumulated E&P should not be excluded from the group's accumulated E&P, any accumulated E&P acquired by a PHC in a merger with a non-PHC would automatically be included in determining the accumulated E&P for the group.

7. Similarly, by virtue of the position stated in Issue 5, all of a PHC member's accumulated E&P, including amounts earned when it was not a PHC, should be taken into account in determining the group's accumulated E&P.

[5] The subsidiaries of * * * are variously engaged in manufacturing and real estate. Historically, the principal subsidiary was * * * which manufactured and sold * * * Another wholly owned subsidiary, * * * owned and operated various subsidiaries that were involved in the milling of wood staves, which were sold to coopers for use in making barrels for storage and fermentation of wine, spirits, and other products. ² * * * merged into * * * in * * *

[6] In the years at issue, * * * was a PHC. ³ In addition, during the * * * tax year, * * * may also have been a PHC until its merger in * * * with * * * According to your memorandum of * * * your calculations indicate that the group was not a PHC group in the taxable years at issue. We have assumed (but not verified) the correctness of this statement for purposes of this FSA. * * * reported net operating losses during * * * and * * * however, and did not report any liability for the PHC tax under I.R.C. section 541 for those tax years. ⁴ Because of substantial net operating loss carryovers, the group did not report any income tax liability for the * * * and * * * tax years.

[7] The Service asserted an AET liability for the * * * group in the amount of $* * * for * * * and $* * * for * * * We understand, however, that the Service did not notify the taxpayer of the proposed AET liability prior to issuing the notice of deficiency pursuant to the procedure specified in I.R.C. section 534(a). Hence, the Service has the burden of proof on the issue of the group's reasonable business needs.

[9] In the case of an affiliated group filing a consolidated return, Treas. Reg. section 1.1502-2(d) provides that the AET is imposed on the consolidated accumulated taxable income of the group unless the group is subject to the PHC tax imposed by I.R.C. section 541. Rules for determining the group's AET are set forth in Treas. Reg. section 1.150243. Treas. Reg. section 1.1502-43(a)(1) expressly notes that the AET does not apply to a group treated as a PHC by application of I.R.C. section 542(b) and further states that "[s]pecial rules are provided in this section for other groups which include one or more personal holding companies." Notwithstanding this statement, most of the contemplated special rules in Treas. Reg. section 1.1502-43 for groups with PHC members are marked "[Reserved]." See, e.g., Treas. Reg. sections 1.1502-3(b)(3)(i), 1.1502-43(c)(2), (4) Example (2).

[10] Treas. Reg. section 1.1502-43 was proposed in 1979 and adopted in its present form in 1984 by T.D. 7937, 1984-1 C.B. 187. As proposed, Treas. Reg. section 1.1502-43 contained no "reserved" provisions. ⁵ The preamble of T.D. 7937, however, states that the Service had reconsidered the "rules relating to the treatment of intercompany dividends and distributions when a personal holding company is a member, the accumulated earnings credit, and the presumption of the proscribed purpose when earnings and profits are allowed to accumulate beyond the reasonable business needs" (id. at 187) and that a new notice of proposed rulemaking on those subjects would be published. For that reason, portions of the regulations in Treas. Reg. section 1.1502-43 were reserved.

[11] Prior to the adoption of Treas. Reg. section 1.1502-43 in 1984, the only provision in the consolidated return regulations with respect to the AET was I.R.C. section 1.1502-2(d), providing that the AET for the group is imposed on the consolidated accumulated taxable income. In Gottesman & Co. v. Commissioner, 77 T.C. 1149 (1981), the Tax Court held that, in the absence of regulations setting forth the method for calculating consolidated accumulated taxable income, it was reasonable for the taxpayer to conclude that a separate computation of accumulated taxable income was required for each member of a group filing a consolidated return. In arriving at that conclusion, the court emphasized that the AET is a penalty tax and should be strictly construed, citing Ivan Allen Co. v. United States, 422 U.S. 617, 627 (1975). The court found that the regulations were ambiguous regarding the manner in which the AET was to be imposed on groups filing consolidated returns and that the ambiguity was of the Service's own making. 77 T.C. at 1157-58. Declining to fill in the gaps, the court concluded that the taxpayer's interpretation of the regulations was reasonable under the circumstances.

[12] In its protest, the taxpayer contends that the rationale of Gottesman applies in this case to require separate (rather than consolidated) treatment for AET purposes since Treas. Reg. section 1.1502-43 does not specify the treatment of an affiliated group with a PHC member. Notwithstanding Gottesman, we believe that since the taxpayer in this case is a consolidated group the AET should be determined on a consolidated basis. Unlike the situation in Gottesman, the consolidated return regulations applicable in this case not only state the general requirement that a group filing a consolidated return determine its AET liability on a consolidated basis but also provide the method for computing that liability. The principal issue in this case is the proper treatment of PHC members for purposes of the computation. Because the regulations reflect a policy of requiring a consolidated group to determine its AET liability on a consolidated basis and prescribe the method for computing that liability, a group should not be allowed to circumvent that policy and revert to a separate, member-by-member AET computation merely because it includes a PHC as a member.

[13] With this threshold issue resolved, we will address each of the specific questions raised in your requests.

Issue 1. Consolidated accumulated taxable income -- treatment of PHC member

[14] As set forth in the 1979 notice of proposed rulemaking, Prop. Reg. section 1.1502-43(b)(3)(i) provided as follows: "Consolidated accumulated taxable income is computed by treating the personal holding company as a member, but by excluding the items of income and deduction of that member and by including dividends received from that member." 44 Fed. Reg. at 28003. Although the final regulations adopted in T.D. 7937 reserved that provision, we believe that as a matter of policy the income and deductions of a PHC member of the group should be excluded in the computation of consolidated accumulated taxable income. If the income and deductions of the PHC member were included in the computation, the effect would be to subject the income of a PHC. member to the AET in contravention of the statutory exception for PHCs in I.R.C. section 532(b)(1). The reason for this exception is that a PHC is subject to tax on the undistributed PHC income under I.R.C. section 541, which similarly imposes a penalty on a PHC's failure to distribute current income to its shareholders. Because a PHC member is generally subject to the tax under I.R.C. section 541, its income and deductions should be excluded from the group's consolidated accumulated taxable income.

[15] Moreover, while the final regulations reserved the proposed provision that would have excluded a PHC member's income and deductions, the file for T.D. 7937 does not indicate that the drafters of the regulations had any doubts concerning that result. The only apparent reason for reserving this provision was that the Service intended to consider the provisions related to PHC members in another rulemaking proceeding. Thus, we do not believe that the exclusion of the income and deductions of a PHC member is contrary to the existing regulatory scheme.

Issue 3. Retained earnings and accumulated E&P

[17] A corporation's accumulated E&P are not necessarily equal to its retained earnings, and we are not aware of any authority for using retained earnings in lieu of accumulated E&P. Because accumulated E&P can be obtained from the amount of retained earnings by making appropriate adjustments, we believe that the Service may use the amount of retained earnings, taking into account any known adjustments, if the amount of accumulated E&P is not available. In our view the taxpayer should have the burden of proof with respect to the amount of its accumulated E&P. In particular, Treas. Reg. section 1.533-2 provides that the corporation may be required to furnish a statement of its accumulated E&P as well as other information related to dividends and shareholders. Therefore, if the taxpayer does not provide the amount of its accumulated E&P, we believe that the Service would be justified in substituting the retained earnings amount.

Issue 4. Accumulated E&P of members of a consolidated group

[18] Under Treas. Reg. section 1.1502-43(a)(3), the E&P for a consolidated group which has no PHC members is the aggregate of the E&P of each corporation that is a member at the close of the taxable year. ⁶ The existing regulations do not contain any rule concerning the E&P of a group with one or more PHC members. Since the group must compute its AET liability on a consolidated basis (as discussed previously), we believe the E&P of consolidated members should be aggregated for purposes of determining the group's E&P against which the reasonable business needs are to be compared. Accordingly, in our view, the general rule should be that the accumulated E&P of a consolidated group should be the aggregate of the E&P of each member of the group as of the close of the taxable year with respect to which the AET liability is being computed.

Issue 5. Accumulated E&P of PHC members of the group

[19] As discussed above in Issue 4, the existing regulations do not provide any rule for determining the E&P of a group that has a PHC member. Because E&P is taken into account only in determining the amount of E&P that may be accumulated for the group's reasonable business needs, the argument could be made that a PHC member's accumulated E&P should be included in the group's accumulated E&P since any previously accumulated E&P of the PHC member is available to be used by the group for its reasonable business needs and would be available, in the amount of the excess, for distribution to shareholders of the parent corporation. Moreover, if the PHC had a loss, this would reduce the amount of resources a group had to take care of reasonable business needs and to distribute (in the amount of the excess) to the parent's shareholders. Accordingly, it makes sense to include the amount of the PHC member's previously accumulated E&P in determining whether the group's consolidated accumulated E&P is sufficient for the group's reasonable business needs and whether there is an excess available to distribute to the parent's shareholders. Moreover, allowing the group to exclude a PHC member's accumulated E&P would provide a group with a potential device to manipulate its accumulated E&P by merging non-PHCs into a PHC or by causing a non-PHC to become a PHC.

[20] Although we believe this argument is reasonable, we recognize that it does not take into consideration that Treas. Reg. section 1.1502-43(a)(4) excludes a PHC member's reasonable business needs from the group's reasonable business needs. Presumably a PHC member may have its own reasonable business needs against which it could use all or a portion of its accumulated E&P. In such a case, the PHC member's accumulated' E&P would not be available to use against the reasonable business needs of the other group members. Thus, an alternative approach would be to include the PHC member's accumulated E&P, reduced by the amount of its own reasonable business needs. Such an approach, however, could be seen as contrary to Treas. Reg. section 1.1502-43(a)(4), which expressly excludes the business needs of a PHC from the group's business needs.

Issue 7. PHC member's accumulated E&P earned as a non-PHC

[22] Because we believe that the PHC member's accumulated E&P should be included in the group's consolidated accumulated E&P, there is no need to carve out accumulated E&P earned in taxable years in which the corporation was not a PHC.

[23] The foregoing discussion sets forth our best judgment on the issues raised by your memoranda. It is evident, however, that our responses to your questions are based primarily on our interpretation of Treas. Reg. section 1.1502-43 within the overall framework of the AET rather than explicit regulatory provisions. * * * See Woods Investment Co. v. Commissioner, 85 T.C. 274, 282 (1985) (Service's apparent reluctance to use its broad powers to amend consolidated return regulations does not justify judicial interference in essentially a legislative and administrative matter); Gottesman & Co., supra, 77 T.C. at 1158 (ambiguity in consolidated return regulations was of Service's own making and court declines to fill in the gaps).

[24] * * * a court may be inclined to rule, as the Tax Court did in Gottesman, that a taxpayer may apply any reasonable method. * * *

[25] * * * See, e.g., Idaho First National Bank v. Commissioner, 95 T.C. 185 (1990) (case might have been resolved on de minimis issue without reaching rehabilitation loss issue).

[26] * * *

[27] Please contact * * * at (202) 566 * * * if there are any questions.

² The principal subsidiaries of * * * were * * * and * * *

³ Your memorandum of * * * states that * * * was a PHC during both * * * and * * * We note, however, that the Revenue Agents Report ("RAR") indicates that * * * was listed as a PHC for the years * * * and * * * (see discussion under "ISSUE: Net Operating Losses") In addition, the taxpayer's protest appears to suggest that * * * was a PHC in * * * but not in * * * (see Protest, dated * * * at 112-13). We have assumed (but not verified) the correctness of your statement that * * * was a PHC in * * * and * * * for purposes of this FSA.

⁴ We note the fact that if the large dividends which * * * and * * * paid * * * in * * * had been treated as income to * * * for PHC purposes, it appears that * * * would have had a PHC tax liability.

⁵ See 44 Fed. Reg. 28001 (May 14, 1979).

⁶ This rule is applicable, however, only with respect to a group having no PHC member. The existing regulations provide no rule for E&P in the case of a group which includes a PHC member. The regulations proposed in 1979, however, provided in Prop. Reg. section 1.1502-43(a)(3)(i) that the group's E&P is the aggregate of the E&P of each corporation "(other than a [PHC])" that is a member at the close of the taxable year. Although the final regulations did not include this provision, the file for T.D. 7937 does not indicate any policy reason for not including it when the final regulations were adopted. Rather, we believe that it was omitted merely because most of the other provisions related to PHC members were reserved for a later rulemaking.