Judgment summary
The United States Tax Court decided cross-motions for partial summary judgment concerning consolidated net operating loss (CNOL) deductions claimed by HBM Holdings Co. (HBM) and its consolidated group for the 2018 short tax year, and the 2020 and 2021 tax years.
The deductions were based on NOL carryovers of Delavau Holdings, LLC (Delavau), which HBM inherited under section 381 following a deemed liquidation of Delavau into HBM on 30 June 2018.
The Court held that Delavau was a predecessor of HBM within the meaning of Treasury Regulation § 1.1502-1(f)(4), that the lonely parent rule in Treasury Regulation § 1.1502-1(f)(2)(i) did not apply to exempt Delavau's separate return years from separate return limitation year (SRLY) status, and that the original members of the HBM group did not constitute an SRLY subgroup. Accordingly, the CNOL deductions were disallowed.
Background
HBM Holdings Co. is a Missouri corporation formed as a holding company and, for the years at issue, was the common parent of an affiliated group filing consolidated federal income tax returns (the HBM group).
Mississippi Lime Co. (MLCO), a member of the HBM group, acquired Delavau Holdings, LLC in 2012 while MLCO was an S corporation. At that time Delavau had accumulated approximately $78 million of NOL carryovers and was treated as a loss corporation under section 382.
HBM was incorporated in 2014 pursuant to a section 368(a)(1)(F) reorganisation and elected S corporation status. MLCO became a wholly owned subsidiary of HBM and elected qualified subchapter S subsidiary (QSSS) status, and MLCO distributed Delavau's stock to HBM.
Effective 1 July 2018, HBM revoked its S corporation election under section 1362(d)(1)(A), causing the QSSS status of MLCO, Aerofil, FLCO and Schafer to cease. Delavau elected to be disregarded as separate from HBM effective 1 July 2018, which caused Delavau to be deemed to liquidate into HBM at the close of business on 30 June 2018 under Treasury Regulation § 301.7701-3(g)(1)(iii). The parties agreed that sections 332 and 381 applied to this deemed liquidation, and that HBM succeeded to Delavau's NOL carryovers, which amounted to $108 million at the time of liquidation.
Beginning with the short tax year from 1 July to 31 December 2018, HBM filed consolidated returns with the Founding Members (HBM, MLCO, Aerofil, FLCO and Schafer). HBM had no separate entity taxable income from the short tax year through the 2021 tax year. The group claimed CNOL deductions of $13,546,306 (short 2018 year), $14,970,260 (2020) and either $1,162,348 or $1,092,709 (2021), all attributable to Delavau's preliquidation NOL carryovers. The Commissioner denied these CNOL deductions in full for 2018 and 2020, and denied $1,092,709 of the 2021 deduction, on the basis that the SRLY rules barred use of the Delavau NOL carryovers to offset the group's income.
Core dispute
The central issue was whether the lonely parent rule in Treasury Regulation § 1.1502-1(f)(2)(i) applied to the Delavau NOL carryovers, which turned on whether Delavau was a predecessor of HBM within the meaning of Treasury Regulation § 1.1502-1(f)(4) notwithstanding that the HBM consolidated group did not exist at the time of Delavau's deemed liquidation.
A secondary issue was whether HBM and the other Founding Members constituted an SRLY subgroup within the meaning of Treasury Regulation § 1.1502-21(c)(2)(i), which would allow the Delavau NOL carryovers to offset the income of the other Founding Members even if the lonely parent rule did not apply.
Petitioner argued that Delavau's tax attributes became indistinguishable from HBM's own attributes under section 381, that Delavau was not a predecessor because HBM was not a member of any group at the time of the deemed liquidation, and, alternatively, that the Founding Members should be treated as an SRLY subgroup based on their common ownership and control. Respondent argued that Delavau was a predecessor, that the lonely parent rule does not extend to predecessors' separate return years, and that no former group existed to support SRLY subgroup treatment.
Court findings
The Court found that section 381 requires a distributor corporation's NOL carryovers to be tracked and integrated separately from the acquiring corporation's own carryovers, rejecting petitioner's argument that Delavau's attributes became indistinguishable from HBM's.
The Court held that Delavau was a predecessor, and HBM a successor, within the meaning of Treasury Regulation § 1.1502-1(f)(4), because Delavau was a distributor of assets to HBM in a section 332 liquidation to which section 381(a) applies. The Court rejected petitioner's argument that successor status required HBM to have been a member of the group at the time of the transaction, finding no textual basis for that reading and noting that other regulatory definitions and examples confirm that predecessor and successor status does not depend on group membership at the time of the transaction.
The Court further held that the lonely parent rule does not apply to a predecessor's separate return years, reasoning from the structure of the three exceptions to the SRLY definition in Treasury Regulation § 1.1502-1(f)(2), where only the second and third exceptions expressly extend to predecessors. Because Delavau was a predecessor that was never a member of the HBM group, none of the SRLY exceptions applied, and Delavau's separate return years were SRLYs.
On the SRLY subgroup issue, the Court found that the Founding Members were never part of any prior affiliated group, since HBM was always an S corporation and the other Founding Members were QSSSs disregarded as separate from HBM under section 1361(b)(3)(A), and S corporations cannot be members of an affiliated group under section 1504(b)(6). The Court rejected petitioner's argument that the Founding Members should be treated as an SRLY subgroup based on common control as an 'economic reality', finding this had no textual basis and misunderstood the purpose of the SRLY subgroup rules, which is to preserve aggregation for corporations that were continuously affiliated, not to aggregate income of related entities generally.
Outcome
The Court granted the Commissioner's Motion for Partial Summary Judgment and denied HBM's Motion for Partial Summary Judgment.
The Court held that the HBM consolidated group was not entitled to CNOL deductions for the 2018, 2020 and 2021 tax years based on the Delavau NOL carryovers, because those carryovers arose in separate return limitation years, HBM had no separate entity taxable income against which they could be applied, and the Founding Members did not constitute an SRLY subgroup whose income could be used instead.
Major issues / areas of contention
- Whether Delavau constitutes a predecessor of HBM within the meaning of Treasury Regulation § 1.1502-1(f)(4), despite the HBM consolidated group not existing at the time of the deemed liquidation.
- Whether the lonely parent rule in Treasury Regulation § 1.1502-1(f)(2)(i) applies to exempt a predecessor's separate return years from being treated as separate return limitation years (SRLYs).
- Whether the Founding Members of the HBM consolidated group constitute an SRLY subgroup within the meaning of Treasury Regulation § 1.1502-21(c)(2)(i).
- Whether the HBM consolidated group is entitled to consolidated net operating loss deductions for the 2018, 2020 and 2021 tax years based on the Delavau NOL carryovers.