Issue
Under the tax code, when cancellation of indebtedness income excluded from gross income results in a reduction of combined net operating losses, and a business entity can carry forward this reduction to offset income in following tax years, must this net operating loss be reduced at the combined entity level or at the individual entity level?
Related Tax Rules And Regulations
Internal Revenue Code Section 108
Facts
Marvel Entertainment Group Inc. and some of its subsidiaries filed for Chapter 11 bankruptcy relief in 1996. The cancellation of indebtedness income (“COD”) income realized by the entities was excluded from gross income pursuant to IRC §108(a)(1)(A). As required by section 108(b)(2)(A), the exclusion of the COD income resulted in subsequently reduced net operating losses (“NOLs”). Marvel reduced each member company’s share of NOLs by its previously excluded COD income, resulting in a combined NOL of some $97.6 million, which Marvel carried forward to its successor company, the Marvel Group, in 1998. Those losses were used to offset the Marvel Group’s income for the years 1999 through 2004.
Because of this manner of loss carry-over, the IRS assessed $16.6 million in tax deficiencies against Marvel Entertainment LLC . The IRS did not examine the Marvel Group’s tax returns for 1999 through 2002, but sent the company a notice indicating it owed $16.6 million in taxes for 2003 and 2004 combined. According to the IRS, Marvel should have reduced its combined NOL by the group’s total COD income, leaving it with just $15.7 million in losses to carry forward to the successor company rather than $97.6 million!
Decision
in a case of first impression, the U.S. Tax Court said the Internal Revenue Service was correct in its assessment of $16.6 million in tax deficiencies against Marvel. Under the IRC, cancellation of indebtedness income that is excluded from gross income results in a reduction of the combined net operating losses that a company can carry forward to offset income in the following years. The court held that Marvel should have reduced its net operating losses at the combined entity level rather than at the individual entity level, leaving it with fewer losses to reduce its taxable income in 2003 in 2004.
The court stated “[n]either the Code nor the applicable consolidated return regulations provide authority for an affiliated group to allocate and apportion CNOL to consolidated group members for purposes of reducing tax attributes.”
On appeal, the IRS argued that this issue, whether the members of a consolidated group have separate NOLs, was decided in United Dominion Industries Inc. v. U.S. by the U.S. Supreme Court in 2001. Despite Marvel’s protests, The Tax Court said that while United Dominion concerned the calculation of product liability losses in a consolidated group, a central question in that case was whether separate NOLs exist for group members.
“The Supreme Court in United Dominion concluded that a consolidated group member cannot have a separate NOL for a consolidated return year unless a specific consolidated return regulation allocates and apportions part of the CNOL to that member,” the court said. “No such regulation existed for petitioner’s short taxable year ending October 1, 1998, and therefore the proper NOL subject to reduction under section 108(b)(2)(A) is petitioner’s CNOL.”
If you have questions about cancellation of indebtedness income and what constitutes taxable income, or any tax-related questions, call THE TAX EXPERTS AT THE Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
