Consolidated Carryback of Product Liability Expenses

Consolidated Carryback of Product Liability Expenses

The U.S. Supreme Court resolved a conflict between the Fourth and Sixth Circuit appeals courts in a case involving the 10-year carryback of product liability losses under IRC section 172(b)(1) for an affiliated group filing a consolidated return. In 2000, in Intermet Corp., 209 F3d 901, the Sixth Circuit had determined Treasury regulations sections 1.1502-11 and 1.1502-21 allowed net operating losses to be carried back for 10 years to the extent consolidated product liability losses exceeded the consolidated net operating loss. However, in United Dominion Industries, Inc., the Fourth Circuit held that the product liability losses to be carried back for 10 years were limited to the individual company’s respective taxable income.

United and its subsidiaries, an affiliated group filing a consolidated return, had a net operating loss for each of the tax years in question. Members of the group had aggregate product liability losses that were less than the entity’s consolidated net operating loss. The specific companies generating the product liability losses each had positive separate taxable income. United carried back the aggregate amount of product liability losses for the full 10-year period. The IRS initially agreed with United but was overruled by the congressional joint committee on internal revenue taxation. The district court also agreed with United. However, the Fourth Circuit disallowed the 10-year carryback, arguing that, since the particular companies with the product liability losses also had positive separate taxable income, none of the consolidated net operating losses qualified for the 10-year carryback.

Result. For the taxpayer. The Supreme Court said the Fourth Circuit was wrong in its holding that no part of the consolidated group’s net operating loss qualified for the special 10-year carryback for product liability expenses.

United had argued that the consolidated return regulations under IRC section 1502 supported its position. Regulations section 1502-11 requires a consolidated group to determine its consolidated net operating loss as follows. Each group member computes its separate taxable income as though it were a separate corporation, with some modifications. These modifications—computed on a group basis—include capital gains and losses, the charitable contribution deduction and the dividends-received deduction. The group then aggregates these separate taxable income amounts. As a result, the group’s consolidated net operating loss is the sum of each member’s separate taxable income, adjusted for items determined on a consolidated basis.

The majority opinion, written by Justice Souter, discusses at length the consolidated return regulations’ single-entity approach to computing certain items such as the net operating loss. He argues that the case for the single-entity approach to calculating an affiliated group’s product liability losses is straightforward. Section 172(f)(1) [formerly (j)(1)] defines a taxpayer’s “product liability loss” as the lesser of its “net operating loss” and its product liability “expenses.” For a taxpayer filing a consolidated tax return, regulations section 1.1502-21 requires the entity to compute the net operating loss at the consolidated level. There is no definition of a separate net operating loss in the consolidated regulations. Consequently, entities should apply section 172, including the subsection relating to product liability losses, at the consolidated—not the separate-entity—level.

Justice Thomas wrote a concurring opinion. Justice Stevens wrote a dissent in which he argued that the consolidated return regulations should be updated to carefully describe this treatment if, in fact, section 172 and the single-entity approach intended the above result.

The single-entity assumption often is discussed in relation to the tax law governing consolidated tax returns. This Supreme Court case resolved one of the many issues in this extremely complex tax law area.

United Dominion Industries, Inc., 87 AFTR2d 2001-986 (6/04/01).

Prepared by Karyn Bybee Friske, CPA, PhD, assistant professor of accounting, and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both at the T. Boone Pickens College of Business, West Texas A&M University, Canyon.