State Revenue Departments Misapplying Federal Tax Law
State income tax laws generally build on federal tax law. The typical pattern is to begin the calculation of state taxable income with federal taxable income and then to modify it by adding or subtracting items where state tax policies differ from federal tax policies. As a result, a corporation’s state taxable income can be affected by the application of the federal Internal Revenue Code. State revenue departments generally do not consider themselves bound by Internal Revenue Service determinations respecting the application of federal tax law and believe that they are free to interpret the Internal Revenue Code as they see fit. Unfortunately, this has led to problems because state tax auditors often are not well trained in federal tax principles. We had an instance earlier this year in which an auditor claimed that the merger of a wholly-owned subsidiary into its corporate parent was taxable because there was an increase in the parent’s retained earnings. The merger was a plain vanilla tax-free liquidation under Sections 332 and 337 of the Internal Revenue Code (there was no intercompany debt and the subsidiary was clearly solvent), but sending copies of these provisions to the auditor left him unmoved. We finally got him to back down by showing that the parent’s increase in retained earnings was matched by a decrease in the subsidiary’s retained earnings so that there was no overall increase. As we explained to the client, a win is a win, even if for the wrong reasons. Nevertheless, if the auditor had been properly versed in the most basic federal corporate tax principles, this exercise would not have been necessary.
Two recent decisions illustrate misapplications of federal tax law by state revenue departments.
The Idaho Tax Commission recently held that a subsidiary’s net operating loss (NOL) carryovers did not pass to its parent in a merger of the subsidiary into the parent. The parent did not continue to operate the business of the merged subsidiary and the Commission held that “based on IRC §382, the Petitioner cannot carry the loss forward after the merger.” Idaho State Tax Commission Ruling No. 25749 (Apr. 17, 2014). The Commission’s statement of federal tax law is incorrect. Section 382 of the Internal Revenue Code does not apply to a merger of a wholly-owned subsidiary into its parent. Because of constructive ownership rules, no change in ownership is deemed to occur. Moreover, Section 382 does not prevent an NOL from passing to the surviving company in a merger; it simply limits the extent to which the NOL can be used. Although it is true that the limitation is zero for years in which the merged company’s business is discontinued, the NOL is not destroyed. If the parent later sells assets received from the subsidiary that had built-in gain at the time of the merger, the loss can be used to offset the gain.
Discussions that we have had with the Commission after the decision came out indicate that the Commission had concluded that there was real doubt as to whether the subsidiary’s losses were valid in the first place. Nevertheless, its explanation of the reasons for preventing the loss from passing to the parent are incorrect as a matter of law and may be a problem to taxpayers if Commission auditors take the Commission’s language at face value in the future.
NIHC, Inc. v. Comptroller of the Treasury (Docket 63, Court of Appeals of Maryland) (August 18, 2014) involved corporations that were filing consolidated federal income tax returns but separate Maryland income tax returns. A subsidiary distributed appreciated property to its parent in a transaction in which, had they been filing separate federal income tax returns, a gain would have been taxed to the subsidiary under Section 311(b) of the Internal Revenue Code. Under the federal consolidated return regulations, however, the subsidiary’s gain was “recognized” but “deferred.” This means that the gain was not immediately taxed but would have been taxed in later years upon the occurrence of certain events (e.g., a breakup of the consolidated return group, the transfer of the appreciated property by the parent outside the group, or the depreciation or amortization of the transferred property by the parent). Under the federal consolidated return regulations, the subsidiary recognized income gradually over the next 15 years as the parent amortized the appreciated property. Thus, the subsidiary reported income in later years but not in the year of the distribution.
In the litigation, the subsidiary took the position that it should have recognized the gain for Maryland income tax purposes in the year of the distribution because the corporations were filing separate Maryland income tax returns. In other words, the taxpayer argued that the deferral principles of the federal consolidated return regulations, which were predicated upon the filing of consolidated returns by the corporations, should not apply for Maryland tax purposes because the corporations were filing separate Maryland tax returns. The statute of limitations for assessing deficiencies for a taxable year of the distribution had expired. The court, without discussing the applicable principles, held that the subsidiary made its bed and should lie in it and should not profit by the mistake that it claimed to have made in filing its tax returns for the year of the distribution. The court failed to analyze the federal tax principles and their relationship with Maryland tax principles.
This may have been a classic case of bad facts making bad law. The subsidiary had been established as an intangible holding company and the court made it clear that it disapproved of the taxpayer’s alleged attempt to divert income from Maryland through the intangible holding company device. Nevertheless, the court clearly misapplied federal tax principles.
The takeaway here is that practitioners should not assume that state tax auditors will understand and correctly apply federal tax principles. It may be necessary to call upon a company’s federal tax advisors to explain these principles to the auditors in simple terms. It may also be necessary to talk to senior people in the department of revenue, who are more likely to be knowledgeable about federal tax rules than are the auditors.