Dr. M. D.

Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 1

TAXATION OF CONSOLIDATED ENTERPRISES

I. REPORTING OPTIONS FOR CONSOLIDATED FIRMS:
A.Members of an "affiliated group" which meet IRC requirements may elect to be taxed as a single entity or as separate entities.
B.IRC under the Tax Reform Act of 1984 states that an "affiliated group" exists only when the parent owns:
1. at least 80% of the voting power of all classes of stock (except the parent) and
2. at least 80% of the Fair Market Value of all the outstanding stock of subsidiary companies
a. this stock must be:
1. entitled to vote
2. convertible
3. not limited and preferred as to dividends, redemption and liquidation rights
II. ADVANTAGES OF THE ALTERNATIVE METHODS OF TAXATION
A. Filing as a consolidated group
1. operating profits and losses are offset
2. capital gains and losses are offset
3. intercompany gains and losses are deferred until realized
B. Filing as separate entities may also provide advantages:
1. Firms may use different tax years and alternative accounting methods
2. Significant intercompany losses which would be deferred on consolidated returns may be deducted immediately
(Most of these losses are specifically disallowed under the IRC
III. ACCOUNTING IMPLICATIONS
A. Consolidated returns:
1. Consolidated income as determined on the working papers is the basis of tax expense;
2. Subsidiaries do not record any provision for income tax based on separate incomes;
3. Once the consolidated tax expense is calculated on the worksheet, it is allocated to and recorded on the books of the subsidiary firms.
B. Separate returns:
1. Each subsidiary computes income tax expense based on its separate income (including intercompany items) as reported on its income
statement;
2. Subsidiaries are entitled to normal deductions for:
a. 80% of dividends from nonaffiliated, taxable domestic corporations;
b. 100% of dividends from affiliated firms;
3. Because intercompany items are not excluded they result in timing differences that require interperiod tax allocation.
a. to illustrate assume the downstream sale of equipment with a life of 5 years for a gain of $20,000. Consolidation procedures
(GAAP) requires the gain to be deferred over the remaining life of the equipment. Tax rules (IRC) require that the gain be
recognized in the period of the sale. Assuming "P" is in the 30% marginal tax bracket, tax allocation procedures would be:
In the year of the sale:
Deferred Tax Expense [(20k / 5yrs) x .30] x 4 yrs....
4,800
Provision for income taxes.......................
4,800
To record deferred tax expense necessary for interperiod tax allocation
(NOTE: the $1,200 for the current year is not deferred due to IRC rules)
In subsequent years:
Deferred Tax Expense (for 3 remaining years)........
3,600
Provision for income taxes (current year)...........
1,200
"P" RE (adjustment for 4 yrs expensed in yr 1)
4,800
IV. CONSOLIDATED TAX RETURNS: Filing as a consolidated entity
A. Procedure:
1. Consolidated net income is determined on the worksheet in the normal manner;
2. tax expense is calculated as a part of the worksheet procedure;
3. Once calculated, the tax expense is allocated and recorded on the books of the individual firms.

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 2

B. Example
--P purchases 80% of S on 1/1/1 and performed the following analysis on the investment:
Analysis:
Cost..........................
$
800,000
Purchased BV:
Common stock ...........
$
500,000
RE (1/1/1)..............
400,000
Total equity
$
900,000
Ownership interest...........
80%
720,000
Excess of cost>BV = GW (40 yr life)
$
80,000
--On January 1, 19x2 P sold a piece of equipment with a net book value of $40,000 to S for $60,000. The equipment is depreciated by S on a
straight-line basis over a 5-year life (Downstream Sale of depreciable equipment).
--Assume a tax rate of 30%;
--The following intercompany sales apply to P and S:
Intercompany sales in beginning inventory (BOY) of P..... $
50,000
Intercompany sales in ending inventory (EOY) of S........
70,000
Sales to S during 19x3...................................
100,000
Gross profit rate........................................
50%
C. Solution:The following work sheet illustrates the procedures to accommodate the taxation of consolidated firms qualifying to file as an
"affiliated group". Special attention should be paid to the following points:
1. The only difference from prior consolidated worksheets is item "I" which calculates the provision for income tax (notice that the
amortization of goodwill had to be added back in that amortizations of excess of cost over book value are normally not deductible for tax
purposes)
2. The distribution of consolidated income is made before tax, then this result is multiplied by (1 - the tax rate) to arrive at the after tax
income (multiply by the tax rate to arrive at S tax itself).
3. It is necessary for each firm to record its share of the consolidated income tax on its own books:
S entry: Provision for income tax..............
37,500
Tax Payable (125,000 x .3)*.......

P entry: Provision for income tax..............

Tax Payable (119,000 x .3)........

37,500

35,700
35,700

"S" adjusted net income x tax rate

See computation of MI NI for detail

"P" adjusted net income x tax rate

See computation of "P" NI for detail

If P books entries (i.e. uses the "sophisticated equity method") it should also make the following entry to adjust the investment account for
taxes:
P entry: Subsidiary Net income.................
Investment in S (37,500 x .8).....

30,000
30,000

PLEASE REFER TO THE WORKSHEET ON THE NEXT PAGE FOR A SUMMARY OF COMPLETE ELIMINATION PROCEDURES

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 3

Worksheet 1: Consolidated Worksheet for a Qualifying " Affiliated Group" Year ended 12/31/x3
Accounts

Trial
"P"

Balance
"S"

Elims &
Dr

Adjstmnts
Cr

Consolid
RE

Minority
Interest

Controlling
Consolidated
Retained Earn Balance Sheet

Cash

200,000

380,000

Inventory 12/31/x3

150,000

120,000

(H) 35,000

235,000

Plant and Equip

900,000

1,100,000

(E) 20,000

1,980,000

Accum Depr-P&E

(440,000)

Investment in "S"

1,120,000

(150,000)

580,000

(E)

8,000
(A) 80,000
(B)960,000
(C) 80,000

Goodwill

(C) 80,000

Liabilities

(582,000)

(D) 6,000

74,000

(150,000)

"P" Common Stock

(800,000)

"P" RE 1/1/x3

(900,000)

(150,000)
(800,000)
(D) 4,000
(E) 16,000
(G) 20,000

(860,000)

"S" C/S

(500,000)

(B) 400,000

(100,000)

"S" RE 1/1/x3

(700,000)

(B) 560,000
(G) 5,000

(135,000)

Sales

(600,000)

(400,000)

(F) 100,000

CGS

350,000

200,000

(H) 35,000

(F)100,000
(G) 25,000

460,000

Expenses

100,000

100,000

(D)

(E) 4,000

198,000

Subsidiary NI

(80,000)

2,000

(900,000)

(A) 80,000

NI Before Tax
Provision for Tax

(242,000)
(I) 73,200

Tax Liability

(I) 73,200
1,383,200

Combined NI

73,200
(73,200)

1,383,200
(168,800)

To MI:

17,500

To CI:

151,300

Total MI
RE, CI 12/31/x3

(17,500)
(151,300)
252,500

(252,500)
(1,011,300)

(1,011,300)
-0-

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 4

Supporting Computations/ Adjustments and Eliminations: Worksheet 1

(A) Eliminate Current Year Subsidiary NI:
Subsidiary NI...........................
80,000
Investment in "S"....................
80,000
(B) Eliminate Pro-Rata share of Investment in "S":
"S" C/S (500,000 (.8))..................
400,000
"S" RE BOY (700,000 (.8))...............
560,000
Investment in "S"....................
960,000
(C) Allocate the Excess of Cost>BV per analysis:
Goodwill...............................
80,000
Investment in "S"...................

80,000

(D) Amortize the Excess of Cost>BV per analysis:

Amortization Expense (current year). 2,000
"P" RE (past years)(2,000 x 2 yrs)...... 4,000
Goodwill (80,000/40 yrs)(3yrs)......

6,000

(E) Eliminate the gain on "Downstream" sale of Equip; Recognize portion allowable to date:
"P" RE (Eliminate Gain).................
20,000
PP & E..............................
20,000
Recognize Gain to date at EOY 2:
A/D PP & E (gain recog. to date)........ 8,000
"P" RE (gain recog. in past).........
Depreciation Expense (current yr)...
(F) Eliminate Intercompany Sales:
Sales...................................
CGS.................................

4,000
4,000

(20,000/5yrs)(2yrs)
(20,000/5yrs)(1yr)

100,000
100,000

(G) Eliminate Gain in BOY Inventory of "P" (upstream Sale):

"P" RE (25,000)(.8)....................
20,000
"S" RE (25,000)(.2)....................
5,000
CGS................................
25,000

Inventory value = $50,000

Gross Profit
.50
Profit in BOY = $25,000

(H) Eliminate Gain in EOY Inventory of "S" (downstream Sale):

CGS.....................................
35,000
Inventory..........................
35,000

Inventory value = $70,000

Gross Profit
.50
Profit in BOY = $35,000

(I) Record Provision for Income Tax:

Income Tax Expense......................
Tax liability......................

73,200
73,200

Consolidated Net Income..............

$
Add: Amort of GW not Allowed for tax.
Consolidated Taxable income..........
$
Marginal Consolidated Tax rate.......
Tax Liability........................
$

242,000
2,000
244,000
.30
73,200

Distribution of Net Income:

To MI: MI % ("S" internally generated NI + intercompany upstream credits - intercompany upstream debits)
.2(400,000 - 200,000 -100,000 + 25,000(G) = .2(125,000)*=
$
25,000
Less tax @ 30% ($25,000 x .30)......................
(7,500)
MI .................................................
$
17,500
*NOTE: $125,000 represents "S" Adjusted Net Income; that is to say "S" internally generated net
income adjusted for the effect of Upstream intercompany transactions.

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 5

To CI: PIGNI + down cr - down dr + [("P"%)("S" Adjusted Net income)("S" tax rate)]
[600k - 350k - 100k + 4k(F) - 2k(D) - 35k(H)] + [(.8)(125,000)(.7)] = $117,000 + 70,000 =
Less tax liability (117,000 + 2,000 GW not allowable for tax)(.3) ................... =
To CI................................................................................

$
$

187,000
( 35,700)
151,300

NOTE: $117,000 represents "P" Internally generated net income; that is to say "P" internally generated
net income adjusted for the effect of Downstream intercompany transactions.
V. SEPARATE TAX RETURNS FILED BY MEMBERS OF THE CONSOLIDATED GROUP
A. Procedure:
1. Tax liability is now based on the income of the separate entities; intercompany gains and losses are included thereby causing timing
differences which will require an tax allocation.
2. Consequently, before P and S can be consolidated, it is necessary to calculate their separate tax liabilities.
3. The tax provision (expense) for "P" requires examination of the status of "S" ni allocable to "P"
a. If conditions for a consolidated return are not met (not if the parent "elects" to file separately) the parent includes 20% of the
dividends it receives from "S" in its taxable income. NOTE: If an "affiliated group" elects separate taxation, no dividends are included
and no additional tax is calculated.
b. IAW APB 23, subsidiary income included in the pretax income of a parent leads to a timing difference between the earning of income
and its inclusion in the tax return as dividend income.
c. APB 23 and SFAS 96 presumes all subsidiary income will be transferred to "P" unless:
1. There are definite plans on the part of the parent to reinvest the undistributed earnings of the subsidiary, which will allow
indefinite postponement of their remittance to the parent; or
2. the earnings will be remitted as part of a tax-free liquidation.
NOTE: If either of these two exceptions exist, "P" does not include "S" income in the computation of consolidated income and subsequent
distributions

B. Example:
--P purchases 75% of S on 1/1/x1 and performed the following analysis of the investment: (note % is under 80% so seperate returns are
required)
Analysis:
Cost.........................
$
285,000
--"S" sells equipment to "P" on 1/1/x3 for $100,000 (BV to S was $60,000)
Purchased BV:
--P is depreciating the equipment over 5 years (no salvage).
Common stock............
$
250,000
--Income and expenses for "P" and "S" are stated on the worksheet on the
RE (1/1/x1).............
100,000
following page
Total equity............
$
350,000
--The following data apply to intercompany merchandise sales to "S" by "P":
Ownership interest:
75%
262,500
Intercompany sales in beginning inventory of S....
$
60,000
Excess of cost>BV =
$
22,500
Intercompany sales in the ending inventory of S....
40,000
GW (20 yr life)
$
22,500
Sales to S during 19x4.............................
100,000
Gross profit rate..................................
40%

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 6

--During 19x4 "P" and "S" reported the following operating incomes before tax:
"P"
"S"
Sales.........................................
$
430,000
$
240,000
Less: CGS.....................................
280,000
150,000
Gross profit................................
150,000
90,000
Less: Operating Expenses........
70,000
30,000
Operating income before tax
$
80,000
$
60,000
--assume a 30% tax rate.
1. Assuming that the exceptions described in V,A,3,c,1 and 2 above do not apply, "P" must provide for tax expense equal to 20% of "S" net
income. This is a secondary tax expense over and above the provision made by "S" on its books. For 19x4 this secondary tax expense
required by "P" would be computed:
"P" equity is "S" after tax net income To "P" (.75)(.7)*($60,000)........ $
"P" tax expense (provision for tax) on "S" NI to "P" (.3)(.2)(31,500)... $
"P" tax expense on internally generated NI (.3)(80,000).................
Total "P" tax expense for year x4...................................
$

31,500
1,890
24,000
25,890

(1-tax rate)

2. Because "P" has not physically received is distribution from "S", the secondary tax is not liable and a deferred tax liability for $1,890 is
recorded. The IRC recognizes the creation of a liability upon the receipt of dividends. Assuming that internally generated taxes are
currently payable the following entry would be required:
"P" tax expense (provision for income tax).............................. 25,890
Income tax payable..................................................
24,000
Deferred tax (liability)............................................
1,890
C. SOLUTION: EXAMPLE 2 (CONSOLIDATED WORKSHEET FOR "NON-QUALIFYING" CONSOLIDATED FIRMS
The completed worksheet for this example is found on the following page. The following points should be noted:
1. The balance of Investment account is computed normally.
Cost.....................................................
$
285,000
Incremental Changes from date of purchase:
Common stock...............................
-0Change in RE since acquisition (350,000 - 100,000)
250,000*
*after tax expenses
Total equity............
$
250,000
Ownership interest: (.75)(250,000)
187,500
Add: Equity in "S" NI (after tax) (.75)(.7)(60,000).....
31,500
Simple equity adjusted balance 12/31/x4.................
$
504,000**
**NOTE: this is "simple equity method" adjusted balance; amortizations must be included for "sophisticated equity method" (APB-18) balance
2. Since the parents share of undistributed income has been recorded from the date of acquisition, a deferred tax liability has been recorded
by "P" each year. The total provision on 12/31/x4 is calculated:
Deferred tax liability on 19x1-19x3 undistributed income:
19x1 - 19x3 inclusive ($187,500)(.2)(.3)................
$
19x4 (Current year deferral) (.2)(.3)(31,500)...........
Total deferred tax liability............................
$

11,250
1,890
13,140

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 7

Worksheet 2: Consolidated Worksheet for a "Non-Qualifying" Consolidated Group (Separate Returns) Year Ended 19x4
Accounts

Cash

Trial
"P"

Balance
"S"

Elims &
Dr

Adjstmnts
Cr

19,200

80,000

Inventory 12/31/x4

170,000

150,000

(H) 16,000

Plant and Equip

600,000

550,000

(E) 40,000

Accum Depr-P&E
Investment in "S"

(410,000)

(120,000)

(510,450)

(D) 3,375
(E) 24,000
(G) 24,000
(250,000)

(B) 187,500

"S" RE 1/1/x3

(350,000)

(B) 262,500
(E) 8,000

CGS

Expenses
Subsidiary NI

(430,000)

(514,000)

(D) 4,500

(474,483)

(62,500)
(I) 2,400

(81,900)

(240,000)

(F) 100,000

280,000

150,000

(H) 16,000

(F)100,000
(G) 24,000

322,000

70,000

30,000

(D)

(E) 8,000

93,125

(31,500)

1,125

(570,000)

(A) 31,500
(154,875)

25,890

18,000

Tax Liability

(24,000)

(18,000)

Deferred Tax

(13,140)
-0-

Combined NI

18,000

(I) 15,408

NI Before Tax
Provision for Tax

1,110,000

(250,000)

"S" C/S

Sales

-0-

(J)

5,052

48,942
(42,000)

(I) 17,808

(J) 5,052

719,360

719,360

( 384)

(105,933)

To MI:

11,900

To CI:

94,033

Total MI
RE: CI 12/31/x4

Consolid
BS

304,000

(E) 16,000

(C) 22,500

"P" RE 1/1/x4

Controll
RE

(A) 31,500
(B)450,000
(C) 22,500

Goodwill
(250,000)

Minority
Interest

99,200

504,000

"P" Common Stock

Consolid
RE

(11,900)
( 94,033)
156,300

(156,300)
( 586,515)

( 586,515)
-0-

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 8

Supporting Computations/ Adjustments and Eliminations: Worksheet 2

(A) Eliminate Current Year Subsidiary NI:
Subsidiary NI...........................
31,500
Investment in "S"....................
31,500
(B) Eliminate Pro-Rata share of Investment in "S":
"S" C/S (250,000 (.75)).................
187,500
"S" RE BOY (350,000 (.75))........
262,500
Investment in "S"....................
450,000
(C) Allocate the Excess of Cost>BV per analysis:
Goodwill...............................
22,500
Investment in "S"...................

22,500

(D) Amortize the Excess of Cost>BV per analysis:

Amortization Expense (current year).....
1,125
"P" RE (past years)(1,125 x 3 yrs)......
3,375
Goodwill (22,500/20 yrs)(4yrs)......

4,500

(E) Eliminate the gain on "Upstream" sale of Equip; Recognize portion allowable to date:
"P" RE (.75)(40,000)....................
30,000
"S" RE (.25)(40,000)....................
10,000
PP & E..............................
40,000
Recognize Gain to date at EOY 2:
A/D PP & E (gain recog. to date)........
"P" RE (gain recog. in past).........
"S" RE (gain recog. in past).........
Depreciation Exp (current yr gain)..
(F) Eliminate Intercompany Sales:
Sales...................................
CGS.................................

16,000
6,000
2,000
8,000

(40,000/5yrs)(2yrs)
.75(40,000/5yrs)(1yr)
.75(40,000/5yrs)(1yr)
(40,000/5yrs)

100,000
100,000

(G) Eliminate Gain in BOY Inventory of "P" (Dounstream Sale):

"P" RE ................................
24,000
CGS................................
24,000

Inventory value = $60,000

Gross Profit
.40
Profit in BOY = $24,000

(H) Eliminate Gain in EOY Inventory of "S" (downstream Sale):

CGS.....................................
16,000
Inventory..........................
16,000

Inventory value = $40,000

Gross Profit
.40
Profit in BOY = $16,000

(I) Adjust BOY RE for Interperiod Tax Allocation Effects of Prior Periods:
(E) tax on unamortized gain of upstream sale of equip paid by "S" (.3)(32,000)..................
(F) "P" secondary tax on unamort after tax gain on up sale of equip (.3)(.2)(.75)(.7)(32,000) *..
*
(tax rate)(.20% dividend inclusion)("P" % ownership)(1-tax rate)
(G) Prepaid tax on downstream sale of inventory (.3)(24,000)....................................
Changes to record in Retained Earnings accounts.............................................
Deferred tax (liability)................
"P" RE...............................
"S" RE...............................

17,808
15,408
2,400

100%
Total
9,600

25%
To MI
2,400

1,008

7,200
17,808

75%
To CI
7,200
1,008

2,400

7,200
15,408

Dr. M. D. Chase
Advanced Accounting 74-B

Long Beach State University

Taxation of Consolidated Enterprises
Page 9

(J) Adjust the current years tax expense (provision) for:

(E) Current yr amortization of gain on upstream sale of equip pd by "S" (.3)(8,000).............
(F) Current yr amort. on secondary tax on up sale of equip pd by "P" (.3)(.2)(.75)(.7)(8,000)...
(G) Current yr amort on downstream sale of inventory (.3)(24,000)...............................
(H) Tax effect originating this year on profit in downstream sale of inventory (.3)(16,000).....
Adjustments required in Current Year Tax Expense (Provision for tax)........................

100%
Total
2,400
252
7,200
(4,800)
5,052

Distribution of Net Income: (Alternative computation, compare to V B 1 and 2)

To MI: MI % ("S" internally generated NI + intercompany upstream credits - intercompany upstream debits)
.25(240k - 150k - 30k + 8,000(E) - 0 = .25(68,000) = $
17,000
Less: Tax Liability (17,000 x .30)............
5,100
MI Net Income Distribution....................
$
11,900
To CI: P adjusted NI = PIGNI + down cr - down dr + [("P"%)("S" Adjusted net income)
= 430k - 280k - 70k + 24,000(G) - 16,000(H) =
$
88,000
Less tax (.30)(88,000)...................
26,400
PIGNI after tax..........................
$
61,600
Add: P% ("S" Adjusted NI) = (.75)(68,000) ..............
$
51,000
Less tax (.3)(51,000)..............................
(15,300)
"P" share of "S" adjusted NI afer tax..............
35,700
Deduct: Secondary tax on 20% of "S" NI (.20)(35,700)(.30)
(2,142)
Goodwill amortization not deductible for tax....
(1,125)
CI Net Income Distribution..............................
$
94,033

25%
To MI
600

600

75%
To CI
1,800
252
7,200
(4,800)
4,452