In HBM Holdings Co. v. Commissioner, the Tax Court narrowed the circumstances in which a consolidated group may utilize net operating loss (NOL) carryovers of a predecessor entity. The court rejected the taxpayer's primary argument that the lonely parent rule applied to NOLs the common parent acquired in a transaction to which section 381(a) applied.

In 2012, Mississippi Lime Co. (MLCO), an S-corporation, acquired Delavau Holdings, LLC, a Delaware limited liability company taxed as a corporation. At that time, Delavau had approximately $78 million of NOL carryovers and was treated as a loss corporation under section 382. In 2014, the shareholders of MLCO formed HBM Holdings Co. (HBM), and HBM elected to be treated as an S-corporation. In an F reorganization, HBM acquired MLCO and MLCO elected to be treated as a qualified subchapter S subsidiary (QSSS) of HBM. Immediately thereafter, MLCO distributed the stock of Delavau to HDM. MLCO also owned three operating subsidiaries that had elected to be treated as QSSSs. As a result of these transactions, both MLCO and Delavau were wholly owned by HBM. Effective July 1, 2018, HBM revoked its S election, and effective that same day, Delavau made a check-the-box election to be disregarded as separate from HBM. As a result of the check-the-box election, Delavau was deemed to liquidate into HMB on June 30, 2018, and under section 381, HBM succeeded to Delavau's NOL carryovers. The revocation of HBM's S election also terminated the QSSS status of MLCO and its three subsidiaries. Effective July 1, 2018, HBM became the common parent of an affiliated group that filed a consolidated federal income tax return (HBM group).

The HBM group claimed consolidated net operating loss (CNOL) deductions that were attributable to Delavau's preliquidation NOL carryovers. The Internal Revenue Service (IRS) disallowed HBM's CNOL deductions, contending that the losses inherited by HBM were separate return limitation year (SRLY) losses subject to the SRLY rules set forth in Treas. Reg. § 1.1502-1(f). As such, the IRS asserted that the NOL carryovers that HBM inherited from Delavau could only offset HBM's income and could not offset the income of the other members of the HBM group. HBM did not have separate taxable income in any of the years. MLCO and the three operating subsidiaries (with HBM, the Founding Members) generated all of the income of the HBM group.

The primary issue before the court was the application of the lonely parent rule under Treas. Reg. § 1.1502-1(f)(2)(i) to HBM's CNOL deductions. Generally, current year losses and NOL carryovers of a member of a consolidated group can be offset by income of other group members. NOL carryovers arising in separate return years (SRYs) are subject to the SRLY limitation, which prevents the SRLY NOLs from being used to offset the income of other group members (or, if applicable, members outside of the SRLY subgroup). The SRLY limitation does not apply to the NOLs of the common parent of the consolidated group under what is known as the "lonely parent rule." The government argued that this lonely parent rule applies only to NOLs of the common parent HBM and not to NOLs of Delavau, a predecessor of the common parent. HBM contended that the lonely parent rule applies because when Delavau liquidated, its losses became indistinguishable from HBM's own losses. A secondary argument advanced by the taxpayer was that the Founding Members constituted a SRLY subgroup within the meaning of Treas. Reg. § 1.1502-21(c)(2)(i). SRLY losses of a SRLY subgroup can be offset against the income of the SRLY subgroup.

The Tax Court denied HBM's CNOL deductions, concluding that Delavau was a "predecessor" of HBM even though the deemed liquidation of Delavau occurred before the HBM group was formed. The taxpayer had asserted that Delavau could not be regarded as predecessor of HBM within the meaning of Treas. Reg. § 1.1502-1(f)(4) because at the time of the deemed liquidation neither HBM nor Delavau were members of the HBM group. In the court's view, Treas. Reg. § 1.1502-1(f)(4) "does not limit successors to corporations that were members at the time of the relevant transaction, it requires only that a corporation be a member for the relevant consolidated return year." The court concluded that the omission of any mention of predecessors in the lonely parent rule precluded the application of the lonely parent rule to NOLs arising in an SRY of a predecessor of the common parent. Accordingly, the court held that NOL carryovers inherited from a predecessor corporation are subject to SRLY limitations, even when acquired by a consolidated group's common parent and upheld the IRS's disallowance of HBM's CNOL deductions. The Tax Court also denied the taxpayer's assertion that the Founding Members constituted a SRLY subgroup. None of the Founding Members had previously been included in a consolidated return and did not meet the requirements of Treas. Reg. § 1.1502-21(c)(2).

For more information, please contact:

David W. Zimmerman, dzimmerman@milchev.com, 202-626-5876

Layla J. Asali, lasali@milchev.com, 202-626-5866

Grace C. Fraser, gfraser@milchev.com, 202-626-5817

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