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 [...]