Opinion ID: 1918302
Heading Depth: 2
Heading Rank: 1

Heading: Overview of Tax Structure

Text: We begin our analysis with a brief examination of the relevant federal tax structure and the manner in which the District tax law differs. The federal Internal Revenue Code of 1986, 26 U.S.C. § 1 to § 9722 (1998) (IRC), [3] defines income tax in Subtitle A, Chapter 1, Subchapter A, which establishes a separate tax for individuals (Part I) and for corporations (Part II). See IRC §§ 1, 11. An affiliated group of corporations have the option of combining their incomes and deductions in a single return. See IRC § 1501. Under these so-called consolidated returns, losses incurred by some affiliated members may be used to offset the income of other affiliated members. See 26 C.F.R. § 1.1502-11 (2000). [4] The way in which partnerships are treated within the federal framework is addressed in Subchapter K of the IRC. This subchapter provides that businesses taking the partnership form are treated as pass-through entities for their principals. See IRC §§ 701-02. Pass-through enterprises are those for which losses or gains are not recognized by the entities themselves, but are allocated to the incomes of the organizations' owners in their capacity as individual taxpayers. These partnerships are nonetheless required to file informational returns under the IRC indicating business performance. See IRC § 6031(a). Net operating loss deductions are generally covered under IRC § 172. That section defines an NOL as the excess of deductions allowed over gross income. See IRC § 172(c). Subsection (a) of that section defines an NOL deduction as the combined net operating loss carry-backs and net operating loss carry-forwards allowed for any particular taxable year. At the times relevant to these appeals, net operating losses incurred in one tax year could generally be carried back three years, while such losses could be carried forward up to fifteen, see IRC § 172(b)(1)(A), [5] although bad debt losses of commercial banks could be carried back as many as ten years or forward as many as five, see IRC § 172(b)(1)(D). Because partnerships are treated as pass-through entities, and pay no taxes as such, NOL deductions are inapplicable to a partnership's federal informational return. See IRC § 703(a)(2)(D). Nonetheless, a partnership's informational return discloses the fact and amount of any actual net operating loss, and any such loss may be passed through to the individual tax payers and offset against other income or to be used as a deduction in a prior or subsequent return. See IRC §§ 172, 6031(a); 26 C.F.R. § 1.702-2. In the context of the consolidated return of affiliated corporations, NOL deductions are, like income and other losses, treated on a consolidated basis. See 26 C.F.R. §§ 1.1502-11(a)(2), -21(b). Similar to a partnership's informational return, however, each member of a group filing a consolidated return must report its separate respective taxable income and losses, and losses of one member may offset the income of another within a given year. See 26 C.F.R. § 1.1502-75(j). In addition, both consolidated net operating losses (as reported in a consolidated return), and net operating losses of individual affiliated member corporations which arose in years where separate returns were filed, may provide the basis for a consolidated net operating loss deduction on a consolidated return. See 26 C.F.R. § 1.1502-21(a).
In marked contrast to the federal system, the District treats most unincorporated businesses as taxable entities in their own right, and rarely allows the use of consolidated returns. Under the District's tax structure, individuals, corporations, and unincorporated businesses are all separately subject to taxation under D.C.Code § 47-1801.1 to § 47-1816.3 (1997). A corporation includes trusts, associations, and companies that are classified as corporations under the federal IRC, and also includes financial institutions. See D.C.Code §§ 47-1801.4(16), -1807.1(1). An unincorporated business is sweepingly defined as any trade or business conducted or engaged in by any non-corporate entity, with four express exceptions. See D.C.Code § 47-1808.1. The most significant are the exceptions for a trade or business in which more than 80% of the gross income is derived from personal services and in which capital is not material, and for professional corporations under Chapter 6 of Title 29 of the D.C.Code, such as law firms, accounting firms, engineers, and medical practitioners. See id. Such excepted trades or businesses are treated as pass-through entities. See D.C.Code § 47-1808.6. In the District, individuals are taxed on personal income, while a franchise tax is levied against the income of all taxable business entities for the privilege of carrying on or engaging in any trade or business within the District. D.C.Code § 47-1807.2(a). Income for all categories of taxpayers is defined in detail in subchapter III. Subchapter VII establishes the franchise tax for corporations and financial institutions; subchapter VIII establishes the franchise tax for unincorporated businesses. Subchapters VII and VIII are in many respects parallel, and both indirectly refer to subchapter III for a definition of taxable income. [6] See D.C.Code § 47-1807.1(2) & § 47-1808.2(1). To avoid double taxation for unincorporated business activity, the distributive share of a trade or business net income that is subject to the unincorporated business franchise tax is excluded from calculation of an individual owner's gross income. D.C.Code § 47-1803.2(a)(2)(D). The structure of a business in the District, incorporated or unincorporated, typically will not have significant local tax consequences insofar as the business itself is concerned because both classifications are treated similarly by the District tax code. Regulations support this intent, explaining that the design of the unincorporated business tax under the law is to impose a tax upon all business income which would be subject to the corporation franchise tax (as though the business were incorporated), without regard to whether the business is carried on by an individual, a partnership, or some other unincorporated entity. 9 DCMR § 117.1 (1996). The District treats affiliated corporations differently from the manner in which they are treated under federal regulations. Specifically, District law requires most such corporations to file separate returns, even where they have participated in a federal consolidated return. D.C.Code § 47-1805.2(5)(B) provides: Affiliated corporations (including affiliated incorporated financial institutions) shall file separate returns unless permitted by the Mayor to file consolidated returns. Along with this general prohibition against consolidated returns, the regulation allowing for exceptions is narrow. Most importantly, under the regulations enforcing § 47-1805.2(5)(B), a consolidated return may be filed only by affiliated groups where all members are subject to the District franchise tax on one hundred percent (100%) of net income from trade or business subject to apportionment. In other words, if a group filing a federal consolidated return includes at least one corporation outside the District's tax jurisdiction, then each individual member of the group within the jurisdiction must file a separate return. 9 DCMR § 109.1. Thus, under most circumstances, participation in filing a federal consolidated return by a corporation doing business in the District would have no readily discernible effect on the corporation's tax liability under the District's franchise tax  whether filing a federal consolidated return or not, the corporation would file an individual District return, and pay local taxes according to that return. Prior to 1987, no business, whether incorporated or not, and without regard to whether it had filed a federal consolidated return, could take advantage of a net operating loss deduction for District tax purposes. Each tax year was treated as a unit unto itself without regard to past or future gains or losses of the enterprise. However, in 1987, in an effort to bring the District tax law into greater conformity with the IRC without any overall increase in District taxes, the Council of the District of Columbia enacted the Tax Conformity and Revision Amendment Act (the Act). Among its numerous provisions, the Act added a net operating loss deduction provision to the list of income deductions set forth in D.C.Code § 47-1803.3: (a) Deductions allowed.  The following deductions shall be allowed from gross income in computing net income of corporations, financial institutions, unincorporated businesses and partnerships: ... (14) Net operating losses.  In computing the net income of a corporation, an unincorporated business, or a financial institution, there shall be allowed a deduction for net operating losses, in the same manner as allowed under § 172 of the Internal Revenue Code of 1986 and as reported on any federal tax return for the same taxable period, except that no net operating losses may be carried back to any year ending before January 1, 1988. The interpretation of D.C.Code § 47-1803.3(a)(14) and its interaction with the IRC is the issue debated by the parties and now before us for resolution on this appeal. [7]