Recently, there have been some very high-profile cases involving the tax consequences that corporate giants are facing resulting from Chapter 11 filings. Net operating losses (more commonly referred to as NOLs) are an excess of deductions over income in any given year. It stands to reason that companies filing for bankruptcy protection under Chapter 11 may have accumulated significant NOLs which they can then carry back to use against taxable income in the two previous years and, to the extent not utilized, carry forward for 20 years. But wait ... before you start celebrating the virtues of bankruptcy ... there is a catch here. It is a provision in the Internal Revenue Code that significantly limits the ability of a company to preserve its NOLs in the event of a change of ownership. Obviously, most corporate reorganizations under Chapter 11 result in a change of ownership.
Let's get back to those high-profile cases. As of December 31, 2007, Delta Airlines reported $9.1 billion in federal and state NOL carryovers, and Northwest Airlines reported $3.6 billion in NOL carryovers. Each company's bankruptcy agreement resulted in an ownership change and there will be a second ownership change with their upcoming merger. Consequently, both companies stand to lose enormous tax benefits.
Eddie Bauer, the specialty retailing giant based in Seattle, recently emerged from bankruptcy. As of June 28, 2008, Eddie Bauer estimated that it had nearly $370 million of pre-bankruptcy federal NOLs. Just last week in an effort to prevent the occurrence of an ownership change, the company announced that it intends to hold a Special Meeting of Stockholders on November 21, 2008 to seek approval from its stockholders of a proposed amendment to its Certificate of Incorporation to extend the expiration date of an existing 4.75% ownership limitation on its securities. Let's stay tuned to see if Eddie Bauer is successful in its efforts to preserve its NOLs.
As we try to understand the nuances of NOLs as it relates to companies filing for protection under Chapter 11, Dr. Larry Maples, Professor of Accounting at Tennessee Technological University, provides some valuable insight in his article entitled "Pitfalls in Preserving Net Operating Losses."
The "value" of a net operating loss (NOL) depends not only upon its size, but also on the amount of income the law allows the NOL to offset. The income offset can range from 100%, if ownership of the entity does not change, to zero, if the continuity-of-business requirement is not met. Between these extremes, the amount of income offset can be affected by a second ownership change, cancelled creditor claims, built-in losses, the presence of nonbusiness assets, stock redemptions, and other factors.
This article provides a framework for working through the complex rules under IRC section 382, which can limit the value of an NOL. Corporations and advisors who are aware of the triggers that reduce an NOL's value may be able to avoid common pitfalls.
The "bankruptcy exception" can be used to avoid the IRC section 382 limitation on the amount of income that can be offset by an NOL. Using the exception may not always be advisable, however, because a "toll charge" may cost some interest deductions, and another subsequent ownership charge can wipe out the NOL altogether.
To qualify for the bankruptcy exception, IRC section 382(1)(5) provides that two requirements must be met:
Debt arises in the "ordinary course" of business if it was incurred in connection with the normal, usual, or customary conduct of the loss corporation's business. For example, trade debt arising from a business relationship with a supplier qualifies, as does debt incurred to pay an IRC section 162 expense. Whether the debt arose from an expense or from a capital expenditure is not relevant [Treasury Regulations section 1.382-9(d)(2)(IV)].
Qualifying under the bankruptcy exception is not the only consideration. A corporation and its advisors should carefully evaluate whether the corporation should use the exception or elect out of it. As illustrated in the Exhibit, a cluster of questions and issues surfaces if the corporation does not elect out. These problems may, in some cases, lead the corporation to accept the IRC section 382 limitations as the less onerous alternative.
The potential of a subsequent ownership change injects risk into the decision to use the bankruptcy exception. Two adverse consequences result if another ownership change occurs within two years. First, the qualification under the bankruptcy exception for the first ownership change is retroactively eliminated. As a result, the corporation is treated as any other loss corporation under IRC section 382 for the years between the ownership changes. Second, the section 382 limitation for all years following the second ownership change is zero. Note in the Exhibit that the arrows bypass the value increase for cancelled creditor claims. This harsh result generally eliminates NOLs in the period between the ownership changes, because most or all of the company's value would come from the canceled claims. In effect, electing out would save the company from being penalized for successive ownership changes without forfeiting the increase in value due to the canceled claims. To the extent feasible, attempting to restrict subsequent transfers of the stock would reduce the risk to die corporation of the harsh result outlined here.
If a corporation elects out of the bankruptcy exception, availing itself of the value increase for canceled creditor claims, then the continuity-of-business requirement does apply (discussed below). A corporation would be excused from the business-continuity requirement if it uses the bankruptcy exception. The 1RS, however, believes that a 100% exemption from the requirement creates a loophole, so it provided in Treasury Regulations section 1.269-3(d) that the NOLs of a corporation could be completely disallowed if it does not carry on more than an insignificant amount of an active trade or business (see the Exhibit).
The other major barrier to using the bankruptcy exception is the so-called "toll charge." A corporation using the exception has no restrictions on the amount of postreorganization income it can offset, but it must pay for this privilege by reducing its NOL and excess credit carryovers [IRC section 382(1)(5)(B)]. A law change effective January 1,1995, confines this toll charge to certain interest deductions [IRC section 382(I)(S)(C)]. The logic behind the change is that debt has been turned into equity in the bankruptcy reorganization; therefore, some interest should lose its deductibility. In effect, the converted debt is treated as equity during a three-year period ending prior to the year of the ownership change, plus the part of the change year that precedes the ownership change. This is can be very significant for corporations with large amounts of debt converted to equity in a reorganization.
If the corporation does not use or does not qualify for the bankruptcy exception, IRC section 382 imposes a continuity-of-business requirement. In effect, if the corporation uses cancelled creditor claims to increase its value, the business-continuity requirement applies.
Failure to meet the business-continuity requirement is fatal; the IRC section 382 limitation becomes zero. None of the pre-change losses can be used. The continuity test piggybacks on the reorganization-continuity rule [Treasury Regulations section 1.368-l(d)]; that is, either the historic business must continue, or a significant portion of the assets must be used. Where multiple lines of business are involved, continuation of one of the significant lines of business will meet the requirement under current regulations. Thus, discontinuing a loss line and using its losses against a continuing profitable line should be allowable. But even if the historic business is not continued, continuity can be met if a significant portion of the historic assets is used. This continuity must be maintained for a period of two years after die change date.
Note in the Exhibit that if the business-continuity requirement is not met, there is one partial alternative. Carryovers of recognized built-in gains and IRC section 338 gains increase the section 382 limitation from zero to the sum of these gains [IRC section 382(C)(2)]. If a given post-change year produces none of these gains, the section 382 limitation is zero for that year. Note that if a built-in gain is recognized, the section 382 limitation for that year is increased, but if a built-in loss is recognized, the pre-change loss, not the limit, is increased. Guidance on alternative approaches to identifying built-in items is contained in Notice 2003-65 (2003-40 IRB747).
IRC section 382 limits a corporation's ability to use pre-change NOLs after an "ownership change." An ownership change occurs when the percentage of stock of a loss corporation held by a 5% shareholder increases by more than 50 percentage points during a three-year period [IRC section 382(g)(l)]. Ownership percentages are based on the value of stock held by each shareholder. Under IRC section 382, "stock" includes voting preferred stock and may include options or warrants under the tests of Treasury Regulations section 1.382-4(4)(d). Under Treasury Regulations section 1.382-2(a)(3)(i), a 5% shareholder's percentage stock ownership on a testing date is the fair market value of the stock owned by the 5% shareholder as a percentage of the value of all the outstanding stock of the corporation.
If a 5% owner is an entity, a look-through approach is used to determine which owners of the entity are indirectly 5% shareholders of the loss corporation [IRC section 3820X3)]. Attribution rules also create a single 5% shareholder from among certain lineal family members. The Fifth Circuit has held that the lineal requirement of IRC section 382 (1X3XA) is to be interpreted literally: A sale of stock to a shareholder's brother resulted in an ownership change (Garber Industries Inc., 97 AFTR 2d 2006-429, aff g 124 T.C. 1). A testing date occurs when the percentage stock ownership-in terms of value-changes for a 5% shareholder. Issuing stock disproportionately to existing shareholders, issuing stock to new shareholders, and the sale of stock by an existing shareholder to a third party would trigger a testing date. If the change is due solely to a fluctuation in the relative value of different classes of stock, however, an ownership change will not have occurred. In one 1RS ruling, a company's common stock declined in value relative to its preferred stock as a result of a deteriorating business situation. The 1RS set out the principle that the value of the common stock should remain constant relative to the value of the preferred stock when determining whether there was an ownership change for any 5% shareholder (PLR 200520011).
This ownership-change rule should be carefully monitored with respect to planned events such as recapitalizations, stock redemptions, and stock issuances. A determination, in advance, of the number of shares that could be recapitalized or redeemed without triggering an ownership change would be advisable. Another crucial question to ask is whether such a transaction should be executed within a particular three-year testing period.
Value of the Loss Corporation
If an ownership change has occurred, the next step in arriving at UK IRC section 382 limitation is to value the stock of the old loss corporation. Stock includes both common and pure preferred stock. If the company is publicly traded, the starting point would be the trading price on the date of the ownership change. If the ownership change is an acquisition, the value of the old loss corporation should, in most cases, be the purchase price with appropriate adjustments. Privately held corporations that undergo an ownership change other than a full sale can present valuation problems. Factors such as control premiums, marketability, and sale restrictions can complicate valuation. An appraisal may be necessary.
A publicly traded corporation that uses an appraisal to establish value may run into an 1RS roadblock. In TAM 200513027, the taxpayer asserted that market capitalization would have resulted in an inappropriately low stock value because the market was too slow in assimilating information about the company's drug technologies. The 1RS ruled, however, that even if it were established that the market was slow in comprehending information, this is not the kind of exceptional circumstance warranting a deviation from the market capitalization approach. The 1RS pointed to court decisions in which sales of smaller lots than the subject block, coerced sales, sales in a restricted market, or price aberrations on the valuation date were held to constitute "exceptional circumstances." This TAM demonstrates that taxpayers will have difficulty proving that exceptional circumstances exist unless they fall into one of the above categories. The 1RS seems intent on using the market capitalization approach for publicly traded companies.
Value Reduction for 'Stuffing'
Because the IRC section 382 limitation is based on the corporation's value just prior to the ownership change, Congress thought a provision was needed to prevent taxpayers from manipulating value by "stuffing" the corporation with assets just prior to the change. Without this anti-stuffing rule, a seller could make a capital contribution, increasing the sales price and the 'Value" of the corporation by the same amount A contribution disqualified by this rule is one made with the principal purpose to "avoid or increase" any IRC section 382 limitation [IRC section 382(1)(1)(A)]. Congress reduced the rule's subjectivity by providing that a capital contribution made in the two-year period ending on the change date is presumed to be part of a plan to increase the IRC section 382 limitation [IRC section 382(1)(1)(B)].
Capital contributions covered by the rule include direct and indirect capital infusions such as stock issued for cash or for acquiring other property, cash received due to the exercise of options and warrants, or stock issued in a reorganization. Even debt contributions will likely trigger the anti-stuffing rule.
Taxpayers can reduce the anti-stuffing adjustment by showing that the contributions are to be used for working capital. Although regulations do not define working capital for this purpose, legislative history and a series of letter rulings make it clear that a loss corporation can demonstrate that funds raised in equity offerings were used to fund working capital and operations.
Tracing borrowed funds to payroll and other operating expenses, for example, should establish that the working-capital exception applies. In letter rulings, the IRS has treated research and product development as triggering a working-capital exception (see LTR 9630038). In addition, bridge loans used for working capital until a permanent offering is completed have been approved by the IRS (LTR 9508035). But a significant delay between the debt and the equity offering may cause the IRS to refuse to apply the working-capital exemption. For example, the IRS has ruled that debt incurred more than 21 months prior to an equity offering lacks the time proximity to qualify, even when the use of the borrowed funds could be traced to operating expenses (LTR 9332004).
Value Reduction for Substantial Nonbusiness Assets
If a new loss corporation has substantial nonbusiness assets, the value of the old loss corporation must be reduced by the amount of the nonbusiness assets less liabilities attributable to those assets. "Substantial" is defined as one-third of total assets. This is a difficult provision to interpret. IRC section 382(1)(4) provides that a value reduction in the old loss corporation is required if, just after an ownership change, the new loss corporation has substantial nonbusiness assets. This language seems odd because the purpose of IRC section 382 is to prevent loss trafficking, so it would seem that the asset test ought to apply to the old loss corporation.
The courts in Berry Petroleum [98-1 USTC 50,398 (CA-9,1998, Aff'g 104 T.C. 584,1995)] grappled with this old/new problem created by the statute. The problem was created when the acquirer of a loss corporation arranged to sell one of its assets at the conclusion of an ownership change. Thus, a business asset was converted into a nonbusiness asset-cash-in the hands of the "new" loss corporation. The Tax Court applied the language literally, concluding that the cash in the hands of the new loss corporation would trigger the value reduction for the old loss corporation. This is a curious result. Suppose a loss corporation with substantial nonbusiness assets merges into a larger corporation with almost all operating assets. Following the literal wording of the statute per Berry would appear to require no reduction in the value of the old loss corporation because the new corporation would not reach the one-third level in nonbusiness assets. This result does not square with the intent of IRC section 382-that is, to reduce trafficking in the old corporation's NOLs. Corporations and their advisors should apply Berry cautiously, because a rationale that produces a result like the above is not on solid ground.
Cash and marketable securities will apparently be considered nonbusiness assets, even if they are held for a bona fide operational reason [see Field Service Advice (FSA) 200140049]. The normal business strategy of stockpiling cash for legitimate operational reasons, such as research and development, should be monitored to ensure that the loss corporation's cash and other nonbusiness assets do not creep over the one-third mark.
Investments in subsidiaries are not treated as nonbusiness assets [IRC section 382(1)(4)(E)]. Instead, the parent loss corporation is considered to own a ratable share of the underlying assets of the subsidiary. Interestingly, there is no guidance on how investments in partnerships and LLCs are to be treated for purposes of the nonbusiness asset rule. Presumably, a "look-through" approach would also be appropriate.
Redemptions and Contractions
IRC section 382(a)(2) provides for a reduction in value of the loss corporation if a redemption or other corporate contraction occurs in connection with an ownership change. In effect, the value of the loss corporation is determined after the redemption or contraction, regardless of whether the redemption occurs before or after the ownership change.
Applying this rule to contractions that are not redemptions may be more complicated. Bootstrap acquisitions will be a contraction because the loss corporation's value is reduced or the corporation takes on debt to put funds into the hands of the old shareholder. For example, in FSA 200140049, a downward adjustment to the value of an acquired loss group was deemed to result in a contraction adjustment under IRC section 382(e)(2) because the group's own liquidity was used to fund the acquisition. The mere use of the company's own liquidity will not, however, apparently automatically result in a contraction adjustment. In LTR 200406027, the acquisition of target stock using a line of credit along with the consolidation of the acquirer's and target's operations and treasury functions was not considered a contraction.
Comparing these rulings gives one a feel for the subjectivity involved in determining whether a contraction has occurred. It is advisable, therefore, to avoid related-party transactions in which the value of the assets of the acquired loss corporation is reduced. That lesson was underlined in Berry, where the Tax Court said that canceled loans which an acquired loss subsidiary made to the parent were not intended to be paid, and therefore a contraction adjustment should be made. The court ruled that the loans were corporate contractions because they would not have been made were it not for the ownership change.
Dr. Larry Maples, firstname.lastname@example.org, DBA, CPA, is the Alumni Professor of Accounting at Tennessee Technological University, Cookeville, Tenn.
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