Whenever there is a significant change in the ownership of a corporation, the Internal Revenue Code requires a determination as to whether the corporation’s tax attributes are affected. In many situations, the most valuable attribute is the net operating loss (NOL) carryover.
Under Section 172, corporate NOLs generally can be carried back two years and forward for 20 years, except NOLs incurred in taxable years ending in 2001 and 2002, which can be carried back five years. After a significant ownership change, Section 382 limits the amount of NOL that can be used each year. The corporation’s accumulated NOL is not reduced. However, the amount of NOL that the corporation may use each year after an ownership change to offset taxable income is limited. In the absence of a significant ownership change, the corporation would be able to use its entire accumulated NOL in one year, if necessary, to offset current taxable income.
In order to be able to use any NOLs after an ownership change, the corporation must meet a continuity of business requirement. The corporation is required to continue a significant line of an historic business or use a significant portion of the assets of an historic business during the two-year period beginning on the date of the ownership change.
Special rules apply when the corporation is involved in a bankruptcy or similar case, where an ownership change can be avoided if a loss corporation meets certain conditions. This article does not cover bankruptcy situations.
Under Section 382, a change in ownership which limits utilization of NOLs occurs whenever there is a shift in the stock owned by 5% shareholders of more than 50 percentage points compared to the lowest percentage that such shareholders owned during the three-year test period prior to the transaction. If there is such a change in ownership, Section 382 imposes a limitation on the utilization of NOLs in future years. Ownership shifts can occur in several ways, including a tax-free reorganization, a stock sale or acquisition and redemption.
The 5% shareholder concept is the most confusing part of Section 382. A 5% shareholder is any shareholder (or group of shareholders) that owns, at any time during the testing period, at least 5% of the stock of the loss corporation (i.e., the corporation with NOLs), directly or constructively through ownership in another entity. All shareholders that own less than 5% of the loss corporation are classified as a group that is treated as a single 5% shareholder for purposes of determining an ownership change.
Preferred stock is not considered to be “stock” for purposes of determining a Section 382 ownership change if it meets all of the following criteria:
* The preferred stock is not entitled to vote.
* The preferred stock is limited and preferred as to dividends and does not participate in corporate growth to any significant extent.
* The preferred stock has redemption and liquidation rights that don’t exceed the issue price of such stock (except for a reasonable redemption or liquidation premium).
* The preferred stock is not convertible into another class of stock.
Ownership of preferred stock meeting all the above conditions will be disregarded in determining a change in ownership. On the other hand, preferred stock not meeting all the above conditions is considered stock and taken into account in determining a Section 382 ownership change.
Generally issuance of options will not be treated equivalent to stock unless the options satisfy any one of three tests: (1) the ownership test (2) the control test and (3) the income test.
* The Ownership Test: An option satisfies the ownership test if a principal purpose of the issuance of the option is to avoid or reduce the impact of an ownership change of the loss corporation by providing the holder of the option, prior to its exercise, with a substantial portion of the attributes of ownership of the underlying stock.
* The Control Test: An option satisfies the control test if a principal purpose of the issuance of the option is to avoid or reduce the impact of an ownership change of the loss corporation and the holder of the option and any persons related to the option holder have, in the aggregate, a direct and indirect ownership interest in the loss corporation of more than 50 percent.
* The Income Test: An option satisfies the income test if a principal purpose of the issuance of the option is to avoid or reduce the impact of an ownership change of the loss corporation by facilitating the creation of income or value prior to the exercise of the option.
Amount of Limitation
Under Section 382, the limitation on the utilization of a NOL carryforward is computed by multiplying the value of the loss corporation immediately before the ownership change by the Federal long-term, tax-exempt rate in effect for the month. The value of the corporation is the fair market value of its stock immediately before the ownership change. This value is reduced by capital contributions that are made during the two years prior to the ownership change for the sole purpose of tax avoidance. Under this “anti-stuffing” rule, owners cannot artificially increase the value of the loss corporation when the only motivation for such transfers is to increase the Section 382 limitation.
If the corporation is subject to the Section 382 limitation on its NOL carryforward and it does not generate enough taxable income to absorb the usable portion of the NOL, the unused portion is carried over into future years and can be used to offset the taxable income in any year provided the carryforward period has not expired.
Example: ABC Corp., with a $1 million NOL carryover, underwent an ownership change to which Section 382 applied. The Section 382 limitation was computed to be $150,000. During the first year after the ownership change, ABC had taxable income of $50,000. ABC would be able to use $50,000 of the $150,000 available NOL and the unused portion ($100,000) would be carried over and added to the $150,000 limitation available for the second year. At the end of the second year, ABC would have a $250,000 usable NOL to offset taxable income for that year. To the extent any portion of the $250,000 NOL is not used, the unused portion would be carried over and added to the $150 limitation available for the third year. However, the aggregate NOLs utilizable during the carryover period could not exceed $1 million.
If a Section 382 ownership change occurs, any built-in losses recognized during the five year period beginning on the date of the ownership change will be treated as if they are pre-change losses and will be subject to the same limitation described above. A “built-in loss” is defined as the excess of the tax basis of an asset over its fair market value. If any built-in gains are recognized during the same period stated above, the Section 382 limitation will be increased by this amount. A “built-in gain” is defined as the excess of the fair market value of an asset over its tax basis.
The amount of net unrealized built-in gain or net unrealized built-in loss is disregarded if it does not exceed the lesser of: (a) 15% of the fair market value of the assets of the corporation immediately before an ownership change, or (b) $10 million.
A change in ownership is most likely to occur after an IPO or a private placement, as well as a tax-free reorganization with an unrelated corporation. Venture capitalists and other investors may intend to obtain future tax benefits arising from the utilization of NOLs when they decide to invest in the corporation. However, if the corporation falls into the Section 382 trap, the ability to use the NOLs may be eliminated or severely restricted. The investors will want to know in advance if their transaction will cause a Section 382 limitation on the use of the NOL, which may have an impact on the future tax liabilities of the corporation and on the current economics of the deal. Therefore, it is very important to update a Section 382 analysis every time new shares are issued. In certain situations, a corporation may avoid a Section 382 ownership change with proper tax planning and by controlling the timing of issuance of new shares.
Vijay Shah is a CPA and partner in Eisner LLP’s Corporate Tax Group. He has more than 18 years of tax experience in corporate and partnership taxation in the apparel, manufacturing, financial services, real estate, new media, and biotech industries. He also has handled federal and state tax examinations of clients.