• Preserving Net Operating Losses for a Reorganized Corporation Post-Bankruptcy
  • April 3, 2008 | Author: Annette M. Ahlers
  • Law Firm: Pepper Hamilton LLP - Washington Office
  • Now that the U.S. economy seems to be coming to a point where corporations are once again seeking the protection of the Bankruptcy laws to regain financial heath, it is a good time to brush up on some key tax issues that arise as corporations consider workout and bankruptcy reorganization plans. There are many potential tax matters that arise in the context of workouts and bankruptcy that must be considered by both creditors and debtor corporations during this process, however, this article will focus only on certain implications that arise with respect to the preservation of net operating losses (NOLs).1

    For corporations seeking the protection of the Bankruptcy laws, NOLs are often a valuable asset and their preservation for future use is a high priority for the corporation. In many cases, the ability to utilize the NOLs of the debtor corporation is a key component of the viability analysis of the newly reorganized entity.

    Most Bankruptcy Plans Involve a Change in the Equity Holders of the Corporation

    In general, Section 382 requires corporations with NOLs and certain tax attributes to review their equity holders over a rolling three-year period of time, or less in some cases (the testing period), to determine if they have undergone an “ownership change.”2 If such a change has occurred during the relevant testing period, then the amount of pre-change NOLs that can be used to offset taxable income in post-change years will be limited. Such limit (Section 382 Limitation) is generally equal to the value of the target corporation at the time of the “ownership change” times the applicable federal long-term tax-exempt interest rate.

    It is the typical case that when a debtor corporation emerges from a workout or bankruptcy proceeding, the shareholders that held the stock prior to the bankruptcy will be different following the bankruptcy. Thus, it is likely that the debtor corporation will need to do an analysis of the impact of Section 382 and whether or not the debtor corporation has undergone an “ownership change” before bankruptcy and after.

    Ownership Change - The process of determining whether or not a debtor corporation has undergone an “ownership change” for Section 382 purposes can be time consuming and is very fact intensive. Many events must be taken into account. For example, the issuance, extinguishment, and conversion of convertible debt instruments are events that Section 382 requires you to analyze to determine whether the instrument must be taken into account as equity. Also, tracking the changes of ownership in certain significant shareholders of the debtor corporation is required because Section 382 requires that the debtor corporation look up through the chain of ownership of its five-percent shareholders to find “arms and legs.” In addition, on each equity event date, the debtor corporation needs to determine the relative percentage ownership of each class of stock of the corporation in order to determine how the ownership of the five-percent shareholders has changed.

    Value Of The Loss Corporation - Section 382(l)(1) generally requires that the debtor corporation back out recent capital infusions in determining the value of the debtor corporation used in calculating its Section 382 Limitation. For this purpose, recent means capital infusions within two years of the ownership change. There are exceptions to these rules, but the default position is to exclude any capital infusions made to the corporation in the two-year period prior to the ownership change.

    A debtor corporation contemplating paying off or renegotiating its debt with various creditors by issuing stock or other equity instruments prior to actually filing for bankruptcy should consider the impact that such issuance may have on the ability of the debtor corporation to utilize its pre-change NOLs to offset taxable income in post-change years. Depending on the value of the bankrupt corporation at the time of these attempted workout (outside of bankruptcy), and the amount of equity issued, an “ownership change” might have occurred before the bankruptcy proceedings commence. As a result, Section 382 would limit the amount of pre-change NOLs that can be used to offset taxable income in post-change years, and if this change occurs at a time when the value of the corporation is very low, the Section 382 Limitation is likely to be very low, if not zero.

    Statutory Help to Minimize the Impact of Section 382

    Because the intent of the Bankruptcy laws is to allow corporations to reorganize and continue operating with less of a debt burden, Sections 382(l)(5) and 382(l)(6) provide help to debtors that are undergoing a bankruptcy reorganization. It is important to note that both of these special provisions only apply if a debtor corporation is under the jurisdiction of the court in a Title 11 or similar case.

    Under Section 382(l)(5), an ownership change that occurs while under the jurisdiction of the court in a Title 11 or similar case will not create a Section 382 Limitation if the debtor corporation’s historic shareholders and/or creditors prior to the ownership change receive more than 50 percent of the newly reorganized corporation pursuant to the bankruptcy plan of reorganization. In such a case, the NOLs are reduced for certain interest payments made within the past three years to creditors that become shareholders of the debtor corporation and certain amounts related to cancellation of debt. In addition, if there is an actual ownership change within two years of emerging from bankruptcy, the Section 382 Limitation for that change is zero.3 In order to avoid a second ownership change that would trigger this draconian result, the debtor corporation may request the bankruptcy court to approve severe restrictions on the transfer of the reorganized debtor’s stock within the two year period following emergence from bankruptcy. This is often justified by arguing that the NOLs are significant assets of the debtor corporation’s estate and there is a strong need to preserve such assets by restricting changes in ownership until the two year period expires.4

    While Section 382(l)(5) is a very favorable provision that allows a very large pool of NOLs to survive post-bankruptcy, its rules often are too restrictive for corporations undergoing bankruptcy. Thus, most debtor corporations emerging from bankruptcy rely on Section 382(l)(6), which essentially allows a debtor corporation to value itself after all the debt cancellation of bankruptcy has occurred. Accordingly, the value of the debtor corporation used for purposes of calculating its Section 382 Limitation should be significantly higher post-reorganization, which increases the amount of pre-change NOLs that can be used to offset taxable income in post-change years. It should be noted, however, that even in a situation where Section 382(l)(6) applies, the normal rules of valuing the loss corporation also apply, and thus the debtor corporation still must back out any capital contributions made within the two year period prior to the ownership change and any cash or cash equivalents that are not used in the debtor corporation’s business.

    Using NOLs after Emergence from Bankruptcy or Workouts

    As debtor corporations look to use the NOLs from their pre-bankruptcy operations after they emerge from bankruptcy, they should be prepared to prove, through Section 382 equity analysis (discussed above), that the NOLs have not already been limited prior to filing for bankruptcy. In addition, several other factors must be considered including:

    • The source of the NOLs, i.e., did the debtor corporation acquire the NOLs through the acquisition of other entities over the years and are those NOLs subject to existing Section 382 limitations);5
    • Documentation for the NOLs through tax return reporting, (this also tells you what year each of the NOLs arose so you can project utilization of such NOLs against future income);
    • Determination of whether or not the debtor corporation conducted the same business during the period after any prior ownership changes. If the corporation has sold its business assets within two years of an ownership change, the Section 382 limitation could be reduced to zero;
    • Determination of whether or not the creditors of the debtor corporation became the true “owners” of the corporation prior to bankruptcy due to triggering certain debt provisions (i.e., the creditors may have basically taken over as the equity holders of the debtor corporation resulting in an ownership change occurring on the date of this “takeover”); and
    • Determination of whether or not the debtor corporation is in a net unrealized built-in-gain or net unrealized built-in-loss position by comparing the difference between the tax basis of the corporation’s assets to the fair market value of those assets on the date of the ownership change (this calculation is important for determining whether certain post-bankruptcy events, such as asset sales, amortization or depreciation will be impacted by the Section 382 Limitation).

    Pepper Perspective

    When contemplating options for working out debt repayment and corporate reorganizations due to insolvency or other distressed situation, debtor corporations and their creditors need to pay very close attention to the application of Section 382 if they plan to preserve the NOLs of the debtor corporation. Such NOLs can be a very significant asset of the debtor corporation and can favorably impact the post-restructuring financial performance of the corporation. Even before the process begins, corporations need to verify that their pool of NOLs is still potentially available for use once income begins to be earned after the reorganization is complete.

    In addition, if a private equity buyer or other purchaser of distressed corporations is considering an investment in, or a recapitalization of, a debtor corporation on the eve of bankruptcy, the debtor corporation must consider the impact that such investment or recapitalization might have on the future availability of the debtor corporation’s NOLs. If a workout is attempted prior to bankruptcy, the debtor corporation has even fewer options to preserve its NOLs as a component of its financial model post-restructuring because of the high likelihood that a recent acquisition of debt or stock will make an ownership change under Section 382 more likely at a time when the value of the corporation is so low that the chances of utilizing any NOLs in the future are slim.


    1. References to NOLs include NOL carryforwards.
    2. All Code Section references are to the Internal Revenue Code, as amended, unless otherwise noted.
    3. See PLR 200751011 (September 7, 2007) for a recent IRS ruling letter on this rule. Private Letter Rulings are not cited as authority for the rule stated, but indicate a consistent ruling position of the IRS.
    4. See PLR 200731020 (August 3, 2007) for an IRS letter ruling that respected restrictions on stock transfers post-bankruptcy in order to prevent an ownership change within two years of emerging from bankruptcy.
    5. It is important to note that a pool of NOLs is always subject to the lowest Section 382 limitation that can be applied to them, even if a higher Section 382 limitation can be calculated for a more recent ownership change