- Had a Section 382 Ownership Change? Maybe the IRS Can Help
- October 18, 2007 | Author: Annette M. Ahlers
- Law Firm: Pepper Hamilton LLP - Washington Office
As many of you know, Section 382 of the Internal Revenue Code (the Code) will generally require a corporation to limit the amount of its income in future years that can be offset by historic losses (NOL carryforwards) once that corporation has undergone an “ownership change.” While the general mechanics of whether or not an ownership change has occurred is beyond the scope of this article, we do address some important considerations for a corporation to consider when determining the impact of an ownership change, and highlight some potential opportunities to obtain a better, if not great, result under these rules.
Calculating the “Section 382 Limitation”
Once a corporation has determined that an ownership change occurred, the corporation is required to calculate the “Section 382 limitation” resulting from that ownership change. Each time a corporation undergoes an ownership change, a separate Section 382 limitation is calculated. Thus, it is very common for a corporation to have more than one ownership change, each generating its own separate Section 382 limitation. It is critical to know each Section 382 limitation because the rules addressing successive ownership changes require that the lowest limitation on NOL carryforwards that exists on the date of an ownership change will be applied, even if another ownership change results in a higher Section 382 limitation.
The Section 382 limitation is a formulaic calculation that is basically equal to the product of the value of the loss corporation and the long-term tax-exempt rate. The long-term tax-exempt rate is published on a monthly basis by the Internal Revenue Service in Revenue Rulings and can be found in IRS publications, including the Internal Revenue Bulletin. Taxpayers are required to use the long-term tax-exempt rate for the month in which the ownership change occurs when calculating their Section 382 limitation for any ownership change.
Value of the Loss Corporation
The determination of the value of the loss corporation is not as straight forward as it might first appear. Many people assume that the value of the corporation on the change date is the value used for purposes of calculating a Section 382 limitation. But as discussed below, this value is rarely the value used in determining the Section 382 limitation.
Differences between the value of the corporation on the change date and the value of the loss corporation used for purposes of calculating a Section 382 limitation can arise because there is a presumption in the Code that any capital contributions made within two years of the change date were made for the purpose of increasing the Section 382 limitation upon an ownership change.
For example, assume the loss corporation is a company that has two classes of stock outstanding; common stock that is publicly traded on a stock exchange, and preferred stock that is not publicly traded. Further, assume that one year before an ownership change, the company engaged in a tax free merger and issued its common stock to the target shareholders as consideration in the merger. In this situation, both the common stock and the preferred stock would be counted in determining the value of the corporation. However, this value must be reduced by the value attributable to any capital contributions made within two years of the change date. Because the merger was an acquisition that resulted in an increase in value of the loss corporation during the two year period proceeding the ownership change date, the value of the target company must be subtracted from the value of the outstanding stock to arrive at the value of the loss corporation for purposes of calculating the Section 382 limitation on the change date. This rule is generally referred to as the “anti-stuffing” rule and is found in Section 382(l)(1). It also is important to note that any cash or other assets coming into the loss corporation on the date of the change are not included in the value of the loss corporation for purposes of calculating the Section 382 limitation.1
Luckily, the Legislative History to Section 382 provides some limited relief from this rule for capital contributions that are made to continue basic operations of the corporation, like paying salaries of employees, lease of equipment or office facilities, etc.2 But the relief does not apply to amounts used to make investments or increases in value due to acquisitions. While no Treasury Regulations have been issued expanding on relief from Section 382(l)(1), the IRS has expanded (and in some cases, limited) the exceptions found in the Legislative History through private letter rulings and technical advice memoranda issued by the IRS to include, for example, infusions of cash to fund minimum capital requirements of banks, payments of salary and routine operating expenses, and most recently, to maintain minimum capital requirements for rating agencies and state regulators of an insurance company.3
We also note that there are several other provisions in Section 382 that address what to exclude from value in determining the value of the loss corporation, including cash not used in the business, investment assets, corporate contraction events, and others. None of these provisions have Treasury Regulations that address their application; however, as in the case of the anti-stuffing rule, the IRS has issued private letter rulings over the years applying these provisions to individual taxpayer situations.
Practicalities of Calculating Value in a FIN 48 World
This brings us to the “it’s not all bad” part of this discussion. As discussed above, the IRS has been willing to assist taxpayers in resolving these issues so taxpayers can obtain certainty with respect to their Section 382 limitation. Indeed, the recent implementation of FIN 48 addressing uncertain tax positions for financial statement reporting purposes has brought the valuation issue to the forefront for companies that are required to provide substantiation for their tax positions. As a result of the increased scrutiny and documentation requirements of FIN 48, external financial auditors are taking a very hard view of a taxpayer’s ability use the exceptions to the anti-stuffing rule from the Legislative History, and some have taken the position, that absent an IRS ruling on the issue, the taxpayer cannot include in its value any capital contributions made within the two year period prior to the ownership change. They believe that, because no Treasury Regulations have been issued under these rules, and the Code creates a presumption “except as provided in regulations,” the capital contribution will be viewed as made for the purpose of increasing the Section 382 limitation.
The other major instance where taxpayers are at risk of a strict interpretation of the anti-stuffing rule is in a due diligence situation where the buyer is challenging the Section 382 limitations resulting from earlier ownership changes. In particular, where many successive rounds of funding occurred to get a new company up and running, it is possible for the Section 382 limitation for an earlier ownership change to be zero when all the funding occurred during a short time period prior to the ownership change. As a result, none of the income of the corporation (or its successor) can be offset by the pool of NOL carryforwards that are subject to such Zero limitation, and such NOL carryforwards will most likely expire unused. The possibility of a Zero limitation has given potential acquiring companies and the external auditor of a public company the impetus to require a loss corporation to prove the continued availability of its NOL carryforwards, even if the NOL carryforwards are not currently being used to offset income. Thus, for financial statement purposes, such NOL carryforwards may cease to be reflected on the company’s balance sheet.
Other Avenues for Increasing the Section 382 Limitation
Once the value of the loss corporation is determined under the parameters described above, opportunities still exist for a loss corporation to increase its Section 382 limitation in years following the ownership change. One such opportunity is for a loss corporation that is in a “net unrealized built-in gain” position on the change date4 to sell an asset that was considered a “built-in gain” asset on the ownership change date within the five year period following the change date. In that situation, the Section 382 limitation can be increased by the amount of the recognized built-in gain and thus, more income can be offset against NOL carryforwards subject to the Section 382 limitation.
In addition, the IRS permits certain increases in the Section 382 limitation for corporations under the rules set forth in Notice 2003-65, 2003-2 C.B. 747. These rules provide limited relief during the five year period following the change date. A more detailed discussion of when taxpayers might want to consider applying Notice 2003-65 can be found in our April 2006 Tax Update, which can be found on Pepper Hamilton’s Web site at http://www.pepperlaw.com/pepper/pdfs/Tax0406.pdf.
Thus, the good news is that taxpayers can go to the IRS to resolve questions on what can and cannot be included in the value of the loss corporation on the change date, even if their auditor or merger partner is not willing to apply the logic of the Legislative History in finding exceptions to the anti-stuffing rule. It does take a few weeks (or perhaps months) to obtain such a ruling, assuming the IRS agrees with your interpretation of the issue. However, if a company believes they are within the exceptions of the Legislative History, it may be worth the effort to approach the IRS with such a request if the alternative is to accept a Zero limitation on the loss corporation’s NOL carryforwards, either for financial statement purposes or in a deal context.
1 This rule is not under the anti-stuffing rule, but is a function of when you determine the value of the loss corporation, which is generally the value immediately preceding the event that caused the ownership change. Section 382(e).
2 See, H.R. Rep. No. 841, 99th Cong. 2d Session 189 (1986) and see also, Joint Committee on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986 318-319 (1987).
3 See PLR 200730003 (April 27, 2007), PLR 9835027 (May 29, 1998), PLR 9541019 (July 10, 1995), PLR 9508035 (November 30, 1994), and TAM 9332004 (April 30, 1993).
4 Section 382(h) has very specific and complex rules that dictate whether or not a loss corporation is in a net unrealized built-in gain or net unrealized built-in loss position on a change date. A discussion of these rules is beyond the scope of this article.
Other Rules Addressing Value
Relief from the Anti-Stuffing Rule