Final Project: Tax Consequences of Net Operating Losses in Corporate
Transactions
Gary Cao
May 1997
Outline
I. Introduction
II. History
II. Current Authorities
IV. Analysis
V. Conclusions and Recommendations
Appendix: List of References
I. Introduction
Purpose of this Paper
A key element in planning many transactions is the
survival and subsequent use of NOL carryovers and other
favorable tax attributes including unused business and research
credits, excess foreign tax credits and capital losses. The Tax
Reform Act of 1986, P. L. 99-514 (the "Act"), made sweeping
changes in the rules governing the use and availability of NOL
carryovers following certain changes in the stock ownership of
a corporation possessing NOL carryovers (a "loss
corporation"). In particular, Section 382 was substantially
altered.
This paper analyzes the preservation of tax attributes of
loss corporations. First, we will have an overview of the NOL
preservation issue; Second, we will review the brief history of
related regulations and code sections; Third, we will describe
the current authorities related to NOL; Fourth, we will analyze
the impact on how corporations preserve NOL under the
current regulations; Fifth, we will have some observations and
recommendations for further improvements on regulations.
Overview of the NOL Issue
Preservation of favorable tax attributes, typically net
operating losses (NOL) of a corporation (a "loss corporation"),
is frequently critical to corporate transactions. Whether an
internal reorganization of a loss corporation or an acquisition of
or by loss corporations is involved, certain statutory rules and
judicial limitations apply to restrict the amount, survival,
carryover, and use of the loss corporation's tax attributes.
The principal general statutory limitations of the Internal
Revenue Code are:
Section 108. Income from Discharge of Indebtedness;
Section 172. Net Operating Loss Deduction;
Section 269. Acquisitions Made to Evade or Avoid Income Tax;
Section 338. Certain Stock Purchases Treated as Asset Acquisitions;
Section 381. Carryovers in Certain Corporate Acquisitions;
Section 382. Limitation on Net Operating Loss Carry-forwards and Certain
Built-in Losses Following Ownership Change;
Section 383. Special Limitations on Certain Excess Credits, Etc.;
Section 384. Limitation on Use of Pre-acquisition Losses to Offset
Built-in Gains;
Section 482. Allocation of Income and Deductions Among Taxpayers;
Section 1371(b). Rules Regarding Carryovers and Carrybacks of Subchapter
S Corporations.
The principal judicial limitations include:
The Libson Shops Doctrine;
Business Purpose, Step Transaction and Form Over-Substance Principles.
Many acquisitions and bankruptcy reorganizations will
also involve affiliated corporations filing consolidated Federal
income tax returns ("Consolidated Groups"). In the simple
case, the acquisition group will wish to have the acquiring
company and the loss corporation file consolidated returns in
order to offset future profits against the loss corporation's
NOL. The important Consolidated Return issues include:
SRLY -- Separate Return Limitation Year rules;
Built-in-deductions;
CRCO -- Consolidated Return Change of Ownership limitation;
The implementation of the rules of new Sections 382 to 384 in the
Consolidated Return context;
Disallowance of losses on the disposition of subsidiary stock
in the Consolidated Return context;
Reverse Acquisitions.
The alternative minimum tax (AMT) applies much more
readily to corporations since the Tax Reform Act of 1986. It
will certainly apply to corporations with large NOL relative to
regular taxable income. The rules of Sections 55 and 56 affect
the amount of existing NOL under the AMT and the amount
that may be used in a taxable year.
II. History
Reasons for Change to Section 382 in 1986
Old Section 382 (before 1986) attempted to restrict
"loss trafficking" by limiting the survival of NOL carryovers
after certain changes in ownership of a corporation. However,
it was evident that revisions to old Section 382 were necessary
to correct technical deficiencies and to reduce the number of
circumstances in which loss trafficking was still possible.
The technical defects and discontinuities inherent in old
Section 382 included the following.
(a) Different continuity of interest requirements were
applicable depending upon whether the change in ownership
occurred through a taxable or a tax-free transaction. (1) If the
acquisition of a corporation took the form of a taxable
transaction, a 50 percent continuity of interest was required. If
the transaction was effected in a tax-free manner, only a 20
percent continuity of interest was required. Thus, economically
similar transactions could receive different tax treatment. (2) In
addition, if the purchase rule applied, all NOL carryovers were
lost completely. However, in the case of tax-free acquisitions,
NOL were proportionately reduced if the continuity of interest
requirements were not met.
(b) Different business continuation requirements
existed. In the case of "purchase" transactions, NOL
carryovers were eliminated if the loss corporation changed its
trade or business. In the case of reorganization transactions,
the more liberal continuity of business enterprise requirement
applied. See Treas. Reg. s1.368-1(d).
(c) Taxpayers could use specially tailored classes of
stock, e.g., participating stock, which could shift the beneficial
interests in a NOL carryover without triggering the section 382
requirements.
(d) Old Section 382 did not regulate certain types of
losses. Built-in losses were not governed by old Section 382
even though such losses are economically equivalent to NOL
carryovers. Taxpayers could recognize built-in losses after the
prescribed change in ownership without triggering old Section
382.
(e) Transactions could be designed to escape the old
Section 382 limitations. Such transactions include: (1) Section
351 exchanges, (2) Capital contributions, (3) Liquidation of
partnerships owning stock in a loss corporation, (4)
Acquisitions of interests in partnerships owning loss corporation
stock, (5) "B" reorganizations, (6) Triangular reorganizations
where the measurement of continuing interests allowed for
circumvention of the continuity of interest rules, and (7)
Reverse mergers where taxpayers took the position that the
reorganization rule did not apply to reverse mergers.
Policy Considerations Behind Limitations
Prevention of loss trafficking: The prevention of loss
trafficking is often cited as a justification for imposing special
limitations on NOL carryovers. The ability of a taxpayer to
acquire stock in a corporation for the purpose of obtaining its
tax benefits has long been perceived as an abuse of the tax
system. One of the best examples of Loss trafficking is the
purchase of a shell corporation possessing large NOL
carryovers.
Prevention of windfalls: The full value of a
corporation's NOL carryovers frequently is not reflected in the
purchase price of the corporation's stock. As a result, the new
owners could unjustly receive a windfall when these carryovers
are realized.
Preventing losses of one business from offsetting
gains of an unrelated business: The NOL carryover
provisions were intended to operate as an averaging device to
mitigate the effects of a strict annual accounting system on
businesses with fluctuating income. This justification is a
variant of the "business enterprise" theory first announced in
Libson Shops, Inc., v. Koehler, 353 U.S. 382 (1957), and later
reflected in the regulations such as Treas. Reg. Sections 1.269-
3(b)(1), 1.382-1A(h)(5) and (7).
Losses of certain corporations should not be
subsidized by the Government: Certain loss corporations
may experience continued losses due to heavy debt, rental
obligations, or compensation payments to shareholder-
employees.
Preventing distortion of business transactions: Free
transferability of NOL carryovers could encourage corporate
acquisitions regardless of the business or financial justification
for the transaction.
Possible Modes of Regulation
Several methods of dealing with NOL carryovers have
been proposed.
Refundability: Under this proposal, a loss corporation
would receive a refund directly from the Federal government
equal to the tax savings that would have resulted, if the loss
corporation had sufficient income to offset the loss.
Free transferability: Under this proposal, tax
attributes such as NOL carryovers would be freely transferable
between corporations. No limitations on the use of NOL
carryovers would apply following a change in corporate
control.
Limitation based on stock ownership: The 1976
version of section 382 imposed limitations on NOL carryovers
based solely on shareholder continuity of interest. Since the
shareholders of a loss corporation bear the economic burden of
the losses incurred, the NOL carryover provisions help reduce
this economic loss by allowing future deduction against income.
Thus, there is less of a reason to allow NOL carryovers where
the original shareholders no longer own stock in the loss
corporation.
Limitations based on continuity of business
enterprise: Limitations based on continuity of business
enterprise reflect the theory that the NOL carryover provisions
intended to average out the income of a single business. Once
the business is no longer continued, NOL carryovers should not
be deductible.
Legislative History and Recent Developments
Congress substantially revised old section 382 as part of
The Tax Reform Act of 1976. P. L. 94-455, sections 806(e) and
(f). However, the 1976 amendments were heavily criticized due
to their complexity and inherent arbitrariness. Consequently,
the effective date of these amendments was postponed several
times to permit further study of this area.
In 1982, the American Law Institute (the "ALI")
released its proposed revisions to Section 382. See American
Law Institute, Federal Income Tax Project: Subchapter C, 198-
301 (1982) (the "ALI Proposal"). The ALI proposal contained
two separate sets of limitations ("purchases" and "mergers").
In February, 1985, the American Bar Association (the "ABA")
released its Section 382 proposals.
In September, 1983, the Senate Finance Committee staff
released its preliminary proposals for revising Section 382.
These proposals, like the ALI proposals, contained two sets of
rules which would limit NOL carryovers following a change of
control in the loss corporation.
In May, 1985, the Senate Finance Committee staff
released its final proposals for revision of Section 382. See
Staff, Committee on Finance, The Subchapter C Revision Act
of 1985: A Final Report Prepared by the Staff, S. Rep. No. 47,
99th Cong., 1st Sess. (1985). In contrast to the preliminary
proposals, the final proposals contained a single rule limiting the
use of NOL carryovers following a more than 50 percent
change in ownership of the loss corporation.
In December, 1985, the House of Representatives
passed H.R. 3838, the Tax Reform Act of 1985. In June, 1986,
the Senate passed its version of H.R. 3838. Section 621 of the
Senate version also bore a strong resemblance to the May, 1985
proposals. In August, 1986, House and Senate conferees
reported an agreement on H.R. 3838. The conference report
was formally issued on September 18, 1986, and passed by the
House of Representatives on September 25, 1986 and by the
Senate on September 27, 1986. The President signed the Act
on October 22, 1986. The Act was signed without the technical
changes contained in House Concurrent Resolution 395.
On August 5, 1987, Treasury released temporary and
proposed regulations dealing with limited aspects of new
section 382. See T.D. 8149, 52 Fed. Reg. 29668 (August 11,
1987), 1987-2 C.B. 85.
On March 31, 1988, identical technical corrections bills
were introduced in the House and Senate. See H.R. 4333 and
S. 2238, respectively. These provisions ultimately were enacted
as the Technical and Miscellaneous Revenue Act of 1988, P.L.
100-647 ("TAMRA"). TAMRA made further changes to
Section 382.
The Financial Institutions Reform, Recovery and
Enforcement Act of 1989, P.L. 101-73 ("FIRREA"), moved
back the effective date for the elimination of certain provisions
granting favorable section 382 treatment for insolvent financial
institutions.
Section 7205 of the Revenue Reconciliation Act of
1989, P.L. 101-239 ("RRA 89") made changes affecting the
built-in gain and loss rules of Sections 382 and 384. See H.R.
(Conf.) Rep. No. 386, 101st Cong., 1st Sess. 559 (1989).
On August 13, 1990, Treasury issued proposed
regulations concerning the interrelationship of Sections 382 and
269, and proposed regulations regarding the Section 382(l)(5)
rules for bankruptcy reorganizations. 55 Fed. Reg. 33137 (Aug.
14, 1990), 1990-2 C.B. 682.
On September 5, 1990, Treasury issued temporary and
proposed regulations concerning application of the option
attribution rules in bankruptcy reorganization transactions
covered by Section 382(l)(5). 55 Fed. Reg. 36657 (Sept. 6,
1990), as corrected by 55 Fed. Reg. 36751 (Sept. 6, 1990),
1990-2 C.B. 680.
On January 29, 1991, Treasury issued proposed
regulations primarily under Section 382(m)(2), concerning short
taxable years, and Section 382(m)(5), concerning adjustments
to value and built-in gain or loss in the case of members of a
controlled group of corporations. 56 Fed. Reg. 4183 (Feb. 4,
1991), 1991-1 C.B. 749. Treasury issued proposed regulations
concerning the application of section 382 to affiliated groups
filing consolidated returns, 56 Fed. Reg. 4194 (Feb. 4, 1991),
1991-1 C.B. 728, as well as revisions to the SRLY rules to
more closely coordinate them with Section 382. 56 Fed. Reg.
4228 (Feb. 4, 1991), 1991-1 C.B. 757.
On June 26, 1991, the definitions of loss corporation
and pre-change loss were finalized, as well as the proposed
regulations under Code section 383). T.D. 8352, 56 Fed. Reg.
29432 (June 27, 1991), 1991-2 C.B. 67.
On September 20, 1991, Treasury issued proposed
regulations concerning the treatment of widely held
indebtedness for purposes of Section 382(l)(5)(E). 55 Fed. Reg.
47921 (September 23, 1991), 1991-2 C.B. 909.
On December 31, 1991, the proposed regulations issued
on August 13, 1990 under Sections 269 and 382(1)(5) were
finalized. T.D. 8388, 57 Fed. Reg. 343 (January 6, 1992),
1992-1 C.B. 137.
On March 27, 1992, the proposed regulations issued on
November 20, 1990 dealing with the "entity" definition were
finalized. T.D. 8405, 57 Fed. Reg. 10739 (March 30, 1992),
1992-1 C.B. 146.
On November 4, 1992, Treasury issued proposed
regulations which would treat an option as exercised only if it
was issued or transferred for a principal purpose of
manipulating the timing of an owner shift to avoid or ameliorate
the impact of an ownership change. 57 Fed. Reg. 52743
(November 5, 1992), 1992-2 C.B. 606.
On November 4, 1992, Treasury issued proposed
regulations which would amend the segregation rules to
presume overlapping ownership between existing less-than-5-
percent shareholders and less-than-5-percent shareholders
purchasing stock in a stock offering. 57 Fed. Reg. 52718
(November 5, 1992), 1992-2 C.B. 621.
On November 18, 1992, Treasury issued proposed
regulations to allow the new loss corporation to make a closing-
of-the-books election instead of applying ratable allocation for
NOL carryovers arising in the year of the ownership change. 57
Fed. Reg. 54535 (November 19, 1992), 1992-2 C.B. 602.
On October 4, 1993, the proposed regulations issued
November 4, 1992, under the segregation rules were finalized.
T.D. 8490, 1993-2 C.B. 120.
On March 17, 1994, the proposed regulations issued
May 7, 1993, under section 382(l)(5) were finalized. T.D. 8529,
59 Fed. Reg. 12844 (March 18, 1994).
On March 17, 1994, the proposed regulations issued on
August 5, 1992, under Section 382(l)(6) providing rules for
calculating the increase in the value of a loss corporation
following an insolvency transaction to which Section 382(l)(5)
does not apply were finalized. T.D. 8530, 59 Fed. Reg. 12840
(March 18, 1994).
On March 17, 1994, final regulations were issued under
Section 382 that provide rules on the treatment of options in
determining change for purposes of Section 382. T.D. 8531, 59
Fed. Reg. 12832 (March 18, 1994).
On June 27, 1996, the proposed regulations issued
January 29, 1991 (relative to short taxable years and affiliated
groups filing consolidated returns) were finalized in
substantially similar form. The only major change was a
provision moved from the consolidated return regulations to the
Section 382 regulations. The final regulations are effective as
of January 1, 1997. T.D. 8677 61 Fed. Reg. 33321 (June 27,
1996); T.D. 8678, 61 Fed. Reg. 33395 (June 7, 1996); T.D.
8679, 61 Fed. Reg. 33313 (June 27, 1996).
III. Currently Authorities
Section 108 - Income From Discharge of Indebtedness
The elimination of debt of a corporation can have
special tax consequences. In general gross income does not
include amounts attributable to discharge of indebtedness in a
title 11 case or to the extent the taxpayer is insolvent. Section
108(a). In such cases the corporation is required to reduce
under Section 108(b) certain tax attributes in a prescribed
order, commencing with NOL and including research credits,
general business credits, capital loss carryovers and foreign tax
credit carryovers and, for discharges after 1993, minimum tax
credits and passive activity loss and credit carryovers.
Section 269 - Acquisitions Made to Evade Tax
Any acquisition of a loss corporation can raise a concern
under Section 269, especially where the price paid is
disproportionate to the value of the loss corporation's assets,
other than its tax attributes. Section 269 disallows the benefits
of tax attributes when the principal purpose of acquiring control
of a corporation or the transferred basis property of another
non-commonly controlled corporation is the avoidance or
evasion of tax by securing a tax benefit which would not
otherwise be enjoyed. Control is defined to mean at least 50%
of the voting power or value of all classes of stock.
Section 368 "G" Reorganization
The Bankruptcy Tax Act of 1980 provided a new form
of tax-free reorganization involving companies subject to title
11 cases or similar proceedings. Section 368(a) (1) (G). The
definition of the reorganization requires a transfer of assets to
or from a corporation, so long as one of the parties to the
reorganization is in a title 11 case and the plan of reorganization
is approved by the court, provided there is an exchange that
qualifies under Sections 354, 355 or 356.
Section 382 - Limitation on Net Operating Loss
Unhappiness with old Section 382 before its amendment
("Old Section 382") resulted (as a matter of hindsight) in a
modest revision in 1976 of Section 382. This new version of
Section 382 attempted to provide a more coherent policy
approach to survival of NOL, but general dissatisfaction with
the provision led to the periodic deferral of the effective date of
this revision of Section 382. The Tax Reform Act of 1986
substantially revised Section 382, generally applicable to
periods after December 31, 1986, but with a stock ownership
change look-back provision to May 6, 1986.
There are various special taxpayer transition rules for
Section 382. Section 621(f) (5) of the Tax Reform Act of 1986
provides a generic transition rule under certain circumstances
for companies in a title 11 or similar case if the petition was
filed before August 14, 1986.
(a) Required Change in Ownership
New Section 382 applies only after a change, however
effected, in ownership of more than 50 percent of the stock (by
value) in a loss corporation over a prescribed period of time.
Such a change is referred to as an "ownership change." The
date on which an ownership change occurs is referred to as the
"change date." An ownership change may occur either through
an "owner shift involving a 5-percent shareholder", an "equity
structure shift," or through a combination of the two.
In general, the change in ownership of the loss
corporation must occur within a three-year testing period
ending on the day of any owner shift or equity structure shift.
A shorter testing period applies where a previous change has
occurred during the testing period, or where the loss
corporation's NOL have all originated after the beginning of the
three-year period. Presumably, there will be no ownership
change unless the technical requirements of section 382 are met,
even if a transaction is specifically designed to avoid triggering
an ownership change. LTR 9630017.
(b) Consequences of an Ownership Change
Section 382 places an annual limit on the amount of
post-change taxable income that may be offset by the loss
corporation's pre-change NOL carryovers. The annual amount
of income which may be offset by pre-change NOL carryovers
is an amount equal to the product of a prescribed rate of return
and the value of the loss corporation. However, the annual
limitation may be increased by certain built-in gains of the loss
corporation and section 338 gain as well.
If an ownership change occurs, a loss corporation's
carryovers will be eliminated unless the loss corporation
satisfies the continuity of business enterprise requirement
applicable to reorganizations throughout the two-year period
beginning on the change date.
(c) NOL Subject to Limitation
In general, NOL incurred prior to the ownership change
are subject to the section 382 limitations. NOL generated in the
year of an ownership change are allocated to the periods before
and after the change. That portion allocated to the period after
the ownership change is not subject to limitation; that portion
allocated to the period prior to the ownership change is subject
to the new section 382 limitations, i.e., those losses may only
offset income to a limited extent.
Recently, the Service finalized regulations to allow the
new loss corporation to make a closing-of-the-books election
instead of applying ratable allocation for NOL carryovers
arising in the year of the ownership change. Treas. Reg. s
1.382-6. In addition, if the corporation has built-in losses as of
the ownership change, such losses may also be subject to
limitation.
(d) Effective Date
In general, the new rules will apply to ownership
changes that occur on or after January 1, 1987. The 1954
version of Section 382 will apply to any transactions not
covered by these new rules because of their effective date.
Under the new law, the earliest testing period will not
begin before May 6, 1986. Thus, any changes in stock
ownership occurring before that date will not be considered in
determining if future stock changes constitute an ownership
change.
Section 383 - Special Limitations on Certain Excess Credits, Etc.
Section 383 as revised by the Tax Reform Act of 1986
is supposed to follow the general principles and limitations of
Section 382. The actual application of the Section 382
principles to various credit carryovers (i.e., general business
credit and alternative minimum tax credit), capital loss
carryovers, and excess foreign taxes is provided in Treasury
Regulation Section 1.383-1. The Section 383 rules generally
provide that the various pre-change credits can be used to offset
taxable income (via offsetting tax liability) to the extent that
NOL and capital loss carryovers used in any particular year are
less than the Section 382 limitation. They also provide ordering
rules for the use of losses and credits and procedures for
calculating any remaining Sections 382/383 limitation to be
carried forward. Treasury Regulation Section 1.383-2 has been
reserved for limitations "on certain capital losses and excess
credits in computing alternative minimum tax."
Section 384 - Limitation on Use of Pre-acquisition Losses to
Offset Built-in Gains
Section 384 was added by the Revenue Reconciliation
Act of 1987. Its stated purpose was to prevent a corporation or
Consolidated Group with NOL that acquires assets, or the
stock of a company with assets, that have significant unrealized
appreciation from using its NOL against the recognition of the
unrealized gain on those assets within five years of the
acquisition. TAMRA made significant amendments to Section
384. The most important change is that Section 384 will apply if
either the acquiring or the acquired corporation has significantly
appreciated assets.
Judicial Limitations on Preserving NOL
In Libson Shops v. Koehler, 353 U.S. 382 77 S. Ct.
990, 1 L. Ed. 2d 924 (1957) the Supreme Court adopted a test
of business continuity in limiting the carryover of NOL
following the merger of seventeen corporations. In effect, the
Court prohibited the income from the profitable businesses from
offsetting the losses generated by the NOL companies. In the
Ninth Circuit, Libson Shops, which was decided under the 1939
Code, did not apply to transactions governed by specific
provisions of the 1954 Code. Also see Maxwell Hardware Co.
v Commissioner, 343 F.2d 713 (9th Cir. 1965), and National
Tea Co. v. Commissioner, 83 T.C. 8 (1984).
Section 382 resulted in the demise of Libson Shops for
situations governed by the new law. Conference Committee
Report p. II-194. Any planning must take account of the
judicially imposed principles of business purpose, step
transactions, and form-over substance.
IV. Analysis
The Neutrality Principle
Neutrality as to Corporate Owners: Neutrality means
that NOL carryovers should neither increase nor decrease in
value as a result of changes in corporate ownership. That is,
NOL carryovers should have the same value to the new owners
as they had to the old owners. (1) If the new owners are
permitted to absorb NOL carryovers at a faster rate than the old
owners could, such carryovers would be more valuable to the
buyer than to the seller. (2) If the new owners are denied the
benefits of the loss corporation's NOL carryovers, such
carryovers would be more valuable to the seller than to the
buyer.
The proposals implement this neutrality concept by
limiting the amount of income which the new owners can offset
by the old owners' NOL carryover to an approximation of the
loss corporation's stream of income.
Neutrality as to Business Decisions: Neutrality has
also been expressed by the view that tax considerations should
not interfere with business decisions to purchase, sell, or
combine loss corporations, or to alter or terminate such
corporations' business operations. The extent to which NOL
carryovers are available after a change in ownership is an
important factor that could affect such business decisions.
In general, new section 382 incorporates the neutrality
principle. However, some of its provisions are unnecessary in
light of the neutrality principle. The analysis below describes
new section 382 and points out where some of the new
provisions deviate from the principle.
Consolidated Return Considerations for Corporation
Transactions
The ability to offset one corporation's income with
another corporation's loss is a major advantage of filing
consolidated returns. Buying or selling a member of a
Consolidated Group - whether a single corporation, a chain of
corporations or the whole group - necessarily involves the
intricacies of the Consolidated Return Regulations. IRS also
changes the circular basis rules and the rules for triggering
excess loss accounts. Treas. Reg. Sections 1.1502-11(b) and
1.1502-19.
Tests for Affiliation: The Tax Reform Act of 1984
amendments to Section 1504 materially changed the test for
affiliation. The amendments were designed to eliminate
consolidated return games played by making equity interests
disproportionate to voting power and creating mechanisms that
resulted in "springing" affiliation or disaffiliation of a
corporation, depending on tax attributes of the member and the
group.
Limitations: The income combining advantages of
consolidated returns are limited by a series of rules (SRLY,
Built-in Deductions, CRCO and Reverse Acquisitions) basically
designed to restrict the benefit of offsetting income and loss to
the same corporations of the Consolidated Group (and
indirectly the ultimate owners thereof) that sustained the losses.
See also J. O. & A. B. Spreckels Co. v. Commissioner, 41
B.T.A. 370 (1940) (business purpose); Canaveral Corp. v.
Commissioner, 61 T.C. 520 (1974) (application of Section
269). The impact of these rules is generally avoided by
combining the income-producing businesses and the loss
businesses in a single corporate entity. Such combination can
itself produce new problems. Section 269(b) plan of liquidation
adopted within two years after a Section 338 qualified stock
purchase; Section 384 limitation on use of pre-acquisition losses
to offset built-in gains.
Consolidated NOL Deduction: The consolidated
NOL deduction of the Consolidated Group is the aggregate of
the individual members' net operating loss carryovers and
carrybacks to the year. In general, the consolidated NOL
deduction is limited to NOL of the same members and their
predecessors that originally sustained the NOL.
Current SRLY Rules: A Separate Return Limitation
Year ("SRLY") is, generally speaking, a year of a member (or
predecessor) other than the Common Parent, during which it
filed a separate return, or joined in the filing of a consolidated
return with another group. Treas. Reg. Section 1.1502-1(f).
The application of the SRLY concept has been changed
pursuant to Temporary Regulations, effective for taxable years
beginning on or after January 1, 1997 and electively for prior
years as well.
Temporary SRLY Rules: The Temporary SRLY
Consolidated Return Regulations filed in June, 1996 make
significant changes in the application of the SRLY concept to
Consolidated Groups. First, fragmentation is eliminated under
certain circumstances. Temp. Treas. Reg. s1.1502-21T(c) (2).
This is a significant beneficial change. Second, the SRLY
limitation contains a cumulative concept applicable to both
NOL and contribution to consolidated income. Treas. Reg.
Section 1.1502-21T(c) (1). Third, the built-in loss rules are
coordinated for purposes of Section 382 and SRLY. Fourth,
the "offspring rule" is significantly altered. Temp. Treas. Reg.
Section 1.1502- 21(b)(2) (ii) (B). While references herein are to
NOL, substantially similar rules apply to capital losses and
Section 1231 losses. Temp. Treas. Reg. Section 1-15- 2-
22T(c).
Built-in Deduction Rules: A built-in deduction in
general is a deduction of a corporation recognized in a
consolidated return year, but which is economically accrued in a
SRLY. Treas. Reg. Section 1.1502-15(a). The built-in
deduction limitations of the current Consolidated Return
Regulations do not disallow the deduction to the loss member in
calculating its taxable income, but limit its use against
consolidated income. Treas. Reg. s1.1502-15A(a)(1).
Temporary SRLY Built-in Loss Rules: Temp. Treas.
Reg. Section 1.1502-15T (June, 1996), essentially adopts the
Section 382 definitions of built-in losses, including the new
threshold rules. Losses characterized as built-in losses are
treated as hypothetical net operating losses or capital losses
arising in the year of recognition and such year is treated as a
SRLY.
A Consolidated Return Change of Ownership
("CRCO") is an Old Section 382(a) type increase of more than
fifty percentage points of ownership of the fair market value of
the stock (except non-voting preferred) of the Common Parent
by its ten largest shareholders over two years. Treas. Reg.
Section 1.1502- 1(g).
The Consolidated Return Regulations had their own
Section 382 limitations on survival of NOL. Treas. Reg.
Sections 1.1502-21A(e), -22(e). They had not been modified to
account for the Tax Reform Act of 1986 but have been replaced
by the Temporary Consolidated Return Section 382 rules.
The Temporary Section 382 Consolidated Return
Regulations: On June 25, 1996, the Service filed three sets of
Temporary (and final in some instances) Regulations. One set
involved various consolidated return issues, including a repeal
of the CRCO rule and a major overhaul of the SRLY rules. A
second set involved the application of Section 382 in the
controlled group context, which will be discussed briefly below.
A third set deals with the application of Section 382 in the
consolidated return context. This third set of Temporary
Regulations (Temp. Treas. Reg. Sections 1.1502-90T through
1.1502-99T) will be the main focus of this section of this
outline.
Loss Disallowance Rules: Treas. Reg. Sections 1.1502-
20 and 1.337(d)-2 were finalized and Treas. Reg. Section
1.337(d)-1 was amended on September 13, 1991 ("loss
disallowance rules"). In general, the regulations disallow the
deduction of any loss recognized upon the "disposition" of the
stock of a member of the Consolidated Group after February 1,
1991. Treas. Reg. Sections 1.337(d)-1 and -2 provide
transitional rules for stock dispositions after January 6, 1987.
Alternative Minimum Tax (AMT)
The AMT as modified by the Tax Reform Act of 1986,
now applies to corporations in much the same way as it has
applied to individuals. A corporation will be subject to the
AMT to the extent that its Tentative Minimum Tax exceeds its
regular tax. Section 55(a). Since many profitable corporations
with NOL or credit carryovers will have no regular tax, it is
quite certain that they will be subject to the AMT. On
December 29, 1992, the Service issued Proposed Regulations
applying the AMT rules in the consolidated return context.
Alternative Tax Net Operating Loss (ATNOL)
Pre-1987 NOL will be treated as ATNOL without
adjustment. Section 56(d)(2)(B). Post-1986 NOL are to be
adjusted by the adjustments of Sections 56 and 58 and reduced
by the preferences of Section 57 in order to arrive at the
ATNOL. Section 56(d)(2)(A). The ATNOL can only offset
90% of AMTI computed prior to taking the reduction. Section
56(d)(1)(A). This limitation is computed separately from any
Section 382 limitation and ignores any deemed closing of the
books for such computation. See, e.g., Priv. Ltr. Rul. 95-29-
041 (April 28, 1995). Therefore, even corporations with very
large NOL will pay a 2% tax (20% of 10%) on AMTI before
ATNOL deductions.
Section 382 NOL Limitation Rules -- Overview
Under Section 382, a debtor corporation's NOL
carryovers may be limited if certain changes in stock ownership
occur. Accordingly, these limitations may be triggered by a
debtor corporation's issuance of stock in exchange for its
outstanding debt.
The goal of a corporate debtor in restructuring its debt
generally is to preserve the full use and amount of the
corporation's net operating loss (NOL) carryovers and other
valuable tax attributes. Indeed, the continued viability of the
corporation following a debt workout often turns upon the
extent to which this objective is met. One strategy frequently
adopted by the corporation to meet this goal involves the
issuance of stock in exchange for outstanding debt. The success
of this strategy depends upon the corporation's ability to
overcome the hurdles posed by Sections 108 and 382.
Ownership Changes
The Section 382 loss limitations apply to a "loss
corporation" that has experienced an "ownership change." A
"loss corporation" generally refers to a corporation entitled to
use an NOL carryover or having an NOL for the taxable year in
which an "ownership change" occurs. Pursuant to Section
382(g)(1), an ownership change is deemed to occur if: (A) the
percentage of stock of the loss corporation owned by one or
more 5-percent shareholders has increased by more than 50
percentage points, over (B) the lowest percentage of stock of
the loss corporation owned by such shareholders at any time
during the testing period.
Thus, the corporation must compare the current
percentage interest of each 5-percent shareholder with the
lowest percentage interest of that shareholder during the testing
period. If the percentage increase, as to those 5-percent
shareholders who have experienced an increase in their interest
during the testing period, exceeds 50 percentage points in the
aggregate, then an ownership change has occurred.
The ownership change calculation must be made at the
close of any "testing date." In general, a testing date is the date
on which occurs any "owner shift involving a 5-percent
shareholder." An owner shift involving a 5-percent shareholder
is deemed to occur if there is a change in the respective
ownership interests in the loss corporation and such change
affects the ownership interest of one or more 5-percent
shareholders. Certain issuance or transfers of options to
acquire loss corporation stock may also give rise to a testing
date.
The testing period generally is the three-year period
ending on the testing date. A shorter testing period may apply,
however, where a previous ownership change has occurred
during the normal three-year period, or where the loss
corporation's losses have originated after the beginning of such
three-year period.
Determination of Stock Interests
In essence, Section 382(g) requires the loss corporation
to track changes in its stock ownership to determine if an
ownership change occurs. However, in order to monitor such
changes, the loss corporation must first determine which
ownership interests constitute "stock" for Section 382
purposes. This determination is often very complicated and
uncertain. Under Section 382(k)(6), the term "stock" means all
stock other than stock described in Section 1504(a)(4). In
general, Section 1504(a)(4) describes stock which is nonvoting,
non-participating, non-convertible, limited and preferred as to
dividends, and not entitled to an unreasonable redemption or
liquidation premium. However, certain ownership interest that
would otherwise constitute "stock" will not be treated as stock
for purposes of Section 382. Conversely, certain ownership
interest that would otherwise not constitute "stock" will be
treated as stock for purposes of Section 382. As the context
may require, loss corporation stock also includes indirect
ownership interests in the loss corporation.
Identification of 5-Percent Shareholders
After the loss corporation has determined which
interests constitute "stock" for Section 382 purposes, it then
must identify which persons will be treated as 5-percent
shareholders. A 5-percent shareholder refers to any person
holding five percent or more of a loss corporation's stock (on
the basis of value) at any time during the testing period.
Shareholders who own less than five percent are aggregated
and treated as one 5-percent shareholder.
Section 382 NOL Limitation Rules
General NOL Limitation Rules
Section 382, if applicable, generally does not reduce the
amount of a loss corporation's NOL carryovers. Rather,
Section 382 generally limits the amount of income generated
after an ownership change that may be offset by losses accrued
prior to the ownership change. That is, Section 382(a)
generally provides that the taxable income of the loss
corporation for any post change year which may be offset by
pre-change losses shall not exceed the Section 382 limitation for
such year.
The Section 382 limitation is an amount equal to the
product of the "value of the loss corporation" and the "long-
term tax-exempt rate." The "value of the loss corporation," in
general, is measured by the value of the corporation's stock
immediately before the ownership change. The "long-term tax-
exempt rate" is based on the adjusted Federal long-term rates in
effect during the calendar year in which a change date occurs.
If the amount of post-change year income is less than the
Section 382 limitation, the unused Section 382 limitation
amount may be carried forward to subsequent years.
Special Rules Relating to the Section 382 Limitation
Valuation Rules: As discussed above, the Section 382
limitation amount is based, in part, on the value of the loss
corporation's stock immediately following an ownership
change. The value of a loss corporation's stock is, however,
subject to various adjustments. In addition, under Section
382(l)(4), if one-third or more of the value of a loss
corporation's assets immediately after an ownership change
consists of "non-business assets," the value of the loss
corporation is reduced for purposes of computing the Section
382 limitation. A "non-business asset" is any asset held for
investment. This limitation could apply to a loss corporation
that sells its assets prior to an ownership change and continues
to hold the proceeds as of the change date.
Net Unrealized Built-in Gains and Losses: The
Section 382 limitation amount can also be affected to the extent
that the loss corporation has a net unrealized built-in gain.
Under Section 382 (h)(1)(A), if the loss corporation has a net
unrealized built-in gain, the Section 382 limitation may be
increased if the corporation recognizes such gains during the
recognition period. Conversely, under Section 382(h)(1)(B), if
the loss corporation has a net unrealized built-in loss,
recognized built-in losses will be subject to Section 382.
Continuity of Business Requirement: Section
382(c)(1) provides that the loss corporation must satisfy the
continuity of business enterprise requirement applicable to
reorganizations throughout a two-year period beginning on the
change date. Failure to satisfy the two year continuity of
business enterprise requirement will result in the Section 382
limitation generally being reduced to zero. Under the tax- free
reorganization provisions, the continuity of business enterprise
doctrine requires that a corporation (which is a party to a tax-
free reorganization) retain a significant portion of its historic
business or assets.
Special Rules for Mid-Year Ownership Changes
Section 382 contains a number of special allocation
rules that apply where the post-change year includes the change
date, i.e., where an ownership change occurs during the loss
corporation's taxable year and the year remains open. In such
cases, Section 382(b)(3) requires that two types of allocations
be made: (i) an allocation of taxable income; and (ii) an
allocation of the Section 382 limitation amount. These special
allocation rules are discussed below.
Allocation of Taxable Income: Pursuant to section
382(b)(3)(A), a loss corporation's taxable income for the
ownership change year is required to be allocated to the period
on or before the change date. Taxable income so allocated may
be fully offset by the loss corporation's NOL carryovers
without regard to the Section 382 NOL limitation rules.
Conversely, taxable income allocated to the period after the
change date is subject to the NOL limitations under Section
382(a). While Section 382(b)(3)(A) generally requires that
taxable income be allocated ratably to each day of the year, a
loss corporation may apply to the Service for a ruling to
allocate its taxable income or NOL between the pre- change
period and the post-change period the basis of a "closing of the
books."
Allocation of the Section 382 Limitation Amount:
Pursuant to Section 382(b)(3)(B), the Section 382 limitation
amount is also subject to allocation. The Section 382 limitation
for the ownership change year is prorated based on the ratio of
the number of days in the year after the change date to the total
number of days in the year. The portion of the loss
corporation's taxable income allocable to the post-change
period may be offset by pre-change period NOL only to the
extent of the prorated Section 382 limitation amount.
However, under Section 382(h)(5)(B), the Section 382
limitation is computed without regard to recognized built-in
gains. Thus, any increase in the Section 382 limitation for
recognized built-in gains is not allocated on a daily basis, but
instead is fully reflected in the Section 382 limitation.
Application of Section 382(l)(5)
(a) Eligibility
Under Section 382(l)(5)(A), the general rules of Section
382(a) do not apply to an ownership change if: (i) the loss
corporation, immediately before the ownership change, was
under the jurisdiction of a court in a Title 11 or similar case; and
(ii) the corporation's shareholders and creditors (determined
immediately before the ownership change) own 50 percent (in
vote and value) of the loss corporation's stock immediately
after the ownership change. The loss corporation's shareholders
and creditors must own at least 50 percent of the loss
corporation's stock as a result of being shareholders and
creditors immediately before the ownership change. Under
Notice 88-57. Stock described in section 1504(a)(4) ("pure
preferred stock") is treated as debt for purposes of Section
382(l)(5).
(b) Effect of Section 382(l)(5)
As discussed above, the principal benefit of applying
Section 382(l)(5) in a Title 11 or similar case is that a loss
corporation's NOL carryovers are not subject to the general
Section 382(a) rules after an ownership change. In addition, the
Section 382(c) continuity of business enterprise requirement is
not applicable. If, however, a loss corporation does not elect
out of the general Section 385(l)(5) rule, the loss corporation's
NOL carryovers and other tax attributes are subject to the
following reductions.
First, the loss corporation's pre-change NOL carryovers
and credits are computed as if no deduction was allowable for
interest paid or accrued during the current year (up to and
including the ownership change date) and the three preceding
taxable years on debt that was converted into stock as part of
the Title 11 or similar case proceedings.
Second, if the claims of creditors discharged in
bankruptcy exceed the value of the stock transferred to
creditors and such excess would have been applied to reduce
attributes but for the stock-for-debt exception of Section
108(e)(10)(B), then the loss corporation's NOL carryovers and
other tax attributes must be reduced by 50 percent of such
excess. In applying the foregoing attribute reduction rule, the
amount of debt exchanged for stock subject to such rule shall
not include debt issued on account accrued but unpaid interest
that is also subject to disallowance pursuant to Section
382(l)(5).
Finally, if a second ownership change occurs during the
two-year period immediately following an ownership change
that is subject to the general rule under Section 382(l)(5), then
the Section 382(l)(5) general rule will not apply to such
subsequent ownership change. In addition, the Section 382
NOL limitation with respect to such second ownership change
will be zero.
(c) Election Out of Section 382(l)(5)
A loss corporation otherwise qualifying under Section
382(l)(5)(A) may elect not to have such provisions apply. If a
loss corporation makes such an election, the Section 382 NOL
limitation rules discussed above would generally apply.
However, the Section 382 limitation amount under such rules
may, as discussed below, be increased pursuant to Section
382(l)(6).
Section 382(l)(6) generally applies to any ownership
change occurring pursuant to a plan of reorganization in a Title
11 or similar case where Section 382 (l)(5) does not apply.
Under Section 382(l)(6), the value of a loss corporation reflects
any increase in value resulting from the surrender or
cancellation of creditors' claims in connection with the
transaction.
The Service recently issued proposed regulations under
Sections 382(l)(5) and (6). Under these regulations, the value
of a loss corporation for purposes of computing the Section 382
limitation is generally equal to the lesser of: (1) the value of the
stock of the loss corporation immediately after the ownership
change, or (2) the value of the loss corporation's pre-change
assets. In adopting this approach, the Service explicitly
recognized that debt may be converted into stock either by: (i) a
direct issuance of debt for stock, or (ii) through issuance of new
stock for cash, where the cash is used to retire outstanding
debt. In either case, the old debt is converted into stock, and
because the two methods are economically equivalent, the
Service sought to apply the benefits of Section 382(l)(6) in both
cases.
Under the proposed regulations, all increases in the
value of the loss corporation resulting from a bankruptcy
reorganization are treated as attributable to the conversion of
debt into stock. However, a limitation applies if the value of
the loss corporation's stock exceeds the value that would have
resulted if the loss corporation's creditors had exchanged all of
their debt for stock (since such excess cannot result from the
direct or indirect conversion of debt into stock). In these
circumstances, the value of the loss corporation is limited to a
value which approximates the value of the loss corporation's
stock if the corporation's creditors had exchanged all of their
debt for stock.
The proposed regulations also contain a number of rules
that coordinate Section 382(l)(6) with other provisions that may
affect valuation. In addition, the proposed regulations provide
that a Section 382(l)(5)(H) election must be made on the return
for the year in which the ownership change occurs. Once made,
the election is irrevocable.
Interrelationship of NOL-related IRC Sections 269, 382, and 384
The limitations of Section 384 are to apply
independently of, and in addition to, Section 382. See Staff,
Joint Committee on Taxation, Description of the Technical
Corrections Act of 1988, at 421 (1988) ("General
Explanation"). See also H.R. Rep. No. 795, 100th Cong., 2d
Sess. 412 (1988) ("House Report"); S. Rep. No. 445, 100th
Cong., 2d Sess. 436 (1988). Thus, for example, it is possible
that both section 382 and 384 will apply as the result of a single
transaction (e.g., gain corporation acquires loss corporation).
Dual application of these sections creates enormous complexity.
Section 384 overlaps to some extent with Section
269(a), except that Section 269(a) may apply where the loss
corporation acquires only 50 percent control of the profitable
corporation. In contrast to Section 269, however, Section 384
is not dependent on the subjective intent of the acquiring
corporation. Also, losses may be disallowed if Section 269
applies, whereas Section 384 only prevents preacquisition losses
from offsetting another corporation's recognized built-in gains.
As originally drafted, Section 384 essentially was the
converse of Section 269(b) (profitable corporation makes a
qualified stock purchase of a loss target without electing
Section 338 and liquidates target). However, revised Section
384 now overlaps to some extent with Section 269(b) except
that no liquidation is needed to trigger section.
Section 384 also overlaps with the SRLY rules where a
gain corporation acquires the stock of a loss corporation (unless
the acquisition is a reverse acquisition, in which case Section
384 generally would apply but not the SRLY rules).
Discussions on Loss Disallowance Rules -- Investment Adjustment Rules
The investment adjustment rules under Treas. Reg.
Section 1.1502-32 require that annual adjustments be made to
the basis of the stock of each subsidiary of a consolidated
group. The adjustments are designed to ensure that
consolidated group members pay a single corporate tax on the
group's income and use losses only once.
The new regulations also make various conforming
changes to the loss disallowance rules. The bulk of the changes
are to replace references to earnings and profits with references
to gain, income, loss, deduction, and so on as the context may
require. In several cases, however, a change to a particular rule
is significant. Such changes are described in the examples which
follow.
Recently, the IRS issued final regulations that revise the
inter-company transaction rules. See T.D. 8597, 60 Fed. Reg.
36, 671 (July 18, 1995). These regulations make a number of
changes to the loss disallowance rules.
Despite the reassurances of Notice 87-14, the loss
disallowance rules (with one minor exception) do apply to
subsidiaries acquired prior to January 7, 1987. That exception,
as shown in the table above, exempts subsidiaries acquired
before January 7, 1987 which are disposed of on or after
January 7, 1987 but before November 19, 1990.
Loss Duplication
In developing the original regulations pursuant to Notice
87-14, IRS also became concerned with the potential
duplication of losses by a subsidiary after the subsidiary left the
group. Preamble to the original -20T regulations, 55 Fed.
For example, P forms S with a contribution of $100. S
has an operating loss of $60, which the P group is unable to use
on its consolidated return.
P's basis in its S stock remains at $100. The current
deficit in earnings and profits decreases P's basis in S by $60.
Prior Treas. Reg. Section 1.1502-32(b)(2)(i). Because the loss
is not utilized, P's basis in S is increased by $60. Prior Treas.
Reg. Section 1.1502-32(b)(1)(ii).
Again, under the new regulations this result does not
change. Treas. Reg. Section 1.1502-32(b)(2) and (3).
P sells S to X for $40, recognizing a $60 loss. S is
apportioned its $60 net operating loss carryover when it leaves
the P group. Treas. Reg. Section 1.1502-79. P's loss on the
sale of S is duplicated when S uses its loss after leaving the P
group. S is restricted in its use of its apportioned losses by
Section 382, Treas. Reg. Section 1.1502-21, Treas. Reg.
Section 1.1502-22 (SRLY rules), etc.
Loss duplication can also occur if S uses the $100
contributed by P to purchase an asset and the asset declines in
value to $40. When P sells S for $40, P recognizes a $60 loss.
When S later sells the built-in loss asset, it duplicates P's loss.
S's loss would be subject to Section 382(h), Treas. Reg.
Section 1.1502-15 (built-in deductions, etc.).
Loss duplication is not unique to consolidated returns; it
also exists when separate returns are filed. Arguably, Congress
has already addressed the problem in Sections 382, 384 and 269
(not to mention the Treasury's own response in Treas. Reg.
Sections 1.1502-15, 1.1502-21, and 1.1502-22).
In the preambles to the proposed and final regulations,
the IRS reaffirmed its concern with loss duplication.
Reorganization Loopholes
The successor rule (and deconsolidation rule) also apply
when a parent exchanges loss subsidiary stock for other stock in
a tax-free reorganization or in a Section 351 transaction with a
non-member.
For example, P owns all the stock of S which is worth
$100. P's basis in the S stock is $150. P wants to dispose of S,
but wants to recognize the built-in loss. X wants to acquire S
for $100.
P transfers the S stock to X solely in exchange for X
common stock worth $100 is a B reorganization. X and S file a
consolidated return. X does not become a member of the P
group. P has a $150 basis in its X stock. Section 358. P later
sells the X stock for $100, resulting in a $50 loss.
The B reorganization triggers the successor rule and
deconsolidation rule. Treas. Reg. Section 1.1502-20(d)(2),
Example 1.
The X stock is treated as a successor interest to the S
stock because P's basis in the X stock is determined by
reference to P's basis in the S stock.
The B reorganization is treated as a deconsolidation
event. According to the IRS, the purposes of Treas. Reg.
Section 1.1502-20 require basis reduction because otherwise P
would be permitted to recognize the $50 loss that was
attributable to the S stock. P must reduce its basis in the S
stock immediately before the deconsolidation from $150 to
$100. Upon the exchange of the S and X stock, P takes a $100
basis in its X stock. No loss is recognized on P's sale of the X
stock.
However, the deconsolidation rule is not applied to the
S stock acquired by X because S is a member of the X
consolidated group. Under Treas. Reg. Section 1.1502-
20(b)(2), a deconsolidation does not occur with respect to
subsidiary stock that is owned by a member of any consolidated
group of which the subsidiary is also a member. Thus, X takes a
$150 basis in its newly-acquired S stock. Section 362.
In the proposed loss disallowance regulations, the
example provided that the application of the deconsolidation
rule required X to take a $100 basis in its S stock rather than a
$150 basis.
Preserving Built-in Loss of Lower Tier Subsidiary
The deconsolidation rule operates to preserve the built-
in loss in lower tier subsidiary stock.
For example, P owns the stock of S and S owns the
stock of T. P has a $200 basis in S. S's only asset is its T
stock, which has a $200 basis and $100 value.
P sells all of the stock of S to X for $100, resulting in a
$100 disallowed loss. X, S and T file a consolidated return.
Because T is still owned by a member of a consolidated
group, the deconsolidation rule does not apply. Treas. Reg.
Section 1.1502-20(b). S's basis in T remains at $200.
X may expect post-acquisition appreciation to be
sheltered by the loss with respect to the T stock. Alternatively,
X may be willing to "stuff and wait" two years and avoid the
application of the anti-stuffing rule.
In anticipation of a possible sale, consolidated groups
may want to preserve a lower tier subsidiary stock's built-in
loss by arranging for a member holding company to own the
stock.
However, if a holding company is formed in a Section
351 transaction and the holding company's stock is sold shortly
thereafter, the step transaction doctrine may be applied to
disqualify the stock contribution as tax-free under Section 351.
See Intermountain Lumber Co. v. Commissioner, 65 T.C. 1025
(1976); Rev. Rul. 70-140, 1970-1 C.B. 73.
Additionally, the contribution of a lower-tier
subsidiary's built-in loss stock to a holding company with a
view to selling the holding company stock and avoiding the loss
disallowance rule may trigger the anti-stuffing rule when the
holding company's stock is sold.
Loss Duplication in the Separate Return Context
Loss duplication could also occur when a member of a
non-consolidated (but controlled) subgroup disposes of a loss
asset to a member of a consolidated group under the recently
superseded temporary Section 267 regulations.
For example, P1 is the common parent of the P
consolidated group. P also owns 75% of the stock of S. The
remaining S stock is owned by X, an unrelated investor. S
forms T with $500. S and T file separate returns.
T buys an asset for $500. The asset later declines in
value to $100. T sells the asset for $100 to P1, a subsidiary in
the P consolidated group. T's $400 loss is deferred. Prior
Treas. Reg. Section 1.267(f)-1T(c)(1)(in effect for years prior
to 1996).
S then sells T to Y, an unrelated investor, and
recognizes a $400 loss. T's deferred loss is not restored.
Treas. Reg. Section 1.267(f)-1T(c)(6). However, P1 is
permitted to increase the basis in its asset in an amount equal to
the unrestored deferred loss -- $400. Prior Treas. Reg. Section
1.267(f)-1T(c)(7). Thus, P1 has a $500 basis in its asset.
P1 sells the asset for $100 outside the group and
recognizes a $400 loss, duplicating S's investment loss in T.
P1's loss is available for use on the P group's
consolidated return, but it may be limited by the built-in
deduction rules of Treas. Reg. Section 1.1502-15.
S and T also could duplicate the loss by selling the asset
outside the group. If T sells the asset to an unrelated investor
and S then sells T to Y, loss duplication would occur. S's
investment loss would remain on the separate return of S. T's
loss on the sale of the asset would remain on T's separate
return, unless T joined the Y consolidated group, in which case
its loss would be limited by Section 382, Treas. Reg. Section
1.1502-21 (SRLY rules), etc.
The recently finalized Section 267(f) regulations, issued
along with the inter-company transaction regulations, would
eliminate many of these planning opportunities for years
beginning after 1995. See also the anti-avoidance rule of Reg.
Section 1.267-1(l)(2).
V. Conclusions and Recommendations
Planning to Preserve NOL in Corporate Transactions
Under the current regulations, corporations can make
careful plans for the NOL-related transactions. Corporations
can take steps to avoid ownership changes by (1) issuing debt
instruments, (2) selling or leasing out Loss Corporation's
assets, and /or (3) using subsidiary tracking stock.
In addition, corporations can plan to increase the
Section 382 limitation on NOL by utilizing (1) corporate
combinations prior to the ownership changes, and / or (2)
leveraged buyout transactions.
Furthermore, corporations can use general planning
techniques such as (1) Loss Corporation purchases assets of
Profit Corporation, and (2) Loss Corporation acquires Profit
Corporation's stock. One of the most important factor is
closely monitoring the stock ownership.
Examples of Planning Techniques
Example (1). Leveraged buy-out (LBO) transaction
P wishes to acquire L using borrowed funds. L is worth
$100 million. P forms N and contributes $10 million. N
borrows $90 million and contributes $100 million ($90 million
plus $10 million) to N-1. N-1 is merged into L, with L
surviving. L's shareholders receive the $10 million in exchange
for the L stock. The bank requires that L and N be combined.
If N is merged into L, the transaction should be viewed as a
redemption by L of $90 million of its stock. L's value for
computing the Section 382 limitation would be $10 million.
However, if L is merged into N, the transaction should
be viewed as a purchase of L stock. L's value for computing
the Section 382 limitation would be $1million. Under TAMRA,
the upstream merger may be treated as a redemption, even
though the transaction is treated as a purchase for other tax
purposes.
Example (2). Loss Corporation purchases assets of Profit
Corporation
L is owned by A, B and C. L conducts business X. P
conducts business Y, and L would like to acquire that business.
A, B and C contribute cash to L, and L uses the money to
acquire the assets of the Y business. Shortly thereafter, L
terminates its business X. L's NOL carryovers should be able
to offset income generated by its new business Y. Sections
269(a) and 382 do not apply. Libson Shops Doctrine should
not apply.
Example (3). Insolvent Corporations
L has a $10 million NOL carryover. L has $3 million in
assets and $7 million in liabilities. L is wholly owned by A.
Investor B has a profitable business, P. He wishes to use L's
NOL to shelter income from the business. B cannot simply buy
A's stock. This would result in an ownership change.
Because L's value is zero, the NOL would be useless.
Consistent with section 382, B may receive up to 50 percent of
the value of L in common stock, participating preferred stock or
convertible preferred stock in exchange for a capital
contribution of the profitable business. The remainder of the
value may be received in the form of debt or straight preferred
stock. As a practical matter, B will want to take the maximum
out in the form of preferred stock or debt, since any value
adhering to A's interest is a windfall.
However, to the extent L remains insolvent or is only
marginally solvent, the Service may take the position that the
creditors own "stock" in the company, or that the straight
preferred stock is stock since it participates in corporate
growth, therefore prompting an ownership change.
There can be no assurance that this type of restructuring
will work in any given transaction. There are too many
unresolved factual issues, including what constitutes stock, and
the valuation of each such class. Further, while a transaction
may work for Section 382 purposes, the Service may take the
position that Section 269 nonetheless applies.
Modes of Attack on Section 384
It is uncertain how the Section 704(c) regulations will
deal with the ceiling rule problem. In the meantime, this
planning device should not be subject to attack under the
substantiality regulations since those regulations defer to the
Section 704(c) rules. See Treas. Reg. Section 1.704-
1(b)(1)(vi).
Where a loss corporation is the cash contributing
partner, Section 382 should not apply either, since no
ownership change occurs in the formation of a partnership. In
addition, regulatory authority under Section 382(m)(3) should
not apply if the allocations of all partnership items are consistent
with the partners' interest in the partnership (with the specific
exclusion for Section 704(c) allocations). See Staff of the Joint
Committee on Taxation, General Explanation of the Tax
Reform Act of 1986, at 327 (1987), excepting qualified
partnership allocations under Section 168(j)(9)(B), now section
168(h)(6)(B).
However, Treasury has authority to attack these cases
under Section 384(f)(1), although it is difficult to see: (1) how
Section 384(a) is triggered by the formation of a partnership,
and (2) how the ceiling rule causes built-in gain to be
recognized. In any event, regulations under section 384(f)(1)
will be prospective only. H.R. Rep. No. 495, 100th Cong., 1st
Sess. 974 (1987).
In addition, the potential to use partnerships to avoid the
corporate level tax on future income derived from property
contributed by a corporation to a partnership may be restricted
by regulations promulgated under Section 337(d). First, the
legislative history indicates that Section 337(d) will be used to
prevent partners from using the ceiling rule to defer the
recognition of built-in gain to a corporate partner. H.R. Rep.
No. 795, 100th Cong., 2d Sess. 65 (1988). Second, it is
uncertain whether regulations under section 337(d) will be
retroactive.
Recommendations
To achieve the neutrality principle, the Internal Revenue
Service should eliminate the NOL-related regulation loopholes
such as loss duplication.
(1) Neutrality as to corporate owners: NOL carryovers
theoretically have equal value to the old and new owners if such
carryovers can be offset by the same level of income after the
acquisition as was generated by the corporation before the
acquisition. However, as described in above analysis, this
principle is not always achieved in different scenarios.
(2) Neutrality as to business decisions: The extent to
which NOL carryovers are available after a change in ownership
is an important factor that could affect business decisions in
corporate transactions. As described in the above analysis,
business decision makers may choose different planning
techniques to achieve more favorable results in preserving
NOL.
The NOL-related regulations are effective as to most
business transactions, but are still far away from fully achieving
the legislative goals and principles.
Appendix: List of References
Hyman and Hoffman, "Consolidated Returns: Summary of Tax
Considerations in Acquisition of Common Parent or Subsidiary
Member of Affiliated Group", 33 Tax Lawyer 383 (1980)
Goldman, "Joining or Leaving an Affiliated Group Which Files
a Consolidated Return: A Checklist for the Agreement", 36 Tax
Law Review 197 (1981)
Mark J. Silverman and Kevin M. Keyes, "Section 382 of the
Internal Revenue Service Code of 1986", Practising Law
Institute, October-November, 1996
David M. Einhorn, Peter C. Canellos, and Jodi J. Schwartz,
"Critical Federal Income Tax Issues Relating to Corporate
Restructurings", Practising Law Institute, October-November,
1996
Mark J. Silverman and Kevin M. Keyes, "Section 384 of the
Internal Revenue Code of 1986", Practising Law Institute,
October-November, 1996
Kevin M. Keyes, "Selected Issues under Sections 108 and 382",
Practising Law Institute, October-November, 1996
(end)