Ownership Changes and Their Impact on Net Operating Losses: Tough to Avoid and Hard to Control
Corporate & Finance Alert
May 5, 2009
While many small business companies and real estate entities are structured as S corporations, partnerships, or limited liability companies treated as partnerships for federal income tax purposes, nearly all publicly traded companies, most large entities, and many older business entities are structured as C corporations for income tax purposes. One advantage of C corporations, unlike their pass-through brethren, is that they can directly make use of net operating loss carrybacks and carryforwards.
Under Section 172(b) of the Internal Revenue Code of 1986, as amended (the “Code”), net operating losses (“NOLs”) can be carried back to the two prior taxable years and carried forward to the succeeding twenty years. The American Recovery and Reinvestment Act of 2009 allows a corporation with average annual gross receipts of less than $15,000,000 to elect to carry back an NOL generated in a tax year ending in 2008 for up to five years.
In the current down economic climate, many corporations have accumulated substantial net operating losses that may possess significant value if the corporation can offset them against income. For example, Citigroup’s Form 10-K fiscal 2008 lists a deferred federal tax NOL asset for financial accounting purposes of a staggering $13 billion.
Critically, however, a corporation that undergoes an “ownership change” will be greatly limited in its use of those NOLs, and under a couple of scenarios, the NOLs can be lost altogether.
1. Code Section 382 and Ownership Changes
More specifically, if as a result of a stock transfer or a reorganization, a corporation undergoes an “ownership change,” Code Section 382 limits the corporation’s right to use its NOLs each year thereafter to an annual percentage (for May 2009, the federal long-term tax-exempt rate is 4.61%) of the fair market value of the corporation at the time of the ownership change (the “Section 382 Limitation”). For example, if a corporation with current NOLs of $20 million underwent an ownership change this month, and assuming that the value of the stock of the corporation is worth only $5 million, the corporation’s annual Section 382 Limitation is $230,500 ($5,000,000 x 4.61%). Over twenty years, the maximum amount of NOLs that the corporation will be able to use is now $4,610,000 ($230,500 x 20 years), effectively losing a NOL tax asset of $15,090,000.
In addition, if an ownership change under Code Section 382 is triggered, a corporation’s “built-in losses,” which include certain built-in deductions, that are recognized during a five-year recognition period after the ownership change, are treated as pre-change losses subject to the Section 382 Limitation. The combination of these rules means that a buyer of a corporation with sizeable NOLs and other tax attributes, such as built-in losses, may find that the tax attributes actually possess a relatively low cash value as a result of a change of control.
A corporation is considered to undergo “an ownership change” if, as a result of changes in the stock ownership by “5-percent shareholders” or as a result of certain reorganizations, the percentage of the corporation’s stock owned by those 5-percent shareholders increases by more than 50 percentage points over the lowest percentage of stock owned by those shareholders at any time during the prior three-year testing period. Code Section 382 only counts ownership increases; to consider decreases would amount to double-counting. Five-percent shareholders are persons who hold 5% or more of the stock of a corporation at any time during the testing period as well as certain groups of shareholders (based typically on whether they acquired their shares in a single offering or exchange transaction) who are not individually 5-percent shareholders.
Importantly, the Section 382 Limitation is zero for any post-change year if during the 2-year period beginning on the change date the new corporation does not either (i) continue the old corporation’s historic business or (ii) use a significant portion of the old corporation’s historic business assets in a business at all times during that 2-year period.
2. Limited Planning to Avoid an Ownership Change
Practically, it can be very difficult to avoid an ownership change under Section 382. If a corporation needs new equity to survive, the bargaining position of the parties contributing that capital may be so strong that it is impossible to prevent them from obtaining a majority equity stake, triggering a 50% ownership change. In addition, at the time that a new equity party is brought into a company, various creditors may have the right or may be forced to convert their debt to equity, and in combination, an ownership change may be triggered. Furthermore, because the test is performed over a rolling three-year testing period, a corporation that may have had a prior equity offering within that three-year testing period may find that in combination with the current equity round, an ownership change can not be avoided.
Sometimes a new equity investor will wish to preserve the net operating losses, and so may be more than willing to work with management to prevent an ownership change. Certain rules under the Section 382 regulations regarding stock options make this planning difficult because certain stock options are “deemed” exercised if their exercise would trigger a Section 382 ownership change.
Sometimes planning can be accomplished with “pure” preferred stock because it does not count as stock for purposes of measuring owner shifts. Stock (often called “Section 1504(a)(4) stock”) that is limited and preferred as to dividends, does not participate in corporate growth to any significant extent, has redemption and liquidation rights that do not significantly exceed the issue price of the stock, is not convertible into another class of stock and is not entitled to a vote (except as a result of dividend arrearages) is not considered stock for determining whether an ownership change has occurred. Of course, investors may be unwilling in this financial environment to take such “pure” preferred stock because of its lack of voting rights.
3. Special Rules in Bankruptcy
A couple of special, and somewhat complicated, rules apply when a corporation is a debtor in bankruptcy.
If a 50% ownership change is expected to result during the bankruptcy proceeding because of the transfer of stock to the former creditors, an exception under Code Section 382(l)(5) may offer some protection. Section 382(l)(5) provides that the Section 382 Limitation will not apply to a corporation if (1) the corporation, immediately before the ownership change, is under the jurisdiction of a court in a Title 11 or similar case, and (2) the shareholders and creditors of the old corporation own at least 50% of the total voting power and value of the stock of the corporation after the ownership change as a result of being shareholders and creditors before the change. Stock transferred to such creditors counts only if it is transferred with respect to “old and cold” indebtedness; that is, if the indebtedness (1) was held by the creditor for at least 18 months before the date of the filing of the Title 11 case, or (2) arose in the ordinary course of the trade or business of the old corporation and is held by the person who at all times held a beneficial interest in that debt. This last rule prevents debtor corporations who have a significant portion of their outstanding debt acquired by vulture funds within 18 months of the bankruptcy petition date from making use of the Section 382(l)(5) protection.
To the extent Section 382(l)(5) applies to the transfer of stock to the old creditors, the NOL carryovers of the debtor corporation must still be reduced by 50% of the cancellation of debt (“COD”) income not taken into account by virtue of the stock for debt exception of Code Section 108(e)(10)(B). Under Section 382(l)(5)(B), the NOL carryovers must also be reduced by the amount of interest accrued with respect to such canceled debt during the three taxable years prior to the taxable year of the ownership change and during the taxable year of the ownership change (up to the change date.) Under Code Section 382(l)(6), a debtor in bankruptcy with an ownership change can also elect not to apply the foregoing rules and instead allow the normal rules of Section 382(a) to apply. If this election is made, the value of the corporation for purposes of determining the Section 382 Limitation is allowed to reflect the increase in the value resulting from the surrender or cancellation of creditor’s claims in the bankruptcy proceeding.
4. Distinguishing Ownership Change Rules from Effects of Cancellation of Debt
Separate from the foregoing rules under Code Section 382, Code Section 108 includes provisions with respect to cancellation of debt income (“COD”) that can have a direct impact on the gross amount of NOLs that a corporation possesses. Under Code Section 108, in a number of circumstances, such as when the debtor is in bankruptcy or to the extent the debtor is insolvent, a debtor does not recognize COD income. The trade-off for this benefit is that the debtor must reduce tax attributes in an amount equal to the unrecognized COD income. Code Section 108 provides for a prioritized list of such tax attributes, the first of which is NOLs.
Whether one is involved in a reorganization of a troubled corporation in or outside of bankruptcy, or is contemplating the acquisition of a corporation with NOLs, significant analysis and planning needs to be conducted to determine the amount of NOLs that can actually be used by the corporation. In some situations, good planning opportunities may be available, but more often the advice of the tax professionals will mainly aid in damage control. Still, given the relative high value of NOLs and other tax attributes of a severely troubled corporation, the value of timely tax advice in this area can’t be understated.