Congress enacted the current version of section 382 of the Internal Revenue Code1 in 1986 to prevent “trafficking” in net operating losses (NOLs) and in no small part to prevent companies with few or no assets from being sold just for their accumulated NOLs. Congress did not like business deals being done for purely tax motivated reasons. Section 382, however, applies to many more situations than the pure sale of a shell company with NOLs. Thus, over the years, the Internal Revenue Service and the U.S. Department of the Treasury have issued guidance to explain certain aspects of the very complicated and far reaching rules that govern whether a loss company has undergone an ownership change as defined in section 382.
An ownership change occurs when one or more of the loss corporation’s five-percent shareholders increase their interest in the loss corporation by more than 50 percentage points. If an ownership change occurs, section 382 limits the loss corporation’s ability to use its historic (and acquired) NOLs against future taxable income.
This article reviews certain recent guidance from the IRS and Treasury, whether in the form of regulations, notices, or private letter rulings. By no means exhaustive, it is intended to provide an overview of guidance of general interest to taxpayers that are determining the potential effect of section 382 on their ability to use accumulated or acquired NOLs to offset taxable income or in determining the financial statement effect of such NOLs.
Recent Guidance
Because of the economic downturn many more companies are both incurring losses and seeing their shareholders change, as investors move their assets around, and companies struggle with lost revenue and a shrinking customer base. Thus, the perfect section 382 storm has arisen to bring many more taxpayers to the IRS and Treasury for guidance on the application of various aspects of section 382.
Fluctuations in Value
Of particular focus for certain taxpayers have been the fluctuations-of-value rules found in section 382(l)(3)(C). Many taxpayers, including start-ups and venture backed companies that typically have several classes of stock, have been faced interpreting a statute providing that “[e]xcept as provided in regulations, any change in proportionate ownership which is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account.” Taxpayers must parse these rules without the benefit of regulations. Consequently, the IRS has issued numerous private letter rulings (PLRs) in recent years, with at least 10 having been issued since the fall of 2009.2 The core holding of the PLRs is to define the “hold constant principle,” as follows:
in determining the ownership percentage of any 5-percent shareholder, the value of each share of such shareholder’s stock, relative to the value of all other shares of the Taxpayer’s stock, shall be considered to remain constant since the Acquisition Date of that share, except as properly adjusted to account for the dilutive effect of subsequent issuances or the accretive effect of subsequent redemptions of other shares of the Tax payer’s stock.3
Each of the rulings generally allows the taxpayer to apply the hold-constant principle on subsequent testing dates, as long as they apply the method in a consistent manner.
Notice 2010-50
Apparently, the number of inquiries by taxpayers on the fluctuation in value interpretations in section 382(l)(3)(C) caused the IRS and Treasury to issue general guidance on June 14, 2010, in Notice 201050, 2010-27 I.R.B. 12, which generally allows taxpayers that do not have a PLR on their specific facts to apply the hold-constant principle or, alternatively, the full-value method to their section 382 analysis of ownership shifts owing to fluctuations in value. Thus, in interpreting the fluctuation-in-value rules, Notice 2010-50 adopts two methodologies with one methodology allowing for two alternative approaches.
Full-Value Methodology. The first methodology is the “Full Value Methodology” (FVM), which is close to a strict statutory interpretation. Under the FVM, the ownership interest of each shareholder is determined on a pure valuation approach on each testing date, regardless of whether a particular shareholder or group of shareholders does anything to affect their equity ownership. For example, if a testing date is triggered by a stock issuance under an employee stock purchase plan, then each class of stock of the loss corporation is valued and compared with the loss corporation’s overall value. The FVM approach would require the loss corporation to take into account any fluctuations in value that occurred since the loss company’s last testing date in determining the percentage ownership shifts among the five-percent shareholders. The Notice provides that the FVM is essentially a “mark-to-market” approach for all shares on each testing date. Under this approach, there would be no mark-tomarket until an equity event triggers a testing date.
Hold-Constant Principle. The second methodology is more complicated. The “Hold Constant Principle” (HCP) is the approach taken by the IRS in the previously discussed private letter rulings. The HCP essentially allows the relative value of each class of stock to be set at the time the stock is issued by “holding constant” the value of the new class of stock compared to the existing classes of stock at the issuance’s relative value for purposes of valuing such stock on subsequent testing dates. The HCP is applied by issuance and by shareholder. In addition, dilutive adjustments are made for subsequent issuances and accretive adjustments are made for subsequent redemptions. HCP, nevertheless, takes into account value fluctuation for actual stock acquisitions.
Notice 2010-50 includes an example of the Hold Constant Principle. In the example in the Notice, on Date 1 Shareholder A purchased 1 share of preferred stock for $20 and Shareholder B purchased 2 shares of common stock for $80 (80%). Two years later, the common stock of X is worth $2.50 a share and the preferred stock is worth $20. B sells one share of common stock to C. For purposes of determining whether X has an ownership change, the percentage changes will be calculated, as follows:
| SH |
P |
C |
Date 1% |
Testing Date 1% |
% Change Increase |
| A |
1 |
| 20% |
20% |
0% |
| B |
| 1 |
80% |
70% |
0% |
| C |
| 1 |
0% |
10% |
10% |
Under the HCP method, only a 10-percent increase in percentage ownership has occurred because of this sale. The only equity position that is marked-to-market is the share acquired by C. The increase in the value of A’s preferred share relative to the common stock is disregarded at the time of C’s acquisition.
The HCP methodology’s approach may cause dispositions of shares acquired at various points in time to have different relative percentage ownership interests. In determining which shares are being disposed of on a particular disposition date, the loss corporation may take the shares pro rata from all owned shares, use a LIFO method, or use a FIFO method to determine which shares must be taken into account in calculating the percentage interest that is being transferred. Whichever methodology is chosen must be applied consistently by the loss corporation on subsequent testing dates.
Disallowed Method. The IRS will not treat certain methods as reasonable under Notice 2010-50. For example, the Notice states that “the IRS intends to challenge a methodology that fixes the relative fair market value of a class of preferred stock to common stock on the issue date of the preferred stock, regardless of the actual value of either class on the subsequent date that a shareholder whose percentage ownership is being computed acquires a share of either such class of stock.” Thus, a corporation taxpayer may not freeze the relative values of common and preferred classes of stock without regard to fluctuations in value that occur upon additional transactions in such stock.
Reliance on Notice 2010-50. Taxpayers may rely on Notice 201050 prospectively until additional guidance is issued under section 382(l)(3)(C). In addition, taxpayers may apply the Notice retroactively to any past tax year that is not barred by the statute of limitations. Despite this permitted retroactive application, taxpayers may not employ a methodology under the Notice for an open year if employing such methodology for that open year would have changed the taxpayer’s federal income tax liability for a “closed year” barred by the statute of limitations.
Even though the IRS and Treasury have clarified the approach that can be used and how it is generally to be applied, as is the case with most section 382 issues, the benefits of the FVM or the HCP methodologies will require significant information gathering on historical pricing, terms, and sales and other dispositions of the loss corporation stock over a significant period of time. A survey of the PLRs that have been issued in the last year reveals the type of information necessary to document the use of the chosen methodology. Without these factual records, the methodologies available to address fluctuation in value issues may not be as beneficial. In addition, a modeling exercise will also likely be required to determine the more optimal outcome using either methodology.
Expanding Relief from Tracking Small Issuances of Stock
In Notice 2010-49, 2010-XX I.R.B. XX, the IRS and Treasury provided a format for allowing taxpayers to suggest modifications to the segregation rules under section 382 for issuances of stock to certain shareholders who are not five-percent shareholders under the rules (“Small Shareholders”) and other suggested changes to the segregation rules. In general, under Temp. Reg. § 1.382-2T(j) a loss corporation is required to “segregate” and track the shareholders who acquire stock directly from the loss corporation, or sell stock directly to the loss corporation, regardless of the amount of stock issued or redeemed. These rules are the mechanism that generally creates new public groups even when relatively small amounts of loss corporation stock are issued or redeemed. Significant modifications were made to these general rules in Treas. Reg. § 1.382-3(j) that provide limited relief in the form of helpful presumptions to loss corporations that issued stock solely for cash, or issued a small amount of stock in a single year (i.e., generally calculated as 10 percent or less of the value of the outstanding stock on the first day of the tax year of the sale) to shareholders who were not five-percent shareholders of the loss corporation.
Although Notice 2010-49 does not provide any direct guidance that taxpayers can rely upon in performing their specific section 382 analysis, it does shed light on the IRS’s view of the policy considerations underlying the segregation rules as they apply to Small Shareholders. For example, in Notice 2010-49 the IRS explores a purpose-based approach (“Purposive Approach”) which starts with the premise that transactions in the loss corporation stock that involve trades by or to the Small Shareholders may be properly disregarded for purposes of tracking ownership shifts because there would be no real threat by these Small Shareholders to manipulate the equity changes of the loss corporation to effectuate the use of losses by new owners.
As part of its review of these rules, the IRS is also considering increasing the amount of stock that can be excluded under the small issuance exception to the segregation rules and possibly allowing the cash issuance exception to apply in the case where stock is issued for debt. The comment period under Notice 2010-49 ends on September 9, 2010, but there is no indication when subsequent guidance may be issued.
Finalization of Regulations Addressing Certain Built-in Items under Section 382(h)
T.D. 9487, issued on June 14, 2010, finalizes temporary regulations providing that prepaid income is not recognized built-in gain (“RBIG”) for purposes of section 382(h). The temporary regulations also provided that prepaid income means any amount received before the change date that is attributable to performance occurring on or after the change date. Examples to which this provision will apply include, but are not limited to, income received before the change date that is deferred under section 455 (prepaid subscription income), Treas. Reg. § 1.451-5 (advance payments for goods and long-term contracts), or Rev. Proc. 2004-34 (certain advance payments for services and other items). The final regulations basically restate the rules found in the proposed regulations and apply to loss corporations that have undergone an ownership change on or after June 11, 2010.
Actual Knowledge and Presumptions Regarding Five-Percent Shareholders
For the past few years, the IRS has provided guidance in PLRs to taxpayers seeking to identify their five-percent shareholders by reviewing the information listed on Schedule 13Ds and 13Gs filed with the Securities and Exchange Commission.4 For a company that is privately held, information must be obtained from company records or other sources. For companies that are owned by one or more funds or series of funds, the determination of who are the economic owners of their stock can be very challenging. In these circumstances, the IRS has asked taxpayers to seek direct knowledge from the funds as to who their investors might be in order to perform a section 382 analysis.
For example, in PLR 201024037 (March 11, 2010), the loss corporation hired a tax adviser to perform a section 382 ownership change analysis and as part of that analysis the company and its tax adviser made written inquiries from the various investor representatives asking (i) whether the participating entities that held the stock were the economic owners of such stock, (ii) the identity of any of the holders of the participating entities that may be indirect five-percent shareholders of the loss corporation, (iii) whether there were any shifts among the indirect owners such that any of them increased or decreased their indirect ownership percentage in the loss corporation, and (iv) whether any of the participating entities or their owners were acting in concert with respect to the ownership of the loss corporation stock. After all this inquiry, the loss corporation concluded that if it took into account its actual knowledge of stock ownership on the relevant stock issuance dates, it would have experienced an ownership change on a date earlier than the date that would be its ownership change date using the presumptions created by the cash issuance exception of Treas. Reg. § 1.382-3(j). The IRS concluded that this taxpayer could rely on the information it gathered through its own corporate records and direct written inquiries to establish actual knowledge of stock ownership under Treas. Reg. § 1.382-2T(k) (2), and that it could use this actual knowledge to determine that it experienced an ownership change on the earlier change date, when its value was higher. Thus, through this ruling and similar ones, the IRS has provided taxpayers with guidance on how to decide who is a five-percent shareholder and how much stock they are treated as owning on each testing date, in addition to clarifying the application of the actual knowledge provisions of the regulations.
Capital Contributions to Continue Basic Operations Exempted from Section 382(l)(1)
In Notice 2008-78, 2008-2 C.B. XX (issued September 29, 2008), the IRS changed the two-year presumption found in section 382(l)(1) and stated that unless a capital contribution made within two years of an ownership change date was part of a plan, a principal purpose of which is to avoid or increase a section 382 limitation, it will not reduce the value of the loss corporation upon an ownership change of such loss corporation. The new presumption was to be effective for ownership changes occurring in a taxable year ending on or after September 28, 2008. Thus, presumably, the old presumption would apply to ownership changes occurring before that date. On September 24, 2009, the IRS issued PLR 200952012, relating to a bank that was taken over after a large cash infusion made to cover losses incurred in the economic downturn. The IRS ruled that the bank did not need to reduce its value for the recent cash infusion, because the money was used “solely to alleviate the financial distress of Target [bank] and continue Target’s basic business operations.” It is not clear whether the date of Target’s ownership change in the PLR was before or after September 28, 2008, but it is helpful to see that the IRS continues to rule in this complicated area, especially where current authority is unclear. For example, in Notice 2008-78, the IRS did not address cash infusions to continue basic operations and did not include them in the listed safe harbors. Therefore, absent relying on the general reversal of the two-year presumption, taxpayers may want to seek private letter rulings when they have a cash infusion within two years of an ownership change.
Conclusion
Section 382 is an evolving area of corporate tax law that is more relevant in times, such as these, when many companies are experiencing losses through their operations or business downsizing. As a result, these rules will need ongoing clarification to adapt to the changes in the economic climate. Taxpayers faced with reviewing the potential effect of section 382 on a yearly and sometimes quarterly basis should ensure that all relevant documentation is assembled for easy access if the need arises to perform an analysis. In addition, because section 382’s application is so dependent on the facts, it is likely that the guidance will continue to come out in the form of private letter rulings. Taxpayers needing certainty on the specific application of section 382 should consider seeking a private letter ruling.
Annette M. Ahlers is a partner in Pepper Hamilton LLP’s Tax Practice Group, resident in the Washington office. She concentrates her practice in corporate tax matters for large corporations. Ms. Ahlers received her B.A. degree from the University of Washington, her J.D. degree from California Western School of Law, and her LL.M. degree from Georgetown University Law Center. She may be contacted at ahlersa@pepperlaw.com.
- All references to sections are to the Internal Revenue Code of 1986, as amended, unless otherwise stated.
- PLR 200952004 (Sept. 23, 2009), PLR 2010024037 (Sept. 27, 2009), PLR 201005019 (Oct. 27, 2009), PLR 201010009 (Dec. 4, 2009), PLR 201015023 (Dec. 30, 2009), PLR 201017002 (Jan. 11, 2010), PLR 201017003 (Jan. 11, 2010), PLR 201017004 (Jan. 11, 2010), PLR 201024037 (Mar. 11, 2010), PLR 201027030 (Mar. 29, 2010).
- PLR 201027030 (Mar. 29, 2010).
- PLR 200747016 (Aug. 20, 2007), PLR 200806008 (Feb. 8, 2008), and PLR 201027030 (Mar. 29, 2010).