CHAPTER SIX

Use of Net Operating Losses

§ 6.1 Introduction

§ 6.2 I.R.C. Section 381

(a) Introduction

(b) Qualifying Acquisitions

(i) Liquidation of Controlled Subsidiary

(ii) Reorganizations

(c) Tax Attributes

(d) Transfer of Net Operating Losses

(e) Limitations on Carryover of Net Operating Losses

§ 6.3 Restructuring under Prior I.R.C. Section 382

(a) Introduction

(b) Old I.R.C. Section 382(a)

(c) Old I.R.C. Section 382(b)

§ 6.4 Current I.R.C. Section 382

(a) Introduction

(b) Overview

(i) Section 382 Limitation

(ii) Value of the Loss Corporation

(A) Options

(iii) Long-Term Tax-Exempt Rate

(c) Allocation of Taxable Income for Midyear Ownership Changes

(d) Ownership Change

(i) Examples of Ownership Changes Involving Sales among Shareholders

(ii) Other Transactions Giving Rise to Ownership Changes

(iii) Examples of Ownership Changes Resulting from Other Transactions

(iv) Equity Structure Shift

(v) Purchases and Reorganizations Combined

(vi) Undoing a Section 382 Ownership Change

(vii) Bailout-Related Section 382 Relief

(A) Introduction

(B) Notice 2008-76: Fannie Mae/Freddie Mac

(C) Notice 2008-84: More-than-50-Percent Interest

(D) Notice 2008-83: Banks

(E) Notice 2008-100: Capital Purchase Program

(F) Notice 2009-14: Capital Purchase Program and Troubled Asset Relief Program

(G) Notice 2009-38: Treasury Acquisitions under Emergency Act Programs

(H) Notice 2010-2: Treasury Acquisitions and Dispositions under Emergency Act Programs

(I) New I.R.C. Section 382(n)

(e) Public Shareholders and the Segregation Rules

(i) Introduction

(ii) Segregation: Old Temporary Regulations

(iii) Segregation: Final Regulations

(A) Segregation Presumption—Cash Issuance Exception

(B) Small Issuance Exception

(iv) Segregation: Nuances

(v) Trading Involving Shareholders Who Are Not 5 Percent Shareholders

(vi) Options: Temporary Regulations

(vii) Options: Proposed Regulations

(viii) Options: Final Regulations

(A) Ownership Test

(B) Control Test

(C) Income Test

(D) Safe Harbors

(E) Subsequent Treatment of Options Treated as Exercised

(f) Reductions in the Section 382 Limitation

(i) Continuity of Business Enterprise

(ii) Nonbusiness Assets

(iii) Contributions to Capital

(A) Notice 2008-78

(B) Notice 2008-78 Rules

(C) Notice 2008-78 Safe Harbors

(D) Avoidance of Duplication with I.R.C. Section 382(l)(4)

(iv) Redemptions and Other Corporate Contractions

(v) Controlled Groups

(g) Special Rules

(i) Introduction

(ii) I.R.C. Section 382(l)(5)

(A) General Provisions

(B) Change of Ownership within Two Years

(C) Continuity of Business Enterprise

(iii) I.R.C. Section 382(l)(6)

(A) General Provisions

(B) Determining Value under I.R.C. Section 382(l)(6)

(C) Continuity of Business Enterprise

(iv) Comparison of I.R.C. Section 382(l)(5) and (l)(6)

(h) Built-In Gains and Losses

(i) In General

(ii) I.R.C. Section 382(h)(6)

(A) Legislative History

(B) IRS Rulings

(C) Notice 2003-65

(D) Prepaid Income

(iii) Treatment of Change Date Items

(A) Introduction

(B) Allocations on Ownership Change Date

(C) Relevant Rulings

(D) Observations

§ 6.5 I.R.C. Section 383: Carryovers Other than Net Operating Losses

(a) General Provisions

§ 6.6 I.R.C. Section 384

(a) Introduction

(b) Overview

(c) Applicable Acquisitions

(d) Built-In Gains

(e) Preacquisition Loss

§ 6.7 I.R.C. Section 269: Transactions to Evade or Avoid Tax

(a) Introduction

(i) Definition of Terms

(ii) Partial Allowance

(iii) Use of I.R.C. Section 269

(iv) Avoiding Tax by Using Operating Losses

(v) Ownership Changes in Bankruptcy

§ 6.8 Libson Shops Doctrine

(a) Overview

§ 6.9 Consolidated Return Regulations

(a) Introduction

(b) Consolidated Net Operating Loss Rules

(c) Application of I.R.C. Section 382 to Consolidated Groups

(i) Background

(ii) Overview

(d) Overlap Rule

(e) Unified Loss Rules

(i) Framework of the Unified Loss Rule

(ii) Basis Redetermination

(iii) Basis Reduction

(iv) Attribute Reduction

(v) Conclusion on Unified Loss Rule

(f) Application of I.R.C. Section 384 to Consolidated Groups

§ 6.1 INTRODUCTION

Internal Revenue Code (I.R.C.) section 172 provides for the carryback and carryover of net operating losses (NOLs). A corporation is, in most cases, allowed to carry over, for up to 20 years, NOLs sustained in a particular tax year that are not carried back to prior years.1 Beginning with tax years ending in 1976, taxpayers have been able to elect not to carry losses back.2 Prior to that time, losses had to be carried back to the three preceding tax years first; if all of the loss was not used against income in prior years, then it might be carried over.

The length of the carryback and carryover periods has varied over the years. The Taxpayer Relief Act of 1997 reduced the carryback period for NOLs from 3 years to 2 years and extended the carryover period from 15 years to 20 years.

The American Recovery and Reinvestment Tax Act of 2009 (ARRA) amended I.R.C. section 172 to allow an eligible small business (ESB) to elect to carryback NOLs incurred in tax years ending or beginning in 2008, for three, four, or five years, instead of the general two-year carryback. An ESB is generally a corporation, partnership, or sole proprietorship with average annual gross receipts of no more than $15 million for the three tax years ending with the NOL year. The same carryback period may apply to alternative minimum tax NOLs.3

Under the Worker, Homeownership, and Business Assistance Act of 2009 (WHBAA) certain taxpayers (including but not limited to ESBs) may elect to carry back an NOL generated in a tax year beginning or ending in 2008 or 2009 for a period of three, four, or five years (instead of the usual two-year carryback period). If an election is made under the WHBAA, such NOLs may not be subject to the alternative minimum tax (AMT) NOL limitations under I.R.C. section 56(d)(1)(A)(i). As described, the ARRA provides a similar election for ESBs with respect to a “2008 applicable NOL.”4

The extent to which the NOL can be preserved in bankruptcy and insolvency proceedings often depends on the manner in which the debt is restructured. The NOL is generally preserved if there is no change in ownership. The forgiveness of indebtedness generally does not affect the ability of the corporation to carry over prior NOLs.5 The loss carryover may, however, be reduced to the extent of the discharge of debt, as discussed in Chapter 2.6

Special problems may arise when the debt restructuring involves the use of another corporation. When a corporation acquires another corporation in certain tax-free asset acquisitions, I.R.C. section 381 permits the acquiring corporation to inherit and use the NOL carryovers of the acquired corporation. Both case law and other I.R.C. sections, however, may limit the use of such acquired carryovers. Even when no new corporation is involved, a number of transactions undertaken to restructure debt can change corporate ownership and trigger the application of I.R.C. provisions or judicial doctrines that limit a loss corporation’s ability to use its NOL carryovers.

The objective of this chapter is to discuss how the NOL can be preserved in an internal restructuring (generally a recapitalization under I.R.C. section 368(a)(1)(E)) or a

restructuring involving another corporation. The first part of the chapter, which briefly describes the provisions of I.R.C. section 381, is followed by a brief discussion of the provisions of I.R.C. section 382 that applied prior to the changes introduced by the Tax Reform Act of 1986. The balance of the chapter discusses the current I.R.C.: the section 382 provisions, the general limitation of section 382(b), the section 383 limitation on the use of credit carryovers, the section 384 limitation on the use of preacquisition losses to offset built-in gains, the bankruptcy exception of sections 382(l)(5) and (l)(6), and the tax avoidance provisions of section 269. The Libson Shops doctrine and the numerous special rules affecting losses in the consolidated return regulations are also discussed.

§ 6.2 I.R.C. SECTION 381

(a) Introduction

I.R.C. section 381 provides that, in certain types of acquisitions of assets of a corporation by another corporation, the acquiring corporation inherits some of the tax attributes of the acquired entity. NOL carryovers are one of the specified tax attributes.

(b) Qualifying Acquisitions

Only liquidations of controlled subsidiaries under I.R.C. section 332 and five types of tax-free reorganization under I.R.C. section 368(a) are subject to the tax attribute carryover rules of I.R.C. section 381(a).7

Unless some other statute provides otherwise, the NOL and other tax attributes of the acquiring corporation are not affected by the acquisition. As a general rule, if a loss is expected after a reorganization, the transaction should be structured so that the corporation with the greatest carryback potential (i.e., the corporation with the most income in prior periods for which a carryback of a subsequently generated NOL would result in the greatest refund) is the surviving corporation in the reorganization.

(i) Liquidation of Controlled Subsidiary

I.R.C. section 381(a)(1) permits the carryover of tax attributes, including NOLs, in a liquidation under I.R.C. section 332. The tax basis of the subsidiary’s assets also carries over to the parent.8 Section 332 applies to a “receipt by a corporation of property.” Thus, if the subsidiary is insolvent and its shareholders receive nothing in the liquidation, I.R.C. section 332 is not applicable because there is no receipt by a corporation of property distributed in complete liquidation of another corporation.9 I.R.C. section 332 treatment has even been denied where the preferred (but not the common) shareholders received property in the liquidation of a subsidiary.10 An insolvent subsidiary cannot be made solvent, prior to its liquidation, by having its parent cancel a debt due from the subsidiary.11 The liquidation of an insolvent subsidiary, however, entitles its parent to claim a bad debt deduction under I.R.C. section 166 and possibly a worthless stock deduction under I.R.C. section 165(g)(3).12

Three conditions must be met for a liquidation to qualify under I.R.C. section 332:

(ii) Reorganizations

I.R.C. section 381(a)(2) requires the carryover of tax attributes, including NOLs, if property of one corporation is transferred pursuant to a plan of reorganization, solely for stock and securities in another corporation (I.R.C. section 361), provided the transfer is in connection with one of these tax-free reorganizations described in I.R.C. section 368(a)(1): A, C, D, F, or G.20 I.R.C. section 381 does not apply to B, divisive D, E, or divisive G reorganizations, nor does it apply to I.R.C. section 351 transfers.21 There is generally no carryover of attributes in these transactions.22

(c) Tax Attributes

As noted, I.R.C. section 381 provides for the carryover of tax attributes of the acquired corporation in certain tax-free reorganizations. Among the tax attributes discussed in I.R.C. section 381(c) are NOLs, earnings and profits, capital loss carryovers, investment credits, inventory and depreciation methods, and accounting methods. Because the I.R.C. lists the items that can be carried over, it might be assumed that unless an item is listed, it cannot be carried over. Legislative history, however, indicates that I.R.C. section 381 “is not intended to affect the carryover treatment of an item or tax attribute not specified in the section or the carryover treatment of items or tax attributes in corporate transactions not described in [I.R.C. section 381(a)].”23

(d) Transfer of Net Operating Losses

An inherited NOL must be used by the corporation that acquires the assets of a loss corporation. Thus, historically, if the acquired (loss) corporation in a C reorganization elected to continue some limited form of business and not liquidate, it would not use any prior NOL, because the loss would have passed to the acquiring corporation.24 This problem has been largely eviscerated for transactions occurring after 1984, however, because such transactions must generally include a liquidation of the acquired corporation in order to qualify as a C reorganization.25 Similarly, this problem should not arise in a G reorganization, because one of the G reorganization requirements is that the acquired corporation liquidate.

Treasury Regulation (Treas. Reg.) section 1.381(b)-1(b)(1) indicates that the NOL will generally pass to the acquiring corporation when the transfer is complete. The tax year of the transferor corporation will also generally end on this date. An alternate date—the date on which substantially all of the assets are transferred—may be used if the acquired corporation ceases operating except for those functions related to winding up its affairs.26 To use this alternate date, the acquired and acquiring corporations both must file written statements with the IRS.27

The NOL of the acquired corporation is carried to the first tax year of the acquiring corporation that ends after the date of the transfer. I.R.C. section 381 limits the amount of NOL that can be used in the year of transfer to the ratio of the remaining days until the end of the acquiring corporation’s tax year to 365 days. This provision is designed to prohibit the acquiring corporation from offsetting income earned prior to the acquisition against the acquired NOL. This formula must be used even though the income of the acquiring corporation may not be earned evenly throughout the year. Any NOL disallowed in the year of acquisition due to this restriction may be used in future years. The transfer of an NOL will usually result in the use of two years of the carryover period. The short tax year of the acquired corporation that ends on the date of transfer counts as one, and the tax year to which the NOL is transferred counts as another.28

An acquired NOL can generally be applied only against postacquisition income of the acquiring corporation. The acquiring corporation may, however, offset postacquisition losses against its own preacquisition income. Postacquisition operating losses of the acquiring corporation, however, generally may not be carried back against preacquisition income of the acquired corporation.29 The NOL carryback is allowed in a B and an E reorganization because there has been no movement of assets at the corporate level. A carryback is also permitted in an F reorganization, which may include an asset transfer, because this reorganization only involves a mere change of identity, form, or place of organization.

(e) Limitations on Carryover of Net Operating Losses

Although I.R.C. section 381 provides for the carryover of NOLs and other tax attributes, as noted in the introduction to this chapter, other I.R.C. sections and case law may limit carryover. Listed next is a summary of these limitations:

• Section 382 limitation. I.R.C. section 382(b) limits the amount of income that can be offset by loss carryovers each year to an amount equal to the value of the old loss corporation multiplied by the federal long-term tax-exempt rate.
• Section 383 limitation. I.R.C. section 383 limits the carryover of certain excess credits and net capital losses.
• Section 384 limitation. I.R.C. section 384 restricts a corporation from offsetting its built-in gains with preacquisition losses of another corporation.
• Bankruptcy exception. I.R.C. sections 382(l)(5) and (l)(6) contain special provisions for corporations in bankruptcy.
• Tax avoidance. I.R.C. section 269 may be used by the IRS to disallow any deduction, credit, or other allowance when the principal purpose of certain acquisitions is to avoid tax.
• Libson Shops doctrine. This doctrine prohibits the carryover of loss from the loss corporation to profits of different businesses.
• Corporate equity reduction transaction (CERT) rules. I.R.C. section 172(b)(1)(E) limits carrybacks of certain losses attributable to a CERT.
• Consolidated returns. The Treasury Regulations under I.R.C. section 1502 contain a number of restrictions on the use of NOLs.

§ 6.3 RESTRUCTURING UNDER PRIOR I.R.C. SECTION 382

(a) Introduction

Prior to the Tax Reform Act of 1986, restructuring of the debt and equity of a troubled corporation that did not involve a change in ownership generally did not affect the future use of NOLs. In selecting the nature of the restructuring, however, the debtor needed to be aware of areas where problems could develop. In particular, if the restructuring came under the provisions of I.R.C. section 382, NOL carryovers could be lost. In general, old I.R.C. section 382(a) eliminated the carryover if, through the purchase of stock, the 10 largest shareholders of the loss corporation increased their ownership by 50 percent or more within a two-year period, and the loss corporation’s old trade or business was abandoned. Old I.R.C. section 382(b) reduced the carryover if, in a tax-free reorganization, the shareholders of the old loss corporation received less than 20 percent of the stock of the reorganized corporation.

(b) Old I.R.C. Section 382(a)

Old I.R.C. section 382(a) applied only to purchases of stock from unrelated parties. Generally, stock was considered purchased if its basis in the hands of the acquirer was determined by reference to cost and if it was acquired from an unrelated party. Thus, acquisition of stock by gift, bequest, or nontaxable exchange (such as in a reorganization under I.R.C. section 368(a)(1)) was not a purchase. Exchanges of bonds, debentures, or other debts evidenced by securities for stock in internal restructuring normally qualified as a nontaxable recapitalization under old I.R.C. section 382(a) and were therefore not purchases within the meaning of the provision. Stock received in satisfaction of trade payables, however, was considered purchased stock.30

This difference in treatment (between debts evidenced by securities and other debts) gave rise to a number of cases construing the meaning of “security.” Courts generally limited the definition of securities to long-term obligations, excluding short-term notes. The line between “short-term” and “long-term” continues to be hazy, however. Some courts consider 5-year notes securities; others require maturities of at least 10 years.

The leading case in this area is a 1954 case in which the Tax Court addressed whether notes are securities for purposes of applying a 1939 code provision (old I.R.C. section 112(b)(5)) that was the predecessor of I.R.C. section 351. The court stated:

The test as to whether notes are securities is not a mechanical determination of the time period of the note. Though time is an important factor, the controlling consideration is an over-all evaluation of the nature of the debt, degree of participation and continuing interest in the business, the extent of proprietary interest compared with the similarity of the note to a cash payment, the purpose of the advances, etc. It is not necessary for the debt obligation to be the equivalent of stock since section 112(b)(6) specifically includes both “stock” and “securities.”31

Bonds payable from 3 to 10 years (averaging 6.2 years) have been classified as “securities” for recapitalization purposes by the IRS.32 Cases have defined the term “securities” to include bonds payable serially with a maximum maturity date of 7 years,33 6-year bonds,34 and 10-year promissory notes.35 A number of cases have held that debt obligations maturing in less than 5 years do not qualify as “securities.”36

Once it was determined that the restructuring involved a purchase of stock within the meaning of the statute, old I.R.C. section 382 would cause the NOL carryover to be lost unless the restructured corporation could demonstrate that it had avoided a prohibited ownership change or that it had not abandoned the loss corporation’s old trade or business. If there was a prohibited change in ownership and the trade or business test was not satisfied, then the NOL carryover was lost. A prohibited change in ownership was one in which the 10 largest shareholders of the loss corporation increased their ownership by 50 percent or more through stock purchases within the previous two taxable years. The total percent increase need not have occurred in a single transaction.

(c) Old I.R.C. Section 382(b)

As noted earlier in the chapter, I.R.C. section 381 permits a surviving corporation in certain tax-free reorganizations to inherit specified tax attributes (including NOL carryovers) of an acquired corporation. Old I.R.C. section 382(b) limited the ability of the surviving corporation to inherit NOL carryovers by reducing them if the stockholders of the loss corporation did not own at least 20 percent of the fair market value (FMV) of the outstanding stock of the reorganized corporation immediately after the reorganization.

The 20 percent ownership had to exist immediately after the reorganization and had to result from the ownership of stock in the loss corporation immediately before the reorganization. Thus, if a stockholder of the loss corporation also owned stock in the acquiring corporation prior to the acquisition, such stock was not considered owned by stockholders of the loss corporation in meeting the 20 percent requirement. Generally, a later sale of the stock did not affect the carryover, but a contractual agreement made prior to the reorganization to sell the stock acquired in the reorganization would have had a negative effect on the carryover.

The amount of reduction required by old I.R.C. section 382(b)(1) was determined by first calculating the percent of the FMV of the acquiring corporation’s outstanding stock owned by the loss corporation shareholders immediately after the reorganization. If the percent was greater than or equal to 20, no reduction was required. If the percentage was less than 20, the NOL was reduced by a percentage equal to five times the difference between the percent ownership and 20 percent. Thus, if the shareholders of a loss corporation received 12 percent of the stock of an acquiring corporation in a qualifying reorganization, 60 percent of the loss corporation’s loss survived.

§ 6.4 CURRENT I.R.C. SECTION 382

(a) Introduction

The Tax Reform Act of 1986 significantly altered I.R.C. section 382 and the manner in which companies can use NOLs. Where old I.R.C. section 382 limited the amount of the NOL that survived a change in ownership, new I.R.C. section 382 leaves the amount intact and limits instead the amount of income generated by the new entity against which the loss can be used.

(b) Overview

(i) Section 382 Limitation

The 1986 Act version of I.R.C. section 382 introduced an annual “section 382 limitation,” which is designed to minimize the effect of tax considerations on the acquisition of loss corporations. Other provisions of current I.R.C. section 382 are not necessarily consistent with the statute’s stated objectives of reducing the role of tax considerations in acquisitions and promoting certainty. For example, the rules reduce carryovers where one-third or more of the loss corporation’s assets are investment assets, and they completely eliminate carryovers where there is no continuity of business enterprise. The limitation permits loss carryovers to offset an amount of income equal to a hypothetical stream of income that would have been realized had the loss corporation sold its assets at FMV and reinvested the proceeds in high-grade tax-exempt securities. The law is considerably complicated by further conditions for loss survival, the coverage of built-in losses, special rules relating to ownership changes, and exceptions for bankrupt corporations.

The section 382 loss limitation provisions are relevant only in the event of a change in ownership of a loss corporation. Where old I.R.C. section 382 provided separate rules, depending on whether the ownership change resulted from a taxable purchase of stock or from a tax-free reorganization, new section 382 generally provides a single regime triggered by an “ownership change.” In general, an ownership change is a change of more than 50 percentage points in ownership of the value of stock of the loss corporation within a three-year period. A loss corporation is defined in I.R.C. section 382(k)(1) as a corporation entitled to use an NOL carryover, a current NOL, or a built-in loss.

The statute provides that a change in ownership can occur either as a result of an owner shift involving a 5 percent shareholder or an equity structure shift. Generally, owner shifts involve stock acquisitions and equity structure shifts involve statutory reorganizations. The two overlap, however, and, apart from effective dates, the distinction has little practical significance.

An NOL that arises before a change in ownership can be used in any period after the change, subject to the annual section 382 limitation. The ability of a loss corporation acquired by taxable purchase to preserve NOLs simply by continuing its historical business is eliminated. The myriad issues that arise in connection with determining whether a loss corporation has undergone an ownership change are discussed in § 6.4(d).

The section 382 limitation generally restricts the amount of income against which prechange NOLs can be applied in any postchange taxable year to the product of the FMV of the stock of the loss corporation37 immediately before the ownership change and the “long-term tax-exempt rate.” Any NOL limitation not used because of insufficient eligible taxable income in a given year is added to the section 382 limitation of a subsequent year.

(ii) Value of the Loss Corporation

The FMV of the loss corporation is thus one of the key factors in determining the use of NOLs. With respect to publicly traded companies, the price at which the stock is trading on an established exchange, or other applicable register, is generally presumed to be an accurate reflection of the FMV of a corporation’s stock. In support of this presumption, many cases hold that stock quotations are the best evidence of FMV.38 Nevertheless, as noted in Amerada Hess Corp. v. Commissioner,39 Moore-McCormack Lines, Inc. v. Commissioner,40 and Technical Advice Memorandum (T.A.M) 9332004,41 there are instances in which an exception to the general rule is appropriate in order to ascertain the true value of a corporation.42

In particular, as noted in Amerada, “[w]here the market exhibits such peculiarities as cast doubt upon the validity of that assumption, the market price must be either adjusted or discarded in favor of some other measuring device.”43

In support for valuing the corporation’s stock at an amount different from the stock trading price on the New York Stock Exchange (NYSE), the court said in Moore-McCormack:

While we are quick to recognize the persuasive importance of stock exchange prices in a stock valuation case, . . . nonetheless, we are convinced that we must carefully consider all of the evidence in the record which indicates the true fair market value for the 300,000 shares here involved. . . .

* * * *

Of paramount importance in our rejection of the mean stock market trading price as determinative of value here is the fact that [we are valuing] a lump, a block, an integrated package or bundle of rights representing ownership of 13 percent of a large and successful corporation. We must not think in terms of 300,000 individual shares of stock at so many dollars per share, but in terms of the overall dollar value of ownership of 13 percent of Moore-McCormack Lines, Inc., with the shares of stock meaningful not as something which can be converted to cash but merely as the formal evidence of ownership of the 13 percent.44

In this case, the court noted that it was not unreasonable under the circumstances that the per-share value resulting from the purchase price exceed the weighted average stock exchange price. Moreover, Congress recognized the fact that the price at which loss corporation stock changes hands in an arm’s-length transaction would be evidence of the value of the stock, although not necessarily conclusive evidence.45

In Technical Advice Memorandum (T.A.M.) 9332004, the IRS supported the taxpayer’s contention that the stock trading price was not representative of the value of the loss corporation. Consistent with comments contained in the legislative history to I.R.C. section 382, the IRS agreed that the ownership of the stock could, in certain circumstances, give rise to a control premium. The IRS concluded that the value of the loss corporation’s stock may be “determined using evidence and methods through which it is concluded that its value was different than the amount determined” by reference to NYSE trading price. The reference to the legislative history by the IRS can be reconciled with Treas. Reg. section 1.382-2(a)(3)(i) (which provides that for purposes of determining ownership percentage, each share of outstanding stock that has the same material terms is treated as having the same value) by recognizing that in T.A.M. 9332004, the IRS and the taxpayer were determining the total value of the loss corporation’s stock as opposed to an individual shareholder’s ownership percentage.

(A) Options

Another issue is whether options and similar interests should be included in determining stock value. I.R.C. section 382(k)(6)(B) gives the Secretary the power to “prescribe such regulations as may be necessary to treat warrants, options, contracts to acquire stock, convertible debt interests, and other similar interests as stock.” The legislative history to I.R.C. section 382 provides that such regulations may treat options and similar interests as stock for purposes of determining the value of the loss corporation.46 To date, such regulations under I.R.C. section 382(k)(6)(B) have not been released. Treas. Reg. section 1.382-2T(h)(4)(vii)(C) states, however, that whether an option was deemed exercised in determining whether an ownership change occurred47 shall have no impact on the determination of the value of the old loss corporation for the computation of the limitation.

In T.A.M. 9332004, the IRS noted that to the extent warrants for a loss corporation’s stock have value, such value derives from the potential they offer their holders to own the underlying stock. For purposes of determining the section 382 limitation, the IRS concluded that it is appropriate to take into account the actual value of warrants.

Based on the rationale of this ruling, it appears that the value of in-the-money options should be included in the value of the old loss corporation in computing the section 382 limitation. Although out-of-the-money options generally do not have a value equal to the underlying shares, they may nonetheless have a speculative or other value and presumably such value should be included in the annual limitation.

In addition, value may be controversial where changes in control are occasioned by reorganizations, particularly where the purchase price consists in whole or in part of stock of a nontraded corporation.

(iii) Long-Term Tax-Exempt Rate

The long-term tax-exempt rate is the highest of the federal long-term rates determined under I.R.C. section 1274(d), as adjusted to reflect differences between rates on long-term taxable and tax-exempt obligations in effect for the month in which the ownership change date occurs or the two prior months.48 The rates are published monthly in revenue rulings. The rate for ownership changes during January 2011 was 4.1 percent.49

The long-term tax-exempt rate is the yield on a diversified pool of prime, general obligation tax-exempt bonds with remaining periods to maturity of more than nine years. This rate has been subject to some criticism, because an investor would not assume the risks associated with a business venture merely to receive a long-term tax-exempt bond rate.

(c) Allocation of Taxable Income for Midyear Ownership Changes

In general, when an ownership change occurs midyear, the loss corporation may use NOL carryovers to shelter taxable income allocable to the prechange period without limitation.50 Taxable income (loss) may be allocated to pre- and postchange periods on a daily pro rata basis. Alternatively, a loss corporation may elect to close the books on the ownership change date and allocate income (loss) between the pre- and postchange periods based on actual financial information.

For ownership changes occurring before June 22, 1994, a closing-of-the-books election required that the loss corporation obtain a private letter ruling from the IRS.51 On June 22, 1994, however, closing-of-the-books regulations were finalized and, as a result, the election can be made without the consent of the IRS.52 These regulations provide that loss corporations may allocate regular and/or AMT income (loss) between pre- and postchange periods based on either (1) closing the books or (2) daily pro rata allocation. The irrevocable closing-of-the-books election is made on the information statement required by Treas. Reg. section 1.382-11 for the change year.53

The regulations provide rules for allocating taxable income (loss) and net capital gain (loss) to pre- and postchange periods. The taxable income (loss) is determined without regard to capital gains or losses, the section 382 limitation, certain recognized built-in gains (losses), or “abusive gains.” The net capital gain (loss) is determined in a similar fashion. The net capital gain (excluding any I.R.C. section 1212 short-term capital losses) allocated to each period is offset by recognized built-in losses of a capital nature and capital loss carryovers subject to the section 382 limitation. Any taxable loss allocated to each period is then reduced by any capital gain allocable to the same period and then by any remaining capital gain from the other period.

The preambles to the proposed and final closing-of-the-books regulations provide that taxable income or loss allocated to either the prechange or the postchange period cannot exceed the total NOL or taxable income for the change year. For example, a corporation with prechange income of $2,000 and a postchange loss of $1,000 would allocate $1,000 of income to the prechange period and $0 to the postchange period if it makes a closing-of-the-books election. A few special points are noted next.

• Recognized built-in gains (losses). Certain recognized built-in gains (losses) (see infra § 6.4(h)) are allocated separately from operating income (loss).54 Thus, to the extent a loss corporation has a net unrealized built-in gain on the ownership change date, built-in gain recognized during the postchange portion of the year is allocated entirely to the postchange period, regardless of whether operating income (loss) is allocated based on daily proration or closing the books. To the extent a loss corporation has a net unrealized built-in loss on the ownership change date, built-in loss recognized during the postchange period is allocated entirely to the postchange period.
• Abusive gain. Income or gain recognized on the disposition of assets transferred to a loss corporation to ameliorate the annual limitation must be allocated entirely to the postchange period.55
• Extraordinary items. The regulations do not contain any special allocation provisions for extraordinary items. The preamble to the regulations, however, indicates that the IRS may give further consideration to the “desirability” of rules regarding the allocation of extraordinary items to pre- and postchange periods.

(d) Ownership Change

Recall that the section 382 loss limitation rules do not come into play unless there has been an ownership change. Until an ownership change takes place, a loss corporation can use all of its losses without a “section 382 limitation,” and none of the numerous restrictions and limitations of I.R.C. section 382 applies. An ownership change occurs if, on a testing date, the percentage of stock of a loss corporation owned by one or more 5 percent shareholders has increased by more than 50 percentage points relative to the lowest percentage of stock of the old loss corporation owned by those 5 percent shareholders at any time during the testing period (generally, three years).57

The determination of whether an ownership change has occurred on a date on which there has been an owner shift (a “testing date”) is made by comparing the increase in value in percentage stock ownership (if any) for each 5 percent shareholder as of the close of the testing date, with the lowest percentage of stock owned by each such 5 percent shareholder during the three-year testing period. The three-year period generally does not begin before the first day of the first tax year from which there is a loss or credit carryover to the first postchange year.58 Stock owned by persons who own less than 5 percent of a loss corporation is generally treated as stock owned by one or more 5 percent shareholder(s).59

The ownership change test bears a distinct similarity to old I.R.C. section 382(a) and the definition of “purchase.” Under the prior law, a determination was made as to whether the 10 largest shareholders of the loss corporation increased their ownership interest of the loss corporation by 50 percentage points or more over the previous two taxable years. Prior law, however, had two completely different tests, depending on whether there was a taxable purchase (10 largest shareholders and 50 percent change of ownership) or a tax-free reorganization (20 percent continuity of shareholder interest). Current I.R.C. section 382(g) has one test: an ownership change by 5 percent shareholders totaling more than 50 percentage points. Although the statutory framework categorizes an ownership change as either (1) an owner shift involving 5 percent shareholders or (2) an equity structure shift (i.e., a reorganization), there is usually no distinction between the two; they are really the same test.

In certain situations, attribution rules apply for I.R.C. section 382 purposes. The aggregation of shares could allow actual shifts in ownership among family members to occur without affecting the corporation’s cumulative section 382 owner shift percentage.60

In determining whether an ownership change has occurred, the general rule is that changes in the holding of all “stock” are taken into account, except that preferred stock described in I.R.C. section 1504(a)(4) is generally disregarded.61 I.R.C. section 1504(a)(4) stock is preferred stock that is nonvoting and nonconvertible, and that does not participate in corporate growth and has a reasonable redemption or liquidation premium. Although such preferred stock is not counted as stock for purposes of determining whether there is an ownership change, it is generally included as stock for purposes of determining the value of the loss corporation.62 There are several additional exceptions to the definition of stock, each of which functions as an anti-abuse rule. More specifically, if certain conditions are met, one exception provides that an ownership interest that is otherwise treated as stock may not be treated as stock for purposes of determining whether an ownership change has occurred. Another exception provides that an ownership interest that otherwise would not be treated as stock and is not an option may be treated as stock in determining whether an ownership change has occurred and in determining the value of a loss corporation to compute the section 382 limitation.63

(i) Examples of Ownership Changes Involving Sales among Shareholders

The determination of whether an ownership change has occurred is demonstrated in Examples 6.4 through 6.7.

An existing public company whose stock is widely traded and whose shareholders completely change during a three-year period does not experience an ownership change. This is because all less-than-5-percent shareholders are treated as one or more 5 percent shareholders, such that a complete change in small public shareholders will, under the statute, represent a zero percentage point change during the three-year period.

Note, however, that a group of shareholders acting pursuant to a plan may be treated as a separate entity, even though none of the shareholders individually acquires 5 percent of the loss corporation’s stock.64 For example, assume Public owns 100 percent of Loss. If Q buys newly issued stock constituting 46 percent of the outstanding stock of Loss Corporation from Loss, and five friends acting in concert each buy 1 percent of the Loss stock from Public, an ownership change will take place. (The new stock in this transaction would not qualify for either the cash issuance or the small issuance exceptions described in § 6.4(e)(iii)). This rule applies for testing dates after November 19, 1990. Because Securities and Exchange Commission (SEC) regulations require disclosure of owners acting in concert, taxpayers may generally rely on the absence of such disclosures to conclude that no such separate entity exists.65

Once a shareholder is a 5 percent shareholder at any time within the testing period, he or she is a separate shareholder even though the interest held may be less than 5 percent at other relevant times within the testing period.66 Assume a loss corporation (L) has 25 separate 4 percent shareholders. Five of those shareholders sell 1 percent each of their stock to the remaining 20 shareholders (each of whom ends up owning 5 percent of L). There is a presumption that each of the 20 shareholders (who own 5 percent of L) owned no stock in L beforehand, causing a 100 percentage point shift in the ownership of L and an ownership change.67 This presumption is overcome by actual knowledge that the 20 shareholders actually owned 4 percent each in L beforehand, resulting in only a 20 percentage point owner shift.68

Because an increase in stock ownership is measured by reference to the lowest percentage of stock owned by a 5 percent shareholder at any time during the testing period, if a 5 percent shareholder disposes of loss corporation stock and subsequently reacquires all or a portion of such stock during the testing period, the increase resulting from the subsequent acquisition is taken into account in determining whether an ownership change has occurred (even if the percentage ownership between the first and last day of the testing period is the same or has decreased).

One I.R.C. section 382 issue that has lurked in the shadows for many years is now receiving significant attention. This issue is how to deal with fluctuations in the relative value of different classes of stock when computing an ownership change. This phenomenon of an ownership change resulting from fluctuations in value may be illustrated as follows:

Assume that a corporation, on formation, issues 100 shares of common stock to individual A at a price of $10 per share (for a total of $1000) and 5 shares of voting preferred stock to individual B at $20 per share (for a total of $100).

One year later A sells 10 shares of common stock to individual C for $5 when the price of the common stock has declined from $20 per share to 50 cents per share. This sale results in a testing date. Individual B continues to own the preferred stock, and such stock retains its value of $20 per share. If fluctuations in value are not removed from the computation of percentage increase in interest by the shareholders, the corporation will have an ownership change, even though only 10 percent of the common stock is transferred and the voting preferred stock continues to be held by the same shareholder. This is because B’s interest has increased from a low of approximately 9 percent of the value of the corporation at the beginning of the testing period (on formation the voting preferred was worth $100 of a total $1100 of equity value) to approximately 67 percent of the equity value of the corporation on the testing date (preferred stock is now worth $100 of a total of $150 of total equity).

The IRS provided guidance regarding this issue in Notice 2010-50.70 The notice provides two basic methodologies for addressing fluctuations in value. The first is the full value methodology. The notice describes this approach including this illustrative example:

Under a Full Value Methodology, the determination of the percentage of stock owned by any person is made on the basis of the relative fair market value of the stock owned by such person to the total fair market value of the outstanding stock of the corporation. Thus, changes in percentage ownership as a result of fluctuations in value are taken into account if a testing date occurs, regardless of whether a particular shareholder actively participates or is otherwise party to the transaction that causes the testing date to occur; essentially, all shares are “marked to market” on each testing date.

Example: Upon formation, corporation X issues $20 of convertible preferred stock to A and issues two shares of common stock to B for $80, such that A and B own 20 percent and 80 percent, respectively, of X. The fortunes of X deteriorate, and, two years later, when the common stock has a value of $2.50 per share and the preferred stock has a value of $20, B sells one share of common stock to C. At the time of B’s sale to C, X is a loss corporation. On that testing date, A will be treated as increasing its proportionate interest from 20 percent to 80 percent ($20/$25) under the Full Value Methodology as a result of the upward fluctuation in value of the preferred stock relative to the common stock.

The second methodology is the hold constant principle (HCP). The notice describes the HCP including this illustrative example:

Broadly stated, under the Hold Constant Principle, the value of a share, relative to the value of all other stock of the corporation, is established on the date that share is acquired by a particular shareholder. On subsequent testing dates, the percentage interest represented by that share (the “tested share”) is then determined by factoring out fluctuations in the relative values of the loss corporation’s share classes that have occurred since the acquisition date of the tested share. Thus, as applied, the HCP is individualized for each acquisition of stock by each shareholder. Moreover, the ownership interest represented by a tested share is adjusted for the dilutive effects of subsequent issuances and the accretive effects of subsequent redemptions following the tested share’s acquisition date.

Example: Upon formation, corporation X issues $20 of convertible preferred stock to A and issues two shares of common stock to B for $80, such that A and B own 20 percent and 80 percent respectively, of X. The fortunes of X deteriorate, and, two years later, when the common stock has a value of $2.50 per share and the preferred stock has a value of $20, B sells one share of common stock to C. At the time of B’s sale to C, X is a loss corporation. On that testing date, although A actually owns 80% of the value of X, A will be treated as owning 20% of the value of X for purposes of § 382 (g), under the Hold Constant Principle.

The notice further provides that there are alternative methodologies for implementing the HCP. One approach—HCP1—recalculates the HCP percentage represented by a tested share to factor out changes in its relative value since the share’s acquisition date.71 Generally, this is accomplished by calculating the percentage interest represented by a tested share on a testing date, beginning with the value of the tested share on the testing date, and then making adjustments based on the changes in relative value of the tested share to the value of all the stock of the loss corporation that have occurred since the tested share’s acquisition date. Another approach (HCP2) for implementing the HCP tracks the percentage interest represented by a tested share from the date of acquisition forward, adjusting for subsequent dispositions and for the subsequent issuance or redemption of other stock. Under this approach, the increase in percentage ownership represented by the acquisition of a tested share during the testing period is established on the date the tested share is acquired. This increase is reduced (but not below zero) for subsequent dispositions of shares by the owner. The notice provides that taxpayers may use any methodology that is a reasonable application of either a full value methodology or the HCP in determining when an ownership change has occurred. The IRS has issued private rulings in this area (many before the issuance of Notice 2010-50), most of which to date appear to have used an HCP1 approach.72

The notice requires that a taxpayer generally must employ a single methodology consistently to all testing dates in a “consistency period.” With respect to a particular testing date (the “current testing date”), the consistency period includes all prior testing dates, beginning with the latest of (1) the first date on which the taxpayer had more than one class of stock; (2) the first day following an ownership change; or (3) the date six years before the current testing date. The notice also addresses other issues that arise due to the fluctuation in value issue.

(ii) Other Transactions Giving Rise to Ownership Changes

Transactions other than sales among shareholders can also result in ownership changes. These include redemptions (including I.R.C. section 303 redemptions to pay death taxes), public offerings, split-offs, I.R.C. section 351 incorporations, recapitalizations, reorganizations, and stock becoming worthless. This is a significant broadening of the transactions covered, compared with the prior-law definition of a “purchase.” Only changes in stock ownership resulting from gift, death, divorce, or separation,73 pro rata dividends and pro rata spin-offs, by the very nature of the distribution, do not result in an ownership change.

It may be possible to structure the stock of an entity to prevent an ownership change from occurring. For example, the IRS has ruled that if a company’s stock certificates are labeled with a legend restricting the transfer of the certificate if such transfer would cause an ownership change, such an arrangement is sufficient to preclude an ownership change. The mechanics of the restriction would prohibit any transfer with the potential to cause an ownership change, including a return of the shares represented by the certificates to non-5-percent shareholders, a return of the purchase price to the purported acquirer, and a return of all vestiges of ownership (e.g., dividends) to the selling shareholder.74

(iii) Examples of Ownership Changes Resulting from Other Transactions

(iv) Equity Structure Shift

An equity structure shift is a reorganization other than a mere change in form (F reorganization) or a divisive reorganization (generally, a spin-off under I.R.C. section 355).78 An equity structure shift that results in an increase of more than 50 percentage points in the stock ownership of a loss corporation is an ownership change.79 The identity of the loss corporation as the transferor or acquiring corporation is irrelevant. Thus, if X Corporation (a loss corporation) merges into Y Corporation (also a loss corporation) in exchange for 60 percent of the stock of Y, there is an equity structure shift. Because the preexisting shareholders of Y own only 40 percent of Y after the merger, there is no ownership change for X, but there is an ownership change for Y. The result would be the same if Y merged into X and the Y shareholders received 40 percent of X. As previously discussed, only changes by shareholders owning 5 percent or more are counted. Although the less-than-5-percent shareholders are aggregated and treated as one shareholder, the less-than-5-percent shareholders of the transferor and acquiring corporation are segregated and treated as separate 5 percent shareholders. For this reason, the relative FMVs of the transferor and acquiring corporation may determine whether an equity structure shift is an ownership change and to which corporation (i.e., the acquiring corporation or the target corporation assuming both the acquiring and target corporations are loss corporations).80

(v) Purchases and Reorganizations Combined

A purchase and an equity structure shift can be combined within the testing period to cause an ownership change.

(vi) Undoing a Section 382 Ownership Change

The IRS ruled that when a bankruptcy court treated a purchase of stock void ab initio, the purchaser would not be treated as having acquired ownership of the stock for purposes of section 382, as long as the court’s order remained in effect and was not set aside by a higher court. It is interesting to note that the court had ordered the purchaser of the stock to sell it, with the proceeds payable to the purchaser up to its net costs and the remainder, if any, payable to a section 501(c)(3) charity.81

(vii) Bailout-Related Section 382 Relief82

(A) Introduction

The IRS issued a series of notices in the I.R.C. section 382 area in late 2008 and early 2009 to address the economic and financial crisis. Discussing the notices (as well as related legislative developments) chronologically allows the reader to track the evolution of this guidance in the context of its historical background. Most of the bailout-related I.R.C. section 382 guidance is related to determining if and when a testing date would occur after a government purchase of stock in a loss corporation. These stock purchases provided necessary capital and in essence bailed out certain troubled corporations. If there is no testing date, then there can be no I.R.C. section 382 ownership change. If there is no I.R.C. section 382 ownership change, I.R.C. section 382 will not limit the utilization of prechange losses. The IRS also issued two other I.R.C. section 382 notices in this time frame. One notice addressed the treatment for losses on loans or bad debts to banks (also described together with its statutory repeal below), and the other addressed the treatment of capital contributions and is discussed in more detail in that portion of this chapter.

The underlying idea behind most of the bailout-related notices discussed below (with the exception of Notice 2008-83) appears to be that the U.S. government, which became a shareholder in certain loss corporations, would not engage in NOL trafficking, the practice I.R.C. section 382 is designed to prevent. Thus, during uncertain economic times, Treasury clarified I.R.C. section 382 for situations when the U.S. government or one of its agencies becomes a shareholder in a loss corporation.

The notices rely either explicitly or implicitly on authority provided to Treasury by I.R.C. section 382(m) to generally prescribe regulations to carry out the purposes of I.R.C. section 382. In addition, the notices related to the Emergency Economic Stabilization Act of 2008 (the Emergency Act), described below, rely on the authority granted to Treasury by section 101(c)(5) of the Emergency Act to issue regulations and other guidance as may be necessary or appropriate to carry out the purposes of Emergency Act.

(B) Notice 2008-76: Fannie Mae/Freddie Mac

At first, Treasury addressed a very small subset of loss corporations. Notice 2008-76, issued September 7, 2008, addressed certain acquisitions by the U.S. government pursuant to the Housing and Economic Recovery Act of 2008 (the Housing Act). The Housing Act allowed the U.S. government to invest in the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Bank system.

The notice announced that the IRS and Treasury would issue regulations to address how I.R.C. section 382 would apply to Housing Act acquisitions. The regulations would preclude any date on or after the date on which the United States (or any agency or instrumentality thereof) acquires either stock83 or an option to acquire stock in the loss corporation from being an I.R.C. section 382 “testing date.” The wording of the notice indicates that after the government’s buy-ins, there would be no I.R.C. section 382 testing dates (even after the government is no longer a shareholder in these loss corporations) unless and until there is further guidance.

The regulations would generally apply on or after September 7, 2008. Notice 2008-76 is sometimes referred to as the Fannie Mae/Freddie Mac Notice.

(C) Notice 2008-84: More-than-50-Percent Interest

The U.S. government did not stop its bailout assistance with the Housing Act. It next moved on to investing in other loss corporations, furthering the need for more I.R.C. section 382 guidance.

Notice 2008-84, issued September 26, 2008, addressed certain acquisitions by the U.S. government that were not covered by Notice 2008-76. These acquisitions resulted in the government becoming a direct or indirect owner of a more-than-50-percent interest in a loss corporation.84 The notice announced that Treasury and the IRS would issue regulations defining the term “testing date” to exclude any date as of the close of which the United States directly or indirectly owns a more-than-50-percent interest in the loss corporation, notwithstanding any other provision of the I.R.C. or the regulations. Thus, the loss corporation would only have to start tracking its I.R.C. section 382 position on any date as of the close of which the United States does not directly or indirectly own a more-than-50-percent interest in the loss corporation. The regulations would generally apply for any tax year ending on or after September 26, 2008.

(D) Notice 2008-83: Banks

This next notice created significant controversy and was eventually legislatively overturned, generally prospectively.

(1) The Notice

Notice 2008-83, issued October 1, 2008, provided guidance to banks on the treatment of losses on loans or bad debts. Unlike the first two notices, this guidance applied with or without government involvement triggering an ownership change.

As background, in addition to limiting NOLs, I.R.C. section 382 can limit certain deductions that were “built in” at the time of the ownership change. Generally, if a corporation is in a net unrealized built-in loss position at the time of the change (i.e., the FMV of its assets is less than the tax basis with certain other adjustments), then such losses/deductions, when recognized within a certain time frame, could also be subject to the I.R.C. section 382 limitation.85

The notice stated that for purposes of I.R.C. section 382(h), any deduction properly allowed after an ownership change to a bank with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) would not be treated as a built-in loss or deduction that is attributable to periods before the change date. Thus, although the banks would still need to include such losses into the net unrealized built-in loss calculations, the losses triggered after an ownership change would not constitute recognized built-in losses (and thus would not be subjected to an I.R.C. section 382 limitation). The notice applied to corporations that were banks (as defined in I.R.C. section 581) both immediately before and after the ownership change date. The banks were allowed to rely on the treatment set forth in the notice “unless and until there is additional guidance” (i.e., the notice appeared to apply both prospectively and retrospectively).

The notice drew the ire of Congress. Senator Chuck Grassley, ranking minority member of the Senate Finance Committee, requested an investigation into the issuance of the notice.86

(2) Repeal of Notice 2008-83

The ARRA repealed Notice 2008-83, generally prospectively, reasoning that Treasury was not authorized under section 382(m) to provide exemptions or special rules that are restricted to particular industries or classes of taxpayer. However, the ARRA left Notice 2008-83 in effect for any ownership change occurring on or before January 16, 2009. In addition, the notice is in effect for changes occurring after January 16, 2009, if such changes are (1) pursuant to a written binding contract entered into on or before January 16, 2009, or (2) pursuant to a written agreement entered into on or before that date and the agreement was described on or before that date in a public announcement or in a filing with the SEC required by reason of the ownership change.

(E) Notice 2008-100: Capital Purchase Program

The next step the U.S. government took in addressing the financial crisis was the Emergency Economic Stabilization Act of 2008 (the Emergency Act). Notice 2008-100, issued October 15, 2008, discussed how I.R.C. section 382 would apply to loss corporations whose instruments were acquired by Treasury under the Emergency Act’s Capital Purchase Program (CPP). The CPP authorized Treasury to acquire preferred stock and warrants from qualifying financial institutions.

Notice 2008-100 was later amplified and superseded by Notice 2009-14, which was in turn amplified and superseded by Notice 2009-38. Further, Notice 2009-38 was amplified and superseded by Notice 2010-2. Notice 2010-2 is discussed in detail below. Accordingly, we will not discuss Notice 2008-100, Notice 2009-14, or Notice 2009-38 in detail.

(F) Notice 2009-14: Capital Purchase Program and Troubled Asset Relief Program

Notice 2009-14, issued January 30, 2009, announced that Treasury and the IRS would issue regulations implementing certain rules described in the notice. Notice 2009-14 covers five programs established under the Emergency Act (compared to Notice 2008-100, which covered only the CPP in general):

Notice 2009-14 amplified and superseded Notice 2008-100 in addressing issues raised by the U.S. government’s investment pursuant to the Emergency Act. However, as noted, Notice 2009-14 was itself amplified and superseded by Notice 2009-38, which in turn was amplified and superseded by Notice 2010-2.

(G) Notice 2009-38: Treasury Acquisitions under Emergency Act Programs

Following the issuance of Notice 2009-14, Treasury added several other programs pursuant to its authority under the Emergency Act. This, plus the need for additional guidance on existing Emergency Act programs, apparently led Treasury to issue another I.R.C. section 382 notice. Notice 2009-38, issued April 13, 2009, provides additional guidance regarding the application of I.R.C. section 382 to corporations whose instruments are acquired by Treasury pursuant to the Emergency Act.

Notice 2009-38 expands the number of programs covered by Notice 2009-14 from five to eight. The three added programs are:

Notice 2009-38 was amplified and superseded by Notice 2010-2.

(H) Notice 2010-2: Treasury Acquisitions and Dispositions under Emergency Act Programs

Notice 2010-2, released December 16, 2009, amplified and superseded Notice 2009-38. The primary goal of issuing one more notice appears to be to address the treatment of the disposition of shares held by Treasury via a public offering. Otherwise, most of the rules originally outlined in Notice 2009-38 stayed the same.

The notice applies to the same eight programs that were subject to Notice 2009-38. Taxpayers may rely on the rules described in Notice 2010-2 unless and until there is additional guidance. Thus, some protection is built into the notice in case of future contrary guidance.

The notice provides seven rules—Rule A through Rule G87—outlined next. The general theme of the guidance appears to be to minimize the impact of the government’s investment on I.R.C. section 382 positions of corporations.

Rule A. Characterization of Instruments (Other than Warrants) Issued to Treasury

Program	Treatment of Instruments for All Federal Income Tax Purposes
All programs except TARP CAP	As debt if denominated as such, or as I.R.C. section 1504(a)(4) stock if denominated as preferred stock whether held by Treasury or by subsequent holders. (I.R.C. section 1504(a)(4) stock is generally not included in I.R.C. section 382 owner shift calculations.) Preferred stock will still count as stock for purposes of section 382(e)(1) determination of the I.R.C. section 382 limitation.
TARP CAP	Determined by applying general principles of federal tax law.

Rule B. Characterization of Warrants Issued to Treasury

Program	Treatment of Instruments for All Federal Income Tax Purposes
All programs except Private CPP and S Corp CPP	As an option (and not as stock) whether held by Treasury or subsequent holders. Shall not be deemed exercised under Treas. Reg. section 1.382-4(d)(2) while held by Treasury.
Private CPP	Ownership interest in the underlying stock, which is treated as I.R.C. section 1504(a)(4) stock. (I.R.C. section 1504(a)(4) stock is generally not included in I.R.C. section 382 owner shift calculations.)
S Corp CPP	Ownership interest in the underlying indebtedness.

Rule C. Value-for-Value Exchange

For all federal income tax purposes, any amount received by an issuer in exchange for instruments issued to Treasury under the programs shall be treated as received, in its entirety, as consideration for such instruments. This rule addresses concerns regarding the treatment of any potential overpayment by Treasury.

Rule D. I.R.C. Section 382 Treatment of Stock Acquired by Treasury

This is one of the two core rules of the notice. Stock issued to Treasury does not increase Treasury’s ownership in the issuing corporation. However, Treasury’s stock is considered outstanding for purposes of calculating ownership of other 5 percent shareholders, except as described in the next sentence. For purposes of measuring shifts in ownership by any 5 percent shareholder on any testing date on or after the loss corporation redeems Treasury’s stock, the redeemed stock is treated as if it had never been outstanding.88

Rule E. I.R.C. Section 382 Treatment of Stock Sold by Treasury to Public

This is the second core rule of the notice, and it constitutes the main difference between Notice 2009-38 and Notice 2010-2. If Treasury sells stock that was issued to it pursuant to the Emergency Act programs and the sale “creates” a public group (New Public Group), the New Public Group’s ownership in the issuing corporation shall not be considered to have increased solely as a result of such sale. The New Public Group’s ownership still can be increased as a result of other transactions, such as issuances of shares treated as issued to public group or redemptions of shares held by public groups. Shares held by the New Public Group are considered outstanding for purposes of determining percentage owned by other 5 percent shareholders on any testing date, and I.R.C. section 382 otherwise applies to the New Public Group in the same manner as with respect to any other public group.

Rule F. I.R.C. Section 382(l)(1) Does Not Apply to Treasury’s Capital Contributions

Taxpayers are instructed to assume that Treasury’s principal purpose was not to increase or avoid the I.R.C. section 382 limitation of the corporation. Query whether this rule was necessary following the issuance of Notice 2008-78, which is discussed below.

Rule G. Certain Exchanges

This rule applies to covered instruments. Covered instruments include instruments received in future exchanges of new instruments for instruments originally issued under the programs (including exchanges of the instruments received in such exchanges).

Rule	Application to Covered Instruments
Rules A and B	Do not apply. Instead, general principles of federal tax law determine the characterization of all covered instruments.
Rules C, D, E, and F	Apply to covered instruments.

The following examples, created by the authors, illustrate the application of Notice 2010-2:

• Example 1. Upon formation, LossCo 1 had one class of common stock (100 shares in total) and four shareholders: A owned 40 percent, B owned 35 percent, C owned 10 percent, and Treasury owned 15 percent. (Treasury investments are generally made into existing corporations; this and the next example start at formation for simplification purposes.) A, B, and C are individuals. Treasury purchased shares pursuant to one of the Emergency Act programs.
  On Date 1, A sold all of its stock to B. The result was a 40 percent owner shift. On Date 2, LossCo 1 redeemed stock held by Treasury, and C sold one of its shares to a new shareholder.89 All dates are within the same testing period.
  
  
  
  How should the lowest percentage ownership be calculated for B on Date 2?
  On Date 2, B owns 75 shares, or 88 percent of the outstanding shares. To calculate B’s lowest ownership percentage, without Notice 2010-2, one would take 35 shares owned on formation out of 100 shares outstanding then, resulting in a 35 percent lowest ownership percentage and a 53 percent owner shift for B on Date 3. However, the notice appears to require that B’s lowest ownership percentage be determined by taking B’s 35 shares owned formation out of 85 shares (disregarding Treasury ownership pursuant to Rule D), resulting in a 41 percent lowest ownership percentage and a 47 percent point shift for B on Date 2. A similar analysis would apply to C’s owner shift on Date 2.
• Example 2. Upon formation, LossCo 2 had one class of common stock (100 shares in total) and two shareholders: A (an individual) owned 85 percent, Treasury owned 15 percent. Treasury purchased shares pursuant to one of the Emergency Act programs. On Date 1, Treasury sold 10 shares to a New Public Group, LossCo 2 redeemed 5 of Treasury’s shares, and A sold 1 of its shares to a new shareholder.90 Formation and Date 1 are within the same testing period.
  
  
  
  How should LossCo 2 compute shareholder increases in ownership for purposes of determining whether an ownership change has occurred?
  On Date 1, shareholder A owns 88 percent (84 shares out of 95). Absent a special rule, A’s lowest percentage ownership would have been 85 percent (85 out of 100 at formation). However, pursuant to Rule D, A is treated as owning 89 percent (85 out of 95 shares) on formation. Thus, the owner shift with respect to A is zero.
  On Date 1, New Public Group owns 11 percent (10 out of 95 shares). Absent a special rule, New Public Group would have been considered going from zero to 11 percent on Date 1 contributing 11 percent to the cumulative owner shift. However, pursuant to Rule E, New Public Group should not contribute to the shift in ownership on Date 1 because its ownership is attributable solely to the sale of shares by Treasury.
  No special rules apply to the new shareholder. Thus, it is treated as increasing its ownership from zero to 1 percent on Date 1 (contributing 1 percent to the cumulative owner shift on Date 1).

One issue that the Treasury has not been willing to issue guidance on is whether it is appropriate to extend relief similar to Notice 2010-2 to foreign banks or other financial institutions receiving capital infusions from foreign governments.91 Without such guidance, any investment by foreign governments, whether made in the spirit of assisting troubled financial institutions or otherwise, appears to be subject to the general rules of I.R.C. section 382.

(I) New I.R.C. Section 382(n)

This item of bailout-related guidance was put into place not by Treasury in a notice but by Congress itself. The ARRA (signed into law by President Obama on February 17, 2009) created new I.R.C. section 382(n). This section removes the I.R.C. section 382 limitation in certain very limited circumstances.

As a starting point, two requirements must be met.

Furthermore, I.R.C. section 382(n) does not remove the I.R.C. section 382 loss limitation if, immediately after the ownership change, any person (other than a voluntary employee benefit association) owns stock possessing 50 percent or more of the total voting power or total value of the stock of the loss corporation.92 I.R.C. section 382(n) applies to ownership changes after February 17, 2009.

(e) Public Shareholders and the Segregation Rules

(i) Introduction

Recall that the less-than-5-percent shareholders of a corporation are aggregated and treated as one individual shareholder. Thus, 25 unrelated but equal shareholders of X Corporation are treated as one shareholder (Public X). Similarly, the stock of IBM Corporation would be owned by one shareholder (Public IBM). Trades among the public shareholders are disregarded. If each of the 25 shareholders of X (above) on one day (but not pursuant to a plan) sells all of his or her IBM stock to 25 new but equal shareholders, there is no ownership change even though the shareholder composition of X has changed completely. If 10 of the X shareholders sell all their stock (40 percent) to A and each of the other 15 equal shareholders sells 4 percent of the stock to 15 other new shareholders (B through P, respectively), there is only a 40 percent owner shift and thus no ownership change.

Although trading among members of a public group is disregarded for purposes of determining an owner shift,93 when a loss corporation makes a public offering or otherwise issues new stock (including issues pursuant to equity structure shifts, redemptions, exchanges of stock for property (I.R.C. section 1032 transactions), and the issuance of some options), the less-than-5-percent shareholders who receive the new stock may be segregated in whole or in part from the existing public group and treated as a new public group.94

Although conceptually sound, this segregation principle is difficult to implement because it requires a corporation to determine the extent to which newly issued stock is acquired by existing, as opposed to new, shareholders. A complex set of temporary regulations addressed this issue.

On November 4, 1992, the IRS issued two sets of proposed regulations under I.R.C. section 382. The first set proposed alterations in the presumption concerning the creation of new public groups as a result of new issuances (the segregation presumption), and also introduced a new exception to the segregation rules for small issuances (the small issuance exception).95 The second set addressed the treatment of options in determining whether a loss corporation has an ownership change.96 The first of these two sets of proposed regulations (the segregation rules) was finalized on October 4, 1993, with only minor changes that will be discussed immediately below.97 These final regulations apply to issuances of stock in tax years beginning on or after November 4, 1992, and they permit taxpayers to elect to apply the rules retroactively.

The second of these two sets of proposed regulations (the option rules) was finalized on March 17, 1994.98 These final regulations are more forgiving than their temporary regulation predecessors, and unlike the proposed regulations, they do include some safe harbors, but these new rules were not given retroactive effect. The effective date of the option regulations is for any testing date on or after November 5, 1992 (the date the proposed regulations were issued).99 The focus of these final regulations is on the testing date and not the date the option is issued. Thus, a 10-year option to acquire 30 percent of the stock of a loss corporation, issued on March 1, 1989, is subject to the final regulations (and not the temporary regulations) if there was no ownership change between March 1, 1989, and November 4, 1992 (i.e., the 30 percent option plus other owner shifts did not add up to a greater-than-50-percent ownership change within any 3-year period prior to November 5, 1992). Conversely, options that contributed to an ownership change under the temporary regulations will not be considered outstanding for any subsequent testing date.

Taxpayers may elect to apply the old temporary regulations for testing dates that would normally be covered by the final regulations for any testing date between November 5, 1992, and May 17, 1994 (60 days after the regulations are finalized). Often it is better to trigger an ownership change earlier rather than later. This would be the case when a corporation continues to generate losses (later losses would not be restricted by an early ownership change) or when the “section 382 limitation” would be greater in the earlier period (e.g., the value of the corporation or the long-term tax-exempt rate is higher in the earlier period). In such cases, this election may be appropriate. In addition, corporations in bankruptcy may elect to apply the old rules for any petition filed on or before May 17, 1994.

Although it has been almost 20 years since the current segregation rules and option rules were proposed in 1992, taxpayers could still be faced with situations in which the old temporary regulations apply. Therefore, the discussion that follows first briefly reviews the old temporary regulations and then discusses the proposed and final regulations. The old, proposed, and then current regulations addressing segregation are discussed first, and the old, proposed, and final option rules are discussed second.

(ii) Segregation: Old Temporary Regulations

The touchstone of the old temporary regulations was the presumption that newly issued shares were acquired solely by new (as opposed to existing) shareholders.

There was a presumption of no overlap (i.e., the shareholders who acquire stock of the loss corporation in the public offering were presumed not to include any member who owned stock in Y beforehand).100 The “overlap” presumption could be overcome by actual knowledge of cross-ownership.

An entire lexicon developed under the old temporary regulations, including first-tier entity, higher-tier entity, highest-tier entity, 5 percent owner, 5 percent shareholder, public shareholder, public owner, and public group. The complexity of these old regulations was wholly disproportionate to their applicability, and the great bulk of transactions were analyzed without resort to them.

(iii) Segregation: Final Regulations

In recognition of the practical problems of determining cross-ownership, the proposed regulations created a new presumption on the subject of cross-ownership (“segregation presumption”). In addition, to reduce the administrative burden created by keeping track of small separate public groups, the proposed regulations excluded from consideration a portion of shares that are issued for cash (“cash issuance exception”) and certain small issuances of stock (“small issuance exception”).

(A) Segregation Presumption—Cash Issuance Exception

If a loss corporation issues stock for cash, the no-cross-ownership presumption is replaced with a presumption that a prescribed percentage of the newly issued stock was acquired by existing direct public groups.101 That prescribed percentage is equal to 50 percent of the total percentage owned by the existing public groups prior to the new issue. Thus, if a corporation with 100 percent of its stock owned by one public group issues 20 new shares to the public, 10 shares (20 shares × 50 percent × 100 percent) would be deemed issued to the existing public group and the remaining 10 shares would be deemed issued to a new public group. As a result, there would be an owner shift of 8 percent (10/120) rather than the 17 percent (20/120) owner shift that would result under the old temporary regulations.

If some of the stock outstanding before the new issue is owned by more-than-5-percent shareholders rather than by public groups, then the percentage of stock owned by public groups will be less than 100 percent and the resulting prescribed percentage will change.

If any of the newly issued stock is acquired by a more-than-5-percent shareholder (either one in existence before the new issue or one created by the new issue, but other than a public group), a limitation applies. Under the limitation, the loss corporation must compute the difference between the value of the total shares newly issued and the value of those shares acquired by a more-than-5-percent shareholder (other than a public group). If that amount is lower than the amount computed by the prescribed percentage, the lower amount is used to determine an allocation of newly issued shares to existing public groups.

The foregoing examples can be summarized by the following rule:

The number of shares deemed issued to the existing public groups is the lesser of:

50 percent × Percent of stock owned by all public groups before the new issue × Number of shares issued in the new issue

or

Total shares issued in the new issue less shares issued to more-than-5-percent shareholders (other than a public group).

(B) Small Issuance Exception

If a loss corporation issues stock to the public (no 5 percent shareholders) other than in an acquisitive reorganization, and the issuance is “small” within the meaning of the proposed regulations, there will be no segregation and the issuance will not result in the creation of a separate public group.102 “Small” is defined as 10 percent, and, at the election of the corporation, can be (1) 10 percent of the value of the loss corporation’s stock outstanding at the beginning of the year (excluding “vanilla preferred” stock under I.R.C. section 1504(a)(4) or (2) 10 percent of the shares of the class of stock being issued that is outstanding at the beginning of the year. Notice that the issuance of a new class of stock can never qualify under (2). If it is a new class, none of it will be outstanding prior to the issue, and 10 percent of zero is zero.

The election is made yearly. If the 10 percent limitation is not met with respect to an issuance, that entire issuance will fail to meet the small issuance exception. If there are multiple public issues during the year, each of which meets the small issuance limitation, those issues combined together must nevertheless meet the 10 percent limitation. If they do not, however, only the excess of the combined yearly issues above the 10 percent limitation will be ineligible for the small issuance exception. If the excess amount was issued for cash, a portion of it may escape allocation to a new public group under the new segregation presumption. If the excess amount was not issued for cash, it will all be deemed issued to a new public group.

Actual knowledge that a new issuance was acquired by an existing public group is a one-way street for the benefit of the taxpayer. If the segregation presumption (or the small issuance exception) results in a greater amount of stock being received by the existing public group than would be received by using actual knowledge, the segregation presumption (or small issuances exception) controls. If actual knowledge results in a greater amount of stock being received by the existing public group than would be received by using the segregation presumption (or the small issuance exception), actual knowledge controls.103

The limitation under the segregation presumption, restricting the amount of the new issue that can be deemed acquired by the existing public groups, also applies to the small issuance exception.104 In the small issuance context, the limitation restricts the amount of a new issue that can be deemed acquired by the existing public groups to the lesser of (1) the amount qualifying for the small issuance exception or (2) an amount equal to the difference between the total shares issued and those acquired by the more-than-5-percent shareholders (other than a public group).

(iv) Segregation: Nuances

When adopting the regulations in final form, Treasury made a couple of minor changes to the previously issued proposed version of the regulations. These changes were:

(v) Trading Involving Shareholders Who Are Not 5 Percent Shareholders

As noted in § 6.4(e)(i), trading among members of a public group is generally disregarded.109 However, if a 5 percent shareholder sells stock to small shareholders, these small shareholders are segregated into a separate public group.110 The IRS recently revisited and requested comments regarding this application of the segregation rules in Notice 2010-49.111

Notice 2010-49 notes that the proper treatment of small shareholders (less than 5 percent shareholders) is based in the policy underlying section 382. The policy identified in the notice is to prevent acquisition of loss corporation stock followed by the contribution of income-producing assets or opportunities to the corporation. The notice goes on to discuss two approaches.

The first approach, referred to as the Ownership Tracking Approach, is the current approach in the regulations that disregards public trading but segregates sales by 5 percent shareholders to a small shareholder. This approach seeks to apply segregation when it is not unduly burdensome to do so.

The other approach discussed in the notice is described as the Purposive Approach. The Purposive Approach attempts to identify situations in which abuses are more likely to arise. Under this approach, one would not take into account every acquisition of stock by small shareholders (e.g., from 5 percent shareholders, because small shareholders are generally not in a position to acquire loss corporation stock or to inflate the income of the corporation by transferring income-producing assets or opportunities). The IRS acknowledges that if the Purposive Approach is adopted, it could result in a reduced percentage change in ownership for acquisitions of stock by small shareholders.

The overall gist of the rules is best reflected by an example provided in the notice:

Facts. All the stock of loss corporation is owned by a single public group, Original Public Group. The following acquisitions and dispositions each occur during the testing period. First, Investor A acquires 10 percent of the corporation’s stock from Small Shareholders, and sells it to Small Shareholders a few months later. Second, Investor B acquires 10 percent of the stock from Small Shareholders, and sells it a few months later to Small Shareholders. Third, Investor C does the same. . . .

Ownership Tracking Approach. The regulations reflect the Ownership Tracking Approach, and require the creation of a new, segregated public group when each of Investors A, B and C sells its stock back to Small Shareholders. As a result, the loss corporation has four 5-percent shareholders, Original Public Group and three new, segregated public groups (New Public Group 1, New Public Group 2, and New Public Group 3). Each investor is treated as acquiring the loss corporation stock proportionately from the direct public groups that exist immediately before the acquisition. See § 1.382-2T (j) (2) (vi). Accordingly, New Public Group 1, New Public Group 2, and New Public Group 3, the only 5-percent shareholders whose interests in loss corporation have increased during the testing period, have increased their respective ownership interest by 27.1 percent, in the aggregate—from zero to 8.1 percent for New Public Group 1, from zero to 9 percent for New Public Group 2, and from zero to 10 percent for New Public Group 3. This is so even though the stock is now, and at the beginning of the testing period was, held 100 percent by Small Shareholders, and even though no actual 5-percent shareholder ever held more than 10 percent of the corporation’s stock. This treatment is justified on the grounds that the corporation is able to track each time a 5-percent shareholder sells stock to new shareholders, including Small Shareholders. . . .

Purposive Approach. Under the Purposive Approach, the amount of change in ownership is different from the amount under the Ownership Tracking Approach. When each investor sells its shares to Small Shareholders, the shares could be treated as being reacquired by Original Public Group rather than the new, segregated public groups. As a result, the aggregate effect on the change in ownership is significantly reduced. Accordingly, Original Public Group is treated as increasing its ownership interest from 90 percent to 100 percent during the testing period.

The notice also observes that the application of the Purposive Approach could be applied in a manner that would provide even further benefits and discusses some of these aspects in more detail.

(vi) Options: Temporary Regulations

Solely for the purpose of determining whether there is an ownership change on any testing date, the old temporary regulations provided that the stock of the loss corporation that was subject to an option would be treated as acquired on any such date (pursuant to an exercise of the option by its owner on that date) if such deemed exercise would result in an ownership change.112 The option rule was applied separately to each class of options and each 5 percent shareholder. Thus, certain options would be counted as exercised and others may be disregarded, depending on whether the deemed exercise would cause an ownership change.

Options were broadly defined to include warrants, rights, convertible debt, convertible stock, a put, a stock interest subject to a risk of forfeiture in favor of another party, an option to acquire an option to acquire stock, and a contract to acquire or sell stock. Thus, an executory contract to sell stock, a bilateral agreement to sell stock, or a contract to sell stock subject to third-party approval (Federal Communications Commission, Justice Department, IRS, shareholders) was an option. Such an option created an owner shift at the time of the preliminary agreement, notwithstanding the contingency involved.

In case of a stock acquisition or similar agreement, the date of the ownership change was generally the time when the transaction had to be carried out, as a legal or practical matter. Thus, an agreement to sell stock became an option at the time the boards of directors of both the target and acquiring companies approved the acquisition,113 and a public stock offering became an option subject to the I.R.C. section 382 attribution rules when it was publicly announced.114

Convertible pure preferred stock (i.e., stock described in I.R.C. section 1504(a)(4) but for the conversion feature and the ability to share in growth as a result of such stock) was treated like convertible debt (i.e., like an option). The effect was to make the convertible stock an evergreen option rather than to classify that stock as a currently acquired outstanding stock interest (limiting the testing period to three years). Such stock (i.e., the option), however, would continue to be treated as stock for purposes of computing the value of the loss corporation. Convertible pure preferred stock with voting rights would be treated as stock and not as an option. These rules were applicable to stock issued after July 20, 1988.115 The IRS reserved the right, in the Treasury Regulations under I.R.C. section 382, to issue exceptions to the option attribution rules merely by publication of notice in the Internal Revenue Bulletin.116 For example, the IRS issued a notice concluding that the transfer of a thrift institution to the Management Consignment Program of the Federal Savings and Loan Insurance Corporation (FSLIC) did not create an option under I.R.C. section 382.117

The actual exercise of an option was disregarded if the existence of the option caused an ownership change. If the exercise took place within 120 days after the date on which the option was deemed exercised (because it created an ownership change), the taxpayer could elect to treat the actual exercise date as the date of the ownership change.118

In the case of an I.R.C. section 338 election, if the signing of the agreement to sell stock of a loss corporation and the closing were within 120 days, the option attribution rules of old Treas. Reg. section 1.382-2T(h)(4)(vi)(B) would permit the I.R.C. section 382 change date to be the actual closing date (which would be the same date as the section 338 acquisition date and the section 338 one-day return). Thus, none of the deemed sale gain under I.R.C. section 338 would be in a postchange year to which the section 382 limitation would apply. Note that I.R.C. section 338(h)(1)(C), as modified by the Technical Corrections Act of 1987, achieved the same favorable result by increasing the section 382 limitation.

Certain options were disregarded under the old temporary rules:

• Options exercisable only upon death, complete disability, or mental incompetency of the owner.
• Options, exercisable upon retirement, between noncorporate owners, both of whom participate in management. Options between a noncorporate owner (who participates in management) and the redeeming corporation are also covered. In both cases, however, the option must have been issued when the corporation was not a loss corporation.
• Options exercisable upon default of a loan from a domestic bank, insurance company, or certain qualified trusts.
• Options between non-5-percent shareholders.
• The right of the loss corporation to redeem stock of less-than-5-percent shareholders.
• Any right to receive, or obligation to issue, stock of a corporation in payment of interest or dividends by the issuing corporation.
• Any option with respect to stock of the loss corporation, which stock is actively traded on an established securities market, if the option has been continuously owned by the same 5 percent shareholder for three years. The exception to option attribution expires at the earlier of when the option is transferred by or to a 5 percent shareholder, or when the FMV of the stock that is subject to the option exceeds the exercise price.
• The right to receive stock at maturity, pursuant to the terms of a debt instrument, if the amount of the stock transferred at maturity is equal to a fixed dollar amount divided by the then value of each share.
• Options that, on the testing date, pertain to stock of a corporation with de minimis loss. De minimis losses are prechange losses that are less than twice the section 382 limitation.
• Options outstanding immediately before and immediately after an ownership change.

If an option caused an ownership change that limited loss carryovers and it turned out that the option was in fact never exercised (due to lapse or forfeiture), the loss corporation could file a claim for refund as if there had been no ownership change.

The IRS ruled that a mere modification of the terms of an exchange offer did not cause a lapse or forfeiture of the original offer, because the holder of the option never relinquished any of its rights. A lapse or forfeiture did occur when an option expires, even though renewed several days later on the same terms.119 Furthermore, a redemption of options that caused an ownership change did not constitute a lapse or forfeiture sufficient to undo the previous ownership change.120

(vii) Options: Proposed Regulations

Under the proposed regulations addressing options, an option (including stock warrants, stock rights, incentive stock options, stock subject to risk of forfeiture, puts, convertible debt, contracts to acquire stock) would be considered the equivalent of the underlying stock (i.e., deemed exercised) so as to contribute to an ownership change under I.R.C. section 382, only if it was “issued or transferred for an abusive principal purpose.”121 Absent such a purpose, the option was disregarded in determining whether an ownership change took place until it was actually exercised. This was a complete reversal from the temporary regulations, which disregarded all contingencies as to time and event and treated the mere existence of the option as ownership of the underlying stock, if such treatment resulted in an ownership change. The result was that an ownership change could occur in a time period before exercise of the option.

Under the proposed regulations, an “abusive principal purpose” is defined as a principal purpose of manipulating the timing of an owner shift to ameliorate or avoid the impact of an ownership change of a loss corporation by (1) providing the holder of the option with a substantial portion of the attributes of ownership of the underlying stock or (2) facilitating the creation of income to absorb the corporation’s losses prior to the exercise of the option. The proposed regulations provided that the determination of principal purpose was to be based on facts and circumstances. Six factors that provided evidence of such a purpose were:

Although these were merely factors in evaluating abusive purpose, if any of these factors was present and the loss corporation did not treat the option as exercised, disclosure on the loss corporation’s return was required.

Factors 5 and 6 on the list above reflect the concern of the Treasury Department, as expressed in the preamble to the proposed regulations, that an investor might contribute money to a loss corporation in exchange for an option, wait until that money is used by the loss corporation to engage in a profitable venture so as to absorb existing losses, and then convert the option. If the investor initially purchased stock instead of an option, an ownership change would take place on the date of that purchase, limiting the use of the losses.

The concern embodied in factors 5 and 6 also formed the basis of the government’s arguments in Maxwell Hardware Co. v. Commissioner,122 in which the taxpayers, who were engaged in the real estate business, invested in a loss-corporation hardware business in exchange for nonvoting preferred stock. The invested proceeds were used to finance a profitable real estate venture with a resulting offset of the losses of the hardware business. The hardware corporation was later liquidated, and the investors received the real estate assets. The government presented evidence that the liquidation had been contemplated from the outset and that one of the investors was made a member of the board and appointed vice president of the corporation and manager of the new real estate department. The Ninth Circuit rejected the government’s argument that the transaction constituted impermissible trafficking in loss carryovers on the narrow ground that the investment had not exceeded the 50 percent threshold of the provisions of I.R.C. section 382 under the 1954 I.R.C.

Under the standards of the proposed regulations, it is possible that the contemplation of a future liquidation and the participation in management would cause an investment such as that in Maxwell Hardware to be treated either as “stock” or as an option issued for “an abusive principal purpose.” If the investment is treated as an option, the mere issuance of that option (as opposed to its later exercise) would trigger an ownership change.

This outcome is justified when an option is issued to a small number of new investors, but it makes little sense when convertible debentures are issued to the public to raise money for working capital, to retire debt, or to make an acquisition. Yet the influx of new money into the loss corporation might be deemed a “contribution to capital” and an abusive principal purpose, which would mandate disclosure even in apparent nonabusive situations.

The proposed regulations provided that an option issued or transferred for an abusive principal purpose is treated as exercised, for purposes of determining whether an ownership change occurred, on the issuance date, the transfer date, and any subsequent testing date. Once such an option was treated as exercised and contributed to an ownership change, it was thereafter treated as exercised and could not contribute to an ownership change on any subsequent testing date. Moreover, any later actual conversion into stock was disregarded. This rule was consistent with the temporary regulations. The proposed regulations, however, provided an exception if the option was subsequently transferred for an abusive principal purpose. Under such circumstances, the proposed regulations provided that the option could again be counted toward an ownership change.

The proposed regulations provided that any stock described in I.R.C. section 1504(a)(4) that was convertible into stock other than I.R.C. section 1504(a)(4) stock issued after November 5, 1992, would be treated as stock for purposes of I.R.C. section 382. There was an exception for convertible stock with a conversion feature that permitted or required the tender of consideration other than the stock being converted. Such stock would be considered both stock and an option.123

(viii) Options: Final Regulations

On March 17, 1994, the IRS published in the Federal Register final regulations under I.R.C. section 382 addressing the conditions under which an option would be deemed exercised for purposes of determining whether an I.R.C. section 382 ownership change has occurred. The final regulations are more forgiving than their temporary regulation predecessors, and, unlike the proposed regulations, they do include some safe harbors. Unfortunately, the new rules were not given retroactive effect.124

The final regulations delete the abusive factors of the proposed regulations and, with them, the disclosure requirement. Now, options are generally not treated as exercised unless they run afoul of an ownership test or a control test or an income test (all described below in this section). The final regulations replace the abusive factors with “a series of factors that exemplify circumstances that may be probative under the ownership, control, and income tests.”125 Although this amorphous, ad hoc, and facts-and-circumstances approach will undoubtedly generate controversy on audit, it is far superior to either the temporary regulations, which had clear and definitive but draconian rules, or the proposed regulations, with their abusive factors and disclosure requirements.

The inherently factual nature of each inquiry (and with it, a “principal purpose” determination) will undoubtedly preclude private letter rulings in this area. Thus, some uncertainty will always exist. Nevertheless, compared with the temporary regulations, taxpayers will certainly benefit from a subjective inquiry into whether the issuance of an option is tantamount to the issuance of stock. The final regulations follow the temporary and the proposed regulations in providing that options will not be deemed stock if stock classification helps the taxpayer avoid an ownership change.126

Unlike the old temporary regulations, the final regulations do not have a “lapse or forfeiture” rule under which options that contributed to an ownership change but were in actuality not exercised (i.e., they lapsed or were forfeited) could be expunged retroactively by the filing of an amended return. Although this rule made sense when practically all options were deemed the equivalent of stock (under the old temporary regulations), it is superfluous in a regime (under the final regulations) in which only specific and defined options are treated as the equivalent of stock.

Under the final regulations, options are treated as exercised if the following two conditions are met.

(A) Ownership Test

The ownership test is satisfied if the issuance, transfer, or structuring of the option provides the holder of the option (prior to its actual exercise or transfer) with a substantial portion of the attributes of ownership of the underlying stock.128 Factors to consider are: (1) the relationship, at the time of the issuance or transfer of the option, between the exercise price and the value of the underlying stock (e.g., deep-in-the-money options are suspect); (2) whether the option provides the holder with the right to participate in management or with rights ordinarily afforded to owners of stock (e.g., future loss or appreciation);129 (3) the existence of reciprocal options (i.e., a call held by the purchaser and a put held by the seller); and (4) whether a fixed exercise price option permits its holder to share in future appreciation. Treas. Reg. section 1.382-4(d)(9)(iv) provides, however, that paragraph (d) does not affect the determination of whether an instrument is an option or stock under general principles of tax law (such as substance over form).130

(B) Control Test

The control test is satisfied if the holder of the option has, in the aggregate (taking into account existing stock, stock held by related parties, and stock that could be acquired by exercising the option or options held by related parties), more than 50 percent of the loss corporation’s stock.131 It is unclear whether merely satisfying the 50 percent test, coupled with a “prohibited principal purpose,” is sufficient. The regulations are contradictory on this point.132

(C) Income Test

The income test is satisfied if the issuance, transfer, or structuring of the option facilitated the creation of net income (accelerating income or deferring deductions) prior to the exercise or transfer of the option.133 Factors to consider are: (1) whether in connection with the issuance or transfer of the option, the loss corporation engages in extraordinary income acceleration transactions, and (2) whether large capital contributions or loans are made to the loss corporation by the option holder, the proceeds of which are not used to continue basic operations of the business.

(D) Safe Harbors

The temporary regulations included a number of safe harbor situations in which options were not deemed exercised. Many of these were narrowly drawn. The proposed regulations dropped these few safe harbors. The final regulations now reinstate and broaden them.134 They include:

I.R.C. section 382(l)(3)(B) contains protective relationships (death, gift, divorce, separation) in which the transfer of stock does not contribute to an owner shift. The final regulations accordingly provide that options given in the context of these relationships do not contribute to an owner shift.

(E) Subsequent Treatment of Options Treated as Exercised

The final regulations provide that an option that satisfies conditions 1 and 2 above is treated as exercised, for purposes of determining whether an ownership change occurs, on the issuance date, the transfer date, and any subsequent testing date until there is an ownership change. Once an option is treated as exercised, it will continue to be treated as exercised until it contributes to an ownership change.136 Thereafter, it will not be treated as exercised and it will not (unless retransferred) contribute to a further ownership change on any subsequent testing date. Moreover, any later actual conversion into stock will be disregarded.

A loss corporation is permitted to treat any option actually exercised within three years of the date of its issuance or transfer as retroactively exercised on the date of such issuance or transfer (the “alternative look-back rule election”). This election could be used to advantage by a taxpayer to avoid a second ownership change, where the issuance of an earlier option that was deemed exercised caused an initial ownership change.

(f) Reductions in the Section 382 Limitation

Notwithstanding the mathematical precision of the “section 382 limitation” under I.R.C. section 382(b) (i.e., the value of the old loss corporation multiplied by the long-term tax-exempt rate), a number of subjective concepts override the formula and either reduce or eliminate the NOL carryover. These are: the requirement for continuity of business enterprise,137 the limitation on nonbusiness assets,138 the restrictions on certain contributions to capital,139 and redemptions and other corporate contractions.140

(i) Continuity of Business Enterprise

Following an ownership change, a corporation’s NOLs are subject to complete disallowance unless the loss corporation’s business enterprise is continued at all times during the two-year period following the ownership change.

The legislative history to the 1986 Act indicates that the continuity of business enterprise requirement is the same requirement that must be satisfied to qualify a transaction as a tax-free reorganization under I.R.C. section 368 and Treas. Reg. section 1.368-1(d).141

Under these continuity of business enterprise requirements, a loss corporation (or a successor) must either continue the old corporation’s historical business or use a significant portion of the old loss corporation’s assets in a business. Thus, the requirement may be satisfied even though the old loss corporation discontinues more than a minor portion of its historical business. Changes in the location of a loss corporation’s business product, plant, equipment, or employees (in contrast to the prior law) will not cause the transaction to fail to satisfy the continuity of business enterprise test.

At a minimum, a corporation with three separate trades or businesses of equal size will be able to terminate two of them without violating continuity of business enterprise. Moreover, after the merger of loss corporation (L) into profit corporation (P), a termination of all active businesses of L and the use of the L assets in a business of P will also satisfy continuity of business enterprise.

(ii) Nonbusiness Assets

The value of the loss corporation may be reduced (for purposes of computing the I.R.C. section 382 limitation) if the loss corporation holds substantial nonbusiness assets after an ownership change.

The purpose of this restriction is unclear. It appears to add nothing not already covered by the continuity of business enterprise requirement. It may also violate one of the stated principles of I.R.C. section 382 (tax neutrality), and it will engender controversy by requiring a determination of the amount of nonbusiness assets. Apparently, the drafters were concerned about the appearance of “trafficking” in loss corporations when a small marginal business with substantial carryovers and substantial nonbusiness assets would advertise itself for sale based on its loss carryovers.

Substantial nonbusiness assets are defined as assets whose value is one-third or more of the value of the total assets of the corporation. Thus, there is a “cliff effect”: Only when the one-third threshold is met will the value of the loss corporation be reduced by the FMV of the nonbusiness assets over the share of the liabilities attributable to those assets. Liabilities are apportioned to business and nonbusiness assets based on the relative FMV of the respective assets. The corporation is not permitted to demonstrate that certain liabilities relate solely to nonbusiness assets. Each loss corporation asset is deemed to carry an equal share of liabilities.

Nonbusiness assets are assets held for investment. Significant controversy will arise over cash or marketable securities that could be deemed to be working capital. Assets held as an integral part of the conduct of a trade or business (e.g., funding reserves of a bank or insurance company) are not considered nonbusiness assets. There is a “look-through” rule for subsidiaries. A parent will be deemed to own a ratable share of its subsidiaries’ assets if the parent owns at least 50 percent of the vote and 50 percent of the value of the subsidiary.142

(iii) Contributions to Capital

Any capital contributions (including transfers under I.R.C. section 351) to a loss corporation, whose principal purpose is to increase the section 382 limitation or to avoid any limitation, are not given effect. This is known as the antistuffing rule. Without this rule, cash or other nonbusiness property could be transferred to a loss corporation prior to the sale of the loss corporation’s stock. The buyer could reimburse the seller for the cash (or, in effect, buy the other nonbusiness property) in return for a greater loss limitation than it would have had if it had merely bought the nonbusiness property and contributed it (along with cash) to the loss corporation.

There is a conclusive statutory presumption (except to the extent provided in future regulations)143 that any capital contribution made within the two-year period ending on the change date will be deemed to be for the prohibited purpose of increasing the loss limitation.144 Hence, such a contribution appears to be disallowed automatically. The legislative history provides for the following permissible contributions to capital even if undertaken within the two-year period (and encourage the drafters of the regulations to include them):145

• Capital contributions received on the formation of a loss corporation (not accompanied by the incorporation of assets with a net unrealized built-in loss) where an ownership change occurs within two years of incorporation
• Capital contributions received before the first year from which there is an NOL or excess credit carryover (or in which a net unrealized built-in loss arose)
• Capital contributions made to continue basic operations of the corporation’s business (e.g., to meet the monthly payroll or fund other operating expenses of the loss corporation)
• Distributions made to shareholders subsequent to capital contributions, as offsets to such contributions

The fate of the following seemingly proper contributions within the two-year period is unclear: (1) non–pro rata contributions to capital, which by their very nature are not schemes but are motivated by sound business reasons; (2) the issuance of common stock to raise funds to retire preferred stock; and (3) the conversion of debt into equity.

(A) Notice 2008-78

Taxpayers finally received some certainty in this area, at least prospectively, with the issuance of Notice 2008-78. The notice provides rules and safe harbors for determining whether the value of a capital contribution within the two-year presumption period in I.R.C. section 382(l)(1)(B) is excluded from the I.R.C. section 382 limitation.

The notice announced that the IRS and Treasury intend to issue regulations under I.R.C. section 382(l)(1) and pending the issuance of further guidance, taxpayers may generally rely on Notice 2008-78. Unfortunately, the notice instructs taxpayers to rely on the notice with respect to ownership changes that occur in any taxable year ending on or after September 26, 2008. Thus, the scope of I.R.C. section 382(l)(1) for prior periods remains unclear.

Some of the terms and definitions in the notice are borrowed from Treas. Reg. section 1.355-7 with certain modifications. A related party is determined based on I.R.C. section 267(b) with certain modifications.

(B) Notice 2008-78 Rules

The notice provides that, notwithstanding I.R.C. section 382(l)(1)(B), a capital contribution shall not be presumed to be part of a plan whose principal purpose is to avoid or increase an I.R.C. section 382 limitation (a Plan), solely as a result of having been made during the two-year period ending on the change date.

The notice does not allow a capital contribution to reduce the value of the loss corporation unless the contribution is part of a Plan. A facts-and-circumstances test is used to determine whether a capital contribution was part of a Plan.

These two provisions are a turnaround from the historical application of I.R.C. section 382(l)(1). Prior to Notice 2008-78, taxpayers had to start with the presumption that any capital contribution within the two-year period prior to the change was made as part of a Plan. The notice now applies a general facts-and-circumstances test. However, a word of caution is warranted: It is important to note the notice’s use of the word solely. The notice states that a capital contribution will not be presumed to be part of a Plan solely because it is made within two years of a change date. It does not say the timing of a capital contribution is not one of the factors to be taken into account when considering the facts and circumstances. In fact, IRS attorneys have unofficially noted on bar panels (in which the author participated) that the IRS is considering circumstances when timing of the capital contribution may generally play a more important role in making this determination. One potential factor they have noted is the relationship of the capital contribution to the ownership change, such as whether the capital contribution caused the ownership change. Another question that arose on these panels that may be worthy of clarification in final regulations relates to who must have the Plan.

The notice also allows taxpayers to use four safe harbors. Notably, according to the notice, the fact that a contribution is not described in a safe harbor does not constitute evidence of a Plan.

(C) Notice 2008-78 Safe Harbors

Safe Harbor A

Safe Harbor B

Safe Harbor C

The contribution is made in exchange for stock issued in connection with the performance of services, or stock acquired by a retirement plan, under the terms and conditions of Treas. Reg. section 1.355-7(d)(8) or (9), respectively.

Safe Harbor D

(D) Avoidance of Duplication with I.R.C. Section 382(l)(4)

In addition to providing guidance on application of I.R.C. section 382(l)(1), the notice also addresses the potential for double counting in situations when both I.R.C. section 382(l)(1) and I.R.C. section 382(l)(4) (dealing with substantial nonbusiness assets) could apply.

Notice 2008-78 prevents this duplicate reduction in value. Although tax practitioners may have applied the same rule prior to the issuance of the notice, it is helpful to have clarifying guidance on this subject.

(iv) Redemptions and Other Corporate Contractions

The value of the loss corporation is reduced by any redemption of stock undertaken as part of the ownership change.146 Thus, if Profit Corporation purchases 100 percent of Loss from Loss’s shareholders for $2,000, the value of Loss is $2,000. If Profit acquires 50 percent of Loss from Loss’s shareholders for $1,000 and Loss redeems the other 50 percent for $1,000, the value of Loss is $1,000. If Profit (a new corporation established to effectuate the purchase) borrows $2,000 from a bank, purchases 100 percent of Loss from Loss’s shareholders, and then Profit merges downstream into Loss (with the debt being assumed by Loss), the value of Loss is presumably zero. Moreover, even if there is no downstream merger but Profit’s debt can be discharged only by Loss’s cash flow, the value of Loss may still be zero.147

A 1995 Tax Court case, Berry Petroleum Co. v. Commissioner,148 provides a first impression interpretation of three of the potential reductions in the I.R.C. section 382 limitation described in this section: I.R.C. section 382(c) (continuity of business enterprise), I.R.C. section 382(e)(2) (corporate contraction), and I.R.C. section 382(l)(4) (nonbusiness assets). The I.R.C. section 382 aspects of the case arose out of Berry Petroleum’s acquisition (through a wholly owned subsidiary) of all the stock of a loss company (Teorco). The acquisition resulted in an ownership change, and thus placed at issue Berry’s ability to use Teorco’s preacquisition losses to offset Teorco’s post-acquisition income.

Teorco’s assets at the time of the acquisition consisted primarily of leasehold interests in four heavy-oil properties. Another suitor (Tenneco) had previously bid $7.5 million for one of these four leasehold interests (Placerita), but the offer had been rebuffed because the seller was concerned with possible environmental liabilities associated with the remaining Teorco assets. Berry’s $6.5 million offer for all of the stock of Teorco was made under an agreement with Tenneco to sell Tenneco the Placerita leasehold following Berry’s acquisition of the Teorco stock. The agreement provided that Tenneco would pay Berry up to $1.25 million more than the final adjusted sales price of Teorco. The sale of Placerita was consummated (for $7.75 million) after the ownership change, in accordance with the agreement.

Shortly before the ownership change, Teorco sold (to an unrelated party) a piece of property adjacent to another of the four leasehold properties (Jasmin) in exchange for a $1.5 million note receivable. Teorco advanced Berry $1 million seven months after the ownership change date and another $2.6 million three months later. Berry executed unsecured promissory notes at a market rate of interest, paid interest monthly, but never paid any principal. Three months after the second advance, Teorco canceled the debts in a formal distribution to Berry.

The IRS first argued that Berry’s prearranged sale of Placerita caused the transaction to fail the continuity of business requirement of I.R.C. section 382(c). The court easily rejected this argument. The court drew an analogy between the I.R.C. section 382 continuity requirement and the continuity requirement in the I.R.C. section 368 regulations (either continue the historical business or use a significant portion of the historical business assets in a business). The court also noted that the governing I.R.C. section 382 continuity requirement was more lenient than the old I.R.C. section 382 requirement (under the 1954 Code), which required the acquired corporation to “continue to conduct a trade or business substantially the same as its historical business.” Although the court acknowledged that Berry had sold Placerita (“the most valuable property owned by Teorco”), the court determined that Berry’s continued operation of the other Teorco assets satisfied the continuity requirement.

The IRS’s second argument was based on I.R.C. section 382(e)(2) (redemption or other corporate contraction “in connection with” an ownership change). The IRS argued that Teorco’s cancellation of the advances it had made to Berry constituted a “corporate contraction” within the meaning of I.R.C. section 382(e)(2), requiring a $3.6 million reduction ($1 million advance plus $2.6 million advance) in the $6.5 million value placed on Teorco by Berry. The Tax Court agreed with this IRS argument. Berry proffered two counterarguments, each of which was rejected by the court. Berry argued that the cancellation, albeit a dividend, was not a “corporate contraction” within the meaning of I.R.C. section 382(e)(2). The court determined that there could be a “corporate contraction” for I.R.C. section 382(e)(2) purposes, even if the contraction did not amount to a partial liquidation under prior law. Furthermore, applying the “special scrutiny” the court found appropriate in cases in which a controlling shareholder withdraws funds from its controlled corporation, the court determined that neither Berry nor Teorco ever intended the advances to be repaid. Finally, the court held that even if the advances had been genuine, Teorco’s formal cancellation amounted to a “corporate contraction.” Berry argued that even if the cancellation were a corporate contraction, it did not occur “in connection with” the ownership change. In response to this argument, the court acknowledged that the Ninth Circuit (to which Berry would be appealable) had construed “in connection with” for purposes of I.R.C. section 162(k) more narrowly than the Tax Court.149 Nevertheless, the Tax Court determined that the Ninth Circuit’s reading of the I.R.C. section 162(k) language did not extend to I.R.C. section 382. Thus, the Tax Court construed the language broadly (as it had in Fort Howard Corp. v. Commissioner150), concluding that the advances and their cancellation were connected to the ownership change because the ownership change occasioned Berry’s need for funds. The court therefore concluded that the value of Teorco established by Berry had to be reduced by $3.6 million, the amount of the canceled advances. The general principle that emerges from this holding is that a dividend shortly after an ownership change may trigger a reduction in value under I.R.C. section 382(e)(2).

The IRS’s third argument was based on I.R.C. section 382(l)(4) (substantial nonbusiness assets). The parties appear to have agreed that both the sale of Placerita and the sale of the Jasmin property converted business assets into nonbusiness assets. With respect to the sale of Placerita, however, the parties offered very different interpretations of I.R.C. section 382(l)(4). The IRS argued that although the sale of Placerita took place after the ownership change, Berry’s binding agreement to sell it (entered into before the ownership change) essentially converted it into a preownership change sale. Thus, according to the IRS, the appropriate reduction in the value of the loss corporation under I.R.C. section 382(l)(4) was the full sales price of Placerita ($7.75 million) plus the $1.5 million for the pre-ownership change sale of the Jasmin property.

Berry countered that I.R.C. section 382(l)(4) did not apply unless at least one-third of the value of the assets of the old (preownership change) loss corporation were nonbusiness assets. According to Berry, because Placerita was not sold until after the ownership change, the old loss corporation did not have substantial nonbusiness assets. Furthermore, as the court acknowledged, the Jasmin receivable, by itself, constituted only one-eighth of the value of the old loss corporation.151 Thus, according to Berry, the appropriate reduction in value of the loss corporation under I.R.C. section 382(l)(4) was zero.

The court recognized that the statute required an I.R.C. section 382(l)(4) reduction if the new loss corporation has substantial business assets but that the statutes test for substantial nonbusiness assets refers only to the old loss corporation. Rather than explicitly resolving this statutory impediment, the court concluded that Berry had 70 percent nonbusiness assets and that this amount was undoubtedly substantial.

Having thus determined that Berry’s valuation of Teorco was subject to reduction under I.R.C. section 382(l)(4), the court, in accordance with the statute, turned to the appropriate amount of that reduction. In computing the amount, the court looked to Teorco’s nonbusiness assets immediately before the ownership change. The net result was that the court declined to reduce the value of the loss corporation by the $7.75 million in cash and notes received upon the sale of Placerita (because Placerita was a business asset in the hands of the old loss corporation) but reduced the value by the $1.5 million attributable to the Jasmin receivable.

Following these adjustments, the value of the loss corporation that the taxpayer asserted was $6.5 million was reduced by the court ($3.6 million for the corporate contraction and $1.5 million for substantial nonbusiness assets) to $1.4 million.

The I.R.C. section 382 issues discussed in Berry are addressed explicitly by the regulations for corporations subject to the special bankruptcy provisions in I.R.C. sections 382(l)(5) and 382(l)(6), discussed later in this chapter. In general, the continuity of business requirement does not apply for purposes of I.R.C. section 382(l)(5) but does apply for purposes of I.R.C. section 382(l)(6).152 The corporate contraction adjustment applies to the stock value test of I.R.C. section 382(l)(6) but not to the asset value test of I.R.C. section 382(l)(6).153 The nonbusiness asset limitation applies for purposes of both the stock value test and the asset value test of I.R.C. section 382(l)(6).154

(v) Controlled Groups

Treas. Reg. section 1.382-8 provides rules to adjust the value of a loss corporation that is a member of a controlled group of corporations on a change date so that the same value is not included more than once in computing the section 382 limitations for loss corporations that are members of the controlled group. Consider the following example:

P (a U.S. corporation) owns business assets and 100 percent of the stock of a subsidiary corporation (S, also a U.S. corporation). P and S do not file a consolidated federal income tax return. P’s business assets have an FMV of $200. The stock of S is worth $50. The owner of P (Mr. Big) sells 100 percent of the stock of P to unrelated Ms. Big Bucks for $150. In computing the section 382 limitation for P, the default rule would generally use a stock value of $100, and one would generally use a stock value of $50 for computing the section 382 limitation for S.

If one used a stock value of $150 for computing the stock value of P and then used $50 for computing the stock value of S, this would double count the value of S for purposes of determining the stock 382 limitation with regard to both entities.

The regulations do generally allow S to elect to restore value to P. If a restoration election is made for computing I.R.C. section 382 limitations, the value of P could be $150 and the value of S would then be zero. This election may be especially useful if the bulk of losses reside at the P level and not the S level.155

The regulations apply the opposite default rule if S, in the last example, is a foreign corporation. Unless elected otherwise, the value of the stock of a foreign subsidiary is included in the value of its parent corporation and not as value for the foreign subsidiary stock unless an election is made to include the value in the foreign subsidiary stock and not in its parent.156 This opposite default rule is generally meant to avoid a trap for the unwary and to preserve value in the stock of the U.S. parent of a foreign subsidiary where U.S. losses are more likely to exist.

The controlled group regulations contain other rules addressing issues that include:

• How to deal with tiers of corporations in a controlled group
• How to compute value, reductions in value, and restorations in value
• Certain net unrealized built-in loss computations
• Coordination with consolidated group rules
• How to file restoration elections

(g) Special Rules

(i) Introduction

Corporations under the jurisdiction of a court in a title 11 or similar case may be subject to special provisions of I.R.C. section 382.157 In general, although a bankrupt corporation undergoes an ownership change pursuant to I.R.C. section 382(g), section 382(l)(5) provides that the I.R.C. section 382(a) limitation will not apply if certain conditions are met.158 Instead of the I.R.C. section 382(a) limitation, any NOL carryover (and excess credits) may be subject to certain limited reductions.

Alternatively, bankrupt corporations meeting the conditions of I.R.C. section 382(l)(5) may elect out of that section and apply I.R.C. section 382(l)(6). Under I.R.C. section 382(l)(6), the I.R.C. section 382(a) limitation will apply; however, the NOL carryovers (including excess credits) will not be reduced, and the value of the bankrupt corporation will be increased for certain items. The increase in value will increase the “section 382 limitation,” thereby increasing the loss corporation’s ability to use its NOL.

(ii) I.R.C. Section 382(l)(5)

(A) General Provisions

The special rules of I.R.C. section 382(l)(5) will apply only if an ownership change occurs within the meaning of I.R.C. section 382(g). To determine whether an ownership change has occurred, the normal rules of I.R.C. section 382 apply, as discussed in §§ 6.3(d) and 6.3(e). Special rules apply for certain options, however.159

I.R.C. section 382(l)(5) provides that the “section 382 limitation” will not apply to a corporation if (1) immediately before an ownership change, the corporation was under the jurisdiction of a court in a federal bankruptcy proceeding or similar case, and (2) after an ownership change, the prechange shareholders and “qualified creditors” of the loss corporation own stock constituting 50 percent or more of the vote and value of the new loss corporation, as a result of being shareholders or “qualified creditors” immediately before such change (the “continuity requirement”).160 “Vanilla preferred” stock (I.R.C. section 1504(a)(4) stock) is not counted in determining this continuity requirement, but parent company stock will be counted, provided the parent company is also in bankruptcy.

For purposes of determining whether the continuity requirement has been met, options are deemed exercised if their exercise would cause the transaction to fail to satisfy the continuity requirement.161 A qualified creditor can, however, treat an option actually exercised during the three-year period following the ownership change as stock outstanding for purposes of determining whether the plan qualifies under I.R.C. section 382(l)(5).162 Thus, a plan that may fail to qualify for I.R.C. section 382(l)(5) treatment due to the deemed exercise of options, which would defeat the continuity requirement, could be revitalized so as to qualify for I.R.C. section 382(l)(5) treatment by the actual exercise of options by qualifying creditors.

For example, suppose loss corporation L in a title 11 case approved by the bankruptcy court proposes to cancel its existing stock in exchange for new stock and options to be acquired as follows: 50 shares of stock and options to acquire an additional 25 shares to qualified creditors; options to acquire 60 shares to a new investor. The options issued to the new investor, if they were deemed exercised, would cause the qualified creditors to own less than 50 percent (50 out of 110 shares, or 45 percent) of the voting power and value of the total stock after the ownership change. The options issued to the qualified creditors would not, if deemed exercised, cause the transaction to fail the continuity requirement; thus, they would not be deemed exercised. As a result, only the new investor’s options would be deemed exercised and the continuity requirement would not be met.

If during the three-year period following the ownership change, however, the qualified creditors actually exercised 15 of their 25 options, those exercised options would be counted as shares outstanding for purposes of the continuity test, and the 50 percent requirement would be met (qualified creditors would own 65 of 125 shares outstanding, or 52 percent).

A “qualified creditor” is the beneficial owner of “qualified indebtedness” of the loss corporation immediately before the ownership change.163 A qualified creditor owns stock of the loss corporation as a result of satisfaction of “qualified indebtedness” pursuant to the bankruptcy reorganization plan.164

“Qualified indebtedness” is (1) indebtedness owned by the same beneficial owner for the continuous 18-month period prior to the bankruptcy filing or (2) indebtedness that arose in the ordinary course of business of the loss corporation and has always been owned by the same beneficial owner.165 Special rules apply if indebtedness is a large portion of a beneficial owner’s assets.166 For purposes of determining whether qualified indebtedness exists, regulations provide special rules for indebtedness not owned by a 5 percent shareholder or a 5 percent entity (the latter defined as an entity through which a 5 percent shareholder owns an indirect ownership interest in the loss corporation).167 Special “actual knowledge” exceptions may also apply.

The IRS has ruled that retirees who are entitled to receive lifetime medical coverage under a corporation’s unfunded welfare benefit plan are treated as unsecured creditors whose claims for benefits arose in the ordinary course of the corporation’s business. Therefore, stock of the corporation transferred in satisfaction of a claim of a retiree is counted for purposes of determining whether the 50 percent test of I.R.C. section 382(l)(5)(A)(ii) is met.168

If I.R.C. section 382(l)(5) applies, two additional special rules169 must be followed:

I.R.C. section 382(l)(5)(B) indicates that the NOL is reduced by the interest paid or incurred on the indebtedness that was converted to stock. If cash, new debt, or other property in addition to stock is transferred in settlement of debt, it would appear that only interest paid or accrued on the debt that was exchanged for stock would be used to reduce NOLs. For example, if $10 cash, new debt with a value of $20, and stock with a value of $30 are transferred in settlement of a $100 debt, it appears that only interest (paid or accrued during the three prior years plus the current year up to the ownership change date) on 70 percent of the $100 debt would reduce the NOL.172

Similarly, in the case of an undersecured debt, only interest on the part of the debt that is considered unsecured and is exchanged directly for stock would be used to reduce the NOL.

(B) Change of Ownership within Two Years

As just noted, I.R.C. section 382(l)(5) deals harshly with taxpayers who undergo a second ownership change within two years of the first ownership change. Section 382(l)(5)(D) provides:

If, during the two-year period immediately following an ownership change to which this paragraph applies, an ownership change of the new loss corporation occurs, this paragraph shall not apply and the section 382 limitation with respect to the second ownership change for any post-change year ending after the change date of the second ownership change shall be zero.

Prior to the issuance of regulations, a literal reading of the statute could have led one to conclude that the punitive provision is retroactive to the first ownership change. “This paragraph” refers to all of paragraph 382(l)(5): As the sentence specifically states that the entire paragraph “shall not apply,” the bankruptcy exception would also not apply to the first ownership change. Thus, upon a second change of ownership within two years, there would be a section 382(a) limitation for the first ownership change and a section 382(a) limitation of zero for all years subsequent to the second ownership change.

Treas. Reg. section 1.382-9(n)(1) contains a provision that modifies the punitive result of section 382(l)(5)(D). Specifically, that regulation states:

If section 382(l)(5) applies to an ownership change and, within the two-year period immediately following such ownership change, a second ownership change occurs, section 382(l)(5) cannot apply to the second ownership change and the section 382(a) limitation with respect to the second ownership change is zero.

The regulation makes clear that the special protection of I.R.C. section 382(l)(5) will apply to the first ownership change even though a second ownership change occurs within two years. The bankruptcy exception of I.R.C. section 382(l)(5) will not apply to the second ownership change and the loss corporation will have a section 382 limitation of zero for all postchange years after the second ownership change.

Recently, the IRS clarified the effect of I.R.C. section 382(l)(5)(D) (a section 382 limitation of zero) on a taxpayer’s proposed transaction that would result in a second ownership change within two years of a bankruptcy reorganization.173

Among other representations, the taxpayer represented they did not make an election to forgo the application of I.R.C. section 382(l)(5).

The IRS’s clarification resulted in three rulings.

Therefore, if a loss corporation anticipates a second ownership change, in most circumstances the loss corporation would choose to elect out of I.R.C. section 382(l)(5).174 Unless the loss corporation is able to use its carryovers (i.e., NOLs, investment tax credits, etc.) in the year prior to the second ownership change, without the election out of I.R.C. section 382(l)(5), such carryovers would be unusable any time thereafter. Also, there will be a disallowance of any recognition of a net unrealized built-in loss during the recognition period after the second ownership change.

With appropriate planning, it is possible to structure a transaction to qualify for the special bankruptcy rules of section 382(l)(5) and also reduce the potential of a second ownership change within two years that could result in a zero limitation as discussed immediately above. In Private Letter Ruling (P.L.R.) 200731020,175 Corporation P filed for chapter 11 bankruptcy. Before filing, it had certain retiree medical benefit plans. Pursuant to the chapter 11 plan of reorganization, P significantly reduced the retiree benefits. The plan provided that P would transfer P stock to certain trusts for the beneficiaries of the plan (the VEBA Trusts). The plan permitted the VEBA Trusts to sell a portion of their contractual entitlement to the P stock under certain terms prior to the issuance of the shares. The portion presumably guaranteed that the requisite stock would be issued to prechange shareholders and qualified creditors as required for I.R.C. section 382(l)(5) treatment. In the event the shares were not issued, the VEBA Trusts had no obligation to the VEBA transferees. The VEBA Trusts sold some of these entitlements to the VEBA transferees.

On the effective date (i.e., the date of emergence from bankruptcy), P issued shares to the VEBA Trusts and to the VEBA transferees. P also issued shares to qualified creditors. The IRS ruled that the sale of the contractual entitlements and the resulting issuances of the P stock pursuant to such entitlements would not constitute a sale of shares following the effective date for purposes of determining if there was an ownership change for P after the effective date.

(C) Continuity of Business Enterprise

In general, following an ownership change pursuant to I.R.C. section 382, a corporation must continue its business enterprise during the two-year period beginning on the change date. If a corporation does not continue its business enterprise for the requisite two-year period, the I.R.C. section 382(a) limitation is deemed to be zero.176 If a corporation is subject to I.R.C. section 382(l)(5), however, the continuity of business enterprise requirement is waived.177

(iii) I.R.C. Section 382(l)(6)

(A) General Provisions

I.R.C. section 382(l)(5)(H) provides that a debtor in bankruptcy may elect not to have the I.R.C. section 382(l)(5) provisions apply. Regulations govern the manner in which the debtor makes this election.178 In addition, even if I.R.C. section 382(l)(5) does not apply, I.R.C. section 382(l)(6) will apply if a corporation undergoes an ownership change in a title 11 or similar case.

The regulations provide that the election not to have the provisions of I.R.C. section 382(l)(5) apply is irrevocable. The regulations also require that the election be made on the return of the loss corporation for the tax year including or ending with the change date. Because the election is irrevocable, corporations are precluded from either making the election after a second ownership change or making a protective election that is revoked after the expiration of the two-year period.

Because the election will not have to be made until the due date of the return (including extensions), proper selection of the effective date still can give the taxpayer extended time in which to make the election not to apply I.R.C. section 382(l)(5).

I.R.C. section 382(l)(6) provides that the debtor may calculate the section 382 limitation based on the enhanced value of the corporation after the ownership change occurs. Thus, the debtor would be able to use the value of the equity on emergence from chapter 11 rather than the value before debt was exchanged for stock.

(B) Determining Value under I.R.C. Section 382(l)(6)

As previously discussed, I.R.C. section 382(l)(6) provides a special rule for purposes of computing the value of the loss corporation under I.R.C. section 382(e), on which the section 382 limitation is based: The value under I.R.C. section 382(e) must be increased to “reflect the increase (if any) in value of the old loss corporation resulting from any surrender or cancellation of creditors’ claims in the transaction.”

Regulations under I.R.C. section 382 provide guidance on determining the value of a loss corporation that is emerging from bankruptcy and elects to apply the provisions of I.R.C. section 382(l)(6).179

The regulations provide that the value of the loss corporation for I.R.C. section 382 limitation purposes is the lesser of (1) the value of the loss corporation’s stock immediately after the ownership change (the stock value test) or (2) the value of the loss corporation’s assets (determined without regard to liabilities) immediately before the ownership change (the asset value test). Under the regulations, increases in the value of the loss corporation are treated as attributable to the conversion of the debt into stock (the stock value test).180 These regulations provide appropriate adjustment for both the stock value and asset value tests.

If the value of the loss corporation’s stock immediately after the ownership change exceeds the value that would have resulted had the loss corporation’s creditors exchanged all of their debt for stock, the loss corporation’s value is limited to an amount that approximates that lower value.

The regulations contain an anti-abuse rule designed to prevent deliberate artificial increases in the value of the loss corporation attributable to stock that is not subject to risks of corporate business operations. Under the rule, the amount determined under the stock value test is reduced by the value of stock that is issued with a principal purpose of increasing the I.R.C. section 382 limitation without subjecting the investment to the entrepreneurial risks of corporate business operations.

Under the regulations, the value of stock of a loss corporation issued in connection with an ownership change in a title 11 or similar case cannot exceed the amount of cash plus the value of any property (including indebtedness of the loss corporation) received by the loss corporation in consideration for the issuance of that stock.

(C) Continuity of Business Enterprise

As stated, the continuity of business enterprise requirement of I.R.C. section 382(c) is waived if a corporation is subject to I.R.C. section 382(l)(5); however, if a corporation is subject to I.R.C. section 382(l)(6), the continuity of business requirement must be met.181

(iv) Comparison of I.R.C. Section 382(l)(5) and (l)(6)

Exhibit 6.3 compares the use of the bankruptcy exception of I.R.C. section 382(l)(5) with the alternative of using the enhanced value of I.R.C. section 382(l)(6). Note that several factors must be considered in deciding whether to use the bankruptcy exception:

• The present value of the projected benefit from NOLs allowable under the section 382 limitation should be compared with the present value of the benefit of the NOL remaining after determining the effect of I.R.C. section 382(l)(5).
• The extent to which the remaining NOL under the bankruptcy exception may be lost due to a change in ownership within two years should be carefully considered. If a change of ownership appears likely, then it may be best to elect not to apply the bankruptcy exception.
• Trading of claims prior to the confirmation of the plan may cause qualifying creditors and stockholders to own less than 50 percent of the reorganized debtor, and thus to fail the continuity requirement of I.R.C. section 382(l)(5).
• The investment of additional capital may result in the loss of significant tax benefits if new investors will own more than 50 percent of the equity. Thus, the potential tax benefit that may be lost if I.R.C. section 382(l)(5) is not applied should be compared with the benefit to the debtor of attracting additional capital.
• If discontinuation of the business within two years is planned, the I.R.C. section 382(l)(5) bankruptcy exception should generally be used.182

Exhibit 6.3 Comparison between Bankruptcy Exception and Enhanced Annual Limit for Debtors in Bankruptcy

Source: Howard I. Sniderman, Molly A. Gallagher, and James H. Joshowitz, “A Tax Overview of Troubled Company Debt Restructuring,” Tax Adviser (April 1990): 212. Reprinted with permission from The Tax Adviser. Copyright © 1990 by American Institute of Certified Public Accountants, Inc.

Area of Comparison	Bankruptcy Exception (I.R.C. Section 382(l)(5))	Enhanced Annual Limit (I.R.C. Section 382(l)(6))
Further ownership changes	If second ownership change within 2 years, annual limit equals zero.	N/A
	Transferability of stock issued in the reorganization may have to be partially restricted to prevent a second ownership change from occurring within 2 years of bankruptcy reorganization or else entire NOL may be lost.	N/A
Interest paid on debt converted to stock	Must reduce NOL by interest paid or accrued on debt converted to stock during the 3 years ending before the year of the ownership change.	N/A
Business continuity	Corporations qualifying for and using I.R.C. section 382(I)(5) must not fail to maintain at least “an insignificant amount of trade/business.” (This is less strict than I.R.C. section 382(I)(6) continuity requirement.)	If debtor discontinues as business within 2 years of the ownership change, the annual limit is zero. No NOL use will be allowed.
Necessity to stop trading in claims prior to plan confirmation	50% of stock in new loss company must be owned by old creditors/shareholders. Extensive trading in claims or stock may prevent the possibility of meeting this requirement.	N/A
	Transferability of stock issued in the reorganization may have to be partially restricted to prevent a second ownership change from occurring within 2 years of bankruptcy reorganization or else entire NOL may be lost.	N/A
Attracting new financing	Disadvantage because limited to giving 50% of equity to new investors.	May give greater than 50% of equity to new investors.

Thus, a loss corporation needs to review carefully its overall tax situation to determine whether I.R.C. section 382(l)(5) is the most beneficial route to take. Particular attention must be paid to the corporation’s prebankruptcy interest expense and any forgiveness of indebtedness income that will arise as a result of its bankruptcy.

(h) Built-In Gains and Losses

(i) In General

As noted, the I.R.C. section 382 limitation applies to prechange losses. Prechange losses include (1) the NOL carryforward to the beginning of the year in which the ownership change occurs, (2) the portion of the NOL allocable (determined on a daily pro rata basis) to the period in the year of the ownership change that occurs before such change date, plus (3) certain “built-in” losses.183 Thus, certain built-in losses are subject to the same restrictions as NOLs. In general, if a loss corporation has a net unrealized built-in loss on the change date, any built-in loss recognized during the five-year period following the ownership change date will be treated as a prechange loss. And a recognized built-in loss that is disallowed for any postchange year may be carried forward as if it were an NOL carryover, subject to the I.R.C. section 382 limitation.184 Conversely, in general, if a loss corporation has a net unrealized built-in gain on the change date, a built-in gain recognized during the five-year period following the ownership change date can increase the I.R.C. section 382 limitation (and, in effect, permit the loss corporation to offset more income with prechange losses).

Built-in gains and losses are defined generally in I.R.C. section 382(h)(3), as the difference between the FMV of the loss corporation’s assets and the tax basis of those assets determined immediately before the ownership change. A number of special rules modify this general calculation.185 If the amount (either gain or loss) is not greater than the lesser of (1) 15 percent of the FMV of the corporation’s assets or (2) $10 million, then the net unrealized gain or loss is zero. Cash, cash equivalent items, and marketable securities are generally excluded from this de minimis computation.186 If the ownership change occurs in connection with a redemption, the net unrealized built-in gain (or loss) is determined after the redemption.187 Finally, if 80 percent or more in value of the stock of a corporation is acquired in one transaction (or a series of transactions within a 12-month period), the determination of FMV for purposes of computing net unrealized built-in loss cannot exceed the grossed-up amount paid for the stock, adjusted for indebtedness.188

(ii) I.R.C. Section 382(h)(6)

I.R.C. section 382(h)(6) expands the definition of a recognized built-in gain or loss to include items of income or deduction that are taken into account during the recognition period but are “attributable to periods” before the ownership change date. In addition, the definition of net unrealized built-in gain or loss is modified to take into account these items of built-in income or deduction, regardless of whether they are included in the recognition period. Specifically, the language of I.R.C. section 382(h)(6) is:

(6) Treatment of certain built-in items.

(A) Income items. Any item of income which is properly taken into account during the recognition period but which is attributable to periods before the change date shall be treated as a recognized built-in gain for the taxable year in which it is properly taken into account.

(B) Deduction items. Any amount which is allowable as a deduction during the recognition period (determined without regard to any carryover) but which is attributable to periods before the change date shall be treated as a recognized built-in loss for the taxable year for which it is allowable as a deduction.

(C) Adjustments. The amount of the net unrealized built-in gain or loss shall be properly adjusted for amounts which would be treated as recognized built-in gains or losses under this paragraph if such amounts were properly taken into account (or allowable as a deduction) during the recognition period.

(A) Legislative History

As originally enacted as part of the Tax Reform Act of 1986, I.R.C. section 382(h)(6) pertained only to built-in deductions and provided that “[t]he Secretary may by regulation treat amounts which accrue before the change date but which are allowable as a deduction on or after such date as recognized built-in losses.”189 In 1988, Congress substantially modified section 382(h)(6) with the enactment of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).190 Congress adopted the phrase “attributable to periods” in lieu of “accrue” to describe built-in deduction items and employed the same new language to describe built-in income items.191

The legislative history of I.R.C. section 382(h)(6) provides examples of built-in items of deduction and income. The examples of “accrued deductions” include deductions deferred under I.R.C. section 267 and/or I.R.C. section 465.192 Examples of built-in income items include gain on the completion of a long-term contract performed by a taxpayer using the completed contract method, I.R.C. section 481 adjustments, and accounts receivable held by a cash basis taxpayer.193

I.R.C. section 267(a)(1) generally places a limitation on losses incurred in connection with sales between related persons. I.R.C. section 267(a)(2) generally places a limitation upon the ability of a taxpayer using the accrual method of accounting to deduct expenses accrued to related persons who use the cash method of accounting. I.R.C. section 465 generally limits the ability of certain taxpayers to deduct losses incurred in connection with activities financed by certain non-recourse borrowings. Both I.R.C. section 267 and I.R.C. section 465 apply in situations in which a loss or deduction would otherwise be allowable under general tax principles. These provisions apply to closed and completed transactions. Similarly, installment gains, I.R.C. section 481 adjustments, and accounts receivable and payable held by a cash basis taxpayer are also examples of “closed” and completed transactions.

The examples of built-in income and deduction in the legislative history satisfy the fundamental tax accrual standards of I.R.C. sections 451 and 461. Both of these standards are based on the “all events” test. This standard is met when all events have occurred that (1) fix the right to receive the income or that determine the fact of the liability; and (2) the amount at issue can be determined with reasonable accuracy. Economic performance, if necessary for I.R.C. section 382 purposes, would also have occurred. Therefore, it is difficult to determine from the legislative history of I.R.C. section 382 whether “attributable to” requires tax accrual, economic accrual, or both. What is also not clear from the legislative history is whether an item that is contingent and requires some future event to occur to fix the liability and the amount of the liability (other than payment or the passage of time), should be considered a built-in item for purposes of I.R.C. section 382(h)(6)(B).

(B) IRS Rulings

Prior to the issuance of Notice 2003-65,194 which is discussed in subsection (C) below, there was little administrative guidance relating to what constitutes a built-in item under I.R.C. section 382(h)(6). In T.A.M. 199942003,195 an accrual method taxpayer received prepaid service income prior to the date of an ownership change (“change date”) as contemplated by I.R.C. section 382. The taxpayer elected to defer reporting the prepaid income pursuant to Revenue Procedure 71-21.196 Revenue Procedure 71-21 permits accrual method taxpayers to elect to defer reporting such payments as income until the time that services are performed, provided that performance occurs no later than the tax period immediately following the one in which payments are received. The taxpayer reported the prepaid amounts as income on its federal tax return for the period immediately following the “change date.” The IRS ruled that the taxpayer, according to its method of accounting, properly reported the prepaid amounts in income in the period subsequent to the “change date” and that “the mere fact that [the t]axpayer actually received the prepaid amounts during the pre-change period does not, under these circumstances, require that such amounts be treated as items of income attributable to the pre-change period for purposes of treatment as [recognized built-in gain under I.R.C. section 382(h)(6)(A)] when the income is later recognized.” The IRS seems to have based its conclusion on the fact that although the amount in question could be determined with reasonable accuracy, the taxpayer did not provide any services with respect to the prepaid amounts prior to the “change date” and, therefore, the amounts were not economically accrued and attributable to the period prior to the “change date.” Recent regulations addressing prepaid income are discussed in § 6.4(h)(ii)(D).

In P.L.R. 9444035,197 an acquiring corporation purchased stock of a target corporation on various dates, causing an ownership change under I.R.C. section 382. Some of the stock was acquired on the NYSE, and some of the stock was acquired directly from shareholders. After the change date, and to facilitate the acquisition of the remaining portion of the underlying stock by the acquiring corporation, a seller (Seller) exercised nonstatutory stock options that the Seller previously received from target for services performed. The IRS, citing I.R.C. section 382(h)(5)(A) and I.R.C. section 382(h)(6)(B), ruled that any deduction by the target corporation attributable to the seller’s exercise of the stock options should be treated as a recognized built-in loss for the taxable year for which it was allowable as a deduction.

The IRS’s conclusion suggested that it did not follow tax accrual concepts for determining what a built-in item is. The IRS ruled that any deduction resulting from the exercise of the stock options issued prior to the change date is a built-in deduction. This may indicate that the performance of work by the employees and the granting or vesting of the options is all that was necessary to make the deduction a built-in item, at least in the eyes of the IRS. The IRS may have viewed as irrelevant the fact that the option may never have been exercised or the amount of the deduction may not have been determined at the time of the ownership change.

Finally, in Notice 87-79,198 the IRS announced that it anticipated regulations that would permit taxpayers to allocate to the prechange period any discharge of indebtedness (DOI) income that was integrally related to a transaction that resulted in an ownership change. This approach was confirmed by P.L.R. 9312006,199 in which the built-in discharge of indebtedness income was specifically limited to the amount of income that would have been included if discharge of indebtedness income occurred on the change date.

(C) Notice 2003-65

In September 2003, the IRS released Notice 2003-65, providing guidance on the identification of built-in items under I.R.C. section 382(h). Notice 2003-65 discusses two alternative approaches for the identification of built-in items for purposes of I.R.C. section 382(h): (1) the “1374 approach,” which identifies built-in items by incorporating the rules of I.R.C. section 1374 (which generally pertain to the imposition of entity-level tax on net realized built-in gains of a subchapter S corporation), and (2) the “338 approach,” which identifies built-in items by comparing the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if an I.R.C. section 338 election had been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation on the ownership change date. Notice 2003-65 provides that, although the alternative approaches serve as “safe harbors,” they are not the exclusive methods by which a taxpayer may identify built-in items for purposes of I.R.C. section 382(h).

Generally, the I.R.C. section 1374 approach treats items of income or deduction as attributable to the prechange period, if such items accrue for tax purposes prior to the ownership change. The 1374 approach generally incorporates the rules of I.R.C. section 1374(d) and the Treasury Regulations to calculate net unrealized built-in gain and net unrealized built-in loss and to identify recognized built-in gain and recognized built-in loss. Under the 1374 approach, net unrealized built-in gain or net unrealized built-in loss is the net amount of gain or loss that would be recognized in a hypothetical sale of the assets of the loss corporation (to an unrelated buyer who assumed all of the loss corporation’s liabilities) immediately before the ownership change. This net amount of gain or loss that would be recognized is calculated by beginning with the hypothetical amount realized, adjusted as follows:

• Decreased by the sum of any deductible liabilities of the loss corporation that would be included in the amount realized on the hypothetical sale,
• Decreased by the loss corporation’s aggregate adjusted basis in all of its assets,
• Increased or decreased by the corporation’s I.R.C. section 481 adjustments that would be taken into account on a hypothetical sale, and
• Increased by any recognized built-in loss that would not be allowed as a deduction under I.R.C. section 382, 383, or 384 on the hypothetical sale.

A positive numerical total is the loss corporation’s net unrealized built-in gain; a negative result is the loss corporation’s net unrealized built-in loss. The amount of gain or loss recognized during the recognition period on the sale or exchange of an asset is recognized built-in gain or recognized built-in loss. The recognized built-in gain or recognized built-in loss attributable to an asset cannot exceed the unrealized built-in gain or loss in that asset on the change date.

For example, suppose that immediately before an ownership change, Lossco has an asset with an FMV of $100 and a basis of $10, and a deductible liability of $30. Applying the 1374 approach, Lossco would have a $60 net unrealized built-in gain ($100, the amount Lossco would realize if it sold all its assets to a third party that assumed all of its liabilities, decreased by $40, the sum of the deductible liability ($30) and the basis in the asset ($10)).

In cases other than sales and exchanges, the 1374 approach generally relies on the accrual method of accounting to identify income or deduction items as recognized built-in gain or recognized built-in loss. Items of income or deduction properly included in income or allowed as a deduction during the recognition period are generally considered “attributable to periods before the change date” and are treated as recognized built-in gain or recognized built-in loss if an accrual method taxpayer would have included the item in income or been allowed a deduction for the item before the change date. Note, however, that in determining whether an item is a recognized built-in loss, “accrual” will be deemed to have occurred even if the “economic performance” rules of I.R.C. section 461(h) have not been satisfied (e.g., a fixed liability will be treated as accrued even if it has not yet been paid). In general, the 1374 approach is best for taxpayers who want to avoid characterization of deductions as built-in losses (e.g., for loss corporations with contingent liabilities).

The 338 approach generally identifies items of recognized built-in gain and recognized built-in loss by comparing the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if an I.R.C. section 338 election had been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation on the change date. As a result, unlike under the 1374 approach, under the 338 approach, built-in gain assets may be treated as generating recognized built-in gain even if they are not disposed of at a gain during the recognition period, and deductions for liabilities, in particular contingent liabilities, that exist on the change date may be treated as recognized built-in loss. Thus, in general, the 338 approach is best for taxpayers that want to treat income from wasting assets as recognized built-in gain. Under the section 338 approach, the net unrealized built-in gain or net unrealized built-in loss is calculated in the same manner as it is under the 1374 approach. Accordingly, unlike the case in which an I.R.C. section 338 election is actually made, contingent consideration (including a contingent liability) is taken into account in the initial calculation of net unrealized built-in gain or net unrealized built-in loss, without further adjustments to reflect subsequent changes in deemed consideration.

For example, suppose that immediately before an ownership change, Lossco has one asset with a FMV of $100 and a basis of $10 and a deductible contingent liability estimated at $40. Applying the 338 approach, Lossco has a $50 net unrealized built-in gain ($100, the amount Lossco would realize if it sold all of its assets to a third party that assumed all of its liabilities, decreased by $50, the sum of the deductible liability ($40) and the basis of asset ($10)). If, during Year 1 of recognition period, a final legal determination fixes the contingent liability at $10, the net unrealized built-in gain is not readjusted to reflect the resolution of the amount of the contingent liability.

As stated, the section 338 approach may be best for taxpayers that want to treat income from wasting assets as recognized built-in gain. The section 338 approach assumes that for any tax year, any asset that has a built-in gain on the change date generates income equal to the cost recovery that would have been allowed for such asset under the applicable code section if an I.R.C. section 338 election had been made with respect to the hypothetical purchase. The approach treats as a recognized built-in gain an amount equal to the excess of the cost recovery that would have been allowable with respect to such asset had an I.R.C. section 338 election been made for the hypothetical purchase, over the loss corporation’s actual cost recovery. The cost recovery with respect to the hypothetical purchase will be based on the asset’s FMV on the change date and a cost recovery period that begins on the change date. The excess amount is a recognized built-in gain, regardless of the loss corporation’s actual gross income in any specific taxable year during the recognition period. For example, suppose Lossco has a $300 net unrealized built-in gain attributable to goodwill with an FMV of $300 and a basis of $0. In Year 1 of the recognition period, Lossco could amortize 1/15th of the $300 basis in goodwill ($20) if the hypothetical I.R.C. section 338 election were made. Lossco’s actual amortization deduction for goodwill will be zero. As a result, Lossco is treated as having $20 of recognized built-in gain and may increase its section 382 limitation by $20.

Notice 2003-65 provides that taxpayers may rely on the 1374 approach or the 338 approach for purposes of applying I.R.C. section 382(h) to an ownership change that occurs any time prior to the effective date of temporary or final regulations yet to be issued under I.R.C. section 382(h).

Notice 2003-65 provides a number of special rules relating to the treatment of DOI income as a built-in item under the two methods. Under the 1374 approach, any DOI income included in gross income under I.R.C. section 61(a)(12) during the first 12 months of recognition period is recognized built-in gain if it arises from a debt owed by a loss corporation at beginning of the recognition period.200 For example, suppose the loss corporation has a $300 net unrealized built-in gain attributable, in part, to an asset with an FMV of $200 and a basis $150, and that the asset is subject to a debt with an adjusted issue price of $100.

During Year 1 of the recognition period, the loss corporation satisfies the debt by paying the lender $60; the $40 of DOI income the loss corporation recognizes in Year 1 is recognized built-in gain for that year. In Year 2, the loss corporation sells the asset for $200; the $50 of gain recognized on the sale of the asset is recognized built-in gain in Year 2. Any DOI income excluded under I.R.C. section 108(a) is not treated as recognized built-in gain. However, any basis reduction under I.R.C. sections 108(b)(5) and 1017(a) is treated as occurring immediately before the ownership change for purposes of determining whether a recognized gain or loss is a recognized built-in gain or a recognized built-in loss under I.R.C. section 382(h)(2). The basis reduction does not affect the loss corporation’s net unrealized built-in gain or net unrealized built-in loss under I.R.C. section 382(h)(3). For example, suppose the facts are the same as just presented, except that $40 of the debt is discharged in a title 11 case and is excluded under I.R.C. section 108(a). The loss corporation will reduce the tax basis of the asset from $150 to $110 under I.R.C. sections 108(b)(5) and 1017(a). The $40 of excluded DOI income in Year 1 is not recognized built-in gain. Because basis reduction is treated as having occurred immediately before the ownership change for purposes of I.R.C. section 382(h)(2), the $90 of gain recognized on sale of the asset is recognized built-in gain in Year 2.

Under the 338 approach, any DOI income included in gross income under I.R.C. section 61(a)(12) and attributable to any of the loss corporation’s pre-change debt is recognized built-in gain in an amount not exceeding the excess, if any, of adjusted issue price of the discharged debt over the FMV of the debt on change date.201 Any DOI income that is excluded under I.R.C. section 108(a) is not treated as recognized built-in gain. However, any basis reduction under I.R.C. sections 108(b)(5) and 1017(a) that occurs during recognition period is treated as having occurred immediately before the ownership change for purposes of I.R.C. section 382(h)(2) to the extent of the excess, if any, of adjusted issue price of debt over its FMV on the change date. The reduction in tax basis does not affect the loss corporation’s net unrealized built-in gain or net unrealized built-in loss under I.R.C. section 382(h)(3).

For example, suppose the loss corporation has a $300 net unrealized built-in gain attributable, in part, to an asset (with a FMV $200, and a basis of $150) that is subject to a debt with adjusted issue price of $100 and an FMV of $60. During Year 2 of the recognition period, the loss corporation satisfies the debt for $60 and $40 of debt is discharged in a title 11 case. The loss corporation excludes $40 of DOI income under I.R.C. section 108(a) and reduces the tax basis of the asset under I.R.C. sections 108(b)(5) and 1017(a) to $110. The $40 of excluded DOI income is not recognized built-in gain. In Year 3, when the tax basis of the asset is still $110, the loss corporation sells the asset for $200 and recognizes $90 of gain. If an I.R.C. section 338 election had been made with respect to a hypothetical purchase of the loss corporation’s stock, the loss corporation would have recognized $0 of gain on the sale, because the loss corporation’s basis in the asset would have been $200 at the time of its sale. Thus, the loss corporation has a $90 recognized built-in gain from the sale of the asset (excess of the actual $90 of gain over the $0 of gain the loss corporation would have recognized had an election under I.R.C. section 338 been made). Thus, the loss corporation’s section 382 limitation for Year 3 is increased by $90.

(D) Prepaid Income

In June 2007, the Treasury Department and the IRS released temporary regulations (T.D. 9330) and, by cross-reference, proposed regulations (REG-144540-06) to provide guidance for corporations that have undergone ownership changes with respect to the treatment of prepaid income under the built-in gain provisions of I.R.C. section 382(h). These regulations were finalized without significant changes in June 2010.202 The final regulations provide that prepaid income is not recognized built-in gain for these purposes. Prepaid income is defined as any amount received prior to the change date that is attributable to performance occurring on or after the change date.

The preamble to the temporary regulations explains that a deferral of prepaid income has been allowed in certain circumstances, the common purpose of which is to provide a better match of income to expenses and to clearly reflect income both in the year of receipt and in the year of performance.203

Treasury and the IRS noted certain taxpayers have taken the position that prepaid income received in the period before the change date but included in gross income in the recognition period is recognized built-in gain; however, Treasury and the IRS believe that prepaid income is attributable to the period on or after the change date—rather than the prechange period. Accordingly, the temporary regulations provide that prepaid income is not recognized built-in gain for purposes of I.R.C. section 382.

The regulations provide that the section 338 approach in Notice 2003-65 is to be applied consistently with the guidance and that this approach will, in most cases, properly identify whether an item of income or deduction is treated as recognized built-in gain or recognized built-in loss.

Treasury and the IRS requested comments on the proposed regulations concerning:

• Identifying cases when taking into account items of income and deduction separately may cause the section 338 approach to not properly identify whether an item of income or deduction is treated as recognized built-in gain or recognized built-in loss
• How the section 338 approach might be adapted so that, in such cases, it properly identifies whether an item of income or deduction is treated as recognized built-in gain or recognized built-in loss

The regulations follow the result in T.A.M. 199942003.204 Both the regulations and the technical advice memorandum focus on the total amount of the prepaid income. They do not mention whether the costs related to the prepaid income, which are also accounted for on or after the change date, are consistently not treated as built-in deductions. They also do not mention whether the prepaid income and related costs are accounted for separately as gross amounts or as a single net amount. The first request for comments appears aimed at the treatment of such costs. It may be inferred that Treasury and the IRS still have not resolved the treatment of such costs.

It bears repeating that the regulations modify the section 338 approach of Notice 2003-65. The section 338 approach measures recognized built-in gain as the excess of the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if a section 338 election had been made with respect to a hypothetical purchase of all outstanding stock of the loss corporation on the ownership change date. The excess may reflect the proper accounting of prepaid income. For this reason, the excess must be adjusted so that the prepaid income is not treated as recognized built-in income.

(iii) Treatment of Change Date Items205

(A) Introduction

The loss limitation rules in I.R.C. section 382 appear to contain conflicting guidance as to the proper treatment of deduction and income items occurring on the date on which an ownership change occurs.

(B) Allocations on Ownership Change Date

The conflict regarding the proper manner for allocating items that occur on an ownership change date may be most easily illustrated in situations in which the loss corporation has made a closing-of-the-books election for purposes of allocating its NOL, taxable income, or specific capital losses or gains in the taxable year in which the ownership change occurs for I.R.C. section 382 purposes.206 Unless otherwise noted, assume that the loss corporation makes a closing-of-the-books election for I.R.C. section 382 purposes.207

If a loss corporation incurs a $15 million allowable deduction on the change date (e.g., settles a lawsuit), should the deduction be allocated to the prechange or postchange period? I.R.C. section 382(b)(3)(A) provides a special rule for the postchange year that includes the change date, indicating that the taxable income allocable to the prechange period including the change date is not subject to the I.R.C. section 382 limitation. That is, the I.R.C. section 382 limitation applies to the postchange utilization of the NOL. I.R.C. section 382(d)(1)(B) defines prechange loss to mean the NOL allowable through the change date of the old loss corporation for the taxable year in which the ownership change occurs to the extent such loss is allocable to the period in such year on or before the change date. Treas. Reg. section 1.382-6(g)(2) defines the prechange period as the portion of the change year ending on the close of the change date. These authorities appear to indicate that the change date is part of the prechange period. Therefore, it appears a change date deduction should be allocated to the prechange period, thus potentially resulting in or increasing a prechange NOL subject to an I.R.C. section 382 limitation when utilized postchange. The same line of reasoning would suggest a change date income item should be allocated to the prechange period and should offset prechange losses without limitation.

Once it is determined that the change date item should be included in either the prechange or postchange period, the next determination is the item’s treatment for purposes of the I.R.C. section 382(h) built-in loss and built-in gain rules discussed above. As noted, the recognized built-in loss (RBIL) and the recognized built-in gain (RBIG) rules apply to items of income, gain, loss, and deduction recognized during the recognition period. With respect to any ownership change, the term “recognition period” means the five-year period beginning on the change date.208 If change date items are included in the recognition period, such items may potentially be treated as RBIL and RBIG items.

The determination of net unrealized built-in loss (NUBIL) and net unrealized built-in gain (NUBIG) is determined by reference to assets held immediately before the change date to the extent of the spread between the tax-adjusted basis of such assets and their FMV on the change date.209 As noted, built-in deduction and built-in income items are included in the NUBIL and NUBIG computations.210 Based on a literal reading, built-in items of income, deduction, gain, or loss that are recognized on the change date appear to be RBIL or RBIG and also appear to be included in the computation of NUBIL or NUBIG.

Some examples illustrating the allocation of the built-in items to the prechange and postchange periods and their inclusion in the NUBIL or NUBIG determination are presented next.

If a change date deductible item is allocated to the prechange period resulting in a loss and is not included in the determination of NUBIL or NUBIG, such item will essentially be treated in the same manner as a prechange NOL subject to the I.R.C. section 382 limitation. For illustrative purposes, assume a loss corporation’s only item of income or deduction in a change year is a $15 million change date deduction. The FMV of the company stock is $100 million, the company has a significant NUBIG, the long-term tax-exempt rate is 4 percent, and the company has a $40 million NOL from prior years. Based on these simplified facts, the allocation of the $15 million deductible item to the prechange period would increase the prechange NOL for I.R.C. section 382 purposes to $55 million (treatment of the $15 million change date deduction as prechange NOL), and therefore the utilization of the NOL would be subject to an annual limitation of $4 million.

Given the facts in the example above, if the change date deduction is allocated to the postchange period, the NUBIG should be reduced accordingly. If the reduction in NUBIG does not create a NUBIL, the deduction will not be subject to limitation, but the deduction could be subject to limitation to the extent the reduction does create a NUBIL.

If the change date deduction item is included in both the prechange period and the NUBIG calculation, then the deduction will be subject to the I.R.C. section 382 limitation and NUBIG will also be decreased, resulting in a double detriment. For illustrative purposes, assume that in addition to the given facts, the loss company has a NUBIG of $35 million, ignoring the change date item. If the $15 million change date deduction item is allocated to the prechange period NOL, it would be subject to an I.R.C. section 382 limitation in the same manner as the $40 million NOL. Both the $15 million deduction and the $40 million NOL would be subject to a cumulative $4 million annual limitation. In addition, NUBIG would be decreased to $10 million (35 – 15 = 20), and potentially $15 million of what would otherwise be RBIG would not result in an increase in the I.R.C. section 382 limitation, and thus impose a potential double detriment.211

(C) Relevant Rulings

In the two private letter rulings noted next, the IRS has ruled on taxpayer-specific fact patterns for change date items of deduction or loss.

In P.L.R. 200442011,212 the taxpayer filed for bankruptcy and was named as a defendant in numerous lawsuits claiming damages for personal physical injury related to the taxpayer’s products. Under the plan of reorganization, the personal injury claims were addressed through the funding of a qualified settlement fund on the ownership change date. The IRS ruled that (1) the deduction attributable to funding the trust on the change date would be allocated to the prechange period, (2) such deduction would not be treated as a built-in deduction item, and (3) such deduction would not be taken into account in determining NUBIL or NUBIG.213 In this ruling, the taxpayer experienced the ownership change at the end of the year, and therefore it was not necessary to allocate items to the prechange and postchange period, as was apparently necessary in the following ruling.

In P.L.R. 200751007,214 on a similar set of facts, the IRS ruled that (1) the deduction attributable to funding the trust on the change date would not be considered a built-in deduction item; (2) such deduction would not be taken into account in determining NUBIL or NUBIG; and (3) assuming the taxpayer does not elect to close the books under Treas. Reg. section 1.382-6(b), any NOL attributable to funding the trust will be allocated between the prechange period and the postchange period ratably by day.

In both private letter rulings, the IRS concluded the change date deduction should not be considered in determining whether the taxpayer was in a NUBIL or NUBIG position preventing the potential for a double detriment to the taxpayer. In P.L.R. 200442011, the IRS concluded that the deduction should be allocated to the prechange period, but in P.L.R. 200751007, the IRS concluded that part of the deduction should be allocated to the postchange period, if the taxpayer does not close the books.

(D) Observations

It is unclear whether the conclusions in the private letter rulings just discussed are limited to situations of RBIL in a NUBIG position or RBIG in a NUBIL position. The conclusions could be viewed as inconsistent with Treas. Reg. section 1.382-6(c) if the taxpayer that has a change date deduction is in a NUBIL position or if a taxpayer that has change date income is in a NUBIG position.

Treas. Reg. section 1.382-6(c)(1)(ii)(A) provides that any income, gain, loss, or deduction to which I.R.C. section 382(h)(5)(A) applies shall be allocated entirely to the postchange period. I.R.C. section 382(h)(5)(A) applies to RBIL that is treated as prechange loss. This rule applies to RBILs only when the corporation is in a NUBIL position. I.R.C. section 382(h)(5)(A) does not apply to RBIL that is not treated as prechange loss such as when the corporation is in a NUBIG position. I.R.C. section 382(h)(5)(A) also applies to RBIG items that increase the I.R.C. section 382 limitation. This rule applies to RBILs only when the company is in a NUBIG position. I.R.C. section 382(h)(5)(A) does not apply to RBIG items that do not increase the I.R.C. section 382 limitation such as when the company is in a NUBIL position.215 Therefore, Treas. Reg. section 1.382-6(c)(1)(ii)(A) applies only in limited circumstances.

It appears the IRS concluded that a double detriment (and potentially a double benefit) for a change date built-in item is inappropriate. It is unclear whether the IRS is applying a broad approach of treating change date items as not impacting the NUBIL/NUBIG/RBIL/RBIG determination or would limit its rulings to situations involving a change date deduction in a NUBIG or change date income in a NUBIL. If the IRS does limit its application, it would appear that the excluded situations would result in change date items not being treated as occurring in the prechange period but including such items in the NUBIL/NUBIG/RBIL/RBIG determinations. This approach also appears to operate to avoid the double detriment or benefit.216

It also appears that in P.L.R. 200751007, the IRS held that the portion of the deduction allocated to the postchange period, if the pro rata method of allocation applies, would not be subject to limitation under I.R.C. section 382. It is interesting to note that the IRS excluded the portion of the change date deduction both from limitation and from reducing NUBIG or being treated as being limited RBIL. In effect, with respect to that portion of the deduction, the private letter ruling transforms what could be a double detriment into no detriment at all.

If a loss corporation recognizes deductions or income on a change date that are attributable to periods prior to the change date, it should consider seeking a private letter ruling to address the treatment of such items.