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By Samuel Newman, CPA, chief financial officer, Bio Compression Systems, Inc.

Generally, when a New Jersey S corporation shows a net loss from operations, such loss deduction passes through to its stockholders for Federal income tax purposes, provided they have adequate basis equal to or exceeding the amount of the loss.

If this loss exceeds a stockholder's other income for the year, the stockholder must decide whether it is more desirable for Federal income tax purposes to elect to carry this loss back first to the third preceding year and thereafter in sequence to the earlier two preceding years, and further forward if necessary, until it is fully consumed, or alternatively, to make the election to carry this loss forward annually for the next fifteen years until it is completely utilized.

The Federal income tax alternatives and consequences thereof have been relatively consistent over the years and, as a result, tax practitioners generally do not have many reservations about how to utilize them.

However, how certain are tax advisors and tax return preparers about the required procedures that are applicable for New Jersey franchise and New Jersey individual income tax purposes in this situation?

New Jersey law does not permit carrybacks of losses for New Jersey franchise tax purposes or for individual income tax purposes. New Jersey law does, however, permit corporate losses to be carried forward.

The instructions for New Jersey franchise tax Form CBT-l00S indicate clearly that if a corporate net operating loss is being carried forward from a previous year, it is first to be included as a deduction in Schedule A-1 of the current year's tax return, from which it will then be carried forward to Schedule A, Page 2, Item 38, as a part of the future net operating loss deduction. These instructions further indicate that any unused net operating loss for any taxable year ending after June 30, 1984, may be carried forward as a net operating loss deduction to a succeeding year for the statutory period of seven years.

It is important and very beneficial to note that an S corporation may carry forward all net operating losses including those that it generated while it operated as a C corporation within the statutory period prior to the election that was thereafter made to become an S corporation. As an S corporation, the present New Jersey franchise tax rate is 2.63%. An interesting situation may occur during the year when an S corporation is sold and subsequently ceases to be an S Corporation for New Jersey franchise tax purposes.

In many cases a successful corporation that is being sold is involved in a number of contractual and other arrangements that are required to be terminated before closing, because the purchaser has its own organization and affiliations that will perform these activities.

Accordingly, in the year of sale, the corporation may incur a substantial net operating loss in order to comply with the purchaser's requirements to terminate these agreements and to contend with its other commitments and responsibilities under the circumstances.

It follows that a proper determination must then be made as to the effect on the sellers of this net operating loss if the New Jersey S corporation status is terminated.

Regarding the Federal income tax net operating loss situation, there would not be any change, and therefore, provided the stockholders have adequate basis, these losses which will be passed through to the stockholders may be carried back or forward, as elected by the individuals involved.

As to the New Jersey franchise tax situation, a major concern would be whether the operating loss status could be substantially different because there was a change in stock ownership which caused the S corporation election to be terminated.

Fortunately for the sellers, New Jersey law provides that if there is a change in 50% or more of the ownership of a corporation because of the redemption or sale of stock and the corporation does not change the trade or business giving rise to such loss, any net operating losses incurred during the statutory period before the change may be carried over to be deducted from corporate income earned in future years.

The director of the New Jersey Division of Taxation may, however, disallow a carryover loss where the primary purpose of an acquisition was to obtain the use of the net operating loss carryover.

It is significant to note that while the value of the net operating loss to the seller when the corporation was operating as an S corporation was 2.63%, the value of the net operating loss carryover after the termination of the S corporation status has the potential of becoming nine percent as a C corporation. For example assuming that the aggregate net operating loss carryover in the year of sale was $2,000,000, its value after the sale could be as much as $180,000, compared with $52,600 before the sale.

Governor Whitman has just proposed that the New Jersey S corporation franchise tax be reduced to 2% from 2.63% for tax years beginning after June 30, 1997. As a result, if this provision is implemented, the value of the net operating loss carryover as an S corporation would be reduced to $40,000.

Furthermore, to the extent that there were any unused net operating losses from any of the six years prior to the year of the sale, the value of such losses against future profits would increase to nine percent.

More Likely than Not

It is also interesting to note that under generally accepted accounting principles, FASB 109 provides that the future tax benefit of a loss carryforward should be recognized as an asset during the loss period if "it is more likely than not" that the amount of the deferred tax asset will be realized. The more-likely-than-not threshold is 50%, and consequently the deferred tax asset may be recognized if the likelihood of realizing the future tax benefit is more than 50%. The annual computation of the deferred tax asset requires recognition of the remaining length of the available carryforward period and the likelihood of profits during that period.

The measure of the total deferred tax asset is the total amount of the operating loss carryforward multiplied by the applicable tax rate. The deferred tax asset must be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.

In the above situation regarding the successful corporation, it would be apparent if the loss resulted from an identifiable, isolated and nonrecurring cause. The profit-and-loss history of the company would also be readily determinable.

In addition, in regard to whether the corporation's potential future taxable income can be expected to be large enough to offset the loss carryforward during the statutory period, the sales price paid by a sophisticated purchaser (who would normally have made a detailed examination of the operations and potential of the company before dosing) may be evidence that could satisfy this requirement, especially if the arrangement is a cash deal and there are no contingent sales price requirements that could possibly reduce the amount to be paid by the purchaser.

Also, if the purchaser is a substantial company in the same industry, it would normally have a much larger sales organization and additional potential customer base that can be expected to add to the future profitability of the business.

These accounting requirements, if satisfied, will result in the creation of a corporate asset for deferred taxes equal to the expected value of the loss as well as a corresponding increase in net worth for accounting purposes, without any reduction in the amount of the available net operating loss deduction for income tax purposes.

In the above illustration, the corporation's total balance sheet assets and net worth would each be increased by $180,000.

Accordingly, in a sales transaction that provided for an increase in sales price based on net worth in excess of a minimum required amount, the final selling price, may have been increased by $180,000 under the above circumstances.

Another desirable concept that should be considered in planning the structure of this type of transaction from the seller's point of view, especially if it is an all stock transaction payable over a period of more than one year, would be to create an installment sale arrangement and minimize the amount of the cash payment to be received in the year of sale.

By isolating the S corporation's net operating loss in the year of sale for Federal income tax purposes, this loss would be passed through to the selling stockholders who could use it to offset ordinary income in the year of sale and carryback any excess to reduce ordinary income and income taxes in prior years, starting with the third preceding year and beginning at the highest level of such year's ordinary income tax rates. The objective is also to have the balance of the cash collections of the stock sales price payable in future years be taxable when received, at the maximum Federal capital gain rate which is currently 28%.

This arrangement could result in a Federal income tax savings of up to approximately 12% (the difference between the 39.6% maximum Federal income tax rate and the maximum Federal capital gain rate).

To the extent that a stockholder of a New Jersey S corporation is a New York resident, the net operating loss would be deductible on such individual's New York State income tax return in a manner similar to the procedure followed when the net operating income was reported in prior years.

Such loss could, however, not exceed the maximum amount that was deductible in determining Federal adjusted gross income in the year of sale.

A three-year carryback and/or 15-year carryover of these losses is also permitted by New York.

Another factor to be recognized and contended with is the potential alternative minimum tax which could result primarily from the future state income tax deductions that will have to be added back annually when computing AMT taxable income during the period of the installment sale.

Estimated Tax Payments

There is also another major benefit available for a taxpayer who incurred a substantial loss in the year of sale and consequently did not have any tax liability for such year. In the year following the loss year, the taxpayer would not be required to make any Federal or New York estimated individual tax payments. Furthermore, none of the Federal or New York income taxes applicable to the gain on sale would have to be paid until April l5th of the year thereafter.

Consequently, assuming the installment sale took place in December 1996, none of the 1997 Federal or New York income taxes would have to be paid before April 15, l998, and accordingly these funds would be available for investment during this entire period.

Those who may now be, or expect to be, involved in situations similar to the above, should recognize that the states of New Jersey and New York and GAAP are waiting to welcome you. *

State and Local Editor:
Marshall L. Fineman, CPA
David Berdon & Co. LLP

Interstate Editor:
Stuart A.Rosenblatt, CPA
Wiss & Company LLP

Contributing Editors:
Henry Goldwasser, CPA
M. R. Weiser & Co. LLP

Leonard DiMeglio, CPA
Coopers & Lybrand L.L.P.

Steven M. Kaplan, CPA
Konigsberg Wolf & Co., PC

John J. Fielding, CPA
Price Waterhouse L.L.P.

Warren Weinstock, CPA
Paneth Haber & Zimmerman LLP


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