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Feb 1993

IRC Sec. 382 limitation - determining value of the old loss corporation. (Federal Taxation)

by Rozell, Mark I.

    Abstract- Section 382 of the IRC sets the limit as to how much net operation losses an organization that has just undergone an ownership change can deduct from its income. The maximum deductible amount is derived by multiplying the value of the old loss corporation's stock prior to the change in ownership, defined by Sec 382(e)(1) as the value of the corporation itself, by the long term tax exempt rate. This limitation does not apply to redemptions and other corporate contractions involving ownership changes. The value of the old loss corporation in such cases is assessed after the redemption or contraction. Likewise, the 382 limitation does not apply to Title 11 bankruptcy situations unless the debtor corporation exercises the option offered under Sec 362(1)(5)(H) to have the bankruptcy exemptions nullified.

What is the value of the old loss corporation? IRC Sec. 382 (e)(1) defines value of the old loss corporation as the value of the stock immediately before the ownership change. If there is a series of acquisitions of company stock, the value would be determined immediately before the transaction that triggered the ownership change. Stock for this purpose means common and preferred stock, including limited, non- voting preferred stock described in IRC Sec. 1504(a)(4) that is not taken into account for purposes of the IRC Sec. 382(g) ownership change calculation. The Treasury is also required to prescribe regulations as are necessary to treat warrants, options, contracts to acquire stock, convertible debt, and other similar interests in the definition of stock for purposes of determining value |IRC Sec. 382(k)(6)(E).

IRC Sec. 382(k)(5) defines value as fair market value. The Conference Report to TRA 86 states in determining value, the price at which the loss corporation stock changes hands in an arms length transaction would be evidence, but not conclusive evidence of the value of the stock. However, what if a recent purchase of the stock contained a control premium which is not representative of the value of all the stock? The Conference Report contains language which anticipates that the Treasury will permit the loss corporation to be valued based upon a formula that grosses up the purchase price of all the acquired loss corporation stock where a control block is acquired within a 12-month period.

In nonpublic corporations, where there are no recent sales, the corporation may wish to acquire an independent appraisal to support the value. In most circumstances where the common stock has value, ascribing a liquidation value to the preferred stock would be reasonable.

Special Rule For Redemptions and Contractions

IRC Sec. 382 (e)(2) provides a special rule for redemptions or other corporate contractions with ownership changes. Value is determined after the redemption or contraction. This is bad for taxpayers, as the value of the corporation would be lower, thus reducing the taxpayer's ability to use the NOL. The Conference Report clearly states that it does not matter whether the redemption or contraction occurs before or after the ownership change as long as it is in connection with the ownership change. The conflict arises here with respect to redemptions after the ownership change for which the taxpayer claims the redemption was not in connection with the ownership change. In other words, the transactions were independent. Thus, it becomes an issue of fact whether there was a preconceived plan to redeem the stock after the ownership change. Certainly, the greater the time between the two transactions, the better the chances of success for the taxpayer.

The general explanation of the TRA 86 discusses transactions that in substance are redemptions. It is the Joint Committee on Taxation that applies the special rule. For example, the Joint Committee would apply the redemption rule to cover a bootstrap transaction whereby the corporation incurs debt to provide funds to old shareholders. Suppose Company X wishes to acquire Company Y from its shareholders. Company Y has a value of $1 million. Company X puts up $100,000 and Company Y borrows the remaining $900,000 to pay the old shareholders. In effect this transaction is a part purchase part redemption. According to the special rule the value of Company Y for IRC Sec. 382 purposes is $100,000, the post-redemption value.

The special rule would also be applied to cases in which debt used to pay the old shareholders remains an obligation of the acquiring corporation or an affiliate if the source of funds for repayment of the obligation is the acquired corporation. For example, an investor group puts up $100,000 and forms Newco to borrow $500,000 to buy Company Y as in the previous example. However, Newco services the debt through distributions from Company Y. In this situation, Company Y would be deemed to have a post contraction value of $100,000 for IRC Sec. 382 purposes.

Special Rule for Bankruptcy

Generally, Title 11 bankruptcy situations do not trigger the IRC Sec. 382 limitation. The bankruptcy exception contained in IRC Sec. 382(1)(5) requires the debtor corporation to reduce its tax attributes (NOL's first) by 50% of discharged debt plus certain interest previously paid. However, the debtor corporation could elect under IRC Sec. 362 (1)(5)(H) not to have the bankruptcy exceptions, apply. In this case a corporation that undergoes an ownership change in bankruptcy may reflect the increase in value of the old loss corporation resulting from any surrender or cancellation of creditors claims. The corporation would then benefit from the higher IRC Sec. 382 limitation |IRC Sec. 382(1)(6).

Anti-Stuffing Rule

Since the shareholder benefits from increasing the value of the stock of the loss corporation, what prevents the selling shareholder from making a capital contribution to the corporation accompanied by an increase in the selling price prior to the ownership change? IRC Sec. 382(1)(1)(A) disqualifies a capital contribution from increasing the value of a corporation if it is made as part of a plan where a principal purpose is to avoid or increase the IRC Sec. 382 limitation. Note that IRC Sec. 382 (1)(1)(B) defines "plan" to cover the preceding two-year period before the ownership change. Reference is made to "a" principal purpose and not "the" principal purpose in this code section.

Therefore, even if the taxpayer has several reasons for making the capital contribution, he or she may still lose the value of the contribution if made within the prescribed two-year period. The Joint Committee provides that the term capital contribution should be interpreted broadly to include any direct or indirect infusion of capital. It cites a IRC Sec. 351 transfer and a merger as two examples of capital contributions for this purpose. It would seem likely that last minute capitalizations of debt would also be disqualified.

IRC Sec. 382 (1)(1)(B) provides for regulations to except certain capital contributions from the definition of a plan. One example of an exception as in the Conference Report is where a shareholder makes a capital contribution to meet monthly payroll or fund other operating expenses.

Substantial Nonbusiness Assets

The value of the old loss corporation may be reduced by its net nonbusiness assets if immediately after an ownership change the new loss corporation has substantial nonbusiness assets |IRC Sec. 382 (1)(4). For this purpose, substantial means that at least one-third of the value of the total assets of the old loss corporation consists of nonbusiness assets |IRC Sec. 382 (1)(4)(B)(i). Nonbusiness assets are assets held for investment |IRC Sec. 382 (1)(4)(C). In general, the Conference Report includes cash and marketable securities in the definition of nonbusiness assets. The concern here is meeting the continuity of enterprise test of IRC Sec. 382(c). However, with respect to cash, this rule is inflexible and unreasonable. The changing cash needs of a business should not be subject to such a strict test. Loss corporations will have to monitor their cash position to avoid meeting the one-third rule.

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