Issue
Corporations planning to raise equity capital face exposure to Internal Revenue Code Section 382, “Limitation on Net Operating Loss Carryforwards and Certain Built-in Losses Following Ownership Change,” which has the potential to substantially limit a company’s ability to deduct losses or to use tax loss and credit carryforwards. Depressed stock and asset values have increased the likelihood that an issuance of equity capital could trigger the application of Section 382.
Taxpayers Potentially Affected
Corporations that have raised or plan to raise equity capital or that have had other significant changes in stock ownership.
Background
Section 382 occurs when a company experiences a significant ownership change while it is a loss corporation.
- An ownership change can be triggered by issuing stock in a public offering, private placement, recapitalization, or acquisition; by issuing additional shares to an existing stockholder; or when a shareholder buys a significant number of shares from other shareholders. Ownership percentages should be tested when any of these events occur.
- A loss corporation is any corporation with a carryforward of net operating loss, capital loss, or tax credits or with net unrealized built-in loss (NUBIL), collectively referred to as tax attributes, at the time of an ownership change.
- A decline in asset values can create a loss corporation, as built-in losses can result from loan and receivable loss reserves not yet deducted for tax purposes, unrealized securities portfolio losses or impairments, or unrealized losses on other assets that have declined in value.
If Section 382 applies, it forces an annual limitation on a corporation’s ability to deduct any realized built-in losses and its use of tax loss or credit carryforwards. Due to time limits on the carryforward of these items, Section 382 can lead to a permanent loss of tax benefits and a negative impact on a corporation’s financial statement.
Ownership Change
An ownership change generally occurs when one or more major shareholders of a loss corporation (specifically those owning five percent or more of the stock of a loss corporation before or after a testing date) increases their stock ownership by more than 50 percentage points over their lowest percentage of ownership within the testing period.1 The testing period generally is a three-year period ending on the testing date. The percentage point increase for each major shareholder is computed separately and then aggregated to determine if there has been an ownership change of at least 50 percentage points.
Loss Corporation and NUBIL
A loss corporation is any corporation with a carryforward of net operating loss, capital loss, or tax credits, or a corporation that has NUBIL. NUBIL is basically the fair market value of a corporation’s assets less its tax basis in those assets, determined immediately before the ownership change. Economic losses not yet recognized for federal income tax purposes can create NUBIL. Examples of NUBIL include loan and receivable loss reserves not yet charged off for tax purposes, impairments or unrealized losses of securities recorded for financial statement purposes but not tax purposes, and financial statement impairments of tax-deductible goodwill.
There is a de minimis exception: If NUBIL does not exceed the lesser of $10 million or 15 percent of the fair market value of total assets, it is disregarded for purposes of determining if an entity is a loss corporation. Unfortunately, some corporations have built-in losses in excess of these limits.
Section 382 Limitation
If a loss corporation experiences an ownership change, it must compute its Section 382 limitation by multiplying the fair market value of its stock immediately before the ownership change by the applicable federal long-term tax-exempt rate. The limitation determines how much of the tax attributes that existed at the date of the ownership change may be used annually after the ownership change. If NUBIL exists, any assets with built-in losses that are sold at a loss within five years of an ownership change will be subject to the annual Section 382 limitation on deductibility. Losses exceeding the annual limit may be carried forward and deducted in future years – within the confines of the annual Section 382 limitation – but could end up expiring unused, resulting in a permanent loss of tax benefits.
Illustrations
Ownership Change
As shown in the table below, for the past three years, X Corp, a loss corporation, has been equally owned by two shareholders whose shares each had a fair market value of $150 on Jan. 1, 2004. On Jan. 1, 2004, the first testing date, a third shareholder purchased $200 of newly issued stock. On Jan. 1, 2005, the second testing date, the outstanding stock owned by the three shareholders declined to a value of $450, and a fourth shareholder purchased $135 of newly issued stock.
| - |
Years 1 – 3
|
Jan. 1, 2004 – First Testing Date
|
Jan. 1, 2005 – Second Testing Date |
| Shareholder |
Ownership Percentage at All Times (%) |
Stock Value ($) |
Ownership Percentage (%) |
Percentage Point Increase Over Lowest Ownership |
Stock Value ($) |
Ownership Percentage (%) |
Percentage Point Increase Over Lowest Ownership |
| No. 1 |
50 |
150 |
30 |
N/A |
135 |
23 |
N/A |
| No. 2 |
50 |
150 |
30 |
N/A |
135 |
23 |
N/A |
| No. 3 |
|
200 |
40 |
40 |
180 |
31 |
31 |
| No. 4 |
|
|
|
|
135 |
23 |
23 |
| Total |
100 |
500 |
100 |
40 |
585 |
100 |
54 |
| Result |
|
< 50 percentage points – No ownership change |
> 50 percentage points – Ownership change |
For purposes of determining whether an ownership change has occurred, the original shareholders are disregarded, as their respective interests have declined at both testing dates. On Jan 1, 2004, the increase in stock ownership by the third shareholder is less than 50 percentage points, so there is no ownership change on the first testing date. However, on Jan. 1, 2005, the aggregate increase in stock ownership by the third and fourth shareholders (over their lowest percentage of ownership) is 54 percent, thus triggering a Section 382 limitation on the second testing date.
Built-in Losses
Even if a company does not have any tax loss or credit carryforwards, it may still be a loss corporation due to declines in asset values that have not yet been realized for tax purposes. Assume X Corp has $14.5 million of NUBIL on Jan. 1, 2005, the date of its ownership change. If the entire securities portfolio were sold for $39.5 million immediately after Jan. 1, 2005, the resulting $10 million tax loss would be subject to a Section 382 limitation. If the annual Section 382 limitation is $1 million, only $1 million of the loss is deductible in the year of sale.
|
Data at Jan. 1, 2005, Ownership Change Date
|
Financial
Statement
Balance
($ in thousands)
|
Tax Basis
($ in thousands) |
Fair
Market
Value
($ in thousands)
|
| Loans and Accounts Receivable |
100,000 |
100,000 |
95,000 |
| Allowance for Credit Losses |
(6,000) |
0 |
0 |
| |
|
|
|
| Securities Available for Sale |
49,000 |
49,500 |
39,500 |
| Unrealized Loss on Securities Available for Sale |
(9,000) |
0 |
0 |
| |
|
|
|
| Other Assets |
2,000 |
2,500 |
3,000 |
| Total |
136,000 |
152,000 |
137,500 |
| Threshold % |
|
|
15% |
| Net Realized Built-in Loss (Tax Basis, less Fair Market Value) |
|
14,500 |
|
| Threshold (Lesser of $10 million or 15 percent of Total Fair Market Value) |
|
10,000 |
20,625 |
| X Corp's NUBIL exceeds the threshold; therefore it is a loss corporation. |
|
14,500 |
NUBIL |
In these times of declining stock and asset values, the rules of Section 382 can limit substantially the use of tax attributes and might be a trap for the unwary. Be sure to consider the NUBIL rules when determining if a loss corporation exists and pay close attention to any changes in stock ownership, particularly as a result of capital-raising activities. The rules of Section 382 are complex; it is imperative to consult with a tax professional to determine if an ownership change has occurred and the potential tax consequences of that change.
Contact Information
For more information on Section 382, please contact:
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Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.
