The value of the loss corporation, however, should not include (i) capital contributions made primarily to decrease the impact of the annual limitation, or (ii) substantial nonbusiness assets (e.g. Another limitation applies when a loss corporation joins a consolidated group. If SRLY limitations apply, the parent and any other members of the consolidated group will be precluded from using NOLs accumulated prior to the loss corporation’s being eligible to join the parent’s consolidated group. Accordingly, SRLY limitations apply only when the parent has held, within the preceding 3 years, enough of the loss corporation’s stock so that it may acquire any additional shares necessary to bring the loss corporation into the consolidated group without triggering an Ownership Change.
by Dustin Liddle and Jason Melville After consecutive unprofitable years, a corporation may find itself with substantial net operating losses (“NOLs”). The Internal Revenue Code, however, imposes a number of limitations on a corporation’s ability to buy or sell NOLs. Further, § 382(c)(1) imposes a continuity of business enterprise requirement for the two years following an Ownership Change. As discussed below, however, it is critical that the parent demonstrate a primary purpose for this transaction other than tax avoidance.
The corporation with the NOLs, which is commonly called a “loss corporation,” will generally be permitted to carryback each NOL as far as the 2 years preceding the year of the loss, or carryover the NOL as far forward as 20 years following the year of the loss. Below is a brief overview of some of these limitations. The loss corporation will lose all of its prior accumulated NOLs if, at any point within the two-years following an Ownership Change, the loss corporation fails to do one of the following: (i) continue a significant line of the loss corporation’s historical business, or (ii) use a significant portion of the loss corporation’s historical business assets.
These NOLs provide a dollar-for-dollar reduction of future or past taxable income and are valuable assets in the hands of a profitable corporation. Accordingly, an Ownership Change may be triggered by a single entity purchasing 51% of a loss corporation’s stock in a single transaction or by 10 unrelated individuals each purchasing 5.1% of the loss corporation’s stock through a series of transactions over a period of 3 years. Moreover, assuming the parent has owned 50% or more of the loss corporation’s stock over the preceding three years, the parent may succeed to these NOLs free of § 382 limitations.
An Ownership Change does not require that the stock be acquired by a single entity or group of related entities, nor does it require the stock be acquired in a single transaction.
An Ownership Change occurs upon (i) a more than 50 percentage point increase in the ownership of the loss corporation’s stock (ii) by one or more shareholders owning at least 5% of the loss corporation’s stock (iii) looking back over the preceding three-years.
C § 382 (“§ 382”), following an “Ownership Change,” a loss corporation’s use of its NOLs to offset taxable income is limited. In addition to the limitations discussed above, the IRS may disallow the use of an NOL carryover if the IRS finds that control of the loss corporation was acquired for the “principal purpose of avoiding or evading federal income tax.” I.
Following an Ownership Change, a loss corporation’s use of its accumulated NOLs will be subject to an annual limitation. § 1.1502-1(f), a SRLY is any year in which the parent did not own the requisite shares of the loss corporation’s stock required to file a consolidated tax return (i.e. § 332, the parent would succeed to the subsidiary’s NOLs and SRLY limitations would not apply.
This annual limitation is computed by (i) determining the value of the loss corporation immediately prior to the Ownership Change and (ii) multiplying this amount by the Internal Revenue Service’s (“IRS”) published long-term tax exempt rate for the month the Ownership Change occurred (3.56% for April 2014). For purposes of calculating this annual limitation, the value of the loss corporation is the value of the loss corporation’s equity (including the value of certain preferred and other stock not considered when determining stock ownership) immediately before the Ownership Change. § 1.1502-21(c), the loss corporation’s NOLs arising from a “separate return limitation year” (“SRLY”) will be available to offset only the future income of the loss corporation–not the parent corporation (“parent”) or any other members of the parent’s consolidated group (“SRLY limitations”). 80% of the loss corporation’s voting stock and 80% of the value of all stock). If causing the loss corporation to join the consolidated group triggers an Ownership Change, the parent and other members of the consolidated group may use the loss corporation’s prior accumulated NOLs subject to § 382 limitations.
§ 1.269-3(b)(1) Accordingly, if the acquiring corporation cannot provide evidence of a primary purpose unrelated to tax avoidance, the IRS may disallow the use of all of the loss corporation’s NOLs. Navigating the maze of statutory and IRS regulations can be complicated, and we can help.