United States: The Sometimes Hidden Implications of Section 382

Section 382, which requires limits on the use of net operating loss carryforwards, was added to the Internal Revenue Code in 1954 and significantly revised in 1986. Since then, both Section 382 and the accompanying Treasury regulations have been a source of confusion for many corporations seeking to determine if and when they experienced an "ownership change" that will trigger a Section 382 limitation. The reason? In general, corporations may begin to focus on Section 382 only when they become profitable after many years of running at a tax loss and/or anticipate a future ownership change or other significant equity event. The rationale is that if a corporation has continuously generated losses and anticipates that it will continue to generate losses for the foreseeable future, the corporation is not in a position to use any of their losses in the current tax year. Therefore, a Section 382 analysis does not appear to be terribly relevant. In fact, however, periodic identification of the corporation’s five-percent shareholders and periodic monitoring of the five-percent shareholders percentage ownership of the corporation can be very helpful and worth a preliminary analysis. The benefit of an ongoing Section 382 analysis is that it allows a corporation to pursue certain equity transactions with an understanding of the Section 382 implications. Once the corporation’s financial position improves such that it can use some of its loss carryforwards to offset taxable income, the corporation will not be surprised to learn that it experienced an "ownership change" in a prior year (or is quite close) and is therefore subject to an annual limitation on the use of its loss carryforwards. To assist in this identification process, we have briefly described a few areas where Section 382 can cause surprising results.

Many corporations are looking for ways to raise cash. Equity offerings and private placement transactions, while not new, continue to be commonly used. These types of transactions typically involve a corporation’s issuance of significant amounts of stock to investors for cash. So why do they matter? For Section 382 purposes, this matters if the transaction causes certain investors to become either new five-percent shareholders of the corporation, or larger shareholders, such that an ownership change occurs. Equity transactions, therefore, should always be "tested" for Section 382 purposes whenever significant amounts of stock will be issued, particularly to new shareholders, as the percentage ownership of new shareholders will generally represent a greater increase (e.g., from zero percent to five percent or more) on the testing date, than the percentage ownership of an existing five-percent shareholder, whose interest may become diluted as a result of new issuances of stock.

Corporations might be surprised to learn that certain convertible debt could actually be includable as stock for Section 382 purposes. For Section 382 purposes, convertible debt is considered an option, and is therefore not treated as exercised, and not considered stock, unless it satisfies certain tests under the option rule (e.g., the ownership test, the control test, or the income test). The ownership test looks at whether or not the holder of the option (or option-like instrument) has received attributes of stock ownership such as the ability to vote, the right to receive dividends, the amount by which the option price is "in-the-money," etc. It may be surprising for many corporations to find that their convertible debt instruments have many of these indicia of ownership. The control test examines whether the holder of the option has or will attain control of the corporation, either directly or indirectly, if the instrument is considered stock. Generally, control is a fifty- percent ownership interest; however, a lesser amount may result in control if the stockholder can exert significant influence over the officers and/or directors of the corporation. The income test inquires as to whether the use of the options will essentially accelerate income or defer deductions whereby losses can be utilized to offset such acceleration or deferral. Thus, the option or option-like instrument will be included in determining if an ownership change occurs if issued or transferred with a principal purpose of avoiding or ameliorating an ownership change and if one of three tests is met: (1) the ownership test, (2) the control test, or (3) the income test.

Essentially, if convertible debt is deemed converted based on the option rule described above, then on the date of issuance the convertible debt would be considered equity of the corpo ration. This means the corporation must determine, on a percentage basis, what value of the corporation this class of equity represents. It may not be as simple as treating the debt as converted and then determining the value of those shares, because holders of these convertible instruments may actually enjoy other valuable rights with respect to the corporation including, for example, liquidation preferences or enhanced voting rights, which would have the consequence of increasing the value of this class of equity. Conversely, if the convertible debt is not deemed converted on issuance, but is subsequently converted into stock, the stock issued will be includible for purposes of determining whether an ownership change occurred on the date it is actually converted. It would be wise, therefore, for corporations to carefully consider the terms of all convertible debt instruments prior to issuance, including how many equity-like features the debt carries, and the timing of the conversion date, to avoid inadvertently triggering owner shifts under Section 382.

For Section 382 purposes, almost every form of corporate equity counts, including common and certain preferred stock, warrants, options, and other classes of stock. A decision to issue new classes of stock or new types of equity has significant consequences under Section 382 for both the ownership change analysis and the valuation of the loss corporation. In this respect, the value of the loss corporation is in fact the value of the stock of the corporation immediately before an "ownership change" (subject to certain adjustments). This value analysis must be made on a class by class basis on each testing date. Value, in turn, affects the amount of the annual Section 382 limitation (i.e., value of the loss corporation, multiplied by the applicable federal long-term tax-exempt rate in effect immediately before the ownership change). Thus, transactions that result in new stock being issued for cash require an analysis of whether or not there has been an ownership change. In addition, if there has been an ownership change under Section 382, a presumption is triggered (with certain exceptions) that requires the corporation to back out any capital infusions over the prior two years when determining the value of the corporation for purposes of calculating the Section 382 limitation.

If a buyer of a corporation is considering making an acquisition of stock, they will most likely want to know the amount and viability of the target corporation’s tax losses and other tax attributes. For example, a target company may list significant net operating loss carryforwards on its financial statements, but, upon further review, the buyer may learn that the losses are not likely to be useful to the buyer because the target company has very little in the way of documentation as to whether the losses are limited by Section 382 or not. Thus, it advisable, for reporting information on your tax return, and for potential diligence reviews in an acquisition setting, to contemporaneously document the Section 382 significant events each year as those events occur.

The indirect ownership of "5-percent owners", and "higher tier" entities in the corporation can be very difficult to identify, but their actions significantly impact the determination of whether or not a corporation undergoes an ownership change. It is imperative that corporations understand how the actions of a five-percent owner may affect the calculation of the percentage ownership of the corporation’s five-percent shareholders, in order to accurately track the increase, if any, from one "testing date" to another "testing date". For example, a loss corporation may be owned twenty percent by Individual A, ten percent by Public, and seventy percent by Corporation, which is in turn owned thirty percent by a different Public group, and seventy percent by Individual B. In this case, Individual B would be an indirect five-percent owner of the loss corporation, by virtue of owning seventy percent of Corporation. But, if no analysis is undertaken to identify the existence of Individual B, then the complete implications of Section 382 cannot be determined. Essentially, the Section 382 rules are based on a "look through" concept, requiring that in the absence of actual knowledge, the loss corporation inquire about the ownership of its five-percent shareholders. Therefore, in addition to periodically reviewing Schedules 13D and 13G that are filed by a public corporation’s direct five-percent shareholders, Schedules 13D and 13G that are filed by a five-percent owner, first tier entity, or higher tier entity with an indirect ownership interest of five percent or more in the loss corporation, should also be reviewed periodically, along with any additional ownership information, including any non-U.S. shareholders.

On January 28, 2004, Treasury and IRS released a new proposed schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or more (IR-2004-14) for reporting annual book to tax reconciliations. The new proposed schedule M-3 would replace the current schedule M-1 by requiring corporate taxpayers to provide a significant amount of detail by completing four separate portions of the form. Part I requires corporate taxpayers to provide the source of the financial information used for determining net income. Part II requires an overall reconciliation of the taxpayer’s worldwide net income (or loss). Parts III and IV are consolidating schedules that require corporate taxpayers to separately report over 70 items of income and expense in reconciling net income (or loss) and identify each item as either a temporary or permanent difference. Of significance, the new proposed schedule would require the separate reconciliation of the following items:

• "Current year acquisition/reorganization investment banking fees";

• "Current year acquisition/reorganization legal/accounting fees";

• "Current year acquisition/reorganization other costs"; and

• "Worthless stock deduction (attach details)."

The Treasury and the IRS are currently collecting comments on the proposed schedule and expect the schedule will be finalized for use with federal tax income tax returns for tax years ending on or after December 31, 2004. Even though form instructions have not been released, corporate taxpayers must keep the increased reporting requirement in mind when engaging in current year tax planning and making quarterly estimated payments.

Copyright 2004 Gardner Carton & Douglas

This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.