Corporate Taxation Chapter Twelve: Corporate Attributes Professors Wells

Presentation:

April 15, 2015

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Fundamental provisions are as follows: 1)  §381 – target corporation’s tax attributes follow its assets in a tax-

free reorganization (other than B and E reorganizations) and tax-free liquidations of subsidiaries.

2)  §382 & §383 – restrict the carryforward of NOLs and other other losses and credits following a change of ownership.

3)  §269 – allows IRS authority to disallow deductions, credits, or other allowances where target corporation stock or assets are acquired with a principle purpose of obtaining tax attributes.

Chapter Twelve p.552 Basic Overview

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Section 381 Carryover Rules p.553

General Rule of §381(a): tax attributes of target carryover to acquierer in asset reorganizations and tax-free liquidations.

Exception in §381(c)(2): hovering deficit rule. Target’s acquired E&P deficit cannot be used to offset pre-acquisition positive E&P of Acquiring.

1.  Target deficit can only offset post-acquisition Accumulated E&P. 2.  Note that post-acquisition current E&P is not offset by

Accumulated E&P and would have nimble dividend.

Profit Co

Loss Co A Reorg.

E&P Deficit= <$100x> Pre-Acq. E&P = $100x

Shareholder

100x

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Section 381 Carryover Rules for NOLs p.554

§381(c)(1) provides that Loss Target’s NOLs generally carryover to the Acquiring Corporation. Exception #1: §381(b)(3) provides that the Acquiring Corporation cannot carryback Target Corporation’s NOLs to the Acquiring Corporation’s pre-acquisition years to get a refund of pre-acquisition tax amounts. Exception #2: §382 provides that the usage of NOLs are limited after an ownership change.

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Problem 1(a) p.555

P Shares

Exchange

Target Assets

Target

P

T S/Hs

P S

hare

s

Liqu

idat

ion

T stock

T A

ssets FACTS: P acquires Target assets in a C reorganization in 2010. P has Acc. E&P of $30,000 and Current E&P of $20,000. T has an E&P Deficit of $50,000. P distributes $20,000 cash to its shareholders in 2010.

RESULT: 1.  Dividend out of current E&P of $20,000 (nimble dividend). 2.  In 2011, hovering deficit is still $50,000. This hovering deficit can

only wipe out subsequent additions to accumulated E&P.

P S/Hs

2010: $20,000

E&P Deficit=($50,000) Pre-Acq. Acc. E&P= 30,000 Current E&P=20,000

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Problem 1(b) p.555

FACTS: Same facts as (a) except P breaks even in 2010 and 2011. P distributes $20,000 in 2011.

RESULT: Dividend of $20,000 out of P’s Acc. E&P. Hovering T deficit is not allowed to offset pre-acquisition accumulated E&P of P by reason of §381(c)(2).

P Shares

Exchange

Target Assets

Target

P

T S/Hs

P S

hare

s

Liqu

idat

ion

T stock

T A

ssets P S/Hs

2011: $20,000

E&P Deficit=($50,000) Pre-Acq. Acc. E&P= 30,000 2010 E&P=0 2011 E&P=0

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Problem 1(c) p.555

FACTS: Same facts (b) except P has current E&P deficit in 2010 of $10,000 and and breaks-even in 2011. P distributes $20,000 in 2011.

RESULT: Dividend of $20,000 out of P’s Acc. E&P. P’s 2010 current E&P deficit reduces its accumulated E&P to $20,000 but the inherited T hovering E&P deficit is not allowed to offset pre-acquisition accumulated E&P of P by reason of §381(c)(2).

P Shares

Exchange

Target Assets

Target

P

T S/Hs

P S

hare

s

Liqu

idat

ion

T stock

T A

ssets P S/Hs

2011: $20,000

E&P Deficit=($50,000) Pre-Acq. Acc. E&P= 30,000 2010 E&P Deficit=<10,000> 2011 Acc. E&P 20,000 2011 E&P=0

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Problem 1(d) p.555

FACTS: Same facts (b) [so, P has $10,000 of remaining pre-acquisition Acc. E&P after 2011 distribution of $20,000] except P has a $10,000 current E&P deficit in 2012 and makes a $20,000 distribution in 2012. What is the result of the 2012 distribution?

RESULT: The inherited T hovering E&P deficit is not allowed to offset pre-acquisition accumulated E&P of

P Shares

Exchange

Target Assets

Target

P

T S/Hs

P S

hare

s

Liqu

idat

ion

T stock

T A

ssets P S/Hs

2011: $20,000 2012: $20,000

E&P Deficit=($50,000) Pre-Acq. Acc. E&P= 30,000 2010 E&P Deficit=0 2011 E&P=0 2012 Acc. E&P=10,000 2012 E&P=<$10,000>

P by reason of §381(c)(2). P has a $10,000 pre-acquisition accumulated E&P at the beginning of 2012 and a 2012 current year E&P deficit of $10,000. The current year E&P deficit is prorated per Rev. Rul. 74-164. Since last day of year, all $10,000 of 2012 current E&P reduces Acc.

E&P to zero.

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Problem 1(e) p.555

FACTS: Same facts as in (d) except P has a $20,000 current E&P in 2013 and makes another $20,000 distribution in 2013. What is the result of the 2013 distribution?

RESULT: P has a $20,000 current E&P in 2013 and thus has a nimble dividend in 2013 by reason of §316(a)(2).

P Shares

Exchange

Target Assets

Target

P

T S/Hs

P S

hare

s

Liqu

idat

ion

T stock

T A

ssets P S/Hs

2011: $20,000 2012: $20,000 2013: $20,000

E&P Deficit=($50,000)

Pre-Acq. Acc. E&P= 30,000 2010 E&P=0 2011 E&P=0 2012 E&P=<10,000> 2012 Acc. E&P = 0 2013 E&P=20,000

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Problem 1(f) p.555

FACTS: Same facts as in (e) [P distributes $20,000 in 2011 & 2012 but no distribution in 2013] and breaks-even in 2014. P distributes $40,000 in 2014. What result for the 2014 distribution?

RESULT: P finally is going to be able to use some of the inherited T hovering E&P deficit. The 2013 post-acquisition E&P of $20,000 is offset by $20,000 of

P Shares

Exchange

Target Assets

Target

P

T S/Hs

P S

hare

s

Liqu

idat

ion

T stock

T A

ssets P S/Hs

2011: $20,000 2012: $20,000 2013: 0 2014: $40,000

E&P Deficit=($50,000) Pre-Acq. Acc. E&P= 30,000 2010-11 E&P=0 2012 E&P=<10,000> 2013 Acc. E&P=0 2013 E&P=20,000 2014 E&P=0

the T hovering E&P deficit. So, in 2014, there remains $30,000 of inherited T hovering deficit. In 2014, P has no remaining accumulated E&P and no 2014 current E&P, so the $40,000 distribution is not a dividend. It would be return of capital to the extent of basis per §301(c)(2) and thereafter creates capital gain by reason of §301(c)(3).

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Problem 2(a) p.555

P

T A Reorg.

Cur. E&P Deficit <$30x>

Pre-Acq. E&P = $30x

Shareholder

Next Year: 20x

FACTS: T merges into P on August 31 (2/3rd of year). P has <$30,000> current E&P deficit and T has Acc. E&P=$30,000. P distributes $20,000 next year and breaks-even next year. RESULT: P has $20,000 of its $30,000 of current E&P deficit that occurs pre-acquisition. This $20,000 portion of the pre-acquisition E&P deficit of P cannot be used to reduce T’s pre-acquisition E&P, but the $10,000 current E&P deficit can be used per §381(c)(2)(B). As of the beginning of next year, P has Acc. E&P of $20,000 ($30,000 - $10,000 post-acquisition deficit) and P has a hovering deficit of $20,000. The P distribution is a dividend in full.

2/3rd of Year

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Problem 2(b) p.556

FACTS: Same as (a) except P has $30,000 current earnings and profits for the year and T has a $30,000 E&P deficit at the time of the acquisition. P distributes $20,000 next year and breaks-even next year.

P

T A Reorg.

Pre-Acq. E&P Deficit = <$30x>

Current E&P E&P = $30x

Shareholder

Next Year: 20x 2/3rd of Year

RESULT: Same result under §381(c)(2)(B). The direction of the merger parties (between loss co and profit co) does not change the result.

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Problem 2(c) p.556

FACTS: Same as (b) except P distributes $30,000 on the last day of the year of the acquisition.

P

T A Reorg.

Pre-Acq. E&P Deficit = <$30x>

Current E&P E&P = $30x

Shareholder

Same Year: 30x 2/3rd of Year

RESULT: The full $30,000 would be a dividend. T has a pre-reorganization deficit which is subject to limitation by reason of §381(c)(2)(B). However, P has $30,000 of current E&P and that alone is sufficient to fund the dividend per §316(a)(2). As a result, P has a $30,000 hovering deficit that remains available at the beginning of the next year.

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Problem 3(a) p.556

FACTS: T merges into P on Dec. 31, 2010 in an A reorganization. T shareholders receive 51% of the outstanding P stock. P & T had been in existence for two years with T sustaining a $20,000 loss in 2009 and 2008 and P earning a profit of $30,000 in 2009 and 2008.

P

T A Reorg.

Pre-Acq. E&P 2009: <$20x> 2010: <$20x>

Pre-Acq. E&P 2009: $30x 2010: $30x

T S/Hs 51% P Shares

Question: Can P carryback T’s losses against P’s profits for 2008 and 2009? Answer: No. T may carry back the losses to its own corporate structure under § 172. Section 381(c)(1)(A) allows only a carryover to P.

12/31/2010

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Problem 3(b) p.556

FACTS: Determine combined net income for 2011 assuming loss pattern continues. Answer: $10,000 per year from 2011 through 2014. T’s pre-acquisition NOL can be used to offset the taxable income on carryforward basis.

P

T A Reorg.

Pre-Acq. E&P 2009: <$20x> 2010: <$20x>

Pre-Acq. E&P 2009: $30x 2010: $30x

T S/Hs 51% P Shares

12/31/2010

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Problem 3(c) p.556

FACTS: Same as (b) except T is profitable with net income of $20,000 in each of the prior and current years but P sustained a $100,000 loss in 2011 followed by a return to regular profitability in 2012.

P

T A Reorg.

Pre-Acq. E&P 2009: $20x 2010: $20x

Pre-Acq. E&P 2009: $30x 2010: $30x 2011: <$100x>

T S/Hs 51% P Shares

12/31/2010

RESULTS: P loss can be carried back on P’s prior returns but not for T’s prior returns because §381(b)(3) precludes carryback to T.

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Problem 3(d) p.556

P

C T A Reorg. A Reorg. FACTS: Same as (c) except T & P

consolidate into new company C. C sustains $100,000 loss in 2011 and $50,000 of profits in 2012.

Pre-Acq. E&P 2009: $20x 2010: $20x

Pre-Acq. E&P 2009: $30x 2010: $30x 2011: <$100x>

RESULTS: Now a carryback to both corporations is precluded by § 381(b)(3) because both are transferor corporations. Thus the $100,000 loss carryover would only offset future income, i.e., the $50,000 of income in 2012 and 2013.

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Section 382 Limitation on NOL Carryforwards p.556

Policy Concern: Congress does not want trafficking in Loss Companies or to have Profitable Companies to be overly motivated to buy the tax attributes of Loss Companies. Congressional Response: §382 limits the ongoing usage of net operating losses if the Loss Company has experienced an Ownership Change.

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Section 382 Ownership Change p.560

§382(g) provides that an ownership change occurs if there is either an “owner shift” involving 5% shareholders or an “equity structure shift.”

A.  Owner Shift of 5% Shareholders: The percentage ownership of a Loss Corporation by 5% or greater shareholders is increased by 50% over the lowest percentage of stock of the loss corporation owned by such shareholders. 1.  Ownership shift can occur by reason of purchase, redemptions,

§351 transfers, issuances of stock, and recapitalizations. 2.  However, owner shifts by reason of gift, death, or divorce are not

counted. See §382(l)(3)(B).

B.  Equity Structure Shift: Includes any reorganization including taxable acquisitions and public offerings that creates an owner shift See §382(g)(2) and (4)(B).

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Section 382 p.563 Garber Industries Holding Co. v. Commissioner

Kenneth & Charles are brothers and so their stock is not attributed to each other under §318(a)(1) as they are siblings. Charles purchase creates an ownership change because we take his lowest ownership (19%) in the testing period and compare it to his highest ownership (84%). This is more than a 50% owner shift. Kenneth had a similar 50% owner shift moving from 65% down to zero.

Garber Industries

Kenneth Charles 68% 19% 84%

26% 65% July 1996 0% April 1998

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Section 382 p.563 NOL Poison Pill Plan

If any shareholder acquires 4.9% or more stock without pre-approval by the board of directors of the company, then all other historic remaining shareholders have the right to acquire stock at 50% of its FMV to keep the new shareholder from becoming a 5% shareholder.

Rationale: Prevent risk of creating an ownership change that would cause a Section 382 limitation on the NOLs of the company.

Notable NOL Right Plans: Citibank, General Motors, Ford, JC Penny, AIG.

Delaware Court of Chancery decision has upheld such rights plans was a reasonable means to defend the company’s value. See Selectica, Inc. v. Versata, Inc., Civ.A. No. 4241, 2010 WL 703062 (Del. Ch. 2010).

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Problem 1(a) p.573

FACTS: Loss Co. has 100 shares of common stock owned equally by Shareholders 1 through 25 who are not related to one another. Loss Co. has assets worth $1,000,000 and an NOL of $8,000,000. Will the Section 382 loss limitations apply if all shareholders sell their stock to J? RESULT: Ownership change under §382. None of the old L shareholders have an owner shift, but J increases her ownership from 0% to 100% and this represents more than a 50% owner shift per §382(g)(2). J is a 5% shareholder within the meaning of §382(k)(7).

Loss Corp

Shareholders Julie

100% L shares

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Problem 1(b) p.573

FACTS: Same as (a) except only Shareholders 1-13 sell their shares to Julie.

RESULT: Ownership change under §382. J’s ownership has gone from zero to 52% and this represents more than a 50% owner shift per §382(g)(1). J is a 5% shareholder within the meaning of §382(k)(7).

Loss Corp

S/Hs (14-25)

S/Hs (1-13) Julie

52% shares

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Problem 1(c) p.573

FACTS: Same as (a) except only Shareholders 1-12 sell their shares to Julie.

RESULT: No ownership change under §382. J’s ownership has gone from zero to 48%. J is a 5% shareholder, but the change in 5% shareholders is less than the 50% owner shift threshold in §382(g)(1). J is a 5% shareholder within the meaning of §382(k)(7).

Loss Corp

S/Hs (14-25)

S/Hs (1-12) Julie

48% shares

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Problem 1(d) p.573

FACTS: Same as (c) except Loss Corp redeems Shareholders 13 & 14 two years later.

RESULT: Ownership change under §382. . When shareholders 13 and 14 are redeemed, only 92 shares remain outstanding. Since J owns 48 of the 92 shares, her ownership at this point exceeds 50 percent. Because the stock purchases by J and the redemptions occurred within a single three year period, the "testing period" is the three year period ending on the date of the redemption. § 382(i)(1). Even though the redemptions of the stock of Shareholders 13 and 14 directly involved only shareholders who were less than 5-percent shareholders, the redemptions resulted in an owner shift involving a 5-percent shareholder

under § 382(g)(1).

Loss Corp

S/Hs (13-14)

S/Hs (1-12) Julie

48% shares

S/Hs (15-25)

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Problem 1(e) p.573

FACTS: Same as (c) except Shareholders 13 sells her stock to new Shareholder 26.

Loss Corp

S/Hs (13)

S/Hs (1-12) Julie

48% shares

S/Hs (14-25)

S/H (26)

RESULT: No ownership change under §382. Both Shareholder 13 and new Shareholder 26 are less than 5% shareholders. Any stock owned by them is therefore deemed to be owned by a single 5% shareholder comprised of the whole group of less than 5% shareholders. See §382(b)(4)(A).

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Problem 1(f) p.573

FACTS: Same as (e) except Shareholders 13 & 14 sell their stock to new Shareholder 26.

Loss Corp

S/Hs (13-14)

S/Hs (1-12) Julie

48% shares

S/Hs (15-25)

S/H (26)

RESULT: An ownership change under §382. Both Shareholder 13 and new Shareholder 26 are less than 5% shareholders. Any stock owned by them is therefore deemed to be owned by a single 5% shareholder comprised of the whole group of less than 5% shareholders. See §382(b)(4)(A).

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Problem 1(g) p.573

FACTS: Suppose Shareholders 1-25 sold their shares to Shareholders 26-50.

Loss Corp

S/Hs (26-50)

100% shares

S/Hs (1-25)

RESULT: No ownership change under §382 even though all of the stock has changed hands in this variation. All of the stock was owned by the less than 5-percent shareholders, who constitute a single 5-percent shareholder under § 382(g)(4)(A). After the stock sales, all the stock is still owned by the single group of less than 5-percent shareholders.

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51% L Shares

Exchange

Gain Corp Assets

Gain Corp

T S/Hs

L S

hare

s

Liqu

idat

ion

G stock

Bill

Loss Corp

T S/Hs FACTS: Loss Corp distributes 51% ownership to Gain Corp shareholders in a C reorganization.

Problem 2 p.573

RESULT: An ownership change under §382. After the reorganization, the prior less-than-5-percent shareholders of Gain Co., as a group, own just over 50% of the stock of Loss Co. Under § 382(g)(4)(A) and (B), the group of less than 5-percent shareholders of Gain Co. are treated as a single shareholder and the prior group of less than 5-percent shareholders of Loss Co. are treated as a separate single shareholder. Reg. § 1.382-2T(j)(2)(iii)(B)(1). The Gain group has increased its ownership from zero to more than 51% of Loss Co. and an ownership change has occurred with the result that the § 382 limitations become applicable.

51%

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Whale Co.

Minnow S/Hs

Minnow Co.

FACTS: Whale purchases all of the stock of Minnow for cash.

Problem 3 p.573

RESULT: An ownership change under §382. §382(g)(4)(B)(i) provides that in an equity structure shift the group of less than 5% shareholders of each corporation is treated as separate 5% shareholders. §382(g)(4)(C) provides that a rule similar to the segregation rules in § 382(g)(4)(B) apply to acquisitions by groups of less-than-five-percent shareholders in this context. Thus, the group of less than 5% shareholders of Whale Co. would be treated as separate from the group of less than 5% shareholders of Minnow Co which had its ownership of Minnow go from 0 to 100%.

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Section 382 Results of an Ownership Change p.574

Policy Concern: Congress does not want trafficking in Loss Companies or to have Profitable Companies to be overly motivated to buy the tax attributes of Loss Companies. But, Congress wanted to allow the corporation to use its losses to offset the income from its own business. §382 does this through two limitations: Continuity of Business Enterprise Limit (§382(c)): Disallows NOLs if the old loss corporation business is not continued for at least two years after the ownership change. §382 Limitation: NOLs can only be used in any “post-change period” only to the extent of the value of the Loss Corporation multiplied by the long-term tax-exempt rate.

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Section 382 Limitation p.574

Carryforward of Unused Limitation. Just like NOLs can be carried forward, §382(b) allows unused §382 limitation in the current year to be carried forward to be added onto the limit in the next year.

Mid-Year Ownership Changes (annual limit is proportionately reduced if the acquisition happens for part of the year.

Long-Term Rate is published by IRS monthly.

Value of Company is determined by appraisal. There are various “anti-stuffing rules to prevent artificial inflation of the Loss Corp’s value.

Limit on Built-In Losses. Assets with unrealized built-in losses are also subject to §382’s limitation. The objective here is to prevent this excess depreciation from being able to be deducted post-ownership change.

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Section 382 Limitation §382(h)’s Built-In Gains & Losses p.579

Unrealized Built-In Gains (UBIG) that are recognized during the five-year recognition period (an RBIG) is allowed to increase the §382 limitation dollar-for-dollar to the extent that the Loss Corp had a net unrealized built-in loss (a NUBIG). Note: One would think that there must be an actual recognition of the built-in gain during the 5-year testing period when one reads the plain meaning of the statute, but the IRS in Notice 2003-65 provides very favorable rules for determining the RBIG that arises in the post-change period. If your client experiences an ownership change, you will want to review this notice in detail in order to maximize the §382 limitation.

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Section 382 Limitation Great Recession Relief p.579

§382(n) exempted ownership changes resulting from the US Treasury Department gaining 50% increase in ownership as part of the Emergency Economic Stabilization Act of 2009. This provision applied to GM to save its $45 billion of NOLs. Notice 2008-83 relaxed §382(h) for banks, stating that any deduction properly allowed after an ownership change to a bank with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) shall not be treated as a built-in loss or a deduction that is attributable to periods before the change date. 1.  After this notice, Wells Fargo Bank bought Wachovia. 2.  Congress enacted legislation to repudiate this notice in 2009. See

American Recovery and Reinvestment Act of 2009, §1261.

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Other Limitation Regimes p.579

§383: States that limitation regime of §382 that applies to NOLs should also apply to limit tax credits.

§269: Applies a subjective test to deny the usage of tax attributes if it is determined that the the principal purpose of an acquisition of Loss Crop was ‘‘evasion or avoidance of Federal income tax by acquiring the benefit of a deduction, credit, or other allowance.’’

§384: Restricts an acquiring corporation from using its preacquisition losses to offset built-in gains of an acquired corporation. Example: L has $100,000 NOL and acquires T in an A reorganization. T’s asset is sold for $100,000 of gain. §384 prevents Loss Corp from using its pre-acquisition NOL to offset the gain on the T asset that arose pre-acquisition.