The "value" of a net operating loss (NOL) depends not only upon its size, but also on the amount of income the law allows the NOL to offset. The income offset can range from 100%, if ownership of the entity does not change, to zero, if the continuity-of-business requirement is not met. Between these extremes, the amount of income offset can be affected by a second ownership change, cancelled creditor claims, built-in losses, the presence of nonbusiness assets, stock redemptions, and other factors.
This article provides a framework for working through the complex rules under IRC section 382, which can limit the value of an NOL. Corporations and advisors who are aware of the triggers that reduce an NOL's value may be able to avoid common pitfalls.
The "bankruptcy exception" can be used to avoid the IRC section 382 limitation on the amount of income that can be offset by an NOL. Using the exception may not always be advisable, however, because a "toll charge" may cost some interest deductions, and another subsequent ownership charge can wipe out the NOL altogether.
To qualify for the bankruptcy exception, IRC section 382(1)(5) provides that two requirements must be met:
* The corporation must have been under the jurisdiction of a court immediately before the ownership change in a 'Title 11 or similar case." This exception is available only if the court ordered the stock-for-debt or other exchange. Informal workouts do not qualify.
* The corporation's shareholders or its "qualified creditors" before the exchange must own at least 50% of the new loss corporation after the ownership change. A qualified creditor generally must have held the debt for at least 18 months before the bankruptcy filing, or have always been the beneficial owner of a debt that arose in the "ordinary course" of business. The regulations permit debt to be treated as having always been owned by the same creditor if, after the ownership change, that creditor is not a 5% shareholder or an entity through which a 5% shareholder has an indirect interest in the loss corporation [Treasury Regulations section 1.382-9(d)(lH3)].
Debt arises in the "ordinary course" of business if it was incurred in connection with the normal, usual, or customary conduct of the loss corporation's business. For example, trade debt arising from a business relationship with a supplier qualifies, as does debt incurred to pay an IRC section 162 expense. Whether the debt arose from an expense or from a capital expenditure is not relevant [Treasury Regulations section 1.382-9(d)(2)(IV)].
Qualifying under the bankruptcy exception is not the only consideration. A corporation and its advisors should carefully evaluate whether the corporation should use the exception or elect out of it. As illustrated in the Exhibit, a cluster of questions and issues surfaces if the corporation does not elect out. These problems may, in some cases, lead the corporation to accept the IRC section 382 limitations as the less onerous alternative.
The potential of a subsequent ownership change injects risk into the decision to use the bankruptcy exception. Two adverse consequences result if another ownership change occurs within two years. First, the qualification under the bankruptcy exception for the first ownership change is retroactively eliminated. As a result, the corporation is treated as any other loss corporation under IRC section 382 for the years between the ownership changes. second, the section 382 limitation for all years following the second ownership change is zero. Note in the Exhibit that the arrows bypass the value increase for cancelled creditor claims. This harsh result generally eliminates NOLs in the period between the ownership changes, because most or all of the company's value would come from the canceled claims. In effect, electing out would save the company from being penalized for successive ownership changes without forfeiting the increase in value due to the canceled claims. …