Academic journal article Northwestern University Law Review

Using Appraisal to Protect Net Operating Loss Carryforwards

Academic journal article Northwestern University Law Review

Using Appraisal to Protect Net Operating Loss Carryforwards

Article excerpt

ABSTRACT-The Internal Revenue Service's net operating loss rules enable corporations to use one year's losses to offset their tax liability in future years. However, a corporation's ability to do so depends on its maintaining the same ownership: if enough of a corporation's stock changes hands, it loses the ability to take advantage of all of its prior losses. In response to the threat of ownership changes, corporations have enacted particularly strict "poison pills," which are designed to prevent stock from changing hands. However, a side effect of these poison pills is that they ameliorate the threat of hostile takeovers, thereby reducing managers' incentives to maximize corporate welfare. In this Comment, I suggest using the appraisal mechanism to alleviate the need for poison pills and ownership-change restrictions by enabling corporations to pursue damages against shareholders who trigger the devaluing of their net operating losses. The proposed appraisal regime properly balances the interests of tax law and corporate law by ensuring that net operating losses will not be freely transferred but will also not serve as an excuse for allowing managerial incentives to deviate from the proper goal of shareholder wealth maximization.

INTRODUCTION

The separation of ownership and control, which requires that control over corporate assets rests in the hands of managers rather than shareholders, is perhaps the most fundamental tenet of the law of corporations.1 It reflects the principle that corporations are democratic bodies2 and ensures that corporate policies reflect the interests of parties with substantial financial stakes.3 In spite of this, § 382 of the Internal Revenue Code (IRC) flouts that principle by enabling minority shareholders to substantially decrease a corporation's value by impairing its net operating losses (NOLs).4

NOLs are tax assets that a corporation earns when its operating losses exceed its income over the course of a taxable year.5 They can be "carried back" to offset past income, thereby reducing tax burdens from prior years, or "carried forward" and used to offset future taxable income.6 Their use, however, is subject to substantial limitations. One such limitation prevents a corporation from taking advantage of the full value of its NOLs if it undergoes a change in ownership.7 Because the IRC permits an owner of a mere 5% of a corporation's shares to bring about an "ownership change" by engaging in a small trade, the NOL is subject to limitation-and consequent devaluing-based on the unilateral acts of minority shareholders.8 The situation is troublesome: minority shareholders are less likely than are managers to take into account the interests of the corporate entity as a whole,9 and therefore, allowing for minority control over substantial assets places corporate interests in peril.

Corporations have attempted to restore managerial primacy by adopting shareholder rights plans ("poison pills") that effectively preclude shareholder engagement in the sorts of trades that result in NOL impairment by limiting shareholders' ability to amass stock beyond a certain threshold.10 Although NOL pills are ostensibly adopted for the laudable purpose of restoring managerial primacy, they come with harmful collateral effects and can work to the detriment of shareholders. By substantially reducing the likelihood that a corporation's management will turn over, the presence of an NOL pill reduces managers' incentives to increase the corporation's profitability.11 Thus, loss corporations with NOL poison pills might suffer further losses simply because of their newfound inability to replace their managers. Despite these concerns, the Delaware Supreme Court validated an NOL poison pill in the 2010 case Versata Enterprises, Inc. v. Selectica, Inc.,12 and it appears that the pill's importance will only increase.13

When used to justify a stringent poison pill, the NOL begets a vicious cycle. …

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