United States

Corporate equity reduction transaction limits are a trap for the unwary

INSIGHT ARTICLE  | 

When looking to carryback a net operating loss (NOL) following a leveraged buy-out (LBO) or leveraged distribution, the corporate equity reduction transaction (CERT) rules of IRC section 172(h) are often a trap for the unwary.1 Further, the CERT rules may limit the ability to carryback an NOL where leverage was not used to make the acquisition or distribution, but was incurred in normal business operations.

Background

In general, IRC section 172 allows a two-year carryback and 20-year carryforward of corporate NOLs. As a result of the LBO boom of the late 1980’s, many corporations were able to carryback excess interest deductions attributable to the acquisition debt in order to receive refunds of taxes paid prior to the LBO. Believing that such a result was outside the intent of IRC section 172, Congress created IRC section 172(h), which limits the ability of corporations to carryback NOLs attributable to the interest expense incurred on certain debt financed acquisitions.2

Analysis

The CERT rules preclude the carryback of net operating losses to taxable years preceding the taxable year in which the CERT occurred, if and to the extent that such losses are attributable to CERT interest.3 A CERT is generally defined as a major stock acquisition4 or an excess distribution.5

The rules preclude the carryback of an NOL to the extent that the corporation generates an NOL that is attributable to excess interest in either the CERT year or the two succeeding taxable years. The limitation does not apply to the third succeeding year and beyond, even if CERT-related interest may contribute to the generation of the losses. Moreover, in the event taxable income is generated in the CERT year or first succeeding year, NOLs generated in first or second succeeding years are allowed as carrybacks to the applicable year without limitation.

To the extent the corporation has undergone a CERT, the loss that is allowable as a carryback is limited to the amount by which the NOL for the year exceeds the interest expense incurred during the year allocable to the CERT (CERT interest loss). For corporations that file as a part of a consolidated group, the CERT rules apply to the group as if it were a single taxpayer.6 Thus, if one member of the group undergoes a CERT, the CERT rules apply to all members of the group.

CERT interest loss

The CERT interest loss is determined by comparing interest deductions in the year in which the CERT occurred and the two subsequent tax years to the average interest expense for the previous three years. There are two exceptions to the CERT interest loss determination which help to mitigate the unfavorable provisions (i.e., if one of the exceptions applies, there is no CERT limit on the NOL). These exceptions are 1) if CERT interest expense for the year is less than $1M, and 2) where the interest expense is due to an unforeseen extraordinary adverse event.7

Major stock acquisition

A major stock acquisition is defined as an “acquisition by a corporation pursuant to a plan of such corporation (or any group of persons acting in concert with such corporation) of stock in another corporation representing 50 percent or more (by vote or value) of the stock in such other corporation.8 In determining whether acquisitions occurred pursuant to a plan, all plans to acquire stock are considered a single plan, and all acquisitions occurring within a 24-month period are considered pursuant to such plan.9 However, stock acquired in a qualified stock purchase with an IRC section 338 election is not considered a major stock acquisition.10

Example 1: Major stock acquisition CERT
Corporation P acquires 100 percent of Corporation X on Jan. 1, 2010, and finances the transaction in part with debt issued by P. For the previous three years P was debt free and generated taxable income of $6M annually. During 2010, P and X file a consolidated tax return, generate a $10M NOL, $6M attributable to P’s ongoing operations and $4M attributable to interest expense incurred by P. The entire $4M of interest expense represents a CERT interest loss ($4M less average interest over the past three years of $0). Therefore, the P-X group is only able to carryback $6M of the $10M NOL ($10M NOL less CERT interest loss of $4M), and must carry the remainder forward (note that the X loss would be carried back to separate X tax years).

Excess distribution

For purposes of the CERT rules, an excess distribution includes both distributions and redemptions.11 Further, a standard LBO generally has the effect of a distribution or redemption potentially subject to the excess distribution rules. A distribution is an excess distribution only if the total distributions during the taxable year exceed the greater of 1) 150 percent of the average distributions made by the corporation during the three prior tax years, or 2) 10 percent of the value of the corporation’s stock as of the beginning of the tax year.12

Example 2: Excess distribution CERT
Private Equity Group (PEG) acquires 100 percent of Corporation X on Jan. 1, 2010, financed in part through an LBO with debt issued by X. For the previous three years X was debt free and generated taxable income of $6M annually. During 2010, X generated a $6M NOL and incurred $4M of interest expense. The entire $4M of interest expense represents a CERT interest loss ($4M less average interest over the past three years of $0). Therefore, X is only able to carryback $2M of the $6M NOL ($6M NOL less CERT interest loss of $4M), and must carry the remainder forward.

Example 3: Excess distribution CERT
Private Equity Group (PEG) acquires 100 percent of Corporation X on Jan. 1, 2007. Average interest expense incurred by X during 2007-2009 was $3M, and X generated taxable income of $4M annually. Due to current market conditions, PEG is unable to sell X and instead decides to extract cash through a leveraged distribution. On Jan. 1, 2010 X borrows $50M and distributes the proceeds to PEG. During 2010, X generates a $10M NOL and incurs $8M of interest expense. Of the $8M of interest expense, $5M represents a CERT interest loss ($8M less average interest over the past three years of $3M). Therefore, X is only able to carryback $5M of the $10M NOL ($10M NOL less CERT interest loss of $5M), and must carry the remainder forward.

CERT “but for” analysis

In addition to its application to debt-financed stock acquisitions and distributions, the CERT rules apply a “but for” analysis, whereby debt incurred to finance capital acquisitions and other general operating expenditures may become subject to the CERT rules. The “but for” analysis applies when a CERT transaction occurs without debt financing, but the corporation prior to or subsequently debt-finances capital expenditures or even general operations. This conclusion is reached under the theory that “but for” the CERT transaction, the corporation would not have needed debt financing for its capital or other expenditures.

Example 4: Excess distribution CERT
Private Equity Group (PEG) acquires 100 percent of Corporation X on Jan. 1, 2007. Average interest expense incurred by X during 2007-2009 was $3M, and X generated taxable income of $4M annually. Due to current market conditions, PEG is unable to sell X and instead decides to extract cash through a distribution of X’s excess cash reserves. On Jan. 1, 2010 X distributes $50M to PEG. During 2010 X constructs a new headquarters at a cost of $30M, which X finances with third party bank debt. During 2010, X generates a $10M NOL and incurs $6M of interest expense. Despite the fact that the distribution was not debt financed and the fact the debt incurred was clearly attributable to the construction of the new headquarters, $3M of the $6M of interest expense represents a CERT interest loss ($6M less average interest over the past three years of $3M). Therefore, X is only able to carryback $7M of the $10M NOL ($10M NOL less CERT interest loss of $3M), and must carry the remainder forward.

Planning opportunities

The statute and legislative history do not appear to include provisions to take into account short tax years or to prevent taxpayers from timing a CERT to avoid or ameliorate the impact of the CERT rules.

Example 5: Excess distribution CERT
Private Equity Group (PEG) acquires 100 percent of Corporation X on Dec. 31, 2009 (rather than Jan. 1, 2010), financed in part through an LBO with debt issued by X. For the previous three years, including 2009, X was debt free and generated taxable income of $6M annually. During 2010 X generated a $6M NOL and incurred $4M of interest expense. The entire $4M of interest expense represents a CERT interest loss ($4M less average interest over the past three years of $0). However, because 2009 was a CERT year, the 2010 NOL is fully utilized as a carryback ($2M to 2008 and $4M to 2009, the CERT year).

Summary

As with many other interest limitations codified following the late 1980’s LBO boom, the CERT rules have again become an issue requiring analysis before getting overly excited about a carryback refund possibility. However, some comfort can be taken in the fact that the NOLs retain their 20-year carryover and with the right planning, taxpayers have the opportunity to limit the applicability of the CERT rules on future transactions.

1All section references herein refer to the Internal Revenue Code of 1986, as amended, and the regulations thereunder 2See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1250 (1989) 3IRC section 172(b)(1)(E)(i)(II) 4IRC section 172(h)(3)(A)(i) 5IRC section 172(h)(3)(A)(ii) 6IRC section 172(h)(4)(C) 7 IRC section 172(h)(2) 8IRC section 172(h)(3)(B)(i) 9IRC section 172(h)(3)(D)(ii) 10IRC section 172(h)(3)(B)(ii) 11 IRC section 172(h)(3)(C)(i) 12IRC sections 172(h)(3)(C)(i) and (ii)

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