Worthless stock deduction may trigger section 382 limitations
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Section 382 in brief
Section 382 limits a corporation's ability to utilize net operating losses (NOLs) following a change in ownership. If an ownership change occurs, the amount of the loss corporation's pre-change losses that may offset taxable income for a post-change tax year cannot exceed the section 382 limitation for such year.1 As defined within section 382(g), an ownership change occurs when the ownership of 5-percent shareholders increases by more than 50 percentage points over the lowest percentage of stock owned by those shareholders at any time during the prior three-year testing period.
An ownership change is often conspicuous where shareholders sell or acquire stock, the loss corporation issues significant shares, or both. In those cases, the loss company is generally aware of such changes and can address the impact of the changes, in some instances by avoiding an ownership change altogether.
However, as discussed in more depth below, an ownership change can occur without any literal change in ownership or transfer of shares, creating a trap for the unwary. In addition, if an ownership change goes unidentified, the company faces exposure to significant tax liabilities, financial statement restatements, and future due diligence issues. One such trap for the unwary exists where a shareholder (e.g., a private equity fund) owning 50 percent or more of the corporation takes a worthless stock deduction, yet continues to hold such shares. Upon claiming the worthless stock deduction, the private equity fund is treated as disposing of and reacquiring those shares on the first day of the following tax year, likely triggering an ownership change.2 This appears to be the case whether or not the shareholder's worthless stock deduction was appropriate in the year claimed (i.e., the corporation does not appear to have the ability to rebut this position).
The section 382 limitation
Section 382 establishes an annual limitation upon the utilization of pre-change losses. In general, the limitation is computed by multiplying the value of the corporation on the date of the ownership change by the applicable federal long-term tax-exempt rate in effect. The section 382 limitation is imposed on pre-ownership change NOLs and built-in losses (BILs), which may include current deductions for items such as depreciation, amortization and depletion.3
In addition to the general annual limitation defined within section 382(b)(1), the annual limitation may be increased if the loss corporation is a net unrealized built-in gain (NUBIG) corporation.4 However, if the loss corporation is a net unrecognized built-in loss (NUBIL) corporation, certain post-change losses and deduction may become subject to the annual limitation.5 If a loss corporation's NUBIG or NUBIL does not exceed a threshold amount (the lesser of $10 million or 15 percent of the fair market value of its assets immediately before the ownership change), the loss corporation's NUBIG or NUBIL is zero.6
If the loss corporation has a NUBIL, "the recognized built-in loss for any recognition period taxable year shall be subject to limitation under this section in the same manner as if such loss were a pre-change loss," limited to the loss corporation's NUBIL reduced by prior recognition of built-in losses.7
Recognition of a built-in loss occurs when an asset is disposed of within the recognition period, that asset was held on the change date, and the loss does not exceed the excess of the adjusted basis over the fair market value of the asset on the change date.8 The recognition period is the five-year period beginning on the change date.9 Recognized built-in losses (RBILs) include depreciation and amortization deductions claimed on depreciable and amortizable assets where the value of such an asset was less than its basis as of the ownership change.
Trap for the unwary: worthless stock deductions
Shareholders of a corporation facing financial distress and a potential bankruptcy or similar debt workout may be anxious to write-off the investment to accelerate the loss into an earlier year to offset gains. However, many times the shareholder does not physically dispose of the shares. In determining worthlessness, an identifiable event establishing worthlessness is required. A company's insolvency or impending bankruptcy or debt workout is not necessarily such an event. As a result, uncertainty often exists as to the validity of a worthless stock deduction claimed by a shareholder who continues to hold the stock. Regardless, the statutory provisions make clear that for purposes of determining whether an ownership change occurs, a shareholder who treats their stock as becoming worthless during any taxable year is treated as having acquired such stock on the first day of their first succeeding taxable year and shall not be treated as having owned such stock during any prior period.10 Assuming a change occurs as a result of the claimed worthlessness, the annual limitation would be zero, subjecting not only NOLs to a zero limitation, but also likely limiting future depreciation and amortization deductions to zero for the next five years.
Example illustrating the application of the section 382 limitation to depreciation and amortization
At the end of 2014, Lossco, a calendar-year NUBIL taxpayer, is experiencing significant financial difficulties, and its ability to survive is highly questionable. PE Fund currently owns 80 percent of Lossco and has identified Lossco as a potential target to write-off in order to offset current-year gains on other investments. PE Fund decides to claim a worthless stock deduction in 2014 but retains legal ownership of the stock. Assume that as of Jan. 1, 2015, Lossco has $100 million of tax basis goodwill with a 10-year remaining life, but due to economic difficulties, the goodwill has zero value. Due to the worthlessness deduction, Lossco underwent an ownership change resulting in an annual section 382 limitation of zero. As a result, in addition to Lossco having a zero limitation on prior-year NOLs, for the next five years Lossco's $10 million annual amortization of goodwill is reduced to zero. Assume finally that Lossco incurs a loss of $5 million in 2015 before applying section 382. After applying the section 382 limitation to the amortization, Lossco would actually have $5 million of taxable income and a tax liability of approximately $2 million (assuming a 40 percent rate).
Ownership changes can significantly limit the benefits of a loss corporation's NOLs. A shareholder's claim for a worthless stock deduction represents a potential trap when the shareholder does not physically dispose of the stock in the loss corporation, as the loss corporation is unlikely to know the worthless stock deduction was claimed. Unidentified ownership changes can expose the corporation to tax liabilities, financial statement restatements, and future due diligence issues. Consequently, loss corporations need to diligently monitor and track all ownership changes to prevent any unintended section 382 limitations. Consult your tax advisor for help identifying if a loss corporation may have incurred an ownership change.
1 Section 382(a). 2 Section 382(g)(4)(D). 3 Section 382(h)(2)(B). 4 Section 382(h)(1)(A). 5 Section 382(h)(1)(B). 6 Section 382(h)(3)(B). 7 Sections 382(h)(1)(B)(i) and (ii). 8 Section 382(h)(2)(B). 9 Section 382(h)(7). 10Section 382(g)(4)(D).