Understand the impact a write-off could have on the company tax-shield
As businesses and investors begin assessing the damage caused by the COVID-19 crisis, it is likely an increased number of investors will consider claiming worthless stock deductions. Where the business is a majority owned private equity fund, venture capital, or family office corporate investment, a worthless stock deduction claimed by the owner could have serious negative consequences to the corporation’s ability to utilize net operating losses, credits and deductions (i.e. the tax-shield) on a go forward basis.
This occurs because of an obscure rule in section 382 that most investors are unaware of at the time they claim the write-off. As is addressed below, the issue arises when the investor owns in excess of 50% of the company (as defined by section 382) and claims the deduction without actually disposing of the business.
Section 382 in brief
Section 382 limits a corporation's ability to utilize net operating losses (NOLs), credits and other attributes following a change in ownership. If an ownership change occurs, the amount of the 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% 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 easier to identify 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.
However, an ownership change can occur without any actual 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 exists where a shareholder (e.g., a private equity fund) owning 50% or more of the corporation takes a worthless stock deduction, yet continues to hold such shares. Upon claiming the worthless stock deduction, the owner is treated as having disposed of and then reacquiring those shares on the first day of the following tax year likely triggering an ownership change.2 This result 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 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 % of the fair market value of its assets immediately before the ownership change), the loss corporation's NUBIG or NUBIL is zero.6
Trap for the unwary: Worthless stock deductions
Investors of a corporation facing financial distress and a potential bankruptcy or similar debt workout may be anxious to write-off their investment to accelerate the loss into an earlier year to offset gains. However, the investor may not physically dispose of the shares, but rather continue to hold them with zero basis. In determining worthlessness, an identifiable event establishing worthlessness is required. A company's insolvency or impending bankruptcy or debt workout may not represent 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 its stock as becoming worthless during any taxable year is treated as having acquired such stock on the first day of its first succeeding taxable year and shall not be treated as having owned such stock during any prior period.7 Assuming a change occurs as a result of the claimed worthlessness, the annual limitation would generally be zero, subjecting not only NOLs to a zero limitation, but also potentially limiting future deductions such as depreciation and amortization to zero for the next five years.
Example illustrating the application of the section 382 limitation to depreciation and amortization
In 2020, PortCo, a calendar-year corporation, is experiencing significant financial difficulties, and its ability to survive is highly questionable. Private equity fund (PE) owns 80% of PortCo and has identified it as a potential investment to write-off. PE decides to claim a worthless stock deduction in 2020 but retains legal ownership of the stock. Assume that as of Jan. 1, 2021, PortCo has $100 million in NOLs and $100 million of tax basis goodwill with a 10-year remaining life. Due to economic uncertainty and lack of operations for much of 2020, the goodwill has zero value. Because of the worthlessness deduction, PortCo underwent an ownership change resulting in an annual section 382 limitation of zero. As a result, PortCo not only has a zero limitation on the $100 million prior-year NOLs, but section 382 further disallows PortCo's annual $10 million amortization of goodwill for the next five-years.
Now assume that PortCo recovers in 2021 and by 2022 generates taxable income of $10 million. PortCo plans to utilize the NOLs to offset the taxable income. Unfortunately, no NOLs are available and further, $10 million in amortization is disallowed, resulting in $20 million in taxable income.
It seems likely that in the aftermath of COVID-19 crisis, investors will look to write-off investments hit by the crisis. However, ownership changes resulting from a write-off 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.