United States

Tax mergers


In an effort to limit loss trafficking by corporations, Congress enacted section 382, which limits the ability of a taxpayer to utilize net operating losses (NOLs) or other tax attributes following an ownership change. An ownership change occurs when there is a greater than 50 percent increase in ownership by 5-percent shareholders during a testing period. The increase of each 5-percent shareholder is determined separately, comparing the 5-percent shareholder's percentage of stock ownership immediately after the close of the testing date with that shareholder's lowest percentage ownership during the testing period. All increases during the testing period are aggregated to determine whether the 50 percentage point increase has occurred during the testing period. As a result, identification of testing dates and the beginning of the testing period is critical.

A testing date occurs at any time there is an owner shift or equity structure shift. Section 382(g)(2) defines an owner shift as any change in the ownership of the stock of the loss corporation that affects the percentage of such stock owned by any 5-percent shareholder. These shifts include purchases or dispositions of stock, redemptions and recapitalizations, stock issuances, and various other transactions, all listed in Reg. section 1.382-2T(e)(1)(i).

Section 382(i)(1) defines the testing period as the three-year period ending on the day of any owner shift. However, the testing period does not begin before the earlier of the first day of either (1) the first tax year from which there is a carryforward of a loss (or of an excess credit) to the first post-change year, or (2) the tax year in which the transaction being tested occurs. In other words, if a company incurs losses from inception and experiences an owner shift two years later, that owner shift is a testing date and the test period will span the date of incorporation through the date of the owner shift.

In a recently issued legal memorandum, ILM 201432015, the IRS stayed the course with prior rulings by holding that the issuance of stock on more than one date undertaken as part of a taxpayer's organization and prior to it commencing operations represents a single stock issuance as of the date of the company's inception for purposes of section 382 testing. As a result, identifying this set of facts can drastically change the results of a section 382 analysis.

In ILM 201432015, the loss company, at its initial incorporation, entered into an agreement with its first investor to sell convertible preferred stock (the first issuance). That same agreement provided two additional investors an option to acquire more convertible preferred stock. On a later date, the two additional investors exercised those options (the second issuance). Thereafter, on another date within the three-year testing period, the company issued additional stock (the third issuance).

The loss company represented that it commenced business on the date of the second issuance and sought advice as to whether the second issuance constituted a testing date under section 382. The loss company contended that the first and second issuances were part of its initial capitalization, occurring before the start of its business activity. In this case, if the loss company was required to treat the first issuance separate from the second, the second issuance would be treated as a testing date since it gave rise to an increase of the ownership of the two additional investors. In turn, at the time of the third issuance, the company would undergo a change in control. Alternatively, if the second issuance was treated as part of the loss company's initial capitalization, the cumulative change in ownership at the later issuance would not trigger a change in control.

The legal memorandum did not make a final recommendation as to the application of the law as this was a question of fact. However, it did address the relevant portions of the statute and that discussion is in line with the outcome of a previous private letter ruling, PLR 9142018. As part of the process of organizing, the taxpayer in PLR 9142018, a commercial bank, issued certain shares of stock to directors. A few months later, the taxpayer issued additional stock to investors and commenced operations. Prior to that second issuance, the taxpayer engaged in no transactions, had no income, and incurred minimal organization expenses. The ruling indicated that the initial issuance to the directors and subsequent issuance to investors were part of an integrated plan to form a company and the issuances were done with expedition consistent with the orderly formation of a company.

Notwithstanding the foregoing favorable ruling and recent legal memorandum, taxpayers should understand that this treatment is not a catchall for all stock issuances that occur close to the initial formation. For example, a company may undertake multiple rounds of financing close to its initial formation to fund internal expenses or research expenses. In that situation, it would be difficult for the company to argue the financing to fund research is still part of the initial organization. In turn, the line defining what is truly encompassed in the initial organization can certainly be blurry. However, in the legal memorandum, the IRS eloquently explained the difference by reiterating the Congressional concern spurring the enactment of section 382–namely situations where the shareholders who bore the economic burden of the losses no longer hold a controlling interest in the corporation. Taxpayers should therefore be cognizant of the difference between the initial formation of the company and raising capital during a time that may otherwise be treated as the start-up phase for other federal income tax purposes, but is subsequent to formation.

Although not a novel ruling, this legal memorandum serves to remind taxpayers and practitioners to review and document the facts surrounding a company's start-up phase to ensure an appropriate and potentially more favorable application of section 382.




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