IRS Makes No Recommendation on Ownership Change of Loss Corporation

Third Party Communication: None

On Date 2, LossCo issued restricted common stock to four employees/consultants pursuant to employment agreements entered into three to four weeks before Date 1. These four individuals are unrelated to the First Investors and not involved in the Agreement. (Date 2 will not be mentioned hereafter since the relative value of the common stock to the convertible preferred stock is so low; it turned out to have had no effect on when LossCo had an ownership change.)

On Date 3, pursuant to the option in the Agreement, LossCo issued b shares of convertible preferred stock to Investor 1 in exchange for $c. If Investor 1 had not exercised its option to purchase convertible preferred stock then the First Investors would have been obligated to purchase 75 percent of the amount of stock Investor 1 purchased on Date 3.

On Date 4, pursuant to the option in the Agreement, Investor 2 purchased d shares for $e.

LossCo was a "loss" corporation for the tax year that included Date 1 through Date 4. LossCo claims that Date 3 was the date it commenced business operations.

On Date 5, f shares of convertible preferred stock were issued to new or existing 5 percent shareholders for $g. Investor 3 and Investor 4, two new 5 percent shareholders, purchased h shares of this total for $i.

The pivotal event that triggers the operation of section 382 is an "ownership change," which occurs under section 382(g) whenever, immediately after (i) an owner shift involving a 5 percent shareholder or (ii) any equity structure shift, the percentage of stock of the loss corporation owned by one or more 5 percent shareholders has increased by more than 50 percentage points over the lowest percentage of stock of the loss corporation (or any predecessor corporation) owned by such shareholders at any time during the testing period. Under section 382(k)(6)(A), preferred stock which is convertible into another class is considered stock for purposed of section 382. As provided in section 382(k)(6)(C), determinations of the percentage of stock held by any person is made on the basis of value. Under section 382(i), the testing period is generally the three-year period ending on the day of any owner shift involving a 5 percent shareholder or equity structure shift.

For an ownership change to occur there must be an increase of 50 percentage points by one or more 5 percent shareholders. 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. Treas. Reg. § 1.382-2T(c)(1).

Section 382(i)(3) states that a testing period shall not begin before the earlier of the first day of either the first taxable year from which there is a carryforward of a loss (or of an excess credit) to the first post-change year, or the taxable year in which the transaction being tested occurs. Similarly, Treas. Reg. § 1.382-2T(d)(3) states that the testing period may begin on the first day of the first year in which a loss occurs. Under Treas. Reg. § 1.382-2(a)(4)(i), a loss corporation is required to determine whether an ownership change has occurred immediately after any owner shift, or issuance or transfer. Each date on which a loss corporation is required to make a determination of whether an ownership change has occurred is referred to as a testing date. All computations of increases in percentage ownership are to be made as of the close of the testing date.

Under these facts, convertible preferred stock was first issued on Date 1 and convertible preferred stock was issued on Date 3 and other dates up to and including Date 5. If Date 3 is a testing date because it is viewed separately from Date 1, (which would mean the testing period for Date 5 would include Date 3) an ownership change will have occurred on Date 5. If instead Date 3 is not a testing date, because it is viewed as integrated with Date 1 as part of the initial capitalization of LossCo, then the integrated transaction could not be either an owner shift or equity structure shift as defined in Treas. Reg. § 1.382-2T(e)(1), because at the beginning of the transaction LossCo had no 5 percent shareholders from which to measure whether a 50 percent increase in percentage of stock ownership had occurred. Thus, the testing period for Date 5 would not include Date 3 and LossCo would not have an ownership change on Date 5.

For example, assume stock of a start-up was issued on two different dates two months apart by a loss corporation where both issuances of stock were part of the initial capitalization of the loss corporation, and they both occurred before business activity had started. These facts do not present the abuse of trafficking in net operating loss carryovers, that section 382 was designed to prevent. Congress was concerned with situations where the shareholders who bore the economic burden of NOLs no longer hold a controlling interest in the corporation. H. Rept. 99-426, at 256 (1985), 1986-3 C.B. (Vol. 2) 1, 256. In this example, the shareholders who purchased stock on the two different dates were both the initial investors under the taxpayer's plan for the corporation's initial capitalization and both equally bore the economic burden of the NOLs arising after business activity commenced. The purpose of the statute would not have been served by treating the second acquisition as a testing date within the testing period of a subsequent testing date.

Please call (202) 317-5362 if you have any questions.