Taxpayers looking to utilize net operating loss (NOLs) among other attributes and excess interest carryovers need to know the rules that could limit or eliminate them, including Section 382. [1] Section 382 requires a corporation to limit the amount of its federal taxable income in future years that can be offset by NOLs once that corporation undergoes an "ownership change." [2] Section 382 and the Treasury Regulations require that a loss corporation calculate increases in the percentage of stock ownership of its 5% shareholders to determine whether an ownership change occurred on a testing date. An ownership change will occur if one or more 5% shareholders increase their ownership, in the aggregate, by more than 50% points during a testing period.
The first step in applying the Section 382 rules is to determine which shareholders to track. After a loss corporation reviews documents, such as capitalization tables and Securities Exchange Commission (SEC) filings, a loss corporation can identity its 5% shareholders and the percentage ownership of each 5% shareholder. It then compares each 5% shareholder's percentage ownership of the loss company stock on each testing date to determine if an ownership shift of 50% points or more has occurred.
Ultimate responsibility for monitoring ownership changes of 5% shareholders falls to the loss corporation itself. To ease the burden on public companies identifying its 5% shareholders, there is a rule of convenience saying that public loss companies may rely on filings (or the absence of appropriate filings) with the SEC. Generally, the SEC filing requirement is triggered by an acquisition that results in beneficial ownership of more than 5% of public company stock by requiring the shareholder to publicly file either a Schedule 13D or Schedule 13G.
If the loss corporation already knows of certain ownership facts, or if the loss corporation subsequently discovers this information, it may be required to take its "actual knowledge" into account in determining whether an ownership change has occurred regardless of the existence or absence of SEC filings. Although the treasury regulations mandate use of actual knowledge for identify its 5% shareholder, the IRS also has rules on other situations where a loss corporation to take actual knowledge into account to determine whether an ownership change has occurred.
The IRS recently issued PLR 202146003 to a taxpayer that was a loss corporation and allowed the loss corporation to use actual knowledge to identify overlapping ownership between a target corporation's shareholder and the loss corporation to avoid creating a new public group in a transaction. [3] By way of background, a loss corporation's issuance of its shares to a target corporation's shareholders is considered an "equity structure shift." Shares issued to non-5% shareholders in an equity structure shift require the loss corporation to create a new public group which would result in an ownership shift because there is a presumption that there is no overlapping shareholder ownership. In the ruling, the loss corporation engaged in written correspondence with overlapping shareholders immediately before the merger to obtain actual knowledge of its overlapping non 5% shareholders in an effort to avoid creating a new public group as a result of the equity structure shift. The IRS concluded that the additional information regarding the overlapping public group is an acceptable method for determining actual knowledge; and the loss corporation was not required to apply the presumption that no overlapping ownership existed between the merged companies. Presumably, this method of obtaining actual knowledge also might apply to other situations in identifying ownership for Section 382 purposes.
PLR 202146003 serves as good example of how to apply the actual knowledge exception to reduce an ownership shift. This is a very fact intensive analysis and often requires reaching out to individual shareholders. In the case of a public company, we strongly advise loss corporation tax preparers to use caution in gathering this information for confidentiality purposes and for compliance with SEC rules as it is a communication between the company and one shareholder. Taxpayers in this situation may want to seek counsel or have an intermediary contact the shareholder.
[1] Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986, and all references to "Regulation" or "Treas. Reg." are to the Treasury Regulations promulgated thereunder.
[2] The amount of the loss that can be used after an ownership change is generally limited to the value of the corporation immediately before the ownership change multiplied by the "long-term tax-exempt rate" subject to other potential adjustments.
[3] November 19, 2021.
