Sec. 382 Operating Rules: Actual Knowledge Regarding Stock Ownership

By Spresa Culafi, CPA, Melissa A. Reinbold, CPA, and Kevin F. Powers, CPA, Oak Brook, IL

Editor: Frank J. O’Connell Jr., CPA, Esq.

Corporations & Shareholders

An ownership change under Sec. 382 can have an onerous impact by substantially limiting a loss corporation’s ability to utilize its tax attributes, such as net operating loss carryforwards or built-in losses, potentially resulting in increased tax liabilities or even a valuation allowance for GAAP purposes. In the current business environment, increased capital-raising activities by corporations may have the unintended consequence of triggering an ownership change under Sec. 382. However, historically it was more common to encounter Sec. 382 through an equity structure shift such as a merger or acquisition. Letter Ruling 201110006 addresses a proposed transaction in which the taxpayer is involved in such a potential change in ownership.

Background

To identify whether an ownership change has occurred under Sec. 382, a taxpayer must generally determine if there has been more than a 50 percentage point increase in the stock ownership of 5% shareholders during a testing period of up to three years. One of the main challenges in making this determination, other than the complex operating rules provided in the regulations, is the logistical process a taxpayer must go through to obtain stock ownership information and identify 5% shareholders and their ownership percentage throughout the entire testing period. Public taxpayers may rely on applicable public filings with the Securities and Exchange Commission (SEC) (generally, Schedules 13D or 13G (beneficial owner reports)) in identifying any individuals or entities (i.e., a corporation, partnership, or trust) that directly or indirectly are the beneficial owners of at least 5% of the total value of the outstanding stock of the loss corporation, while nonpublic taxpayers may endure a more laborious process.

The regulations also provide mechanisms by which shareholders owning less than 5% of the outstanding stock are combined into public groups, with each public group being treated as a 5% shareholder. To the extent the taxpayer has actual knowledge that a member of one public group is also a member of another public group, it may use such actual knowledge in determining whether an ownership change occurred; however, “actual knowledge” is not a defined term. Letter Ruling 201110006 responds to a taxpayer’s request for clarification on what constitutes acceptable actual knowledge and discusses the impact of using actual knowledge of stock ownership under Temp. Regs. Sec. 1.382-2T(k)(2) in determining whether an ownership change has occurred.

Summary of Facts

Letter Ruling 201110006 demonstrates how one loss corporation obtained actual knowledge regarding stock ownership to identify an overlapping public group through various methods, including phone calls and written inquiries. Both the undisclosed acquiring consolidated corporation (Acquiring) as well as the target corporation (Target) had significant net operating loss carryforwards. Acquiring did not have any 5% shareholders within the meaning of Sec. 382, other than direct public groups (acquiring public groups) within the meaning of Temp. Regs. Sec. 1.382-2T(j)(2)(ii). Target was aware of only three 5% shareholders other than its public groups (target public groups). Acquiring and Target executed an agreement whereby Acquiring’s merger subsidiary, Merger Sub, merged with and into Target, with Target surviving as a wholly owned subsidiary of Acquiring. Under the agreement, Target shareholders would exchange their Target stock for stock in Acquiring and cash in lieu of fractional shares. Acquiring shareholders would continue to own their existing shares, which would not be affected by the proposed transaction.

Acquiring’s management believed that certain of its shareholders were also shareholders in Target, each owning less than 5% of Target. Thus, they were members of both Target public groups and Acquiring public groups. The shareholders with overlapping ownership (overlapping shareholders) would constitute a separate public group (overlapping public group). Acquiring proposed to use actual knowledge of stock ownership to identify the amount of stock owned by members of the overlapping public group. Acquiring did this in two phases. First, it developed a list of possible overlapping shareholders through:

  • Inquiries with the investor relations departments at Acquiring and Target;

  • The use of electronic research resources provided by an unrelated shareholder research organization; and

  • A review of applicable public filings with the SEC.

Second, once Acquiring identified the potential overlapping shareholders, it contacted those persons directly by telephone and e-mail to confirm whether each person constituted an overlapping shareholder and to determine the amount of Acquiring and Target stock that such persons owned immediately prior to the proposed transaction. If the investor was willing to share such information, the Acquiring investor relations department e-mailed a written request to confirm the ownership, identify any potential indirect 5% shareholders, and determine whether the ownership might be viewed as a single 5% shareholder under the entity rules of Regs. Sec. 1.382-3(a). If it was determined that the overlapping shareholders had economic ownership of Acquiring’s stock, the written request would ask for further information to confirm the number of shares owned immediately before the transaction took place, and the investor department would follow up to confirm and clarify any responses if necessary.

Ruling

The IRS ruled that the additional information that Acquiring proposed to obtain in order to identify the overlapping shareholders through the use of written inquiries is an acceptable method of determining actual knowledge within the meaning of Temp. Regs. Sec. 1.382-2T(k)(2). Letter Ruling 201110006 also states that Acquiring is allowed to use this actual knowledge to treat the overlapping shareholders as a separate public group of Acquiring (i.e., the overlapping public group) for purposes of applying the segregation rules of Temp. Regs. Sec. 1.382-2T(j)(2). The ruling also provides that the presumption described in Temp. Regs. Sec. 1.382-2T(j)(2)(iii)(B)(1)—which states that a direct public group that acquires the stock of the loss corporation in certain transactions is presumed not to include any members of any direct public group that existed immediately before the transaction—would not apply.

Perhaps the most significant outcome of Letter Ruling 201110006 is that for purposes of determining the increase in the overlapping public group’s percentage ownership, Acquiring is not required to determine the overlapping public group’s stock ownership in Acquiring throughout the entire three-year testing period. Rather, Acquiring is only required to determine the stock ownership of the overlapping public group immediately before and after the proposed transaction.

Application of Regs. Prior to Letter Ruling 201110006

Notwithstanding the taxpayer-favorable ruling by the IRS in Letter Ruling 201110006, eliminating the need to determine the overlapping public group’s stock ownership for the entire testing period, Temp. Regs. Sec. 1.382-2T(k)(2)(ii) provides for the identification of an overlapping shareholder group based on actual knowledge. For example, using the facts from the ruling, the segregation of the overlapping public group would likely reduce the percentage point increase for purposes of determining whether a 50% or greater change in ownership occurred, since the overlapping shareholders would have held stock in Acquiring before and after the proposed transaction. Thus, the overlapping public group’s ownership in Acquiring immediately after the proposed transaction may have decreased from its lowest ownership in the testing period due to dilution from the stock issued to the Target shareholders. Alternatively, it may have increased, but to a lesser extent than if its lowest ownership in the testing period had been zero, as would be the case for target public groups. As such, the mere segregation of overlapping shareholders out of target public groups has a favorable impact on avoiding an ownership change.

Significance

As mentioned, the most significant outcome of Letter Ruling 201110006 is that when actual knowledge is used to identify an overlapping public group that will be treated as an additional direct public group of the loss corporation, the loss corporation is not required to inquire as to stock ownership held by the overlapping public group throughout the entire testing period. This will alleviate the tedious and time-consuming administrative burden of gathering up to three years of stock ownership information for the overlapping shareholders who may have previously been members of multiple public groups. The other significant contribution the ruling makes to the application of Temp. Regs. Sec. 1.382-2T(k)(2) is to provide clear and detailed guidance on an acceptable method for determining actual knowledge. The following examples demonstrate how the application of actual knowledge can make the difference between the avoidance—or occurrence—of an ownership change.

Example 1: A Corp. proposes to acquire B Corp. in a stock-for-stock exchange in which B shareholders will receive 1.5 shares of A stock for each share of B stock. Each company has 100,000 shares of common stock outstanding and only one class of stock. Neither company has any 5% shareholders under the meaning of Sec. 382 other than direct public groups. A issues 150,000 shares of common stock in exchange for ownership in B. The ownership interest of A’s old public group, composed of the original A shareholders, decreased from 100% to 40%. The ownership interest of former B shareholders, now A’s new public group, in A has increased from zero to 60%, for a total 60 percentage point increase. Thus, an ownership change has occurred with respect to A.


Example 2: The facts are the same as in Example 1, except A believes that certain of its shareholders are also shareholders in B. A queries its shareholders and obtains actual knowledge that some shareholders own shares in both A and B. A identifies the overlapping shareholders and aggregates them into overlapping public group OV. Shareholders in OV own 30,000 shares of A and 20,000 shares of B. Immediately before the acquisition, old public group OPG owns 70,000 shares or 70% of A and OV owns 30,000 shares or 30% of A. B shareholders exchange their B stock for 1.5 shares of A stock. New public group NPG receives 120,000 shares of A stock and OV receives 30,000 shares for a total of 60,000 shares of A stock. OPG’s ownership percentage decreases. NPG’s ownership percentage increases from zero to 48%, for a 48 percentage point increase. OV’s ownership percentage decreases from 30% to 24%. Thus, the total percentage point increase of 48 does not trigger an ownership change. Use of actual knowledge and applying the rulings in Letter Ruling 201110006 mitigate the impact of Sec. 382.

Challenges in Obtaining Actual Knowledge

In Letter Ruling 201110006, Acquiring obtained its actual knowledge by developing a list of possible overlapping shareholders, contacting those shareholders by phone, and following up with a written inquiry. This methodical approach of obtaining actual knowledge was developed specifically by the taxpayer. One of the complexities that taxpayers face in gathering this information is that the process of obtaining actual knowledge, and what qualifies as acceptable actual knowledge, is not clearly defined in the Code or regulations. This leads taxpayers to use various methods to identify 5% shareholders and overlapping shareholders. Common methods to obtain shareholder ownership information include examining SEC filings, obtaining a list of the registered shareholders or nonobjecting beneficial owners, and even making phone calls.

Once shareholder information has been obtained, it must be compared to identify overlapping shareholders. This comparison process may be more difficult considering shareholders may have different transfer agents, and shareholder lists may also come in different formats. Given these challenges, permitting the information to be gathered only for the point in time immediately prior to the transaction, as opposed to throughout the entire testing period, is a gift to taxpayers.

Conclusion

Amid the complex and administratively burdensome rules associated with Sec. 382, Letter Ruling 201110006 is a welcome practical example of an acceptable method to determine actual knowledge. Even more welcome is the guidance that when actual knowledge is used to identify an overlapping public group that will be treated as an additional direct public group of the loss corporation, the loss corporation is not required to inquire as to stock ownership held by the overlapping public group throughout the entire testing period. This can save taxpayers the time and expense of having to gather and investigate up to three years of ownership information for the overlapping public group. As a result, the ability to use actual knowledge, which has the potential to mitigate an ownership change under Sec. 382, is more readily accessible.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

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