Beware of Sec. 382 When Issuing Stock Warrants or Convertible Debt

By Sheryl L. Vander Baan, CPA, and Bonnie B. Koppenol, CPA, Grand Rapids, Mich.

Editor: Howard Wagner, CPA

Corporations & Shareholders

Corporations raising capital may issue either preferred stock with warrants to purchase additional stock at some future time or debt that is convertible to common stock in an effort to make the investment more attractive to would-be investors. If the issuing corporation is a loss corporation under Sec. 382, there is risk that the warrants or conversion features will trigger an unintended ownership change when they are issued. It is important for loss corporations to understand the rules surrounding the treatment of warrants and equity conversion features under Sec. 382.


Sec. 382 applies to loss corporations, which are defined as corporations entitled to use a net operating loss (NOL) carryover, having an NOL or a net unrealized built-in loss (aggregate tax basis of assets in excess of their aggregate fair market value) for the tax year in which a testing date (the issuance of stock, convertible debt, or warrants) occurs. Sec. 382 also limits the ability to deduct certain built-in losses realized within five years of the change date. If an ownership change occurs under Sec. 382, the limitation may result in an NOL, capital loss, and other credit carryovers expiring with no tax benefit. Sec. 383 effectively extends the rules of Sec. 382 to corporations with current-year capital losses, as well as capital loss or tax credit carryovers.

In general, a Sec. 382 ownership change occurs when, on a particular testing date (here, the date the stock or warrants are issued), the percentage of stock ownership of one or more 5% shareholders increases by more than 50 percentage points over the lowest percentage of stock ownership held by those shareholders at any time during the testing period. The testing period is generally the three-year period ending on the testing date. This period is shortened if there has been a prior ownership change in the three-year period or if the losses subject to Sec. 382 arose after the start of the three-year period. For Sec. 382 purposes, ownership percentages are based on the value of equity characterized as stock. (A detailed analysis of when an ownership change occurs under Sec. 382 is beyond the scope of this item.)

Common stock and preferred stock generally constitute stock for Sec. 382 purposes. However, under Sec. 382(k)(6)(A), preferred stock meeting all of the requirements of Sec. 1504(a)(4) (often referred to as pure preferred stock), or any option to acquire pure preferred stock, is not treated as a stock interest for ownership change purposes and is not counted in either the numerator or denominator of any ownership percentage computation. The following are the Sec. 1504(a)(4) requirements:

  • The stock is not entitled to vote;
  • The stock is limited and preferred as to dividends and does not participate in corporate growth to any significant extent;
  • The stock has redemption and liquidation rights that do not exceed the issue price of the stock (except for a reasonable redemption or liquidation premium); and
  • The stock is not convertible to another class of stock.

Additionally, per Regs. Sec. 1.382-2(a)(3)(i), stock that would meet the Sec. 1504(a)(4) criteria, but for voting rights granted in the event of dividend arrearages, does not lose its characterization as pure preferred stock.

Options, Warrants, and Conversion Features

Regs. Sec. 1.382-4(d)(9) provides that generally any contingent purchase, warrant, convertible debt, put, stock subject to a risk of forfeiture, contract to acquire stock, or similar interest is treated as an option for Sec. 382 ownership purposes. Under Regs. Sec. 1.382-4(d)(1), an option generally is treated as not exercised prior to its actual exercise. However, under Regs. Sec. 1.382-4(d)(2), an option is treated as exercised on the date of its issuance or subsequent transfer if, on that date, it satisfies any one of three tests: the ownership test of Regs. Sec. 1.382-4(d)(3); the control test of Regs. Sec. 1.382-4(d)(4); or the income test of Regs. Sec. 1.382-4(d)(5). (Application of these tests is discussed further in Regs. Sec. 1.382-4(d)(6).)

If any option is deemed to be exercised immediately upon issuance or transfer, it must be tested for Sec. 382 ownership change purposes as if it were stock. For purposes of the remainder of this item, any reference to options includes traditional options or warrants as well as convertible debt.

The Tests: A Prohibited Principal Purpose

A common element to all three tests is whether a principal purpose of the issuance, transfer, or structuring of the option (alone or in combination with other arrangements) is to avoid or ameliorate the effect of an ownership change on the loss corporation (a prohibited principal purpose). Note that this only needs to be a principal purpose, not the principal purpose. In fact, the preamble to the regulations (T.D. 8531) states that "an abusive purpose can be a principal purpose even when it is outweighed by the non-tax reasons (taken together or separately) for the occurrence or structure of a transaction." Among the factors relevant in applying all three tests are:

  • The business purpose for the issuing, transferring, or structuring of the option;
  • The likelihood that the option will be exercised, taking into account any contingencies to its exercise;
  • Transactions related to the issuance or transfer of the option (such as concurrent issuances of other stock); and
  • The consequences of treating the option as exercised.

For the consequences of treating the option as exercised factor, an option is not treated as exercised if a principal purpose of its issuance, transfer, or structuring is to avoid an ownership change by having it treated as if it were immediately exercised. This might be the case, for example, if, in connection with issuing stock and warrants to a new major shareholder, warrants also are issued to existing shareholders to prevent dilution of their ownership and to keep the new investor's ownership below 50% (if all warrants were treated as immediately exercised for testing purposes).

Conversely, if treating the option as exercised either itself causes, or contributes to, an ownership change, the likelihood that the option will be treated as having a prohibited principal purpose will be enhanced. (Per Sec. 382(l)(3)(A)(iv), except to the extent provided by regulations, an option to acquire stock shall be treated as exercised if the exercise results in an ownership change.) In those cases, it will be critical to determine the effect of the other factors relevant in applying each of the three tests.

Ownership test: Under Regs. Sec. 1.382-4(d)(3), the prohibited principal purpose of the ownership test is satisfied by providing the option holder (or a person related to the holder), prior to option exercise or transfer, with a substantial portion of the attributes of ownership of the underlying stock, which could include voting rights or rights to receive dividends. Regs. Sec. 1.382-4(d)(6)(ii) describes relevant factors to consider in applying this test, including:

  • The relationship, at the time of issuance or transfer of the option, between the option exercise price and the value of the underlying stock. For example, a warrant with an exercise price below, at, or just slightly above the stock's current fair market value is more likely to be exercised than a warrant with an exercise price that is 200% of the current value of the company's stock, increasing the likelihood that the option holder will become a stock owner.
  • Whether the option provides the holder, or a related person, with the right to participate in management or with other rights ordinarily afforded to owners of stock. For example, if, as a condition of purchasing pure preferred stock with common stock warrants, the investor requires representation on the issuer's board of directors, the warrants could be viewed as conveying the rights of ownership. Similarly, it could be problematic if the option holder, or a related person, is a member of the corporation's management team.
  • The existence of reciprocal options (such as a call option held by the prospective purchaser and a put option held by the prospective seller).
  • A fixed exercise price. This allows an option holder to share in future appreciation of the stock, an attribute present in actual stock ownership; however, the regulations indicate that this factor alone is not sufficient to cause the option to satisfy the ownership test. Conversely, the fact that the option holder does not bear the risk of loss due to declines in value of the underlying stock does not preclude the option from satisfying the ownership test.

Control test: The control test of Regs. Sec. 1.382-4(d)(4) is satisfied if both the prohibited principal purpose is present and the holder of the option, together with all related parties, has an aggregate direct and indirect ownership interest in the loss corporation of more than 50%. This percentage is determined as if exercise of both the option in question plus any other loss corporation options of the holder, and any other intended increases in that person's percentage ownership interest, all occurred on the date the option in question was issued or transferred. Regs. Sec. 1.382-4(d)(4)(ii) contains the operating rules for determining indirect ownership and related persons. Related persons include any persons having a formal or informal understanding among themselves to make a coordinated acquisition of stock, within the meaning of Regs. Sec. 1.382-3(a)(1)(i).

Regs. Sec. 1.382-4(d)(6)(iii) also requires consideration of the option holder's economic interest in, and influence over the management of, the loss corporation, either directly or via related persons. Either economic interest or the ability to influence management could be attained through ownership of the option itself, through a related arrangement, or through rights in stock. Thus, an option holder that already sits on the board or owns significant amounts of voting stock is more likely to satisfy the control test.

Income test: Under Regs. Sec. 1.382-4(d)(5) and Regs. Sec. 1.382-4(d)(6)(iv), the prohibited principal purpose of this test is satisfied if the structuring of the option facilitates the creation of income or value (including unrealized built-in gains) before the exercise or transfer of the option. The prohibited objective is to avoid causing an ownership change until carryovers are used or to reduce or eliminate an unrealized built-in loss that would exist at an ownership change date.

Factors to consider are whether, in connection with the issuance or transfer of the option, the loss corporation engages in extraordinary income acceleration transactions—in other words, transactions that are outside the ordinary course of business that are entered into purely to accelerate income in periods just before the exercise of an option or that defer deductions to a period after the exercise of an option.

Also problematic here is whether the option holder (or related persons) purchases stock (including pure preferred stock) or makes a capital contribution or loan to the loss corporation that can be reasonably expected to avoid or ameliorate the effect of an ownership change. The larger the stock purchase, capital contribution, or loan, the more likely the option will satisfy the income test. However, these transactions generally are not taken into account if they are made to enable the loss corporation to continue basic operations of its business. Examples of basic operations are to meet monthly payroll or to fund other operating expenses.

Safe Harbors

Regs. Sec. 1.382-4(d)(7) describes certain options that are not treated as exercised under the above tests. This list of safe-harbor options includes:

  • Contracts to acquire stock. This includes a stock purchase agreement or similar arrangement, the terms of which are commercially reasonable, in which the parties' obligations to complete the transaction are subject only to reasonable closing conditions, and which is closed on a change date within one year after it is entered into. However, such a contract is not exempt from the income test solely by being described in this regulation.
  • Escrow, pledge, or other security arrangements. These include options that are part of a security arrangement in a typical lending transaction, if they are subject to customary commercial conditions, such as an agreement for holding stock in escrow or under a pledge or security agreement, or an option to acquire stock contingent upon a loan default.
  • Certain compensatory options.
  • Options exercisable only upon death, disability, mental incompetence, or retirement.
  • Options constituting a right of first refusal, with customary terms.
  • Options designated by the IRS in an Internal Revenue Bulletin as being exempt from one or more of the ownership, control, or income tests.

The rules of Sec. 382 and its accompanying regulations are very complex. It is extremely important for loss corporations issuing preferred stock with warrants or convertible debt to be aware of the option rules to avoid inadvertent and unwelcome ownership changes that could limit a corporation's realization of tax attributes.


Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or

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

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