Corporations incurring net operating losses (NOLs) are often in the unenviable position of watching the price of their stock fluctuate drastically. This can occur with a publicly traded corporation or a privately held venture incurring losses and raising capital through numerous capital increases. For a corporation with more than one class of stock, the effects of this stock price fluctuation can play a significant role in determining whether use of the NOLs could become limited as a result of trading and other equity shifts. In the context of applying the new Sec. 6694 more-likely-than-not (MLTN) standard for undisclosed positions, it is apparent that the IRS needs to issue additional guidance for taxpayers.
Background
In an effort to limit loss trafficking, Congress enacted Sec. 382 to limit the use of corporate NOLs following an ownership change. An ownership change is defined generally as a greater than 50% change in the ownership of stock among certain 5% shareholders over a three-year period (Sec. 382(g)). In the event of an ownership change, use of the loss corporation’s NOLs and certain built-in losses is limited to the value of the loss corporation multiplied by the adjusted federal long-term tax-exempt rate (Sec. 382(b)).
In determining a shareholder’s percentage ownership change, often-overlooked Sec. 382(l)(3)(C) states, “Except as provided in regulations, any change in proportionate ownership which is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account.” Interestingly, the regulations state that “[t]he determination of the percentage of stock of any corporation owned by any person shall be made on the basis of the relative fair market value of the stock owned by such person to the total fair market value of the outstanding corporation” (Regs. Sec. 1.382-2(a)(3)(i)). It is not clear how the regulation affects the application of Sec. 382(l)(3)(C), and Temp. Regs. Sec. 1.382-2T(l) reserves guidance on the issue.
Guidance on Sec. 382(l)(3)(C)
The IRS has issued a series of private letter rulings that, depending on one’s perspective, either fill in the gap or further confuse the issue (Letter Rulings 200622011, 200520011, 200511008, and 200411012). Each ruling makes the following statement with respect to fluctuation in value of classes of stock:
On any testing date, in determining the ownership percentage of any five percent shareholder, the value of such shareholder’s stock, relative to the value of all other stock of the corporation, shall be considered to remain constant since the date that shareholder acquired the stock; and the value of such shareholder’s stock relative to the value of all other stock of the corporation issued subsequent to such acquisition date shall also be considered to remain constant since that subsequent date.
Also worthy of note is that each ruling provides that the taxpayer requesting the ruling “may apply” this principle.
Consider a few examples:
Example 1: Upon incorporation, A acquires all common shares of ABC, valued at $3,200, and B acquires all preferred stock, valued at $800. All shares are issued for $1 per share. As a result of a business downturn, A sells all common stock to C for $200 while, due to a liquidation preference, preferred stock remains valued at $800. The sale of A to C results in a 20% change in ownership for Sec. 382 purposes (C’s ownership increases from 0 to 20% ($200 of $1,000 total), and A’s decrease is ignored). B’s ownership is unchanged despite the fact that B’s actual ownership increased from 20% to 80% ($800 of $1,000); the increase is due to the fluctuation in value of the common stock. (See Hoffenberg, “Owner Shifts and Fluctuations in Value: A Theory of Relativity,” 2005 TNT 54-29, March 22, 2005.)
Example 2: Reverse the transaction in Example 1 and assume that C buys B’s interest for $800. The result is an 80% increase ($800÷$1,000) and a Sec. 382 ownership change.
In Example 2, what is A’s ownership following B’s sale to C? A’s ownership should not fluctuate based on the value of the common or preferred stock. As such, it seems reasonable to assume that A’s interest remains at 80%, which results in total ownership for purposes of Sec. 382 of 160% (80% for A and 80% for C).
But how can this be? Accountants know that there cannot be more than 100% ownership of a company. Consider the first example again: When C buys A’s interest, C owns 20% of the value; however, B’s increase is attributable solely to value fluctuation, so B’s ownership remains at 20% and total ownership for purposes of Sec. 382 is only 40%.
On further review, this analysis makes perfect sense. A shareholder’s ownership is determined based on the value of the stock acquired as compared with the value of the loss corporation as of the date the shareholder acquires the stock. A shareholder should not have an increase in ownership as the result of an issuance of additional shares to an unrelated shareholder or as a result of the buying and selling of shares already in existence at the time of the shareholder’s acquisition of his or her shares. In the previous examples, the total number of shares remained constant, so any change to the value of a particular class of stock related solely to value fluctuation, and the buyer and seller of the shares are the only parties that incurred changes not attributable to fluctuation in value. These two examples are very basic, and the calculations become exponentially more complex as the number of classes and issuances of stock increases.
Example 3: Instead of C buying shares from A, as in Example 1, ABC issues 3,200 additional shares to C for $200. C’s ownership is fairly simple. C owns $200 out of a total of $1,200 ($400 common + $800 preferred), or 16.7%, and has a corresponding ownership increase of 16.7%. B’s ownership is not as straightforward: It should not increase or decrease as a result of value fluctuation when compared to common stock outstanding during the same period that the preferred is outstanding. However, this is not the case for the newly issued common stock. As a result, B’s ownership would decrease from 20% to approximately 19% ($800÷($4,000 + $200)). (See Hoffenberg, above.)
In determining B’s ownership, the actual value of B’s stock is the numerator ($800), and the denominator is the value of all outstanding shares issued as of the issuance date of the preferred after removing fluctuation in value ($4,000), and the value of the newly issued shares ($200). Determining A’s interest is even less intuitive. A’s ownership would decrease from 80% to 44.4% ($200 ÷ ($250 + $200)), which is calculated by backing out the effect of the value fluctuation of the common shares.
Speaking at a District of Columbia Bar Association Taxation Section luncheon, Mark Jennings, Branch 1 Chief in the IRS Office of Associate Chief Counsel (Corporate), responding to questions likely arising from the aforementioned rulings, made clear that nothing in the regulations under Sec. 382 limits the applicability of Sec. 382(l)(3)(C) (Tandon, “IRS Official Sheds Light on NOL Carryover Rules,” 2006 TNT 35-3, February 22, 2006). In addition, Mr. Jennings stated that eliminating value fluctuation is not elective but instead is the appropriate method of determining changes under Sec. 382. Due to the confusion surrounding the applicability of Sec. 382(l)(3)(C), this method may differ substantially from the methods historically used by many taxpayers. Moving forward, especially under the Sec. 6694 MLTN standard, the appropriate methodology for determining ownership is key.
Potential Conflicts Between Advisers?
With the implementation of FIN 48 and a shift toward corporate taxpayers using different firms for their tax and audit functions, application of a particular methodology could cause disagreements among advisers, as many are taking alternative approaches to deal with the issue.
Approach 1—Apply Sec. 382(l)(3)(C) methodology similar to examples above: This approach appears reasonable in that it attempts to apply the existing statute in a way that conforms to the interpretation of private letter rulings issued by the IRS and represents a taxpayer’s reasonable attempt to comply with the statute. The drawback to this approach is in the complexity, time, and additional costs that arise from applying the methodology as well as the lack of clarity as to the appropriate methodology.
Approach 2—Interpret regulations to turn off Sec. 382(l)(3)(C): This approach seemingly looks to the “[e]xcept as provided in regulations” language of Sec. 382(l)(3)(C) and the language in Regs. Sec. 1.382-2(a)(3)(i) discussed above as well as the language in the private letter rulings that seemingly allows the specific taxpayer to apply the methodology, to argue that fluctuation in value is properly taken into account.
Approach 3—Value all preferred stock on an as-if-converted basis: In most situations, preferred stock is convertible into common stock. This approach treats the value of the preferred stock as equal to the value of the common under the assumption that the preferred stock will ultimately convert into common. This approach seems reasonable as long as the value of the common shares exceeds the liquidation value of the preferred stock. However, when the value of the common stock falls significantly below the liquidation value of the preferred stock, such an assumption does not appear nearly as reasonable.
Questions for Practitioners
1. While it may be reasonable to conclude that an adviser could reach an MLTN determination on any of the three approaches above, is it reasonable for an adviser to reach an MLTN determination using the approach that best suits the taxpayer?
2. Does the language in the private letter rulings allowing taxpayers to apply a Sec. 382(l)(3)(C) methodology give comfort for the position that one can look to Sec. 382(l)(3)(C) if the taxpayer would otherwise have an ownership change under a different methodology, and Sec. 382(l)(3)(C) would allow the taxpayer to avoid a change?
3. Should practitioners advise clients to seek a private letter ruling if they are going to apply the methodology from the rulings?
4. Is it important for advisers to understand the position of their client’s audit firm regarding Sec. 382(l)(3)(C) when performing a Sec. 382 analysis for purposes of establishing a FIN 48 position? It would be unfortunate for both the practitioner and the client to prepare an analysis only to have the audit firm tell the client that the analysis is not an acceptable interpretation of the law.
5. Will the application of an approach determined not to meet the MLTN standard satisfy the Sec. 6694 reasonable cause exception due to the lack of clear guidance?
Summary
Sec. 382 is one the Code’s most complex sections, and careful consideration needs to be given to all aspects of the section and regulations thereunder. Sec. 382(l)(3)(C)’s removal of value fluctuation from the ownership change calculation is a perfect example of the complexity and demonstrates the inability of taxpayers or advisers to perform a “quick and dirty” or “back of the napkin” ownership change analysis with any certainty. Furthermore, if tax advisers are going to be held to a higher standard of advice, it is only fair that Treasury and the IRS provide clearer guidance for tax preparers to use in the application of Sec. 382(l)(3)(C).
EditorNotes
Nick Gruidl, CPA, MBT, Managing Director, National Tax Department, RSM McGladrey, Inc., Minneapolis, MN
Unless otherwise indicated, contributors are members of RSM McGladrey, Inc.
If you would like additional information about these items, contact Mr. Gruidl at (952) 893-7018 or nick.gruidl@rsmi.com.
