Sec. 382 and the Hold Constant Principle

Corporations & Shareholders

With the recent downturn in the economy, many corporations have incurred net operating losses (NOLs) and have been placed in the unenviable position of having to raise new capital to survive. In many cases, the capital raised may result in an ownership change in the corporation under Sec. 382. Since the determination of an ownership change under Sec. 382 is based on value, for corporations with multiple classes of stock the price fluctuations in the stock will add complexities in determining whether the use of the corporation’s NOL carryovers and other various tax attributes will be limited.

Sec. 382(l)(3)(C) addresses the issue of fluctuations in stock price for corporations with multiple classes of stock, stating that, “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.” However, the regulations do not specifically address how to apply Sec. 382(l)(3)(C) and have therefore left both taxpayers and practitioners to struggle with this issue. In prior years, the IRS has sought to clarify its position through the issuance of private letter rulings and, most recently, Notice 2010-50.

Prior Guidance on Sec. 382(l)(3)(C)

Since 2004, the IRS has issued a series of letter rulings addressing the application of Sec. 382(l)(3)(C). The earlier letter rulings generally have ruled that “on any testing date, in determining the ownership percentage of any 5% shareholder, the value of such shareholder’s stock, relative to the value of all other stock of a loss corporation issued subsequent to such acquisition date shall also be considered to remain constant since the acquisition date.” In the most recent letter rulings (e.g., Letter Rulings 201017004, 200952004, and 200901003), the IRS adopted what is commonly referred to as the hold constant principle (HCP). For example, in Letter Ruling 201017004, the IRS ruled that the “[t]axpayer may apply a method employing the Hold Constant Principle to determine the increase in percentage ownership of each of its 5% shareholders on each of its testing dates . . . for purposes of Section 382.” While a full analysis of the application of this issue is beyond the scope of this item, the HCP and the Treasury and IRS interpretation of Sec. 382(l)(3)(C) as outlined in the notice are discussed below.

Notice 2010-50

On June 11, 2010, the IRS provided long-awaited interim guidance on Sec. 382(l)(3)(C) with the issuance of Notice 2010-50. To the authors’ knowledge, this is the first guidance from Treasury and the IRS that provides specific application of Sec. 382(l)(3)(C) and acceptable methodologies to account for fluctuations in the value of one class of stock relative to another class of stock for purposes of Sec. 382. In the notice, the IRS states that it will accept certain methodologies for taking into account, or not taking into account, fluctuations in value. As described below, the notice outlines two general applications of Sec. 382(l)(3)(C): the full value methodology (FVM) and the HCP.

Full Value Methodology

Under the FVM, the determination of the ownership percentage of stock owned by a shareholder is based on the fair market value of the stock owned by the shareholder relative to the total fair market value of the corporation’s outstanding stock on a testing date. Essentially, under the FVM all shares are marked to market regardless of whether the shareholder actively participates in or is otherwise party to the transaction. This methodology is a narrow interpretation of Sec. 382(l)(3)(C) and gives effect to the statutory language by not requiring accounting for daily fluctuations in value between different classes of stock that occur between testing dates.

Hold Constant Principle

The HCP, on the other hand, gives effect to the statutory language of Sec. 382(l)(3)(C) by factoring out fluctuations in the value of stock held by passive shareholders across multiple testing dates. In the notice, the IRS broadly states that

under the Hold Constant Principle, the value of a share, relative to the value of all other stock of the corporation, is established on the date that share is acquired by a particular shareholder. On subsequent testing dates, the percentage interest represented by that share (the “tested share”) is then determined by factoring out fluctuations in the relative values of the loss corporation’s share classes that have occurred since the acquisition date of the tested share.

In other words, under the HCP, when a loss corporation has multiple classes of stock:

• The value ratios between and among various classes of stock are fixed, or held constant, on the date the particular share is acquired;
• Any change in ownership that is attributable solely to fluctuations in the relative fair market values of different classes of stock is not to be taken into account when determining ownership change; and
• The “factoring out” process generally continues for a particular share until the holder is no longer treated as owning the tested share for Sec. 382 purposes.

Unlike the FVM, the HCP is individualized for each acquisition of stock by each shareholder, and the ownership percentage of each tested share is adjusted for the dilutive effects of issuances and the accretive effects of redemptions subsequent to the acquisition date. The notice illustrates the HCP with the following example:

Example 1: Upon formation, X Corp. issues $20 of convertible preferred stock to A and two shares of common stock to B for $80, such that A and B own 20% and 80% of X, respectively. X’s fortunes deteriorate, and two years later, when the common stock has a value of $2.50 per share and the preferred stock has a value of $20, B sells one share of common stock to C. At the time of that sale, X is a loss corporation. On that testing date, although A actually owns 80% of X’s value, A will be treated as owning 20% of X’s value for purposes of Sec. 382(g) under the HCP.

As illustrated in the example, under the HCP the increase in A’s ownership percentage interest (60%) is attributable solely to fluctuations in the relative fair market value of common stock. The only share that is marked to value is the one share acquired by C, representing 10% of the corporation’s equity value on the date of acquisition. When determining ownership change under the HCP, the ownership percentage point increase as a consequence of the acquisition by C is only 10%; therefore, no ownership change occurs. This example is consistent with the IRS representation in the prior guidance pertaining to Sec. 382(l)(3)(C). The two methodologies that implement the HCP specifically outlined in the notice are described below.

Alternative methodology 1—Lookback from testing date: This methodology recalculates the HCP represented by a tested share to factor out changes in its relative value since the share’s acquisition date. Under Alternative 1, the percentage interest represented by a tested share on a testing date is determined at the beginning with the value of the tested share on the testing date, and then adjusted by the subsequent changes in relative value of the testing share to the value of all the stock of the loss corporation that have occurred since the tested share’s acquisition date.

Alternative methodology 2—Ongoing adjustments from acquisition date: This methodology tracks the percentage interest represented by a tested share from the date of acquisition forward, adjusting for subsequent dispositions and for the subsequent issuance or redemption of other stock. Under Alternative 2, to the extent a particular shareholder is not engaging in acquisitions or dispositions, the percentage ownership calculation “rolls over” from one testing date to another. Whereas under Alternative 1 the loss corporation generally determines the relative value of shares of its stock at the beginning of the testing period or at an earlier date, this may not necessarily be the case under Alternative 2. Hence, Alternative 2 may involve fewer calculations on a particular testing date than Alternative 1.

Common Elements of Both HCP Methodologies in Notice 2010-50

Acquisitions: Under either HCP methodology, a loss corporation does not factor out value fluctuations for an acquisition. Instead, for any share acquired, the loss corporation determines the percentage interest represented by that share by comparing its value to the value of all the stock of the loss corporation on the date of acquisition.

Dispositions: Under either HCP methodology, a shareholder’s increase in proportionate interest during a testing period will be reduced by share dispositions. The notice describes two methods, the fair market value approach and the share equivalent approach, to account for dispositions. Under the fair market value approach, the effect of a share disposition is based upon the percentage ownership that the sold share represents on the date of its disposition as opposed to the percentage represented by that share on its acquisition date. Under the share equivalent approach, the effect of a share disposition is based upon the percentage ownership that the sold share represented on another testing date during the testing period upon which the selling shareholder acquired shares. The notice illustrates the share equivalent approach with the following example:

Example 2: A purchases 10 shares of X’s common stock for $10 on testing date 1, when each share of common stock represents 1% of X. X is a loss corporation. On testing date 1, A also holds two shares of participating preferred stock, with each share valued at $2 and each preferred share representing 2% of X. On testing date 2, A disposes of one share of the preferred stock. Under a share equivalent approach, A may be considered to have disposed of two shares of common stock, which is the common share equivalent of one share of preferred stock as determined on the acquisition date of the common stock.

Sourcing: The notice also states that if a loss corporation determines the effect of a share disposition based upon the percentage represented by the sold share on the share’s acquisition date, and if a 5% shareholder has had multiple acquisitions and dispositions of the loss corporation stock, under either of the two methodologies the corporation must also determine the source of shares disposed of. In that case, the corporation may treat sold shares as being sourced pro rata from all acquisitions, as being sourced first from the most recent acquisition (LIFO), or as being sourced first from the first acquisition (FIFO).

Nondisposition transactions: To the extent a shareholder remains as an owner of a loss corporation or its successor, the original acquisition date and other hold constant characteristics are preserved, and the loss corporation is not treated as disposing of or acquiring loss corporation stock. The notice states that this principle applies to value-for-value recapitalizations, in which a shareholder exchanges loss corporation stock for other loss corporation stock, as well as to certain reorganizations and holding company formations.

Redemptions and issuances: Sec. 382 also takes into account redemptions and issuances of a corporation’s stock by the corporation for purposes of tracking 5% shareholder ownership percentages. For purposes of Sec. 382, a redemption constitutes a pro-rata acquisition by nonredeeming shareholders of the redeemed shares, while an issuance constitutes a pro-rata sale of shares by shareholders holding stock immediately before the issuance to the shareholders purchasing shares in the issuance. In applying the HCP in a redemption or issuance, the effect of both situations on preexisting shares could be determined by reference to current or relative historical values. Utilizing current or historical values can produce substantially different outcomes for purposes of determining whether an ownership change has occurred. In addition, even if historical values are used, applying the two HCP alternatives may produce differing outcomes.

Comments Requested

While Notice 2010-50 is welcome guidance for many practitioners, the IRS is looking for further assistance in a number of areas related to Sec. 382(l)(3)(C) before it issues proposed or temporary regulations. It is requesting comments, particularly on the application of the HCP and whether the regulations should interpret Sec. 382(l)(3)(C) to require rules for factoring out fluctuations in value. In the meantime, taxpayers and their advisers should continue to use their judgment in applying Sec. 382(l)(3)(C) as outlined in Notice 2010-50. As the notice states, factoring out fluctuations in value of multiple classes of stock is a complex issue, and it will need ongoing analysis before the IRS issues any proposed or temporary regulations.

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

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.