Proposed Sec. 382 Regs. Simplify Small Shareholder Treatment

Editor: Greg A. Fairbanks, J.D., LL.M.

Corporations & Shareholders

Sec. 382 and the regulations thereunder rank among some of the most complex, nonintuitive rules in federal tax law, all aimed at curbing the practice of trafficking in net operating losses (NOLs), or other loss attributes, in a corporation. If a corporation undergoes a change in ownership, then the NOLs (or other loss attributes such as research and development credits or capital losses) that are attributable to periods before the change in ownership are subject to a Sec. 382 limitation for use in periods after the ownership change. Sec. 382(g) defines what constitutes a change in ownership with three major factors: (1) There must be a greater than 50% change in ownership (2) by the 5% shareholders in the corporation (3) within a given “testing period” (generally a three-year window). At first blush, the statute appears fairly simple.

There are many examples of ownership changes within the meaning of Sec. 382 that not only result from following the statute but also appear fully intuitive in light of the above rules. For example, LossCo is 100% owned by Founder. Founder then sells all the stock to Buyer. This clearly is an ownership change. Another slightly more nuanced example is if LossCo is equally owned by A, B, and C. In year 1, A sells his one-third interest to D, and in year 2, B sells his one-third interest to E. A practitioner at first blush may wonder if this is an ownership change, but simple application of the statute makes the result quite clear. Within two years, there has been a two-thirds change in ownership by significant shareholders.

One of the many areas of complexity within the regulations under Sec. 382 is how to apply the statute (and legislative intent) with regard to “small shareholders,” i.e., shareholders (whether individuals, corporations, partnerships, etc.) who own less than 5% of the corporation. Temp. Regs. Sec. 1.382-2T provides an array of rules by which such shareholders are aggregated or segregated, and it governs simple transactions such as stock issuances, stock redemptions, and the sale or exchange of stock where one party to the sale is a small shareholder. The result is situations where an ownership change can occur in very nonintuitive circumstances. One of the classic situations is the “yo-yo ownership change.”

The yo-yo ownership change occurs when a 5% shareholder sells its stock to small shareholder(s), and those shareholders are segregated into a new agglomeration of such shareholders (a direct public group) that will be treated as a new and distinct 5% shareholder; however, when a new investor that will become a 5% shareholder purchases stock from small shareholders, it is assumed to come from the old-and-cold small shareholders that existed immediately beforehand.

Example 1: F owns 30% of LossCo, and small shareholders hold the rest. F subsequently sells all his stock to small shareholders, while G purchases 25% of LossCo from small shareholders. This results in an ownership change. The small shareholders that purchased F’s stock will be treated as a distinct group from the original small shareholders. Thus, G is a new 25% owner, and the small shareholders are treated as a new 30% owner.

In a real-life situation, the yo-yo ownership change usually involves far more complex facts with many purchases and dispositions. There does not appear to have been a trafficking of losses, just a change in a significant shareholder. The yo-yo effect occurs when there is a lot of arbitrage occurring whereby investors are acquiring stock and then disposing of it on the open market, one after the other.

In Notice 2010-49, the IRS solicited comments as to whether the above rules (the ownership tracking approach as it was dubbed) should be modified to a “purposive” approach to ameliorate some of the effects on small shareholders where it appears no real loss trafficking is occurring. In proposed regulations (REG-149625-10) published on November 23, 2011, the IRS proposed three fundamental rule changes in implementing the purposive approach that are taxpayer favorable and should simplify some (but certainly not all) of the complexities of applying Sec. 382.

Sell-Downs by 5% Shareholders

Prop. Regs. Sec. 1.382-3(j)(13) adds a “secondary transfer exception.” Under current law, each time a 5% shareholder sells down stock to small shareholders, each such sale gives rise to a testing date and such small shareholders are segregated into new direct public groups of the loss corporation. The proposed regulation instead treats such sell-downs as if the preexisting small shareholders are acquiring their proportionate share of stock.

Example 2: Under the current rules, if LossCo were wholly owned by a single direct public group (an “initial” or “root” public group) of small shareholders, and three investors, A, B, and C, sequentially each bought 20% from small shareholders and sold the stock to other small shareholders, the company would be on the precipice of a yo-yo ownership change. After A’s purchase and sell-down, the initial public group owns 80% and the first segregated public group owns 20%. After B’s subsequent purchase and sell-down, the stock is owned 64% by the initial public group; 16% by the first segregated public group; and 20% by the second segregated public group. After C’s purchase and sell-down, the stock is owned 51.2% by the initial public group; 12.8% by the first segregated public group; 16% by the second segregated public group; and 20% by the third segregated public group. The total ownership by “new and hot” 5% shareholders (the segregated public groups) is 48.8%, just a shade away from triggering a greater-than-50% change in ownership.

Under the proposed regulations, each such sell-down by A, B, and C is treated as having been reacquired by the initial public group. Thus, after the third and final sale, the ownership is still treated as 100% owned by the initial public group. The cumulative shift is only 20%, as the lowest such public group percentage ever owned after each purchase was 80%.

Stock Redemptions

Under existing regulations, both issuances and redemptions, to or from small shareholders, are events that putatively result in segregated public groups. Looking at a basic example, if LossCo (wholly owned by small shareholders) issues 10% new stock to small shareholders, those shareholders are segregated into a new public group such that afterward the initial public group owns 90% and the segregated, newly issued public group owns 10%. Inversely, if instead of issuing stock, LossCo redeems 10% from the initial public group, those shares first are segregated into a new public group and then redeemed. The result is that, while the initial public group still owns 100%, the group is treated as having a historic ownership of only 90%, resulting in a 10% ownership shift.

However, under the same existing regulations, there are two exceptions to the general rule of segregation for issuances: the small-issuance exception and the cash-issuance exception. The former applies to issuances that are “small” by either a function of number of shares or the value of the issuance. The latter applies to shares issued that are solely for cash. “Small” is defined as 10% for the whole tax year (by number per class or by overall stock value, with the taxpayer generally able to elect which index to use to set the small-issuance limit). Once the small-issuance limit is exhausted, it does not get replenished until the start of the next tax year. However, it basically means that up to 10% new stock can be issued and, instead of being segregated, be allocated back to the preexisting public groups. There is no analogous rule for redemptions, though.

Thus, under the basic example above, in the case of the issuance, the 10% is allocated to the initial public group, and there is no ownership shift. In the case of the redemption, the answer is still the same, and there is a 10% cumulative shift due to the segregation event deemed to occur.

A “small redemption exception” is added under Prop. Regs. Sec. 1.382-3(j)(14) that provides an analogous rule for certain small redemptions just like issuances. Thus, it is a 10% exhaustible limit set as a function of either the number of shares in the class or by total stock value. There is no requirement of consistency between the small-issuance limit and the small-redemption limit (thus a taxpayer could set one as a function of value and the other as a function of number of shares within the same tax year).

The proposed regulations provide the same answer to the basic example regardless of whether 10% of the stock is newly issued or, instead, 10% is redeemed. One practical aspect of the proposed regulations, especially for smaller corporations, is that they effectively allow a 20% putative ownership shift per year to be mitigated by a conjunction of both small-issuance and small-redemption exceptions if a company plans appropriately. Instead of issuing 20% new stock over a tax year, where only the first 10% would be eligible for the small-issuance exception (assuming each such issuance over the year is 10% or less), the company could instead issue 10% new stock but then redeem out 10% as well.

Entity Lookthrough

Another complexity of Sec. 382 is the affirmative requirement to look through entities that own 5% or more of the loss corporation (first-tier entities) and applicable succeeding entities up the chain (“higher-tier entities” and “highest-tier entities”) to effectively try to find who owns the stock and apply the aggregation and segregation rules at those levels. The goal is to prevent indirect loss trafficking. Absent such a rule, taxpayers could easily thwart Sec. 382 by interposing such entities and then selling or exchanging ownership interests in those entities. A side effect of these rules is that it can be extremely difficult to obtain information about nonpublicly traded first- or higher-tier entities. Under the current rules, there is no solution, and taxpayers struggle to determine what is the proper position to take for both tax return signing positions as well as for purposes of FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes (now incorporated into FASB Accounting Standards Codification Topic 740, Income Taxes).

Example 3: LossCo is owned 40% by an initial public group of small shareholders, and the remaining 60% is owned by six unrelated investment funds (numbered 1 through 6), each owning 10% of LossCo. The ownership has been static since the company began incurring NOLs. No ownership change appears to have occurred at the LossCo level. However, LossCo must look through each investment fund and apply the Sec. 382 rules at the fund (or higher) level. If the ownership of each fund were each held by six unrelated, wealthy individuals (A through F) and those individuals sold their stock to six other unrelated individuals (G through L), a 60% ownership shift would occur, triggering a Sec. 382 ownership change.

What if each such fund refuses to respond to LossCo’s repeated inquiries on the investment funds’ ownership and changes in ownership? LossCo does not know, and cannot know, what changes may or may not be occurring with each fund. Can LossCo conclude, more likely than not, there has been no ownership change for FIN 48 purposes? Is this a Schedule UTP, Uncertain Tax Position Statement, item? Can a tax preparer sign the return at substantial authority, or is there even a reasonable basis to disclose and sign the return?

The proposed regulations help remove some of this uncertainty by providing a broad exception to the lookthrough rules. There is still an affirmative duty to inquire and try to look through. However, Prop. Regs. Sec. 1.382-3(j)(15) provides that the segregation rules do not apply if the entity owns 10% or less of LossCo and the total investment in LossCo by the entity is less than 25% of the entity’s gross assets. The practical effect is that, for entities that own 5% to 10% of the company, one can generally ignore lookthrough consequences. Thus, in the above example, the indirect shift at investment funds 1 through 6 may be disregarded, provided the requirements under the proposed regulations are met.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.