IRS Issues Guidance on Corporate Equity Reduction Transactions

By Brian Peabody, J.D., LL.M., and Donald W. Bakke, J.D., LL.M., Washington, D.C.

Editor: Michael Dell, CPA

Corporations & Shareholders

On Sept. 17, 2012, the IRS published a significant proposed regulation package (REG-140668-07) providing the first published guidance addressing corporate equity reduction transactions (CERTs) since the CERT rules were enacted in 1989. The proposed regulations include rules generally applicable to all corporate taxpayers, as well as special rules for consolidated groups, that will become effective when finalized.


Sec. 172(b)(1)(E) states that in the event of a CERT, if an “applicable corporation” has a corporate equity reduction interest loss (CERIL) for any loss limitation year, that loss cannot be carried back to a tax year preceding the year of the CERT. A CERT is a major stock acquisition (MSA) or an excess distribution (ED), as described below. A CERIL is defined as the excess of the net operating loss (NOL) for the year over the NOL for the year determined without any allocable interest deductions otherwise taken into account in computing the NOL.

Taxable income is computed by taking allocable interest deductions into account after all other deductions. The “allocable interest deductions” are those deductions allowed for interest on the portion of any indebtedness allocable to a CERT under the principles of Sec. 263A. The amount is limited to the excess of (1) the amount allowable as a deduction for interest during the loss limitation year over (2) the average of those amounts for the three tax years preceding the CERT year.

An “applicable corporation” is a C corporation that (1) is the acquiring or acquired corporation in an MSA; (2) makes a distribution with respect to its stock (or redeems its stock) in connection with an ED; or (3) is a successor corporation of a corporation described in (1) or (2).

An MSA is defined as an acquisition by a corporation under a plan of the corporation (or any group of persons acting in concert with the corporation) of stock in another corporation representing 50% or more, by vote or value, of the acquired corporation’s stock. An ED is the excess of (1) the aggregate distributions (including redemptions) made during a tax year by a corporation with respect to its stock over (2) the greater of (a) 150% of the average of those distributions for the three tax years immediately preceding the tax year or (b) 10% of the fair market value (FMV) of the stock of the corporation as of the beginning of the tax year. For this purpose, there is a reduction for certain stock issuances; in addition, distributions with respect to “plain vanilla” preferred stock (Sec. 1504(a)(4) stock) are disregarded.

Proposed Regulations

The statute does not exclude tax-free transactions from treatment as MSAs or EDs, and the proposed regulations confirm that MSAs include tax-free transactions that meet the criteria. For example, the proposed regulations state that acquisitions of stock under a Sec. 351 exchange or Sec. 368(a)(1)(B) reorganization may constitute an MSA; similarly, tax-free distributions under Sec. 355 may be treated as an ED.

The proposed regulations specify that an integrated plan of stock acquisition that has multiple steps will be tested as a single potential MSA. The proposed regulations also state that, to the extent a distribution is part of an integrated plan that is treated as an MSA, the distribution is excluded from the computation of the taxpayer’s three-year distribution average that is relevant to any other potential ED. Additionally, the proposed regulations create rules for calculating the taxpayer’s three-year distribution average under Sec. 172(h)(3)(C)(ii)(I) when a potential ED occurs in a short tax year.

The proposed regulations define a loss limitation year as the tax year in which the CERT occurs and each of the two succeeding tax years. Note that a short tax year counts as a tax year for this purpose. However, the IRS is considering the inclusion of an anti-avoidance rule to prevent taxpayers from engaging in Sec. 381 transactions to shorten loss limitation years.

Determination of CERT Costs

The proposed regulations create MSA- and ED-specific rules for computing costs associated with a CERT (CERT costs) when applying the rules of Sec. 263A. The CERT costs of an MSA include the FMV of the stock acquired (whether acquired for cash, stock, or other property). The CERT costs of an MSA will include any distribution that is part of an integrated transaction constituting the MSA (i.e., MSA and ED overlap transactions are treated as MSAs). Under the proposed rules, CERT costs will include amounts paid or incurred to facilitate any step of the MSA to the extent that those amounts are required to be capitalized under Sec. 263(a) or disallowed under Sec. 162(k).

The CERT costs of an ED include the FMV of distributions determined to be EDs during the CERT year. Similarly, CERT costs will also include amounts paid or incurred to facilitate the distributions to the extent such amounts are required to be capitalized under Sec. 263(a) or disallowed under Sec. 162(k).

The IRS requested comments (by Dec. 17) regarding the extent to which certain borrowing costs should be included in CERT costs as facilitative of an MSA or an ED.

Special CERT Rules for Consolidated Groups

Under Sec. 172(h)(4)(C), consolidated groups are generally treated as a single entity. Accordingly, the proposed regulations provide that transactions and expenditures of members are not separately tracked. Additionally, intercompany transactions are generally disregarded (unless a party to the transaction becomes a nonmember as a part of the same plan).

If an applicable corporation that experienced a CERT in a separate return year joins a consolidated group, the group is treated as a single applicable corporation with regard to that CERT (i.e., the new member “taints” the group). The debt of the new member, its corresponding interest expense, and its interest deduction history are included in the group’s CERIL computation.

If a member deconsolidates on or after the CERT date of the group, or the date the group acquires a member with an existing CERT, both the deconsolidating member and the group will be treated as applicable corporations. Generally, the deconsolidating member will be apportioned a pro rata share of the group’s CERT costs (based on the FMV of the corporations), which are then subtracted from the group’s costs. A departing member may elect out of the general rule, but this will result in a permanent waiver of all carrybacks of losses allocable to the departing member to years of the former group, and none of the interest history of the group will be allocated to the deconsolidating member, including determining the CERIL related to any future CERT.

The proposed regulations include rules to determine the three-year interest expense average of a group. When a new member joins a group, the interest history of the new member is combined with that of the acquiring group. This interest is then treated as having been paid or accrued by the group and is no longer separately tracked. When a deconsolidation occurs, a portion of the group’s entire interest history is generally apportioned to the deconsolidating member.

Special rules also apply during transitional years. A group that includes a particular member for only a portion of a loss limitation year includes only a pro rata portion of that member’s three-year interest history. A group that includes a member for only a portion of a year of a potential ED takes into account only a pro rata portion of that member’s distribution history.


The guidance described in the proposed regulations will, when applicable, clarify many issues that have arisen in this area of practice. In particular, the general guidance regarding which collateral transaction-related costs will be treated as part of the CERT costs, and how to incorporate the principles of Sec. 263A(f)(2)(A), for purposes of computing the allocable interest deductions and CERIL represent needed, practical guidance. This is true as well of the rules addressing how to compute consolidated-level CERT costs or CERILs when a corporation joins a consolidated group, or how to apportion an amount of CERT costs or related distribution or interest history (if any) to a departing member.

This regulatory package also elevates the importance of planning for application of the CERT rules. The broad definitions of an MSA and an ED included in these proposed regulations (to include all manner of tax-free transactions as well as certain internal restructuring transactions) increase the likelihood that a corporation’s or group’s ability to carry back some amount of its NOL or consolidated net operating loss will be restricted (e.g., when consolidated group members take back more than 50% of the stock of a controlled foreign corporation in a Sec. 351(a) exchange, the transaction would be treated as an MSA for which the group would be an applicable corporation). Finally, owing in part to these regulations, the IRS is more aware of CERT issues, and there is an increasing likelihood that CERT issues will be raised by IRS field agents in examination. Accordingly, consideration should be given to the CERT rules any time a corporate taxpayer attempts to carry back an NOL.


Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact Mr. Dell at 202-327-8788 or

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.