NOL Carrybacks Limited by Excess Distributions

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

Gains & Losses

As 2012 drew to a close, many public and private companies paid significant dividends in advance of higher income tax rates and the 3.8% supplemental Medicare tax. If these companies incur a net operating loss (NOL) in 2013 or 2014, the corporate equity reduction transaction (CERT) rules could provide an unpleasant surprise and limit the carryback of NOLs. While practitioners typically think of the application of the CERT rules in cases of debt-financed distributions or stock acquisitions, the rules could apply even if the underlying transaction is not debt-financed.

The application of the CERT rules is a multistep process.

• Step 1: Determine if there is a CERT transaction involving an applicable corporation.
• Step 2: Determine if there is an NOL in a loss limitation year (LLY).
• Step 3: Determine if there is a corporate equity reduction interest loss (CERIL) in a loss limitation year.
• Step 4: Determine the portion of an NOL that can be carried back.

If there is a CERIL in a loss limitation year, a C corporation can carry back only the portion of the NOL for the loss limitation year in excess of the CERIL to a year prior to the year of the CERT transaction. Any NOL in excess of the CERIL not absorbed in a carryback year, and any portion of the NOL attributable to the CERIL can be used as a carryforward (Sec. 172(b)(1)(E)).

An applicable corporation is defined as: (1) a C corporation that acquires stock, or the stock of which is acquired in a major stock acquisition; (2) a C corporation making distributions with respect to, or redeeming, its stock in connection with an excess distribution; or (3) a C corporation that is a successor of a corporation making a major stock acquisition or an excess distribution (Sec. 172(b)(1)(E)(iii)). A major stock acquisition exists when a C corporation purchases more than 50% of the stock (by vote or value) of another corporation and an election under Sec. 338 is not made (Sec. 172(h)(3)(B)).

Many practitioners are aware of the application of the CERT rules to stock acquisitions but frequently overlook the application of the CERT rules to excess distributions. C corporations that made large distributions at the end of 2012 in anticipation of a higher top tax rate on dividends in 2013 should carefully consider the excess distribution rules. For purposes of the CERT rules, distributions include taxable and nontaxable distributions, as well as redemptions.

An excess distribution exists when the aggregate distributions (including redemptions) made during a tax year by a corporation with respect to its stock exceed the greater of:

• 150% of the average distributions during the three tax years immediately preceding the tax year; or
• 10% of the fair market value (FMV) of the stock of the distributing corporation as of the beginning of the tax year (Sec. 172(h)(3)(C)).

The following examples illustrate the calculations to determine whether an excess distribution is present.

Example 1: At the close of business on Dec. 31, 2012, ABC Corp. made a $50 million distribution to its shareholders. The FMV of ABC at the beginning of 2012 was $200 million, and the total shareholder distributions paid by ABC from 2009 through 2011 were $30 million.

Of the $50 million distribution, $30 million is an excess distribution because it exceeds the greater of:

• $15 million (150% of the $10 million average distributions during the three tax years immediately preceding the tax year); or
• $20 million (10% of ABC’s fair market value at the beginning of 2012).

Example 2: At the close of business on Dec. 31, 2012, DEF Corp. paid a $20 million distribution to its shareholders. The FMV of DEF at the beginning of 2012 was $225 million, and no distributions were made to shareholders from 2009 through 2011.

None of the $20 million is an excess distribution because it does not exceed the greater of:

• $0 (the average of distributions during the three tax years immediately preceding the tax year); or
• $22.5 million (10% of DEF’s FMV at the beginning of 2012).

If a CERT transaction has occurred, the next step is to determine whether there is an NOL in a loss limitation year, which is the tax year of the distribution and the two immediately succeeding tax years (Sec. 172(b)(1)(E)(ii)). If there is a CERT and an NOL in a loss limitation year, the next step is to calculate the CERIL. A CERIL generally represents the amount of interest expense allocable to the CERT under the rules and limitations of Sec. 172(h)(2).

If the taxpayer has a CERT transaction and a CERIL, the taxpayer cannot carry back the portion of the NOL attributable to the CERIL to a year prior to the CERT year and can only carry it forward. This limitation on carrybacks applies to losses incurred in the year of the CERT and the two subsequent tax years. A CERIL is defined as the excess of the NOL for the tax year over the NOL for such tax year determined without regard to any allocable interest deductions otherwise taken into account in computing such loss (Sec. 172(h)(1)).

The CERIL is computed in three steps:

• Step 1: Compute the interest expense allocable to the CERIL.
• Step 2: Apply the three-year lookback rule.
• Step 3: Determine if the de minimis threshold applies.

CERIL Step 1

Allocable interest deductions are computed on an avoided-cost method that uses the avoided-cost rules of Sec. 263A(f)(2)(A), without regard to the specific tracing rules of Sec. 263A(f)(2)(A)(i). Under these operating rules, interest is allocated to a CERT as if the interest expense had been avoided but for the CERT under Prop. Regs. Sec. 1.172(h)-2(b).

In Example 1 with ABC, the $30 million was an excess distribution. The corporation made the distribution with cash on hand as of Dec. 31, 2012. The next step is to compute the allocable interest deduction for 2013. During 2013, the average outstanding debt of ABC was $100 million, and interest paid for the year was $10 million. Under the avoided-cost method, had the distribution not been made, the average outstanding debt would have been $70 million ($100 million outstanding debt less the $30 million excess distribution), and interest expense would have been $7 million ([70 ÷ 100] × $10 million). As a result, the interest allocable to the CERT is $3 million ($10 million interest paid less $7 million interest that would have been paid without the CERT).

CERIL Step 2

The first limitation that applies provides that allocable interest deductions for a loss limitation year are limited to the amount allowable as a deduction for interest paid or accrued by the taxpayer during the loss limitation year, over the average of interest paid for the three tax years preceding the tax year in which the CERT occurred. In applying this test for 2013, the three tax years preceding the CERT are 2009 through 2011.

For 2009 through 2011, ABC’s average interest expense was $6 million. The allocable interest expense is $3 million, which is the lesser of:

• The $3 million interest expense allocated to the CERT; or
• $4 million, which is the excess of ABC’s $10 million interest expense for the loss limitation year (2013) over the $6 million average interest expense for 2009 through 2011.

CERIL Step 3

The last step is to apply the $1 million de minimis threshold. Allocable interest expense is not a CERIL unless it exceeds $1 million.

The final piece of the puzzle is to apply the limitation of the CERIL to determine the portion of the NOL that can be carried back to a year prior to the CERIL. Under the general rules of Sec. 172(b)(1)(A), a corporate NOL can only be carried back two years, with the remainder carried forward for 20 years.

The taxable income of ABC for 2011 through 2013 is shown here:

Absent the application of the CERT rules, ABC would carry back the entire $3.5 million loss to eliminate its regular taxable income for 2011 and 2012, with nothing remaining as a carryforward. However, because of the CERIL, ABC can carry back only $500,000 of the 2013 NOL to 2011, the year prior to the year of the CERT transaction, with the results shown here:

Because of the CERT rules, ABC could use only $500,000 of its $3.5 million NOL carryback, with $3 million remaining as a carryforward.

The CERT rules can be especially harsh when an applicable corporation engages in a transaction that results in increased interest expense in a year following a CERT transaction. Assume a corporation made an excess distribution in 2012. The corporation had no debt on its balance sheet, and it funded the excess distribution from cash on hand. In 2013 the company borrowed $50 million to complete an asset acquisition. The company incurred interest expense of $4 million and an NOL of $5 million. Even though an asset acquisition is not a CERT transaction, the 2013 NOL nevertheless must be tested under the CERT rules to determine whether a CERIL is present.

State Income Tax and Income Tax Accounting Considerations

Not all states allow NOL carrybacks. Some states adopt the provisions of Sec. 172, other states adopt selected portions of Sec. 172, and still others have their own NOL rules that apply in lieu of Sec. 172. Taxpayers should not assume that the CERT rules apply in states that allow an NOL carryback; they need to analyze the rules in each state to determine whether they apply.

Businesses potentially subject to the CERT limitation should consider the impact of the CERT limitations on their NOL carrybacks on their FASB ASC Topic 740, Income Taxes, tax provision. Absent the CERT rules, ABC would typically record the tax benefit of the entire $3.5 million NOL carryback as a receivable. With the application of the CERT rules, the tax benefit of only $500,000 of the NOL is recorded as a receivable, with the remaining tax benefit of the $3 million treated as a deferred tax asset. For many corporations this will be only a balance sheet classification issue. However, the CERT rules may result in a detrimental rate impact for businesses that are required to maintain valuation allowances on their deferred tax assets.

EditorNotes

Frank J. O’Connell Jr. is a partner with Crowe Horwath LLP in Oak Brook, Ill.

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.