Corporate contraction and Sec. 382

By Kevin Ainsworth, CPA, J.D., Boston

Editor: Kevin D. Anderson, CPA, J.D.

Corporations with federal net operating losses (NOLs) or built-in losses need to be cognizant of the potential limitations imposed by Sec. 382. When an ownership change occurs within the meaning of Sec. 382, a loss corporation may be limited in its ability to use NOLs and certain tax credits, as well as deduct built-in losses. Generally, an ownership change occurs when the cumulative ownership of 5%-or-more shareholders of a loss corporation increases by more than 50 percentage points within a three-year period. An ownership change may occur from a variety of transactions, such as stock issuances and stock acquisitions by 5%-or-more shareholders. Stock redemptions, or transactions having the effect of a redemption, may also cause an ownership change and are the focus of this item.

When an ownership change occurs, the annual limitation is calculated under Sec. 382(b)(1) as the value of the old loss corporation multiplied by the applicable long-term tax-exempt rate. Value is generally determined as the value of the corporation's stock immediately before the date of the ownership change. Therefore, if an issuance of shares triggers an ownership change, the value infused by that issuance is not taken into account in calculating the Sec. 382 limitation. An exception to this general rule is provided in Sec. 382(e)(2), which requires value to reflect any redemption or corporate contraction that takes place in connection with an ownership change. Therefore, where an ownership change is triggered by a redemption, the limitation is based on the value of the loss corporation after the redemption has occurred.

The application of Sec. 382(e)(2) may not always be clear. Corporate contraction language was added to Sec. 382(e)(2) as part of the Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647, which expanded the scope of Sec. 382(e)(2) to apply to a reduction in value to loss corporations undergoing one or more events that in substance have the effect of a redemption. The Joint Committee report describes the additional language as applying to acquisitions in which "aggregate corporate value is directly or indirectly reduced or burdened by debt to provide funds to the old shareholders" (Staff of the Joint Committee on Taxation, Description of the Technical Corrections Act of 1988 (H.R. 4333 and S. 2238) (JCS-10-88), p. 44 (March 31, 1988)). One such transaction is a purchase where the acquirer uses third-party debt to fund a portion of the consideration and thereafter pays it off with funds of the target, sometimes referred to as a "bootstrap" acquisition. This may include scenarios where the debt is "pushed down" to the books of the target by the acquirer. It may also include situations where the target's operations are the source of repayment for the debt despite the actual liability being booked on a separate entity, for example, a new holding company.

Example 1: P, a partnership, wishes to acquire T, a corporation with NOL carryovers. To acquire T, P forms S, a merger subsidiary, by contributing cash of $50 and debt of $50 in exchange for shares of S. S is then merged with and into T with T surviving, with shareholders of T receiving $100 of consideration in exchange for their shares of T. As a result of the merger, T is owned 100% by P and is determined to have undergone an ownership change within the meaning of Sec. 382. Subsequent to its acquisition, the operations of T pay down the outstanding $50 of debt that became a liability of T as a result of its merger with S. This transaction appears to be a redemption in part for federal tax purposes (see Rev. Rul. 78-250).

Example 2: P, a partnership, wishes to acquire T, a corporation with NOL carryovers. To acquire T, P forms a holding company, H, by contributing $50 of cash and $50 of debt in exchange for shares of H. H then purchases all the shares of T solely for $100 of cash consideration. As a result of the purchase of shares, T is owned 100% by H and is determined to have undergone an ownership change within the meaning of Sec. 382. Subsequent to the acquisition, H and T file a consolidated federal tax return. H has no other subsidiaries and holds no assets other than its investment in T. The debt used in acquiring the shares of T remains on the books ofH.

In both Examples 1 and 2, corporate value is burdened by debt incurred to provide a portion of the proceeds to selling shareholders. In Example 1, the debt is a direct obligation of T, the target, as a result of its merger with S. In Example 2, although the debt resides at H, the operations of T appear to be the primary means of paying off the liability. Both Examples 1 and 2 appear to be corporate contractions within the meaning of Sec. 382(e)(2). Therefore, in both scenarios, the initial value of the loss corporation T as of the ownership change date should be reduced from $100 to $50, accounting for the redeemed value. In contrast, a contraction does not appear to occur where the acquiring entity has other business lines and/or subsidiaries that are able to repay debt incurred in the acquisition. Changing the facts of Example 2, where H also owns S1 and S2, operating subsidiaries with revenue sufficient to pay down the $50 of debt held at H, a contraction does not appear to occur within the meaning of Sec. 382(e)(2) (see Letter Ruling 200406027).

The language of Sec. 382(e)(2) states it applies to redemptions and contractions that occur "in connection with an ownership change." Therefore, the portion of the transaction involving a redemption or contraction does not need to occur before or simultaneous with the ownership change date, as long as it occurs "in connection with" the ownership change. This appears to broaden the scope of the limitation to transfers, such as loans or distributions, made from the loss corporation following an ownership change (see Field Service Advice 200140049).

Further, the application of Sec. 382(e)(2) will not necessarily apply parallel to the determination of share basis, specifically, under the consolidated return regulations. To illustrate, in Example 2, P would appear to take an initial basis in H of $50, the amount of the cash contributed. However, H appears to take an initial basis in T of $100, although it may have an acquired value of $50 for Sec. 382 purposes. There is no equivalent provision within the consolidated return regulations such that the basis of T shares held by H would be reduced without H actually contributing the $50 liability to T, with the exception that basis would be reduced when and if T made a distribution to H under Regs. Sec. 1.1502-32(b)(2)(iv).

Corporations undergoing a Sec. 382 ownership change should devote attention to understanding the substance of the transactions causing the change. A review of the sources of funds and plans for the repayment of debt is important in understanding whether Sec. 382(e)(2) applies, even where the structure does not appear to be a redemption. Where a redemption or corporate contraction does occur, the corporation's value must be reduced in calculating the Sec. 382 limitation.


Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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