Preserving Corporate NOLs After a Bankruptcy
By Tracee Handy, Senior Manager, Tax & Business Services
COVID-19 has dealt a blow to our once-thriving economy, leading to an increase in the number of bankruptcy filings. Under the terms of a bankruptcy plan, it is not uncommon for lenders to receive equity in the debtor-company in exchange for the outstanding debt. This restructuring could have a significant impact on any net operating losses (“NOLs”) and other tax attributes that the corporate taxpayer wishes to preserve if it triggers an “ownership change” under IRC Section 382.
In general, IRC Section 382 limits the utilization of NOLs (and other tax attributes) generated by a loss corporation following an “ownership change.” Such a change occurs when there is a more-than-50-percentage-point increase in the stock percentage of a loss corporation held by five percent or more shareholders during a testing period. A loss corporation is any corporation entitled to use a net operating loss or generating a net operating loss in the year in which the ownership change occurs. Additionally, it includes a corporation entitled to use specified tax attributes.
However, special rules apply in bankruptcy and similar cases. IRC Section 382(l)(5) provides an exception to the general rule if the following conditions are met:
- Immediately before the ownership change, the loss corporation is under the jurisdiction of the court in a title 11 or similar case; and
- The corporation’s shareholders and “qualified creditors” (determined immediately before the ownership change) own at least 50% of the stock’s value and voting power immediately following the ownership change.
If a corporation satisfies the above requirements, NOLs will not be limited under IRC Section 382, but additional factors will need to be considered with this exception. First, the NOLs will be reduced by any interest expense related to debt converted to stock for the current year and the three preceding tax years. Second, if a second ownership change occurs within two years of the original ownership change, the IRC Section 382 limitation will be zero. Essentially, the pre-change NOLs will be lost.
A loss corporation meeting the requirements for the exception under IRC Section 382(l)(5) may choose to elect out. This election is irrevocable and must be made by the due date (including extensions) of the loss corporation’s tax return for the tax year that includes the ownership change. There are several reasons a taxpayer would choose to elect out of the exception, including the expectation of a second ownership change within two years of the original ownership change.
Additional relief is provided if a corporation elects out or fails to meet the exception’s requirements. IRC Section 382(l)(6) allows the corporation to use its value immediately after the ownership change, rather than before, to determine the limitation on its NOLs. This may result in an increase in the corporation’s value from the debt that was converted to stock and, consequently, increases the limitation amount.
At first glance, the bankruptcy exception might seem to provide a great advantage to the taxpayer. However, further analysis should be completed to determine if this would be most beneficial for the corporation or if there is a possibility of a second ownership change, which would eliminate the corporation’s NOLs.
For additional information, please contact your Marcum tax professional.