A 1939 frame of mind: old-school NOL carryover rules prevail in some states.

• Author: Holley, Ann
• Position: Net operating losses

When it comes to the carryover of net operating losses (NOLs) after a merger or reorganization, certain states still follow the Internal Revenue Code of 1939 and largely adopt the U.S. Supreme Court's decision in Libson Shops, Inc. v. Koehler, 353 U.S. 382 (1957). This item briefly explains the issue as applied in Arizona, Connecticut, and North Carolina. Note that certain other states, such as New Jersey and Tennessee, have their own rules for determining the carryover of NOLs following a merger or reorganization and follow neither Sec. 381 nor Libson Shops.

Life, and NOLs, Before Sec. 381

Sec. 381 permits corporations to carry over NOLs and other tax attributes following certain types of reorganizations. Prior to the adoption of Sec. 381 in 1954, no statutory provisions in the 1939 Code specified how NOLs under Sec. 172 should be treated in the context of a merger or reorganization. Several courts interpreted the 1939 Code as providing that NOLs generated by an entity that ceased to exist as a result of a statutory merger were automatically lost; i.e., only the same entity that created the NOLs could use the NOLs post-transaction (see, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934)). This came to be known as the "entity theory" and led to cases of what was termed "minnows swallowing whales," whereby large companies with positive taxable income (whales) entered into reorganization transactions with smaller loss companies (minnows), and the loss company--with its NOLs preserved--was the surviving entity at the conclusion of the transaction (Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, H 16.02, p. 16-7 (5th ed. 1987)).

In an effort to more closely align with the legislative intent behind NOL carryovers and dispel the operational fiction created by minnows swallowing whales, the U.S. Supreme Court abandoned the entity theory in favor of the "continuity of business enterprise" theory in Libson Shops (see also F. C. Donovan, Inc., 261 F.2d 470 (1st Cir. 1958);/G. Dudley Co., 298 F.2d 750 (4th Cir. 1962); Federal Cement Tile Co., 338 F.2d 691 (7th Cir. 1964); and Westinghouse Air Brake Co., 342 F.2d 68 (Ct. Cl. 1965)). Specifically, the Court held that NOLs generated by an entity that ceased to exist as a result of a statutory merger were not automatically lost but could be claimed only if the post-transaction income against which a carryover was claimed was produced by substantially the same business that incurred the losses.

For federal income tax NOL carryover purposes, the continuity-of-business-enterprise theory was largely rendered moot by the adoption of Sec. 381 in 1954. However, the theory fives on in certain states that still follow the 1939 Code for purposes of determining the availability of an NOL carryover.

Continued Life, and NOLs, Without Sec. 381 in Certain States

For purposes of determining the federal taxable income starting point in calculating state taxable income, states generally conform to the Internal Revenue Code as of a particular date (known as static conformity) or on a rolling basis, subject to any adjustments adopted by the state. Many states have decoupled from the federal NOL rules under Sec. 172 and provide a state-specific NOL calculation. Arizona, Connecticut, and North Carolina (the latter for tax years beginning before Jan...