State tax treatment of net operating loss carryovers in corporate acquisitions.

• Author: Faber, Peter L.

Introduction

Many state tax statutes, unlike their federal counterpart, do not provide for the transfer of net operating loss carryovers (NOLs) from one corporation to another in an acquisition. These statutes typically provide that NOLs can be carried forward by a "taxpayer" and can be applied against the taxpayer's income over a specified period of years, but they say nothing about the use of NOLs against the income of any other taxpayer. The courts have had to address the question of the extent to which an acquiring corporation in a merger or other acquisition should be treated as the same "taxpayer" as the target corporation for purposes of these provisions. Although the word "taxpayer" typically applies only to a particular individual or entity, an argument can be made that in the context of the NOL provisions it should be given a broader reading in order to avoid distortion of income.

Some state tax departments and courts have read the statutory language literally, preventing the transfer of NOLs under any circumstances or only in limited circumstances. Other courts have read the statutory language more expansively.

Some themes are beginning to emerge in the cases and one of the interesting phenomena has been the reappearance of the continuity-of-business approach that was applied by the federal courts to taxable years before the Internal Revenue Code of 1954, when the federal statute was similar to the state statutes under discussion. The state courts have often looked to the old federal case law for guidance, reaffirming the proposition that state tax law cannot be practiced in a vacuum without regard to federal tax principles.

The Federal Statutory Scheme

1. NOLs Generally

   It would be hard for a tax system based on net income to function without the use of a fiscal period. If income taxes were imposed on gross receipts, taxes could be paid to the government as income was received and the timing of income and expenses would be immaterial. If the tax is imposed on a net figure after subtracting the cost of earning income (and such other items that the legislature chooses to subsidize), however, a fiscal period is an administrative necessity. The system requires that there be a specified time frame in which income and deductions can be matched and a net figure computed. Although it would theoretically be possible for taxpayers to pay taxes whenever they received income and claim refunds whenever they incurred deductible expenses, such a system would be unworkable. Congress and the States have chosen a period of a year to be the fiscal period for income tax purposes, but there is no reason in tax policy or otherwise why this should necessarily be the case.

   The annual accounting system can create distortions if a corporation loses money in one taxable year and has profits in another. If a corporation had an operating loss of $100,000 in year l and taxable income of $100,000 in year 2, its net income for the two years would be zero and natural law and logic would dictate that it should not have to pay income taxes for the two-year period. Some adjustment to the annual accounting concept must be made to produce this result, because otherwise the corporation would have a tax liability for the profitable year. One possibility would be for the government to pay a negative tax (that is, a refund) to a corporation for a year in which it incurred losses based on that year's tax rates. Hence, a corporation would be entitled to a cash subsidy from the government for every loss year, even if it never had profits. Congress has never adopted this approach. Although the negative income tax has been discussed as an alternative to the present welfare system for individuals (and appears to a limited extent in the present earned income tax credit), it has not been used to help indigent corporations. Instead, Congress has adopted a system under which operating losses can be carried back and forward to other years of the taxpayer. Under this system, a corporation that never makes profits does not benefit from its losses, although its shareholders may to the extent that they realize capital losses when they dispose of their stock. The corporation benefits from operating losses only if has taxable income in other years not too far removed from the loss year. Moreover, the tax benefit from the loss is based on the tax rates in effect during the profitable years to which it is carried and not on the rates in effect during the years in which the loss is sustained.

   Under present law, NOLs must be carried back to the three immediately preceding taxable years (unless the carryback is waived). To the extent that they are not used up by profits in those years, they can be carried forward 15 years.(1)

2. NOLs in Acquisitions

   Until the passage of the Internal Revenue Code of 1954, the federal statutory provisions allowed NOLs to be used only by the "taxpayer" that sustained them. The 1954 Code introduced express statutory rules for the transfer of tax attributes, including NOLs, from one corporation to another. Under section 381 of the Code, operating rules were provided for the transfer of corporate tax attributes in many transactions, including tax-free reorganizations under sections 368(a)(1)(A), (C), and (F) of the Code. If a transaction failed to qualify as a reorganization for technical reasons, the NOL did not move to the acquiring corporation and if the loss corporation was liquidated the NOL disappeared. Since the provision applied only to transfers of corporate tax attributes, it did not affect the acquisition of a profitable corporation by a loss corporation in which the NOLs stayed where they were.

   The post-acquisition use of NOLs is subject to certain restrictions under federal law. Under section 269 of the Code, a taxpayer that acquires control of another corporation (defined in terms of 50 percent ownership of voting power or value) or a corporation that acquires another corporation's property in certain transactions for the principal purpose of securing the benefit of certain tax attributes, including NOLs, cannot use them.

   Under section 382 of the Code, a corporation's use of its NOLs is restricted if in general more than 50 percent of its stock is acquired by new shareholders. The NOLs are not extinguished, but the income each year against which the NOLs can be applied after the acquisition is limited to a percentage of the value of the loss corporation on the date of the acquisition equal to the return that federal long-term bonds could be expected to yield if their interest were exempt from tax. The theory is that the use of the NOLs in the hands of the buyer (or in the hands of the target now owned by the buyer) should be limited to the use that the loss company could have made of them if the acquisition had not occurred. It is assumed that the loss company would have earned income each year equal to a reasonable return on its value and, further, that the return is reflected by the federal long-term tax-exempt bond rate.

   Even if the use of a loss company's NOLs is not restricted or eliminated by sections 269 and 382, the federal consolidated return regulations provide that, if the loss company remains a separate corporation in the hands of the buyer and files a consolidated return with the acquiring corporation, its post-acquisition losses within the consolidated return group can be applied only against its own income and not against that of other members of the group.(2)

   State Statutory Provisions

1. NOLs Generally

   The States vary considerably in the extent to which they allow NOLs to be carried forward and back. Some States incorporate the federal 15-year carryforward and 3-year carryback periods.(3) Other States allow the 15-year federal carryforward but allow no carryback, apparently being reluctant to allow a corporation that sustains losses to request an immediate refund with respect to prior years.(4) Other States allow shorter carryforward periods.(5)

   All States have some mechanism for limiting carryforwards and carrybacks to NOLs attributable to the State. The most common approach is to apply the State's apportionment formula to taxable income determined by taking the NOL into account.(6) Other States limit NOLs to losses actually sustained in the State.(7) Some States require the corporation to have been a taxpayer in the State for the year in which the loss was sustained.(8)

   Some States have limited the use of carryforwards and carrybacks in order to raise revenue. Sometimes, these limitations apply only to carrybacks.(9) In other cases, they apply to carryforwards.(10) Some States have even suspended the use of NOLs on a temporary basis.(11)

   The implication of these special rules for tax planning purposes is that corporations contemplating acquiring another corporation with NOLs should not assume that NOLs that are available for federal tax purposes will also be available for state tax purposes.

2. NOLs in Acquisitions

   Many States allow the transfer of NOLs from one corporation to another in certain acquisitions in the same manner as does the federal tax law. Some state statutes expressly adopt section 381 of the Internal Revenue Code.(12) Other States adopt section 381 implicitly under their federal/state conformity provisions because no express variance from federal law is provided.(13)

   Other States, however, have no provision for the transfer of NOLs in corporate acquisitions. These statutes typically provide that a "taxpayer" can apply NOLs from one year against the income of another year but no mechanism is provided for the movement of an NOL from one corporation to another in an acquisition, even if the acquisition is a statutory merger or other form of tax-free reorganization.

   Survival of NOLs in States Lacking Statutory Provisions for Their Transfer

   The remainder of this article focuses on the extent to which NOLs survive a corporate acquisition in States that lack express statutory...