Sec. 382 and the hold constant principle.

• Author: O'Connell, Frank J., Jr.

With the recent downturn in the economy, many corporations have incurred net operating losses (NOLs) and have been placed in the unenviable position of having to raise new capital to survive. In many cases, the capital raised may result in an ownership change in the corporation under Sec. 382. Since the determination of an ownership change under Sec. 382 is based on value, for corporations with multiple classes of stock the price fluctuations in the stock will add complexities in determining whether the use of the corporation's NOL carryovers and other various tax attributes will be limited.

Sec. 382(l)(3)(C) addresses the issue of fluctuations in stock price for corporations with multiple classes of stock, stating that, "Except as provided in regulations, any change in proportionate ownership which is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account." However, the regulations do not specifically address how to apply Sec. 382(l)(3)(C) and have therefore left both taxpayers and practitioners to struggle with this issue. In prior years, the IRS has sought to clarify its position through the issuance of private letter rulings and, most recently, Notice 2010-50.

Prior Guidance on Sec. 382(l)(3)(C)

Since 2004, the IRS has issued a series of letter rulings addressing the application of Sec. 382(l)(3)(C). The earlier letter rulings generally have ruled that "on any testing date, in determining the ownership percentage of any 5% shareholder, the value of such shareholder's stock, relative to the value of all other stock of a loss corporation issued subsequent to such acquisition date shall also be considered to remain constant since the acquisition date." In the most recent letter rulings (e.g., Letter Rulings 201017004, 200952004, and 200901003), the IRS adopted what is commonly referred to as the hold constant principle (HCP). For example, in Letter Ruling 201017004, the IRS ruled that the "[t]axpayer may apply a method employing the Hold Constant Principle to determine the increase in percentage ownership of each of its 5% shareholders on each of its testing dates ... for purposes of Section 382." While a full analysis of the application of this issue is beyond the scope of this item, the HCP and the Treasury and IRS interpretation of Sec. 382(l)(3)(C) as outlined in the notice are discussed below.

Notice 2010-50

On June 11, 2010, the IRS provided long-awaited interim guidance on Sec. 382(l)(3)(C) with the issuance of Notice 2010-50. To the authors' knowledge, this is the first guidance from Treasury and the IRS that provides specific application of Sec. 382(l)(3)(C) and acceptable methodologies to account for fluctuations in the value of one class of stock relative to another class of stock for purposes of Sec. 382. In the notice, the IRS states that it will accept certain methodologies for taking into account, or not taking into account, fluctuations in value. As described below, the notice outlines two general applications of Sec. 382(l)(3)(C)...