Section 382 guidance - an update.

• Author: Ahlers, Annette M.

Congress enacted the current version of section 382 of the Internal Revenue Code (1) in 1986 to prevent "trafficking" in net operating losses (NOLs) and in no small part to prevent companies with few or no assets from being sold just for their accumulated NOEs. Congress did not like business deals being done for purely tax motivated reasons. Section 382, however, applies to many more situations than the pure sale of a shell company with NOEs. Thus, over the years, the Internal Revenue Service and the U.S. Department of the Treasury have issued guidance to explain certain aspects of the very complicated and far reaching rules that govern whether a loss company has undergone an ownership change as defined in section 382.

An ownership change occurs when one or more of the loss corporation's five-percent shareholders increase their interest in the loss corporation by more than 50 percentage points. If an ownership change occurs, section 382 limits the loss corporation's ability to use its historic (and acquired) NOLs against future taxable income.

This article reviews certain recent guidance from the IRS and Treasury, whether in the form of regulations, notices, or private letter rulings. By no means exhaustive, it is intended to provide an overview of guidance of general interest to taxpayers that are determining the potential effect of section 382 on their ability to use accumulated or acquired NOEs to offset taxable income or in determining the financial statement effect of such NOEs.

Recent Guidance

Because of the economic downturn many more companies are both incurring losses and seeing their shareholders change, as investors move their assets around, and companies struggle with lost revenue and a shrinking customer base. Thus, the perfect section 382 storm has arisen to bring many more taxpayers to the IRS and Treasury for guidance on the application of various aspects of section 382.

Fluctuations in Value

Of particular focus for certain taxpayers have been the fluctuations-of-value rules found in section 382(1)(3)(C). Many taxpayers, including start-ups and venture backed companies that typically have several classes of stock, have been faced interpreting a statute providing that "[e]xcept 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." Taxpayers must parse these rules without the benefit of regulations. Consequently, the IRS has issued numerous private letter rulings (PLRs) in recent years, with at least 10 having been issued since the fall of 2009. (2) The core holding of the PLRs is to define the "hold constant principle," as follows:

in determining the ownership percentage of any 5-percent shareholder, the value of each share of such shareholder's stock, relative to the value of all other shares of the Taxpayer's stock, shall be considered to remain constant since the Acquisition Date of that share, except as properly adjusted to account for the dilutive effect of subsequent issuances or the accretive effect of subsequent redemptions of other shares of the Taxpayer's stock. (3) Each of the rulings generally allows the taxpayer to apply the hold-constant principle on subsequent testing dates, as long as they apply the method in a consistent manner.

Notice 2010-50

Apparently, the number of inquiries by taxpayers on the fluctuation in value interpretations in section 382(1)(3)(C) caused the IRS and Treasury to issue general guidance on June 14, 2010, in Notice 201050, 2010-27 I.R.B. 12, which generally allows taxpayers that do not have a PLR on their specific facts to apply the hold-constant principle or, alternatively, the full-value method to their section 382 analysis of ownership shifts owing to fluctuations in value. Thus, in interpreting the fluctuation-in-value rules, Notice 2010-50 adopts two methodologies with one...