Section 382 Ownership Testing & Fluctuation in Stock Value

M&A Alert 2007-4

Key points and opportunities
Corporations incurring net operating losses (NOLs) are oftenin the unenviable position of watching the price of their stock fluctuatedrastically. For a corporation with morethan one class of stock, the effects of this fluctuation in stock price play asignificant role in determining whether utilization of the NOLs could becomelimited as a result of trading and other equity shifts.

Background
In an effort to limit loss trafficking, Congress enacted IRC§ 382, which operates to limit the utilization of corporate NOLs following anownership change. An ownership change isdefined generally as a greater than 50% change in the ownership of stock amongcertain 5% shareholders over a 3-year period. IRC § 382(g).

In determining a shareholder’s percentage ownership change,often overlooked IRC § 382(l)(3)(C) states, “[e]xcept as provided inregulations, any change in proportionate ownership which is attributable solelyto fluctuations in the relative fair market values of different classes ofstock shall not be taken into account.”

Unfortunately, the Treasury and IRS are yet to issue formalguidance on how this section should be applied, and Treas. Reg. § 1.382-2T(l)reserves guidance on the issue.

Guidance
PLR’s 200622011, 200520011, 200511008, & 200411012appear to fill in the gap. Each rulingmakes an identical ruling with respect to fluctuation in value of classes ofstock. The rulings hold that therelative value of a shareholders stock remains constant relative to all otherstock outstanding on the date the shares were originally acquired, and willalso remain constant in relation to the value of subsequent issuances ofshares.

Interestingly, application of this ruling will result incombined ownership of the corporation for testing purposes of either greaterthan or less than 100%. One might wonderhow this could be correct, but it makes perfect sense since for IRC § 382purposes as ownership is determined based on the value at the date ofacquisition and the effect on the seller is disregarded. See Hoffenberg, “Owner Shifts andFluctuations in Value: A Theory of Relativity”, 2005 TNT 54-29.

Consider the following example. Upon incorporation A purchases all commonshares of ABC valued at $3,200 and B purchases all preferred valued at $800. As a result of a business downturn A sellsall common stock to C for $200 while, due to a liquidation preference,preferred stock remains valued at $800. Thesale of A to C results in a 20% change in ownership for IRC § 382 purposes (C’sownership increases from 0 to 20% ($200 of $1,000 total). B’s ownership is unchanged despite the factthat B’s actual ownership increased from 20% to 80% ($800 of $1,000) becausethe increase is due to the fluctuation in value of the common stock. Reverse the transaction and assume C buys B’sinterest for $800; the result is an 80% increase ($800/$1,000) and an IRC § 382ownership change.

Applying the facts of the examples to shareholder A providesan interesting result. Consider thefirst example again. When C buy’s A’sinterest, C owns 20% of the value; however as we saw, B’s increase is attributablesolely to value fluctuation, so B’s ownership remains at 20% and totalownership for purposes of IRC § 382 is only 40%. Similarly with the last example A’s interestremains unchanged at 80%, which results in total ownership for purposes of IRC§ 382 of 160% (80% for A and 80% for C).

The required calculations become exponentially more complexas the number of classes and issuances of stock increases. Also worthy of note with respect to the PLRsis that the rulings approve a specific taxpayer’s request, and “allow” thetaxpayer to apply this methodology. Whether such a methodology is required or is an opt in methodologyremains unclear.

Summary
IRC § 382 is one the Code’s most complex sections andcareful consideration needs to be given to all aspects of the section andregulations thereunder. IRC §382(l)(3)(C) removing value fluctuation form the ownership change calculationis a perfect example of the complexity, and taxpayers should carefully considertheir ability to rely on imprecise estimations and other short cuts indetermining the application of IRC § 382.

This bulletin discusses certain general principles of taxlaw. This bulletin does not address all the specific requirements orexceptions that may apply, and it does not apply these general tax principlesto any particular transaction or situation. Accordingly, you should notrely upon the information in this bulletin for the purpose of implementing orreporting any particular transaction, and this bulletin may not be relied uponto provide any relief from any penalties under the Internal Revenue Code or anystate, local, or foreign tax law. Consult your tax advisor regarding theapplication of these general tax principles to your specific situation.

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