Category: Corporations
Subject: Section 382
Title: Various Section 382 Matters
IRC Sections: 108, 368, 382
Filename: 1256.html
Date Produced: 07/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer is a C corporation engaged in the business of renting and servicing agricultural and construction equipment. Taxpayer has an October 31 year end. During FYE 10/91, Messrs. X and Y purchased 50% of the outstanding stock of Taxpayer. During FYE 10/93 these same individuals purchased the remainder of Taxpayer shares.

Taxpayer has not been profitable. At 10/91 Taxpayer had an NOL carryforward of $108,000. Taxpayer lost $425,000 for FYE 10/92. Taxpayer lost $120,000 for FYE 10/93 and earned $34,000 in FYE 10/94.

XYZ Company is a very profitable S corporation engaged in the same type of business as Taxpayer. XYZ Company earns in the range of $400,000 annually (before reductions for officer salaries). XYZ Company has at all times been owned 100% by Messrs. X and Y.

The parties are contemplating a merger of Taxpayer into XYZ Company with XYZ Company as the surviving entity. It is anticipated that the merger will qualify as an A-reorganization under Section 368(a)(1)(A).

At some point prior to the merger, the creditors of Taxpayer will forgive some of Taxpayer's outstanding indebtedness. Since Taxpayer will be insolvent both before and after the debt relief, cancellation of debt (COD) income will be excluded under Section 108(a), and attribute reduction will be required by Section 108(b).

For purposes of this memorandum, it is assumed that the purchase of 50% of Taxpayer's shares during FYE 10/91 did not create a change of ownership under Section 382. It is further assumed that the purchase of the remaining 50% of Taxpayer's shares did create a change in ownership under Section 382.Issue One:
Does the merger of Taxpayer into XYZ Company create a Section 382 ownership change.

Answer One:
Assuming the ownership of Taxpayer and XYZ Company has been identical at all times since the purchase of Taxpayer stock that occurred in FYE 10/93, the merger does not create a second ownership change.

Discussion One:
An ownership change occurs under Section 382 if there is a difference of more than 50 percentage points as between the aggregate ownership of all 5% shareholders during the testing period and the ownership of all 5% shareholders immediately after a testing event.

-Testing periods cannot overlap. If there is a change of ownership under Section 382, a new testing period begins. Section 382(i)(2).

-In general, tax free reorganizations are taken into account for purposes of determining whether a Section 382 change of ownership has occurred. Section 382(g)(3).

To determine whether a change of ownership occurs as a result of merging Taxpayer into XYZ Company, look at the lowest amount of stock owned by all 5% shareholders of XYZ Company (the surviving entity) at any time during the testing period. Start at the date of the last ownership change during FYE 10/93. 100% of Taxpayer's stock is owned by Messrs. X and Y as of the FYE 10/93 change date. Now examine the ownership of those same individuals after the merger. There is no change in the stock holdings of Messrs. X and Y as a result of the merger; accordingly, there is no change of ownership under Section 382 as a result of the merger.

Issue 2:
Given that the FYE 10/93 change of ownership under Section 382 has divided Taxpayer's NOL's into two pools, a pre-change pool and a post-change pool, does the reduction of NOL's required by Section 108(b) come from the pre-change or the post-change pool?

Answer 2:
There is no special rule regarding the interaction of Section 382 and attribute reduction under Section 108(b). In other words when NOL's are reduced under Section 108(b), there is no special rule that governs whether such reductions come from pre-change NOL's or post-change NOL's.

Section 108 provides ordering rules with respect to tax attribute reduction required by Section 108(b). In general, NOL's are reduced in the order in which they arose.

Discussion 2:
Section 108(b)(4) provides the ordering rules for reduction of the various tax attributes required under Section 108(b). Focusing just on NOL reductions, the following rules apply.

1. Reduction occurs after the determination of tax for the year in which the COD event occurs. Section 108(b)(4)(A).

2. Any NOL arising in the year of discharge is reduced first. Section 108(b)(4)(B).

3. Thereafter, NOL's are reduced in the order in which they arose. Section 108(b)(4)(B).

Following are two examples from BNA, Tax Management Portfolio 466-2nd which serve to illustrate the principles set forth above.

Example 1:
In a proceeding under Title 11 of the Bankruptcy Code, a discharge in the amount of $100,000 is received from the Bankruptcy Court in the bankruptcy estate's taxable year ending December 31, 1988. The estate has taxable income of $50,000 for this taxable year before use of an NOL carryover in the amount of $75,000. Under Section 108(b)(4)(A), the $75,000 carryover is first applied to eliminate the estate's taxable income of $50,000. Under Section 108(b)(2)(A), the $100,000 of discharged indebtedness is then applied to eliminate the remaining $25,000 of the carryover. Under Section 108(a)(1)(A), the entire $100,000 of discharged indebtedness is excluded from the estate's gross income.

Example 2:
In a proceeding under Title 11 of the Bankruptcy Code, a discharge in the amount of $100,000 is received from the Bankruptcy Court in the estate's taxable year ending December 31, 1988. The estate has an NOL of $50,000 for its taxable year ending December 31, 1988, and NOL carryovers of $25,000 and $50,000 for its taxable years ending December 31, 1986, and December 31, 1987, respectively. Under Section 108(b)(4)(B), the $100,000 of discharged indebtedness is first applied against the $50,000 NOL for the estate's taxable year ending December 31, 1988. The remaining $50,000 of discharged indebtedness is then applied to eliminate the $25,000 carryover from 1986, and then applied to reduce the $50,000 carryover from 1987 to $25,000.

Practical Application
Taxpayer has a Section 382 change of ownership for FYE 10/93 and $34,000 of income generated in FYE 10/94. Assume that the value of the Taxpayer at the time of the ownership change was $300,000, and the long-term tax-exempt rate was 6% such that the annual limitation under Section 382(b)(1) is $18,000. Assume the ownership change occurred at mid-year, and Taxpayer lost $120,000 for the entire year. Assume an NOL carryforward at 10/92 of $533,000.

-For purposes of Section 382, the 10/93 tax year is split into two pieces, a pre-change piece and a post-change piece.

-Absent an election to close the books as of the ownership change, $60,000 (50% of Taxpayer's $120,000 current loss) is pre-change and $60,000 (the remaining 50%) is post-change. Section 382(d)(1) flush language.

-The $18,000 annual Section 382 limitation is prorated for FYE 10/93 down to $9,000 because only 50% of the tax year remained at the time of the ownership change. Section 382(b)(3)(B).

-For FYE 10/94, Taxpayer has $593,000 ($533,000 from 10/92 plus $60,000 from 10/93) of pre-change loss carryover, $60,000 of post-change loss carryover, and an unused Section 382 limitation of $27,000 which is $9,000 carried over from 10/93 and $18,000 generated in FYE 10/94.

-The normal NOL ordering rules apply. Accordingly, Taxpayer utilizes its oldest NOL carryforwards first. Accordingly, taxable income of $34,000 is first offset against pre-change loss carryovers up to the $27,000 limit imposed by Section 382. The remaining $7,000 of taxable income is offset by the post change loss carryover of $60,000. This leaves a pre-change loss carryover of $566,000, and post-change loss carryover of $53,000. See Section 382(l)(2).

Collateral Unresolved Issues
The following matters came to light during the course of my work. These issues were not included in the initial scope of my assignment and may require follow up.

-Possible application of Section 269 to this transaction. See the discussion of the topic in the accompanying memo regarding continuity of business enterprise.

-There is a rule within Section 381 that limits the amount of loss that can be utilized from a merged entity in the first year after the merger. This limitation is completely independent of any Section 382 limits but applies only to year of (or possibly the year following) the merger.