Corporations & Shareholders

Assumption of Liabilities in Taxable Asset and Sec. 338(h)(10) Acquisitions

When a purchaser (P) acquires the assets of a target (T) in an applicable asset acquisition as defined in Sec. 1060 or acquires the stock of T and a joint Sec. 338(h)(10) election is made, the basis in the assets acquired will generally include T’s liabilities assumed in the transaction. However, determining the appropriate treatment of these liabilities is often a difficult task. This item addresses only the buyer’s treatment (P or new T in the case of a Sec. 338(h)(10) transaction), not the seller’s, in an acquisition.

Assumption of Liability

The first and most important step is to determine whether P has assumed a T liability. If P is able to establish that a liability did not exist at the time of the acquisition, the subsequent satisfaction of the liability would result in a deductible expense to P, subject to general tax law determining deductibility. Obviously, this result is favorable to P because the alternative to liability assumption generally results in 15-year amortization under the residual method for allocating the purchase price (Regs. Secs. 1.338-6 and 1.1060-1).

So how does one determine whether a liability exists at the time of the acquisition? Whether the liability is fixed or contingent is not determinative (Illinois Tool Works, Inc., 355 F3d 997 (7th Cir. 2004); David R. Webb Co., 708 F2d 1254 (7th Cir. 1983)). Rather, the existence of a T liability is generally enough to require capitalization. To determine whether a liability existed, the courts have generally looked to a number of factors, including:

Unfortunately, not all liabilities are easy to identify. Based on the various factors above, a reserve for unsettled litigation related to T’s preacquisition activities would clearly represent a liability assumed by P in the acquisition. However, the treatment of other reserves on T’s balance sheet is more difficult to determine.

Example: T manufactures widgets. A warranty is provided with each widget sold, and there are currently over 5 million widgets under warranty. In accordance with financial accounting principles, T has a warranty reserve liability. In addition, T has historically provided “goodwill” warranty services for widgets outside of the warranty period in order to maintain good customer relationships. The reserve is strictly an estimate of expected warranty costs that will be incurred on products under warranty and outside the warranty.

Should this reserve be considered a liability assumed by P? Presumably, P was aware of this potential liability; however, what if P does not expressly assume the liability and the actual liability does not legally arise until the widget is brought in for warranty service, which is a postacquisition event? What about the liability associated with goodwill warranty services? These seem clearly to fall within P’s postacquisition activity. Finally, with so many products under warranty, it seems reasonable to argue that ongoing warranty services provided on widgets are so intertwined with the ongoing P business that the postacquisition services relate to P’s operation and not T’s operation. Perhaps in this case, the warranty reserve is not a liability assumed by P, and the warranty costs incurred by P will result in immediate deductions to P as incurred.

As a result of this favorable treatment, purchasing taxpayers will look to report as many liabilities as possible as operating liabilities. Close attention needs to be paid to these liabilities, especially when the adviser is also a tax preparer and is subject to the Sec. 6694 more-likely-than-not standard.

Treatment of Assumed Liabilities

Once it has been determined that P assumes a T liability, the amount of the liability and the timing of taking it into account need to be determined. There are three categories for assumed liabilities: (1) liabilities for which the all-events test has been met and economic performance has occurred (e.g., accounts payable), (2) liabilities for which the all-events test has been met and economic performance has been met by the express assumption of the liability (Regs. Secs. 1.461-4(d)(5) (e.g., liability for the use of property) or (g)(1)(ii)(C) (e.g., accrued rebates)), and (3) contingent liabilities (i.e., T liabilities that have not yet met the all-events test). A fourth category exists for related assumptions of Sec. 404 liabilities; however, these liabilities are outside the scope of this item. Those interested in reading more on the subject should consider reviewing the analysis in Ginsburg and Levin, Mergers, Acquisitions, and Buyouts ¶304 (Aspen, July 2007).

With respect to the first two categories, P receives no deduction upon satisfaction of the liability but rather includes the liabilities in the basis of the acquired assets upon assumption. For contingent liabilities, P will generally include the assumed liability in basis only as the liability is satisfied. For Sec. 338 transactions, the regulations make this determination clear, citing application of general tax principles (Regs. Sec. 1.338-7(e), Example 1 (satisfaction of contingent liability results in P’s taking the liability into account as additional adjusted grossed-up basis)). In non-Sec. 338 transactions, an argument may be made that P receives a deduction under a similar analysis to that above related to the assumption of a liability; however, most practitioners would agree that satisfaction of the liability results in additional basis in the T assets acquired and not a P deduction. 

Then there is the liability that exists and is assumed as a result of T’s prepaid income or deferred revenue. The law in this area is not clear. One approach requires P to include the full amount of the deferred revenue as income in the year assumed, under the theory that T actually paid consideration to P for P’s assumption of the liability. (See Rev. Rul. 71-450 and James M. Pierce Corp., 326 F2d 67 (8th Cir. 1964).) Under this theory, the amount of consideration received (or deemed received) is income in the year of assumption, and if the consideration is deemed received by P it would presumably further increase the consideration paid to T in the acquisition. Fortunately, this method has thus far been limited to prepaid subscription income under Sec. 455. A second, and perhaps more reasonable, approach is found in Rev. Rul. 76-520, which requires P to include the actual amount incurred to satisfy the deferred revenue as additional purchase price only as incurred, which coincides with the normal treatment of contingent liabilities discussed above.

Conclusion

As with so much advice to clients, the devil is in the details. Did the purchaser truly assume a liability? Does that liability result in an immediate step-up in basis? One cannot assume that the tax treatment of liabilities will conform with financial reporting, and with stricter FIN 48 and Sec. 6694 standards it is more important than ever that tax advisers get it right.

From Nick Gruidl, CPA, MBT, Minneapolis, MN

Restricted Stock in Acquisitions: IRS Provides Much-Needed Guidance

It is common for key employee shareholders to retain an interest in the target business following either a taxable or tax-free acquisition. In many cases, the key employees’ stock is either converted into or exchanged for stock that vests over time based upon the shareholders’ continued employment with the target or the acquirer. Such stock is commonly referred to as “restricted” or “substantially nonvested” stock. The receipt of restricted stock is generally treated as a taxable event under Sec. 83 when the transfer is made in connection with the performance of services.

For many years, the application of Sec. 83 to an employee’s conversion or exchange of “fully vested” or “unrestricted” shares for restricted shares has been unclear. For example, has a transfer been made in connection with the performance of services when a restriction is placed on previously unrestricted shares? What about when restricted shares are received in exchange for unrestricted shares in a taxable or tax-free reorganization, particularly when other shareholders receive unrestricted stock of an equal value (ignoring discounts)? Rev. Rul. 2007-49 provides much-needed guidance and some answers to the questions raised above; however, many still remain unanswered. Specifically, the ruling is conspicuously silent as to the larger issues that may affect the overall impact of restricted stock exchanges in tax-free reorganizations.

Sec. 83

Sec. 83 treats a transfer made in connection with the performance of services as an exchange of property (e.g., restricted stock) for the performance of services and requires the recipient to recognize ordinary income equal to the amount by which the fair market value (FMV) of the property received exceeds the amount paid (Sec. 83(a)). In the case of restricted property, the timing and amount of income recognition is dependent on whether a Sec. 83(b) election is made. If no election is made, the exchange is taxed and the property is valued at the time the restrictions lapse. The recipient’s basis in the property will equal its FMV at that time; similarly, the property’s holding period does not begin until the restrictions lapse.

Without a Sec. 83(b) election, the recipient is not deemed the owner of the property for federal income tax purposes until the restrictions lapse (Regs. Sec. 1.83-1(a)(1)), despite the fact that in many cases restricted stock has equal voting and dividend rights to that of unrestricted stock. If a Sec. 83(b) election is made, the recipient is considered the owner of the property upon transfer; however, the exchange is taxed on the day of the property transfer, rather than on the day the restrictions lapse. The recipient’s basis is then equal to the FMV of the property upon transfer, and the holding period likewise begins on the transfer date. While the recipient takes obvious risks in making a Sec. 83(b) election, assuming future appreciation, it effectively defers income recognition on the appreciation until disposal of the stock and replaces future ordinary income with capital gain.

In Connection with the Performance of Services

For Sec. 83 to apply to a transaction, the property must be transferred in connection with the performance of services, as determined by all the facts and circumstances. The courts cast the Sec. 83 net broadly and do not limit its application to compensatory grants. Any relationship between the services performed and the property transferred generally indicates that a compensatory transfer has occurred, and the placement of buyback restrictions on the stock, which are contingent on employment, may be sufficient by itself to establish this (see Montelepre Systemed, Inc.,TC Memo 1991-46, aff’d, 956 F2d 496 (5th Cir. 1992); Alves, 734 F2d 478 (9th Cir. 1984), aff’g 79 TC 864 (1982); Regs. Sec. 1.83-2(a)).

Further, a compensatory transfer can occur regardless of whether the employee pays fair value for the stock (Alves; Regs. Sec. 1.83-2(a)). However, the regulations provide that the existence of other persons (e.g., nonemployee shareholders) entitled to buy stock on the same terms and conditions indicates that Sec. 83 does not apply (Regs. Sec. 1.83-3(f)). Based on Sec. 83’s broad application, it is easy to understand how the conversion or exchange of unrestricted shares for restricted shares may be considered to fall within the statute, especially when restrictions are contingent on employment. Clearly there are no easy answers.

Issues Arising from Tax-Free Exchanges

If one presumes that a tax-free exchange was made in connection with the performance of services and Sec. 83 applies, significant collateral issues arise. For example, as noted above, Sec. 83 provides specific rules for determining a stock’s basis and holding period. However, the tax-free reorganization provisions have similarly specific rules. In a tax-free reorganization described in Sec. 368(a), a shareholder’s exchange of stock is tax free under Sec. 354, the stock received has a carryover basis under Sec. 358, and the holding period of the exchanged stock is tacked onto that of stock received in the exchange under Sec. 1223. Clearly the two sets of rules are at odds, and a balanced approach is needed. What is the proper mix of carryover basis and step-up related to income recognition and between the historical holding period and the new period beginning with vesting? Despite numerous reasonable methods put forth by practitioners and commentators, no guidance has been provided by Treasury or the IRS. (See, e.g., Levin, Rocap, and Ginsburg, “Surprising Tax Issues for Shareholder-Execs Receiving Unvested Stock for Vested Stock in Reorg,” 89 Tax Notes 1289 (12/4/00).)

The confusion of Sec. 83’s application to tax-free exchanges is further exacerbated by restricted stock’s effect on continuity of proprietary interest (COI). A fundamental principle in tax-free reorganizations, COI requires target shareholders to receive significant qualifying consideration (i.e., stock or securities) in the acquiring corporation. The IRS and Treasury announced in the preamble to the final COI regulations issued in September 2005 that they were continuing to consider the appropriate treatment of restricted shares in determining COI (TD 9225). Why the uncertainty? With respect to COI, the key question is whether the restricted shares are outstanding and can therefore count toward continuity.

The IRS’s practice is to generally treat restricted stock for which a Sec. 83(b) election is in place as outstanding. (See, e.g., Letter Ruling 9712029 and Chief Counsel Advice 199944001 in the consolidated group context; but see Letter Ruling 9422048 with respect to a Sec. 382 ownership change.) However, it seems perfectly reasonable to count restricted stock toward continuity when restricted shares have identical voting rights and dividend rights as non-restricted shares. Certainly the holders of restricted shares have a proprietary interest in the acquirer if they can vote and receive dividends. But what if the restricted shares never vest and the holders never acquire “true” ownership rights? Thus, the confusion.

New Guidance

Rev. Rul. 2007-49 addresses some of the issues raised above and specifically addresses Sec. 83 in three different scenarios. The first considers the placement of restrictions on previously unrestricted shares. The final two scenarios consider the exchange of unrestricted shares for restricted shares in a taxable and a tax-free transaction, respectively. The following examples address each scenario in turn.

Example 1—Restrictions on unrestricted shares: A private equity group (PEG) invests in the target corporation. A condition of the investment is that certain management shareholders agree to subject their unrestricted shares to restrictions that result in the shares’ becoming substantially nonvested. The ruling holds that subjecting unrestricted stock to a restriction is not a transfer of property; therefore, Sec. 83 cannot apply to the conversion. This conclusion is consistent with Letter Ruling 200212005, in which the IRS ruled on a similar transaction.

Example 2—Receipt of restricted stock in exchange for unrestricted stock in a taxable transaction: A PEG or strategic buyer acquires a target corporation in a fully taxable transaction. In exchange for his fully vested shares with a basis of $10, shareholder X, an executive of the target, receives restricted shares valued at $100. Other nonemployee shareholders receive fully vested shares. The restrictions placed on X’s shares enable the acquirer to buy back the restricted shares if X’s employment is terminated for any reason within three years. The buyback price is the lesser of $100 or the stock’s value on the day of the buyback. X completes three years of service. The value of the shares when the restrictions lapse is $200. Two years after vesting, X leaves the company and sells his shares for $400.

Rev. Rul. 2007-49 holds that the exchange described above was made in connection with the performance of services, so Sec. 83 applies. This conclusion was reached despite X’s receiving the same consideration as a nonemployee shareholder. Regardless of the application of Sec. 83, each shareholder’s initial exchange is taxable under Sec. 1001. X recognizes capital gain to the extent the FMV of property received ($100) exceeds X’s basis in the shares sold to the purchaser ($10). Therefore, X recognizes capital gain on the exchange of $90. When the restrictions lapse, X recognizes compensation under Sec. 83 equal to the amount by which the restricted shares’ value upon vesting ($200) exceeds the value of the amount paid (i.e., the value of the target shares given up in return for the restricted shares ($100)). Therefore, X recognizes compensation of $100 ($2002$100) when the restrictions lapse. When the shares are sold two years later, X recognizes capital gain equal to the amount realized ($400) over X’s basis in the shares (i.e., the value upon vesting ($200)). As such, X’s capital gain is $200.

If X makes a Sec. 83(b) election, the answer is decidedly better. He would recognize income on the day of transfer to the extent the value of the restricted stock ($100) exceeds the amount paid (i.e., the value of the stock transferred ($100)). This is of course zero, and X does not recognize any compensation with respect to the restricted stock. X recognizes no income at vesting and will recognize a capital gain upon disposal of the shares of $300 ($400 received over the amount paid for the shares of $100). By making the Sec. 83(b) election, X eliminated the ordinary income recognition of $100 and was taxed on all future appreciation at preferential capital gain rates.

Alternatively, if the stock had depreciated, X would not have been in a worse position than if no Sec. 83(b) election had been made because no additional income was recognized. The example demonstrates that the Sec. 83(b) election has no apparent downside on such a transaction.

Example 3—Receipt of restricted stock in exchange for unrestricted stock in a tax-free reorganization: Assume the same facts as above except that the target corporation is acquired in a tax-free Sec. 368(a) reorganization, X receives restricted shares worth $100, and X makes a Sec. 83(b) election.

Not surprisingly, the ruling holds that this transfer was also made in connection with the performance of services to which Sec. 83 applies. However, in this case no gain is recognized on the exchange. The ruling provides that the exchange of target stock for restricted stock is tax free to X and no gain or loss is recognized. The Sec. 83(b) election also does not result in income recognition because the FMV of the restricted shares on the day of transfer ($100) is equal to the amount paid (i.e., the value of shares given up ($100)). The ruling further states that upon ultimate sale, capital gain is recognized based on the shareholder’s basis in the stock given up. The basis in the stock is not stepped up to the FMV due to the Sec. 83(b) election but remains $10. There is again no apparent downside in making a Sec. 83(b) election because the carryover basis insulates the shareholder from any risk associated with the election.

Conclusion

The examples from the ruling demon-strate a number of key points. First, consistent with previous guidance, a restriction placed on already fully vested shares is not a Sec. 83 event. Second, an exchange of unrestricted shares for restricted shares in either a taxable or tax-free transaction can be subject to Sec. 83. The third key point is that there is no downside to making a Sec. 83(b) election in such a transaction. A timely election (when applicable) is essential, as the tax situation of the recipient is substantially improved with the making of a valid election.

The transferring shareholder in a tax-free reorganization has a carryover basis in the newly received restricted shares when a Sec. 83(b) election is made (see Example 3 above). One can assume that the restricted stock is received in an exchange under Sec. 368(a), for which Secs. 354 and 358 must then apply. Basis in the shares is not stepped up to the FMV of the shares on the day of transfer under Sec. 83(a) but is carried over presumably under Sec. 358. If the restricted stock is received tax free, it is also reasonable to assume that the stock is qualifying consideration for purposes of determining whether the tax-free reorganization meets the various requirements, including COI. However, the ruling does not state this specifically, and the facts in the ruling do not provide enough information to conclude that the restricted stock is counted in determining COI for the reorganization. Even more uncertain is the result if no Sec. 83(b) election is made and whether restricted shareholders can contribute to COI if they are not treated as owners of the shares for federal tax purposes. Can a restricted share contribute to COI if the recipient is not treated as owner of the share for federal tax purposes? With or without a Sec. 83(b) election, is the stock “good consideration” upon receipt, and, if so, is COI tested again upon the forfeiture of the stock?

Rev. Rul. 2007-49 provides valuable guidance in determining whether Sec. 83 applies to the receipt of restricted stock in taxable and tax-free reorganizations. However, many questions remain unanswered. Until further guidance is received, it would be wise to structure tax-free reorganizations in a manner that satisfies COI without relying on the restricted shares as good consideration.

From Nate Beadle, CPA, Minneapolis, MN

Sec. 382 Ownership and Fluctuation in Value

Corporations incurring net operating losses (NOLs) are often in the unenviable position of watching the price of their stock fluctuate drastically. This can occur with a publicly traded corporation or a privately held venture incurring losses and raising capital through numerous capital increases. For a corporation with more than one class of stock, the effects of this stock price fluctuation can play a significant role in determining whether use of the NOLs could become limited as a result of trading and other equity shifts. In the context of applying the new Sec. 6694 more-likely-than-not (MLTN) standard for undisclosed positions, it is apparent that the IRS needs to issue additional guidance for taxpayers.

Background

In an effort to limit loss trafficking, Congress enacted Sec. 382 to limit the use of corporate NOLs following an ownership change. An ownership change is defined generally as a greater than 50% change in the ownership of stock among certain 5% shareholders over a three-year period (Sec. 382(g)). In the event of an ownership change, use of the loss corporation’s NOLs and certain built-in losses is limited to the value of the loss corporation multiplied by the adjusted federal long-term tax-exempt rate (Sec. 382(b)).

In determining a shareholder’s percentage ownership change, often-overlooked Sec. 382(l)(3)(C) states, “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.” Interestingly, the regulations state that “[t]he determination of the percentage of stock of any corporation owned by any person shall be made on the basis of the relative fair market value of the stock owned by such person to the total fair market value of the outstanding corporation” (Regs. Sec. 1.382-2(a)(3)(i)). It is not clear how the regulation affects the application of Sec. 382(l)(3)(C), and Temp. Regs. Sec. 1.382-2T(l) reserves guidance on the issue.

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

The IRS has issued a series of private letter rulings that, depending on one’s perspective, either fill in the gap or further confuse the issue (Letter Rulings 200622011, 200520011, 200511008, and 200411012). Each ruling makes the following statement with respect to fluctuation in value of classes of stock:

On any testing date, in determining the ownership percentage of any five percent shareholder, the value of such shareholder’s stock, relative to the value of all other stock of the corporation, shall be considered to remain constant since the date that shareholder acquired the stock; and the value of such shareholder’s stock relative to the value of all other stock of the corporation issued subsequent to such acquisition date shall also be considered to remain constant since that subsequent date.

Also worthy of note is that each ruling provides that the taxpayer requesting the ruling “may apply” this principle.

Consider a few examples:

Example 1: Upon incorporation, A acquires all common shares of ABC, valued at $3,200, and B acquires all preferred stock, valued at $800. All shares are issued for $1 per share. As a result of a business downturn, A sells all common stock to C for $200 while, due to a liquidation preference, preferred stock remains valued at $800. The sale of A to C results in a 20% change in ownership for Sec. 382 purposes (C’s ownership increases from 0 to 20% ($200 of $1,000 total), and A’s decrease is ignored). B’s ownership is unchanged despite the fact that B’s actual ownership increased from 20% to 80% ($800 of $1,000); the increase is due to the fluctuation in value of the common stock. (See Hoffenberg, “Owner Shifts and Fluctuations in Value: A Theory of Relativity,” 2005 TNT 54-29, March 22, 2005.)

Example 2: Reverse the transaction in Example 1 and assume that C buys B’s interest for $800. The result is an 80% increase ($800÷$1,000) and a Sec. 382 ownership change.

In Example 2, what is A’s ownership following B’s sale to C? A’s ownership should not fluctuate based on the value of the common or preferred stock. As such, it seems reasonable to assume that A’s interest remains at 80%, which results in total ownership for purposes of Sec. 382 of 160% (80% for A and 80% for C).

But how can this be? Accountants know that there cannot be more than 100% ownership of a company. Consider the first example again: When C buys A’s interest, C owns 20% of the value; however, B’s increase is attributable solely to value fluctuation, so B’s ownership remains at 20% and total ownership for purposes of Sec. 382 is only 40%.

On further review, this analysis makes perfect sense. A shareholder’s ownership is determined based on the value of the stock acquired as compared with the value of the loss corporation as of the date the shareholder acquires the stock. A shareholder should not have an increase in ownership as the result of an issuance of additional shares to an unrelated shareholder or as a result of the buying and selling of shares already in existence at the time of the shareholder’s acquisition of his or her shares. In the previous examples, the total number of shares remained constant, so any change to the value of a particular class of stock related solely to value fluctuation, and the buyer and seller of the shares are the only parties that incurred changes not attributable to fluctuation in value. These two examples are very basic, and the calculations become exponentially more complex as the number of classes and issuances of stock increases.

Example 3: Instead of C buying shares from A, as in Example 1, ABC issues 3,200 additional shares to C for $200. C’s ownership is fairly simple. C owns $200 out of a total of $1,200 ($400 common + $800 preferred), or 16.7%, and has a corresponding ownership increase of 16.7%. B’s ownership is not as straightforward: It should not increase or decrease as a result of value fluctuation when compared to common stock outstanding during the same period that the preferred is outstanding. However, this is not the case for the newly issued common stock. As a result, B’s ownership would decrease from 20% to approximately 19% ($800÷($4,000 + $200)). (See Hoffenberg, above.)

In determining B’s ownership, the actual value of B’s stock is the numerator ($800), and the denominator is the value of all outstanding shares issued as of the issuance date of the preferred after removing fluctuation in value ($4,000), and the value of the newly issued shares ($200). Determining A’s interest is even less intuitive. A’s ownership would decrease from 80% to 44.4% ($200 ÷ ($250 + $200)), which is calculated by backing out the effect of the value fluctuation of the common shares.

Speaking at a District of Columbia Bar Association Taxation Section luncheon, Mark Jennings, Branch 1 Chief in the IRS Office of Associate Chief Counsel (Corporate), responding to questions likely arising from the aforementioned rulings, made clear that nothing in the regulations under Sec. 382 limits the applicability of Sec. 382(l)(3)(C) (Tandon, “IRS Official Sheds Light on NOL Carryover Rules,” 2006 TNT 35-3, February 22, 2006). In addition, Mr. Jennings stated that eliminating value fluctuation is not elective but instead is the appropriate method of determining changes under Sec. 382. Due to the confusion surrounding the applicability of Sec. 382(l)(3)(C), this method may differ substantially from the methods historically used by many taxpayers. Moving forward, especially under the Sec. 6694 MLTN standard, the appropriate methodology for determining ownership is key.

Potential Conflicts Between Advisers?

With the implementation of FIN 48 and a shift toward corporate taxpayers using different firms for their tax and audit functions, application of a particular methodology could cause disagreements among advisers, as many are taking alternative approaches to deal with the issue.

Approach 1—Apply Sec. 382(l)(3)(C) methodology similar to examples above: This approach appears reasonable in that it attempts to apply the existing statute in a way that conforms to the interpretation of private letter rulings issued by the IRS and represents a taxpayer’s reasonable attempt to comply with the statute. The drawback to this approach is in the complexity, time, and additional costs that arise from applying the methodology as well as the lack of clarity as to the appropriate methodology.

Approach 2—Interpret regulations to turn off Sec. 382(l)(3)(C): This approach seemingly looks to the “[e]xcept as provided in regulations” language of Sec. 382(l)(3)(C) and the language in Regs. Sec. 1.382-2(a)(3)(i) discussed above as well as the language in the private letter rulings that seemingly allows the specific taxpayer to apply the methodology, to argue that fluctuation in value is properly taken into account.

Approach 3—Value all preferred stock on an as-if-converted basis: In most situations, preferred stock is convertible into common stock. This approach treats the value of the preferred stock as equal to the value of the common under the assumption that the preferred stock will ultimately convert into common. This approach seems reasonable as long as the value of the common shares exceeds the liquidation value of the preferred stock. However, when the value of the common stock falls significantly below the liquidation value of the preferred stock, such an assumption does not appear nearly as reasonable. 

Questions for Practitioners

1. While it may be reasonable to conclude that an adviser could reach an MLTN determination on any of the three approaches above, is it reasonable for an adviser to reach an MLTN determination using the approach that best suits the taxpayer?

2. Does the language in the private letter rulings allowing taxpayers to apply a Sec. 382(l)(3)(C) methodology give comfort for the position that one can look to Sec. 382(l)(3)(C) if the taxpayer would otherwise have an ownership change under a different methodology, and Sec. 382(l)(3)(C) would allow the taxpayer to avoid a change?

3. Should practitioners advise clients to seek a private letter ruling if they are going to apply the methodology from the rulings?  

4. Is it important for advisers to understand the position of their client’s audit firm regarding Sec. 382(l)(3)(C) when performing a Sec. 382 analysis for purposes of establishing a FIN 48 position? It would be unfortunate for both the practitioner and the client to prepare an analysis only to have the audit firm tell the client that the analysis is not an acceptable interpretation of the law.

5. Will the application of an approach determined not to meet the MLTN standard satisfy the Sec. 6694 reasonable cause exception due to the lack of clear guidance?

Summary

Sec. 382 is one the Code’s most complex sections, and careful consideration needs to be given to all aspects of the section and regulations thereunder. Sec. 382(l)(3)(C)’s removal of value fluctuation from the ownership change calculation is a perfect example of the complexity and demonstrates the inability of taxpayers or advisers to perform a “quick and dirty” or “back of the napkin” ownership change analysis with any certainty. Furthermore, if tax advisers are going to be held to a higher standard of advice, it is only fair that Treasury and the IRS provide clearer guidance for tax preparers to use in the application of Sec. 382(l)(3)(C).

From Nick Gruidl, CPA, MBT, Minneapolis, MN

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