CERTs and NOL Limits

With the recent decline in the economy, some corporations will inevitably incur net operating losses (NOLs). The Job Creation and Worker Assistance Act of 2002 amended Sec. 172(b)(1)(H) to allow taxpayers a five-year carryback for losses incurred in tax years ending in 2001 and 2002, instead of the standard two-year carryback period. A flurry of refund claims is sure to follow. Many of these claims will be ultimately reviewed by the Joint Committee on Taxation (JCT).

However, an obscure rule may limit NOL carryback potential for some corporations that have financed either a recent acquisition of stock of another corporation or a capital distribution. Sec. 172(b)(1)(E) and (h), enacted by the Revenue Reconciliation Act of 1989 (RRA), contain rules on corporate equity reduction transactions (CERTs) and are unrelated to the Sec. 382 NOL limits. Taxpayers should consider these provisions, especially if quick refund claims are being filed. IRS sources have indicated that the JCT has alerted examiners to consider the CERT issue.

Background

The RRA Committee reports state that corporations ability to carry back NOLs created by certain debt-financed transactions is contrary to the purpose of Sec. 172. Specifically, the rules purpose is to allow corporations to smooth out the swings in taxable income that can result from business-cycle fluctuations and unexpected financial reverses. The Committee believed that when a corporation is involved in certain debt-financed transactions, the corporations underlying nature is substantially altered. In addition, the interest expense in such transactions does not have a sufficient nexus with prior-period operations to justify a carryback of NOLs attributable to such expense. Accordingly, the Committee determined that it is inappropriate to permit a corporation to carry back an NOL generated by such transaction to a year before the year in which such transaction occurred; thus, only a carryover is permitted.

What Is a CERT?

A CERT is a major stock acquisition or an excess distribution. A major stock acquisition is defined by Sec. 172(h)(3)(B)(i) as the acquisition by a corporation (pursuant to a plan) of at least 50% (by vote or value) of the stock of another. Qualified stock purchases for which a Sec. 338 election is in effect are excepted under Sec. 172(h)(3)(B)(ii). Sec. 172(h)(3)(D) provides that all of a corporations plans (or group of persons acting in concert with such corporation) as to another corporation are deemed one plan; all acquisitions made during any 24-month period are treated as pursuant to one plan.

An excess distribution under Sec. 172(h)(3)(C) is the excess of the aggregate distributions (including redemptions) made by a corporation during a tax year as to its stock, over the greater of (1) 150% of the average of such distributions during the three tax years immediately preceding such tax year or (2) 10% of the stocks fair market value (FMV) at the beginning of such tax year. (For these purposes, Sec. 172(h)(3)(E) ignores nonvoting, nonconvertible preferred stock and distributions (including redemptions) thereon.) Additionally, (1) aggregate distributions made during a tax year by a corporation as to its stock and (2) 150% of the average distributions during the three preceding tax years, are reduced by the aggregate stock issued by the corporation during the applicable period for money or property other than such stock. Further, for both stock acquisitions and excess distributions, all members of a consolidated group are treated as one taxpayer by Sec. 172(h)(4)(C).

CERIL Carryback Limit

Sec. 172(b)(1)(E) provides that if there is a CERT and an applicable corporation has a corporate equity reduction interest loss (CERIL) for any loss limitation year (LLY) after Aug. 2, 1989, the CERIL cannot be carried back to a tax year before the tax year in which the CERT occurs. Under Sec. 172(b)(1)(E)(ii), an LLY is defined as the tax year in which the CERT occurs and each of the two succeeding tax years. Sec. 172(b)(1)(E)(iii) defines an applicable corporation as (1) a C corporation that acquires stock, or the stock of which is acquired in a major stock acquisition; (2) a C corporation making distributions as to (or redeeming) its stock in connection with an excess distribution; or (3) a C corporation that is a successor of a corporation in (1) or (2) above.

CERILs

Under Sec. 172(h)(1), a CERIL is, as to any LLY, the excess of the NOL for such tax year over the NOL for such tax year, determined without regard to any allocable interest deductions otherwise taken into account in computing such loss. Allocable interest deductions are defined in Sec. 172(h)(2) as deductions allowed for interest on the portion of any debt allocable to a CERT. Debt is to be allocated to the CERT under Sec. 263A(f)(2)(A) rules (i.e., the avoided-cost method).

Sec. 172(h)(2)(C) and (D) limit the interest that can be allocated to a CERT. First, allocable interest deductions for any LLY cannot exceed the excess of the amount allowable as a deduction for interest paid or accrued by the taxpayer during the LLY, over the average of such amounts for the three tax years preceding the tax year in which the CERT occurred. Presumably, in a stock acquisition, interest expense for the three prior tax years of the acquiring and acquired corporations would be taken into account. Second, a de minimis rule treats a taxpayer as having no allocable interest deductions for any tax year if such deductions total less than $1 million.

Unforeseeable Events

Special rules under Sec. 172(h)(2)(E) address unforeseeable extraordinary adverse events that occur during an LLY, but after a CERT. Debt may be allocated to unreimbursed costs paid or incurred in connection with the unforeseeable event before being allocated to the CERT. The interest allocated to such debt is not taken into account in determining whether the corporations interest expense in the LLY exceeds the prior three-year average.

Unfortunately, there is no statutory or Congressional guidance as to what constitutes an extraordinary unforeseeable adverse event. Clearly, a plant fire or interruption of business caused by a natural disaster would qualify. Likewise, the contraction the economy experienced after Sept. 11, 2001 might be eligible.

Example 1: In 2002, P Corp., a profitable calendar-year C corporation, was capitalized with $150 million debt and $50 million equity. Ps annual interest expense was $15 million for the prior three years; it paid a 1% annual dividend to its shareholders (an average of $500,000) for each of the prior three years. On Dec. 30, 2002, P borrowed $50 million and distributed the proceeds to its shareholders. Due to the $5 million increase in interest deductions, P incurred a 2002 $4 million NOL.

P was involved in a CERT in 2002, because it made a Sec. 172(h)(3)(C) excess distribution to its shareholders (i.e., the $50 million distribution exceeds 150% of the average $500,000 dividend). The portion of Ps $4 million NOL limited by Sec. 172(h) is the lesser of (1) the interest expense allocable to the CERT ($5 million) or (2) the excess of 2002 interest expense ($20 million) over Ps average interest expense for the prior three years ($15 million), or $5 million. Thus, P would not be able to carry back the $4 million NOL to any tax year prior to 2002. In addition, if P has 2003 and 2004 NOLs due to interest deductions allocable to the 2002 CERT, a similar computation would be made in each of those years; P might be limited in its ability to carry back the losses to a pre-2002 tax year. P would be able to use the NOLs to offset income in subsequent years.

Example 2: The facts are the same as in Example 1, except that P did not incur any additional borrowing in 2002; rather, it distributed $50 million from its reserves to its shareholders. Ps annual interest expense remained at $15 million after the distribution. Because the distributed funds no longer generated earnings, however, P incurred a 2002 NOL of $3 million.

P was involved in a CERT in 2002, because it made an excess distribution to its shareholders. The portion of its $3 million NOL limited by Sec. 172(h) is the lesser of (1) the interest expense allocable to the CERT ($5 million, because it could have paid off $50 million in debt) or (2) the excess of 2002 interest expense ($15 million) over average interest expense for the prior three years ($15 million), or zero. Thus, Ps NOL carryback is not limited; it can carry back the $3 million loss to its pre-2002 tax years, subject to any other restrictions. (Future regulations would exempt P from Sec. 172(h) if interest expense in the LLY exceeded the prior three-year average solely due to an interest-rate increase.)

Example 3: For 19992001, the average interest expense of R, a profitable calendar-year corporation, was $3 million. In December 2002, it purchased all of the stock of M, a corporation with a $20 million stock FMV. R borrowed $15 million to finance the transaction and incurred $2 million in related interest expense. Its total 2002 interest expense was $5 million; its 2002 NOL was $8 million.

R was involved in a CERT, because it acquired more than 50% of Ms stock and is an applicable corporation. Rs allocable interest deduction for 2002 was $2 million, the amount by which its interest expense could have been reduced had it not entered into the transaction. The portion of its $8 million NOL limited under Sec. 172(h)(2) is the lesser of (1) the interest expense allocable to the CERT ($2 million) or (2) the excess of 2002 interest expense ($5 million) over average interest expense for the prior three years ($3 million), or $2 million. Thus, R would not be able to carry back $2 million of the $8 million NOL to any tax year before 2002.

Note: There is no requirement to allocate CERT-year taxable income between pre- and post-CERT dates; any CERILs generated in a subsequent LLY may be carried back to the CERT year in full, regardless of any taxable income generated before the CERT.

Example 4: In 2002, Q, a profitable calendar-year corporation, purchased $30 million of assets and finances the transaction with a term loan. Later in the same tax year, Q purchased 100% of the stock of N Corp. for $30 million and generated a $10 million NOL. Q could have paid off the term loan instead of purchasing the N stock; thus, the interest on the term loan is allocable to the CERT (assuming the de minimis rule does not apply). This illustrates how the CERT rules can unexpectantly taint an NOL.

Conclusion

Corporations that want to use the Sec. 172 five-year carryback provisions should be aware of the CERT rules. The avoided-cost method of interest allocation may unexpectedly taint an otherwise expected NOL carryback claim. However, the vagueness of the unforeseeable extraordinary adverse event exception, coupled with the recent economic decline, may create opportunities to minimize the rules effects.

From Matthew Coscia, CPA, Coscia Greilich & Company LLP, Dallas, TX (Not Affiliated With Grant Thornton LLP)