Sec. 382 Limit—Special Rule for Controlled Groups

The most difficult technical issue under Sec. 382 often involves determining wheth-er a loss corporation has experienced an "ownership change." Once it is determined that an ownership change has occurred, the tax practitioner faces another daunting task—calculating the annual "Sec. 382 limit."

One component of the annual limit described below, the stock value of the loss corporation, is not as simple to determine as it first appears. Several potential adjustments to value are reflected in the law and regulations, including a special rule (Regs. Sec. 1.382-8) that in some circumstances requires a downward adjustment to value of stock of a loss corporation that is a member of a nonconsolidated controlled group. This important (although sometimes overlooked) adjustment effectively requires a controlled group to allocate value of its members so that the same value is not included more than once in calculating the Sec. 382 limit. Unfortunately, the interpretation of the antiduplication rule in the regulations seems to go beyond the rule's legislative purpose.

Sec. 382 Limits

In general, Sec. 382 limits use of a loss corporation's pre-change losses to offset post-change income when an ownership change occurs. A loss corporation is a corporation that either has a net operating loss (NOL) for the tax year in which an ownership change occurs or is entitled to use an NOL carryover. An ownership change is defined (in very complex rules) as a more-than-50% increase in the stock of the loss corporation owned by five-percent shareholders.

Under Sec. 382(a), the taxable income of a loss corporation for any post-change year that may be offset by pre-change losses may not exceed the Sec. 382 limit for the year. The Sec. 382 limit is calculated by multiplying the value of the loss corporation by the long-term tax-exempt rate. The fair market value (FMV) of the loss corporation's stock (including Sec. 1504(a)(4) stock) is determined immediately prior to the ownership change.

The value of the loss corporation used in determining the annual Sec. 382 limit must be reduced for:

• Tax-motivated capital contributions preceding the ownership change under Sec. 382(l)(1);
• Redemptions or corporate contractions in connection with the ownership change under Sec. 382(e)(2);
• The value of substantial nonbusiness assets under Sec. 382(l)(4); and
• Stock owned in certain controlled but nonconsolidated corporations under Regs. Sec. 1.382-8.

Taxpayers typically are familiar with the first three adjustments to value, but the special adjustment for controlled groups is less well known and can be a trap for the unwary.

Controlled Groups

Pursuant to a grant of authority in Sec. 382(m)(5), temporary regulations were issued in 1996 and final regulations in 1999 to prevent double counting by 50%-controlled groups. These rules generally are effective for ownership changes under Sec. 382 after 1996. The regulations were issued at the same time as the consolidated Sec. 382 and separate return limitation year regulations. The attention received by these two apparently more widely applicable sets of regulations may account for the relative obscurity of the antiduplication rule in Regs. Sec. 1.382-8.

Two basic rules relate to the value of a loss corporation used to calculate the annual Sec. 382 limit.

First, Regs. Sec. 1.382-8(c)(1) requires a decrease to the value of a loss corporation in determining its Sec. 382 limit, equal to the value of the stock of lower-tier component members of its controlled group (not included in its consolidated group) that it directly owns immediately after its ownership change and that were controlled group members when pre-change losses arose. The regulations contain a special definition of a controlled group, beginning with the definition found in Sec. 1563(a), but substituting 50% for 80%. As a result, the stock ownership connecting the chain of corporations generally must be at least 50% of the total combined voting power of all classes of stock entitled to vote, or at least 50% of each involved corporation's total value of shares of all classes of stock. Consolidated groups are treated as a single entity for purposes of the rules.

Second, Regs. Sec. 1.382-8(c)(2) allows a lower-tier component member (the electing member) and the loss corporation to elect to increase a loss corporation's value by some or all the value of such a lower-tier component member that otherwise would reduce the loss corporation's value under the first rule.

The requirement that a controlled group member must be related to the loss corporation both at the time of the ownership change and in the year when a loss arose means that a year-by-year analysis is required, and the adjustment under Regs. Sec. 1.382-8 will depend on relationships in the year that a given NOL was generated.

Election to Restore Value

Under Regs. Sec. 1.382-8(h), the election to restore the value of component members to the loss corporation's value for purposes of the Sec. 382 limit must be filed by the loss corporation with its return for the tax year in which the ownership change occurs, or with an amended return filed by the due date (including extensions) of a component member's return. A consolidated group's common parent must make the election on behalf of the group.

The election is made by attaching a statement to the returns of the common parent and each electing component member, listing the name and identification number of each component member to be included in the election. The statement must be signed by the loss corporation (or common parent) and by the component member whose value is restored to the loss corporation. An explanation of the election, as worded in Regs. Sec 1.382-8(h), must also be included on the statement. The lower-tier component members must attach a copy of the statement to their returns for the tax year that includes the ownership change.

The advantage of making an election to restore the value of component members to the loss corporation's value is that the loss corporation can increase the stock value used to calculate its Sec. 382 limit; the increased limit will expand the use of pre-change losses and credits. To the extent that the controlled subsidiaries whose value is restored do not have tax attributes limited by Secs. 382 and 383, the election does not produce adverse consequences to a loss corporation or to its controlled subsidiaries.

Unfortunately, the antiduplication rule automatically applies to stock in controlled group lower-tier members that satisfy the definition, regardless of whether such members have losses or credits that can be used on a U.S. return. Obviously, this affirmative election is beneficial if the lower-tier member does not have any NOL carryovers or insufficient NOL carryovers to benefit from, including its full value in its own Sec. 382 limit.

Example of Antiduplication Rule

Example 1 presents the basic operation of the controlled group antiduplication rule under Regs. Sec. 1.3828.

Example 1: P is a loss corporation and the common parent of a large U.S. consolidated group. P owns 70% of the stock of X, also a loss corporation. X is ineligible to file with the P group and files a separate Federal return. P also owns all of the stock of Y, a life insurance company. Y is ineligible to be included in the P consolidated group and files a separate Federal return. Y is profitable and has no NOLs. P also owns all of the stock of Z, a foreign corporation not engaged in a U.S. trade or business, which does not file a U.S. return.

P owned its stock in X, Y and Z throughout the tax years it generated NOLs. Due to a series of transactions that results in new shareholders increasing their ownership in P, P undergoes an "ownership change" under Sec. 382 that also causes an ownership change of X.

The FMV of the P stock is $1,000,000,000. The FMV of the X stock owned by P is $100,000,000. The FMV of the Y stock owned by P is $75,000,000. The FMV of the Z stock owned by P is $50,000,000. The applicable Federal rate at the date of the ownership change is five percent.

Disregarding any other adjustments to value under Sec. 382 (and absent application of Regs. Sec. 1.382-8), P's annual Sec. 382 limit would be $50 million—the total stock value ($1 billion) times the applicable Federal rate (five percent). However, under Regs. Sec. 1.382-8(c), P must reduce its stock value by the value of the stock of X, Y and Z that it holds; therefore, its annual Sec. 382 limit would be only $38.75 million (($1 billion – $225 million) x 5%). At the same time, X would have a Sec. 382 limit of $5 million ($1 billion x 5%). If P makes a timely election under Regs. Sec. 1.382-8(h), it could include some or all of the value of X, Y and Z in its Sec. 382 limit calculation. Because Y and Z have no NOLs, restoring their value to P would increase P's Sec. 382 limit with no cost to Y or Z.

It is important to note that Regs. Sec. 1.382-8 applies to any 50%-or- more-owned nonconsolidated subsidiary of P in the example, even though only one of such subsidiaries (X) could use any portion of its value for purposes of a separate Sec. 382 limit. This result with respect to Y, which has no NOLs, and Z, a foreign corporation, seems unnecessary and beyond the apparent antiduplication purpose of the regulations.

Taxpayers are well advised to be aware of the harsh rule in Regs. Sec. 1.382-8(c) and to elect to restore value to higher-tier controlled group members under Regs. Sec. 1.382-8(h) in all appropriate circumstances.

From Julie M. Allen, CPA, and Richard F. McManus, J.D., LL.M., Washington, DC