Caveat Emptor: Stock Acquisition CERT Limit on NOL Use

There are numerous provisions within the Code that limit a taxpayer’s ability to use net operating losses (NOLs) (e.g., Secs. 172(b)(1)(E), 269, 382 and 384), each of which was enacted to address a perceived abuse. For example, Sec. 382 prevents taxpayers from trafficking in loss corporations, and Sec. 384 restricts a corporation’s ability to offset certain recognized built-in gains with a loss corporation’s pre-acquisition NOLs.

Sec. 172(b)(1)(E) and (h) generally apply in leveraged buyout transactions in which substantial interest expense is created post-acquisition and NOLs result from the payment of such interest. Originally enacted in 1989, Sec. 172(b)(1)(E) and (h) limit the ability of a C corporation involved in a corporate equity reduction transaction (CERT) to use post-acquisition NOLs, arising from interest expense deductions in the year in which the CERT occurs (or in either of the two years succeeding that year), in any year prior to that year. Consequently, the CERT rules only limit carrying back NOLs, not carrying them forward. Taxpayers contemplating a transaction that would qualify as a CERT should give due consideration to the effect of the CERT rules on the transaction’s economics as part of determining how to structure the transaction.

Mechanics of Sec. 172(b)(1)(E) and (h)

A CERT is defined under Sec. 172(h)(3) as either (1) a major stock acquisition or (2) an excess distribution. A “major stock acquisition” generally means the acquisition of stock pursuant to a plan by an acquiring corporation in a target representing 50% or more (by vote or value) of the target’s stock. However, a “major stock acquisition” does not include a qualified stock purchase pursuant to which an election under Sec. 338 applies. Taxpayers should note that, under Sec. 172(h)(3)(D), all plans by any acquiring corporation, with respect to acquiring stock in a target, are considered to be one plan, and all acquisitions during any 24-month period are considered to be undertaken pursuant to one plan. Additionally, under Sec. 172(h)(4)(C), all members of an affiliated group that file a consolidated return are treated as one taxpayer for Sec. 172(b)(1)(E) purposes. Consequently, if one member of a consolidated group is involved in a CERT, the rules under Sec. 172(b) (1)(E) and (h) apply to all group members.

An “excess distribution” generally means the excess amount of the (1) aggregate distributions (including redemptions) made during a tax year by a corporation over (2) greater of 150% of the average of such distributions over the three prior tax years or 10% of the fair market value of the stock of such a corporation as of the beginning of such tax year. This discussion focuses on a CERT that qualifies as a major stock acquisition and not as an excess distribution.

Under Sec. 172(b)(1)(E) and (h)(1), the portion of the NOL relating to a CERT that cannot be carried back to prior tax years under Sec. 172 is the difference between the (1) NOL for the tax year and (2) NOL for the tax year without including deductions for interest on the portion of any debt allocable to a CERT (i.e., allocable deductions). The Code generally requires taxpayers to use an avoided-cost method when allocating debt to a CERT. This generally produces unfavorable results for them.

However, the Code does provide ways to mitigate this. For example, if the amount of allocable deductions for any tax year is less than $1 million, there is no CERT limit on the NOLs. Further, if the allocable deduction for any year to which Sec. 172(b)(1)(E) applies is less than the average yearly interest expense deduction for the three tax years prior to the CERT, there is no CERT limit on the NOLs. However, in determining the amount of the allocable deduction, only nonintercompany debt should be taken into account.

Lack of Guidance and Considerations

Congress has authorized the promulgation of regulations relating to the NOL limit rules for a CERT in Sec. 172(h)(5); however, regulations have not yet been issued. Instead, the application of the CERT rules must be gleaned from the Code and limited guidance issued by the IRS. Consequently, certain considerations should be taken into account when computing the amount of the CERT taint. These considerations include, without limit, the time remaining in the tax year following the CERT, whether to include the interest expense deductions of both the acquiring and target corporations when computing the “safe haven” interest calculation in Sec. 172(h)(2)(C), and whether interest expense deductions from any short tax years should be annualized in computing the safe-haven interest calculation.

Summary

Sec. 172(b)(1)(E) and (h) often go unnoticed when companies plan a major stock acquisition transaction. However, the effect of these rules on the transaction’s economics may be significant. As a result, Sec. 172(b)(1)(E) and (h) should not be overlooked when analyzing the tax benefits associated with a transaction that includes NOLs.

From John R. Lehrer, J.D., LL.M., Washington, DC