The problem. The problem the Notice addresses can exist only for loss corporations with multiple classes of stock, for example, common stock and one class of pure preferred stock. Multiple classes cause uncertainty about how to factor into the change of ownership calculation changes of stock value. The Notice’s solution is to give taxpayers two alternative choices, which must be used consistently.
Example. X Corp. has outstanding only common stock. On Day 1 A owns 40 shares and B owns 60 shares. On Day 360 B sells the 60 shares to C. This causes a more than 50-percent change of ownership of X, and if X is a loss corporation section 382 will apply to limit its ability to deduct its pre-change NOLs (and sometimes built-in losses) going forward. If all of the X stock was worth $5 million on Day 1, it doesn’t matter whether it is worth $10 million or $2 million on Day 360. In either event, the relative ownership by value has shifted more than 50 percent.
Example. But if X Corp. also has a class of preferred stock outstanding, which is owned by D and is worth $1 million on Day 1 and Day 360, then the sale of 60 percent of the common stock is not more than 50 percent of the total stock value using Day 1 value of the common of $5 million, but is more than 50 percent using Day 360 value of the total common of $10 million.
Section 382 change of ownership calculations are based on relative value and involve a three-year look-back testing period. Many practitioners have been concerned that all of the stock of loss corporations must be valued every time an ownership change occurs (a “testing date”) in order to keep track of the cumulative changes. This is called the “Full Value Methodology.” In many cases this could occur almost daily as contributions to capital are made, stock is issued to employees, options are exercised and the like. Complexity is relieved to some extent by the fact that only five percent shareholder shifts count, but groups can be treated as one five-percent shareholder under the complex rules in the regulations.
An alternate method of dealing with value changes is to treat each particular share’s relationship to shares in other classes as fixed based on the relative class values at the time the share was acquired (“Hold Constant Principle”). The basic theory behind the Hold Constant Principle (HCP) is that it treats all other shares as rising or falling in value in tandem with the share being tested, during the look-back period involved. This is certainly not a simple method but it can avoid full revaluations.
The Notice gives loss corporations the opportunity to choose between the Full Value Methodology and the Hold Constant Principle. The Notice illustrates the Hold Constant Principle as follows:
Example. Upon formation, X Corp. issues $20 of convertible preferred stock to A and issues two shares of common stock to B for $80, such that A and B own 20 percent and 80 percent, respectively, of X. The fortunes of X deteriorate and, two years later, when the common stock has a value of $2.50 per share and the preferred stock has a value of $20, B sells one share of common stock to C. At the time of B's sale to C, X is a loss corporation. On that testing date, although A actually owns 80 percent of the value of X, A will be treated as owning 20 percent of the value of X for purposes of section 382(g), under the Hold Constant Principle. Therefore only a 10-percent owner shift has occurred, and the section 382 limit not triggered. The key to the Hold Constant Principle (HCP) is that it prevented A from going from 20 percent ownership to 80 percent ownership by virtue of value changes. The HCP prevents shares in other classes from being marked to value relative to total value when shares in another class cause a testing date.
Practitioners need to know these practical takeaway points about the Notice:
- The choice of which method to elect will depend on how many five-percent shareholders the corporation has, whose stock transfers must be tracked, whether the common stock value is expected to rise or fall and how hard it is to value the stock. Generally falling common stock value can skew the results toward an ownership change under the Full Value Method. But when common stock value rises, the Full Value Method may be easier to apply than the HCP.
- Redemptions and stock issuances also can cause ownership changes.
- Mark-to-market and deemed acquisitions by non-redeeming shareholders do not cause testing dates.
- If a taxpayer chooses to apply one of the alternate methods to a testing date it must apply the same method throughout the consistency period with respect to that testing date, which runs backward to the latest of:
- The last more than 50-percent ownership change,
- The date on which two classes of stock were first created or
- Six years earlier.
This may require amending returns for closed years; there are special rules preventing such amendments form changing results in open years.
Accounting for value changes is just one of multiple complexities in applying section 382 to loss corporations. Any C corporation with substantial NOLs or built-in losses that does not have totally static stock ownership should plan to maintain period review of its ownership change status.
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Jasper L. Cummings, Jr., JD, is of counsel in the Raleigh office of Alston & Bird LLP. He practices in the areas of corporate taxation and has served as Associate Chief Counsel (Corporate), IRS. He can be reached at 919-862-2302.