As shares of a company change hands, there can be tax implications if those sales result in a “change of ownership.”
The IRS considers that a change of ownership occurs if there has been an increase of more than 50 percentage points between groups of 5 percent shareholders, says John Brogan, shareholder, tax, Burr Pilger Mayer.
“Once it is determined that an ownership change has occurred, it is necessary to calculate the amount of net operating loss carryover that can be used against taxable income in the years following the change,” he says.
Smart Business spoke with Brogan about Section 382 and how it can affect the taxes your company pays.
What is Section 382?
It is a section of the Internal Revenue Code that imposes significant limitations on the use of net operating loss carryovers after certain changes of corporate ownership. A company needs to do an analysis to determine the occurrence of ownership change, which is oftentimes more than once over the history of a company. It’s basically an analysis of share transfers, and share issuances that occurred from inception to the current date. Warrants and options must also be factored in.
What limitations may be imposed on the use of losses when there has been a shift in the stock ownership of a corporation?
The limitation is calculated by taking the equity of the company immediately before the ownership change and multiplying that value by an IRS-prescribed amount, which changes every month; for ownership changes that occur in May 2011, that amount is 4.3 percent.
Say you have equity value for common and outstanding preferred stock of $10 million. You calculate the annual Section 382 amount by multiplying that by 4.3 percent. The result is $430,000, which is the company’s operating loss carryover prior to ownership change that can be used each year following the ownership change. So if you had $5 million of net operating carryover as of the ownership change, you could only use $430,000 a year in post change losses. The balance of the NOL would carry over until it expired.
If a corporation anticipated a shift in the ownership, why would it bother to analyze its historic share transfers?
In many cases, it is not apparent that an ownership change is about to occur. There are complex Treasury regulations, in which certain shareholder groups are treated as designated 5 percent shareholders, and it may be possible to avoid an ownership change if the company knows exactly where it is in terms of approaching the more than 50 percentage points cumulative increase.
How do you track ownership changes when stock is publicly traded?
With publicly traded companies, the IRS allows some administrative shortcuts. For example, transactions that occur between shareholders who don’t individually own 5 percent can be disregarded. If someone who has 1 percent of the company’s stock sells half of that to another person who doesn’t have 5 percent or more of the stock, you can disregard that — unless the transaction is done by someone who historically owned 5 percent of the stock in the company. For public companies, the IRS allows you to rely exclusively on shareholder filings with the SEC.
Are there similar assumptions for a non-publicly traded company?
The same assumptions can be made with a privately held company. For example, sales of stock between those holding less than 5 percent of the company can be disregarded.
The issue with private companies is that shares can be transferred without SEC filings, so you must actually investigate who owns shares at different points in time and examine those stock transactions.
With a privately held company, often a venture-backed entity, you typically have the issuance of common stock to the founder and key employees, with one or more rounds of preferred stock issued to investor groups. Testing is done based on the fair market value of those shares transferred, which adds complexity as the value of that stock fluctuates.
How has the recent increase in M&A activity impacted these rules?
In an M&A transaction, regardless of whether there is a taxable or tax-free acquisition, the share transaction needs to be factored into the equation, testing a loss corporation based on different testing dates and comparing ownership percentage following a merger.
For example, if a loss corporation acquires a profitable company in a tax-free merger, it is necessary to look at the historic shareholders of the loss company and — even though the loss company is the surviving company — look at historical ownership. If you assume no cross ownership before the transaction, that transaction could and often does create ownership.
How can business owners prepare for this type of analysis?
Companies should adopt shareholder rights plans to put them in control of their situation and adopt provisions in their articles of incorporation that render void a contract of stock if transfer of that stock would cause an ownership change. That allows them to act proactively if someone threatens a transaction that would cause a change in ownership.
Some companies may want to do an analysis yearly, particularly companies that are interested in preserving operating losses or that place a high value on net operating losses.
Once you know an ownership change has occurred, there are steps to push losses into the post-change period where the loss is not subject to limitations, or push income into the pre-change period so that losses can fully offset income that was accelerated.
John Brogan is a shareholder, tax, Burr Pilger Mayer. Reach him at (415) 288-6260 or firstname.lastname@example.org.