When a corporation with net losses undergoes an ownership change, within the meaning of the tax code's Section 382(g), limits are imposed on the amount of taxable income1 that may be offset by the company's prechange losses. This limit is known as the "Section 382 limitation" and it is calculated by multiplying the fair-market value of the loss corporation's stock, immediately before the ownership change, by the long-term tax-exempt rate.
However, under Section 382(c), if the new loss corporation (the loss corporation in its postownership change state) does not continue the business enterprise of the old loss corporation (the loss corporation in its prechange state) at all times during the two-year period beginning on the change date, the Section 382 limitation for any postchange year is zero. Accordingly, no amount of postchange income — except to the extent of recognized built-in gains — can be offset by the prechange losses in cases where, in connection with an ownership change, the so-called continuity of business enterprise (COBE) requirement is not met.
One issue that has arisen, and has been resolved favorably, is whether the business enterprise that the new loss corporation must continue is the business enterprise that produced the losses that will be used to offset otherwise taxable income. That's what is at issue in Exel Corp. v. United States, 451 F.2d 80 (8th Cir. 1971).
In that case, the taxpayer, Eclipse Lumber Co., had operated a chain of retail lumber yards from 1902 through April 1959. On May 1, 1959, Eclipse sold all of its assets to another company — H.B. Pearl — for $2,275,000 in cash. The sale produced a net operating loss (NOL) of $1,089,358, a portion of which was carried back to taxable years preceding the year in which the NOL arose.
The proceeds of the sale were invested by Eclipse in "short-term government securities." As a result, the only income against which the NOL was claimed arose out of income generated by the investment of the proceeds of the sale of Eclipse's operating assets.
In October 1960, by virtue of the redemption of more than 50% of its outstanding stock, Eclipse experienced an ownership change. It was the position of the Internal Revenue Service that "old" Section 382 (the version in place from 1954 through 1986) barred the use of Eclipse's NOL carryover. The IRS contended that the statute — in which COBE was and remains an indispensable element — should be interpreted to mean that the business enterprise that must be continued is the one that produced the loss.
- "Can an investment business function as the loss corporation's historic business? The answer would appear to be yes." — Robert Willens
The court disagreed. It noted there is no language in the statute that (1) expressly states or (2) fairly implies that the business that produced the loss must be continued. Under the 1939 Internal Revenue Code, as interpreted by the Supreme Court in Libson Shops v. Koehler, 353 US 382 (1957), the loss carryover was allowable only if the income against which the offset was claimed was produced by "substantially the same business" that produced the loss. However, by enacting the 1954 Code, Congress destroyed the precedential value of Libson Shops. The court stated that Libson Shops "is no longer the law."
Historic Business
The regulations explaining the COBE requirement (Regulation Section 1.368-1(d)) provide that the historic business of the old loss corporation — the one that the new loss corporation must continue at all times during the two-year period beginning on the change date — is the business that the old loss corporation "has conducted most recently." However, the regulations go on to say that a corporation's historic business is not one the corporation enters into "as part of a plan of reorganization." (See Reg. Sec. 1.368-1(d)(2)(iii).)
Accordingly, we can surmise that the historic business is the business the old loss corporation is conducting at the time of the ownership change, provided that such business was not entered into as part of a plan (or series of related transactions) that includes the ownership change. The fact that this business is not the one that produced the NOLs that are sought to be used is simply not relevant.
The question then becomes: Can an investment business function as the loss corporation's historic business? The answer would appear to be yes. This is true despite the fact that in Exel Corp. v. United States, the loss corporation was denied the right to carry forward its NOLs when its only activity at the time of, and immediately following, the ownership change was investing in short-term government securities.
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