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As companies emerge from the financial crisis and begin to consider applying NOLs against taxable income, two older court rulings seem more relevant than ever.
Robert Willens, CFO.com | US
March 15, 2010
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.
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."
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.
The court, in denying the carryover on COBE grounds, observed: "we find no substantial evidence to support a finding that [Eclipse's] investment activities constitutes a trade or business." The court pointed out that Eclipse had failed to establish that its purchase of short-term government securities in the interval between the sale of the lumber assets and the redemption of the stock constituted a trade or business.
Later, however, in Honbarrier v. Commissioner, 115 T.C. 300 (2000), the court noted that a corporation that had historically been engaged in the trucking business had successfully shifted its business focus to investing for its own account. The court found that (1) a corporation's historic business is "the business" it has conducted most recently and (2) the instant corporation's most-recent business type activity was acquiring and holding tax-exempt bonds (obtained with the proceeds of the sale of its trucking assets) and this was its historic business at the time of the merger.2
Therefore, two conclusions seem inescapable: the first is that, even after an ownership change has transpired, the income (subject to the dictates of the Section 382 limitation) against which a corporation's NOLs may be offset need not be produced by substantially the same business that generated such a NOL. The second is that, for purposes of Section 382(c), an investment business can be the historic business of the old loss corporation that the new loss corporation is tasked with continuing.
The Honbarrier decision suggests that the level of activity need not be so regular, frequent, and continuous that the taxpayer is properly classified as a trader. Apparently, sporadic purchases and sales of investment securities can constitute the conduct of an investment business and, if this business is continued throughout the period specified in Section 382(c), the limitation need not be reduced to zero. This is true, moreover, even though the investment business is not the line of business that produced the losses the new loss corporation is seeking to use.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 The taxable income from any taxable year ending after the ownership change date.
2 Unfortunately, the transaction at issue in Honbarrier v. Commissioner did not, in the final analysis, qualify as a reorganization because the acquiring entity did not continue the target's historic business. The tax-exempt bonds in which the target had invested were all sold or otherwise disposed of shortly after the consummation of the merger. Thus, the court did not conclude that investing could not be a business for COBE purposes but, merely, that such business was not continued by the acquiring corporation after the merger.