Escaping Post-Bankruptcy Tax Constraints

When product liability claims lead to Chapter 11, the "bankruptcy exception" can protect net operating losses from Sec. 382 limitations.
Robert WillensNovember 6, 2002

Bankruptcies that stem from product liability claims—like asbestos—can hound corporations even after the company satisfies the claimants and emerges from insolvency. Witness the company executives that aim to preserve and utilize, as quickly as possible, the net operating losses(NOLs) created by the settlement of product claims.

In many cases, the corporation, in the course of emerging from bankruptcy, also issues new securities to various classes of claimants, and experiences an ownership change. In general, when a loss corporation experiences an ownership change, its NOLs can only be used to a limited extent in future years.

More specifically, the amount of taxable income (in any year ending after the date of the ownership change) that the pre-change NOLs can offset cannot exceed the so-called “Sec. 382 limitation.” This limitation is an amount equal to the value of the loss corporation’s stock immediately before the ownership change, multiplied by the long-term tax-exempt rate.

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But, if the loss corporation is under the jurisdiction of a court in a Title 11 or similar case at the time it undergoes its ownership change, special ameliorative rules can apply. As a result, the Sec. 382 limitation will not apply, and the amount of taxable income the NOLs can offset is not limited.

Note however, that the amount of the NOLs may be reduced to the extent of certain interest deducted by the corporation with respect to indebtedness converted into equity in the bankruptcy case. Therefore, the conversion must take place during the period that begins on the first day of the third year preceding the year in which the ownership change occurs. It also must extend through the date of the ownership change. See Sec. 382(l)(5).

For this special rule (known as the “bankruptcy exception”) to apply, the loss corporation must be under the jurisdiction of the court in a Title 11 or similar case—such as a receivership, foreclosure or similar proceeding in a court. In addition, the corporation’s shareholders and “qualified creditors” must emerge with at least 50 percent (measured by voting power and value) of the reorganized debtor’s stock.

For this purpose, a qualified creditor is: (1) one who has held the claim for at least 18 months prior to the filing of the bankruptcy case, or (2) one whose claim arose “in the ordinary course” of the debtor’s trade or business, but only if such claim has, at all times, been held by the same beneficial owner.

Here’s a practical example put forth in the Internal Revenue Service’s LTR 200242035. In that letter, a corporation’s product liability claims overwhelmed its available cash flow and insurance coverage. Thus, the company was forced to file a petition in U.S. Bankruptcy Court. The arrangement called for the establishment of a “Sec. 524(g)” trust that was to be funded with a sufficient amount of the corporation’s securities to constitute an absolute majority of its voting stock.

The trustee of the trust, at the same time, assumed all present and future liabilities for product liability claims. Clearly, the corporation experienced an ownership change based on the issuance of stock to the trust.

However, the company’s NOLs were “protected,” because concurrently, with respect to ownership change, the company qualified for the bankruptcy exception. Note that in this case the NOLs were created by the company’s ability to deduct the amount of cash and the value of the securities that were conveyed to the trust. The NOLs qualified because the IRS ruled that the claims (that were transferred to the trust) arose in the ordinary course of the debtor’s trade or business. Therefore, these claims constituted “qualified indebtedness” to the extent that the same beneficial owner held such claims (from inception).

For this purpose, the IRS ruled that the conveyance of the claims to the trust did not break the “continuous ownership” requirement, and therefore, the trust—to which the stock was issued—was a qualified creditor for purposes of Sec. 382(l)(5). Accordingly, the bankruptcy exception protected the corporation’s NOL from the ravages of the Sec. 382 limitation.