Capital Contribution to Struggling Corporations a Trap with a Glimmer of Hope

With a struggling economy, many previously successful corporations find themselves in desperate straits.  One of the consequences of a weak economy is generating “net operating losses (“NOL”).  At times when all else fails, a corporation’s un-utilized NOL becomes its most valuable asset.

However, usually before corporations sell their NOLs, they (and their owners) try mightily to “turn-around” their operations.  Those efforts are funded by loans or capital contributions from both current owners and “angels”.  An NOL’s value to a third party is controlled by an evolving provision in the Internal Revenue Code (the “IRC”).  Correspondingly, shepherding the NOL’s value becomes a meaningful exercise.

Transferring corporate NOLs –

Historically, Congress and the Internal Revenue Service (the “IRS”) took repeated steps to restrict and devalue NOLs transferred to those who didn’t create them.

Caveat:  Discussions of the “separate return limitation year” (aka “SRLY”) consolidated return regulation limitations are beyond the scope of this web piece, but the ensuing discussion below is applicable in both consolidated and separate return environments.  See Treas. Reg. § 1.1502-21A(c), et. seq.

Early on, IRC § 382 restricted “trafficking in NOLs” be denying an NOL’s use by an acquirer if the NOL’s acquisition was tax avoidance motivated.  Using a subjective standard was not satisfactory to both taxpayers and Congress.

This “early” subjective standard was subsequently replaced by an “objective” standard.  Generally, the objective standard imposes a limit on the NOL’s use if during a three (3) period a more than 50 percentage point increase stock ownership among 5% owners occurs.  If such ownership change occurs the corporation’s NOL whose stock is the subject of the ownership change can only be applied to that amount of income equal to the product of the corporation’s fair market value (“FMV”) at the time of the ownership change multiplied by the “federal long-term tax-exempt rate” (aka the “382 Limit”).

The FMV factor within the 382 Limit was frequently inflated by current owner-pre-ownership change capital contributions.  Customarily, the price of the acquired corporation’s stock was increased by the amount of those capital contributions making those contributions’ real substance the inflation of the 382 Limit (i.e. the amount of income against which the acquired NOL could be utilized).

IRC § 382 was amended to prevent this “scheme” by adding “anti-stuffing” provisions.

When is a capital contribution within the “anti-stuffing” trap?

If a capital contribution is within the “anti-stuffing” provisions it isn’t part of the loss corporation’s FMV and hence the 382 Limit is unaffected.  Generally, any capital contribution made within two (2) years of the ownership change is presumed to be part of a plan a principal purpose of which is to avoid or increase the 382 Limit, unless the regulations provide otherwise.   In short, well intentioned capital contributions made to “save the corporation” are at risk of being snared by the anti-stuffing provisions.

Relief – maybe yes; maybe no –

This two (2) year “presumption” was ameliorated in 1986 Congressional Committee Reports where (a) capital contributed at the corporation’s formation, (b) contributed prior to incurring losses, and (c) capital contributed for basic working capital they aren’t to be part of “stuffing”.  The IRS articulated four (4) “safe harbor” anti-stuffing presumption limitations in an notice.

The safe harbors are unfortunately hyper-technical so owners of “loss corporations” with un-utilized NOLs should contact their H&M tax advisor before attempting, or permitting others, to make contributions to the loss corporation’s capital.