Section 382 limits a loss corporation’s ability to use its tax net operating loss (NOLs) carryforward following an "ownership change."1 An ownership change is triggered if one or more "5-percent shareholders" of the loss corporation increases their ownership in the aggregate by more than 50 percentage points during a testing period. Once an ownership change has occurred, the amount of NOLs that the corporation may use to offset taxable income in any year is limited to the "Section 382 limitation" resulting from the ownership change.2 One of the key questions for loss corporations trying to determine if they have had an ownership change is identifying who are the 5-percent shareholders. A 5-percent shareholder, for purposes of Section 382, includes individuals, entities, and "public groups." Under Treas. Reg. Section 1.382-3(a), a group of investors should be aggregated into a single "entity" based on the investors’ understandings or communications with each other or with third persons, such as the loss corporation or an underwriter that it is coordinating an acquisition (Coordinated Acquisition Rule).
The Coordinated Acquisition Rule provides, in relevant part: "An entity includes a group of persons who have a formal or informal understanding among themselves to make a coordinated acquisition of stock.3 A principal element in determining if such an understanding exists is whether the investment decision of each member of a group is based upon the investment decision of one or more other members."4 Thus, if a group of otherwise unrelated individuals agrees among itself to acquire more than 5 percent of a loss corporation’s stock and no single member of the group owns, directly or indirectly, 5 percent or more of the loss corporation’s stock, the members of that group will nonetheless be aggregated into a separate public group that will be presumed to consist exclusively of persons unrelated to the members of any other public group that owns the loss corporation’s stock. Recently the IRS issues proposed regulations and requested comments on the application of the coordinated rules.
Three examples in the existing regulations illustrate the operation of the Coordinated Acquisition Rule. The Coordinated Acquisition Rule applied in the first two examples where: (i) a group of individuals, acting pursuant to a common agreement, acquired 60 percent of a loss corporation’s stock (with each individual acquiring approximately 3 percent of the loss corporation’s stock); and (ii) a loss corporation’s management separately convinced each of 15 investors to acquire 4 percent of the loss corporation’s stock in the market based on the understanding that the loss corporation would assemble an investor group that, in the aggregate, would acquire more than 50 percent of the loss corporation’s stock.5 The Coordinated Acquisition Rule, however, did not apply in the third example where 20 unrelated individuals, in the aggregate, acquired 6 percent of a loss corporation’s stock (with no investor individually acquiring at least 5 percent of such stock) based on the advice of a common investment advisor, but where no understanding existed among the investors to purchase the stock.6
Although these examples are helpful, it is often difficult for a loss corporation to obtain this information from its shareholders to make a determination as to the application of the Coordinated Acquisition Rule, particularly if it is a public company. Often the economic owners sharing a common investment advisor will file a Schedule 13D or Schedule 13G with respect to loss corporation stock with the Securities and Exchange Commission, with the investment advisor reporting the shares even though it is merely a custodian for the loss corporation shares, and the investment advisor, in its filing, does not confirming the existence of a "group" within the meaning of Section 13(d)(3) of the Securities Exchange Act of 1934.7 In these situations it is common for economic owners of the stock to not file a Schedule 13D or 13G themselves. Thus, it can be difficult for a public company to determine whether or not the acquisition is considered a coordinated acquisition with the stock being treated as one entity for Section 382 purposes.
It’s also common for related private equity funds, distressed debt funds or other investment funds to acquire loss corporation stock where they share the same investment objectives and typically invest in the same stock and invest the same percentage of each fund’s assets in such stock and, yet, have no plan or understanding among the parties to coordinate their stock acquisitions for the above purposes. These funds often have different investment managers who can make purchasing and selling decisions independently of each other.
In PLR 200806008, the IRS ruled that if an investment manager files a Schedule 13D or Schedule 13G that reports ownership on behalf of two or more economic owners of shares representing, in the aggregate, more than 5 percent of a loss corporation’s stock, and those economic owners do not file a Schedule 13D or Schedule 13G that affirms the existence of a group, the loss corporation can rely on that absence to determine that the economic owners are not members of a group that constitutes an entity under the Treasury Regulations.8 Accordingly, neither the investment manager nor its clients constituted an entity whose members are properly regarded as a public group. The IRS reasoned that the mere fact that the investment advisers in PLR 200806008 retained the right to vote the stock that they had acquired on behalf of their clients and possessed discretionary powers to acquire or dispose of that stock did not mandate that the clients constituted a group of persons who had a formal or informal understanding among themselves to make a coordinated acquisition of stock. The investment decision of each client was not based on the investment decision of any other client. Their only connection was that they were clients of a common investment manager that had, in its discretion, purchased shares of the loss corporation on behalf of those clients. That sort of connection is not nearly sufficient to transform a group of clients who are unaware of one another’s existence into an entity whose ownership of stock must be aggregated in assessing whether the loss corporation in whose stock they have invested has undergone an ownership change.
In the continuing saga, the IRS released chief counsel advice 201215007 (the ILM) on January 5, 2012 to further address the issue.9 The ILM was in response to a taxpayer that had submitted a private letter ruling request on the application of the entity rules in a bankruptcy situation and that later withdrew the private letter ruling request. In the ILM, the taxpayer was the parent of a consolidated group that had filed a chapter 11 bankruptcy.10 There were several funds that held varying amounts of overlapping beneficial ownership of the taxpayer and were managed by a common group of individuals that act through several entities and an LLC, which the group of individuals owns. The group of funds sought to acquire more shares of the taxpayer in bankruptcy. The taxpayer was concerned that if the funds were grouped together and treated as one entity, that may create an ownership change limiting its ability to use its NOL carryforward. The taxpayer agreed the funds could acquire additional shares, provided each fund would own a certain number of shares or less, and the ownership of each fund would be treated separately and not aggregated for Section 382 purposes under an agreement. If the ownership were aggregated for Section 382 purposes, however, the agreement treated the acquisition by the funds in excess of the shares acquired as void ab initio. Unless waived by the taxpayer, the funds would be required to sell any shares held in excess of the shares acquired. The number of shares to be sold by the funds would have been calculated for the group as a whole because the group’s ownership would have been aggregated. The funds proceeded with the acquisition per the agreement. In the ILM, the IRS noted that no fund had its own acquisition limit within which to operate under the agreement. To avoid exceeding the maximum ownership limit in the agreement, each fund had to know how much taxpayer common stock the other funds were acquiring (or not acquiring). The failure of each fund to calculate its own, separate ownership limit created coordination efforts among the funds, regarding the acquisition of taxpayer common stock, necessary. As a result, the IRS concluded that the funds were deemed to be an entity pursuant to Treas. Reg. Section 1.382-3(a)(1) as the Coordinated Acquisition Rule applied and their respective shares were aggregated for Section 382 purposes.
As evident in the patchwork of guidance, the IRS takes a very facts and circumstances approach to applying the Coordinated Acquisition Rule. Taxpayers would be advised to thoroughly consider the application of this rule when determining who is and who is not a 5 percent shareholder for purposes of Section 382.