Can there ever be such a thing as too many net operating losses (NOLs)? Surprisingly enough, sometimes the answer to that question may be "yes."
The problem arises from an obscure provision in the consolidated return regulations dealing with basis adjustments for stock of consolidated subsidiaries. The regulation requires a downward adjustment in the stock basis upon the expiration of a NOL carryover. This downward basis adjustment can even create an "excess loss account" with respect to the subsidiary that functions much like a negative basis.
The operation of this provision is best illustrated with an example. Some of the assumptions are a bit unrealistic, but they help illustrate the point without unnecessarily complicating matters. Assume that Buyer is a corporation that operates a business. Target is an unrelated corporation that also operates a business, but Target has not been doing well. The stock of Target is worth $10 million, but because of prior losses, Target has a NOL carryover of $50 million that expires in 2015.
Buyer purchases 100 percent of the Target stock for $10 million, and Target joins Buyer's consolidated tax return in 2011. Buyer's purchase of the Target stock is a change of control of Target for Section 382 purposes. Subject to a number of potentially material adjustments, Buyer's ability to utilize Target's NOL carryover is capped at an annual amount equal to the value of Target on the change of control date ($10 million) multiplied by a tax-exempt interest factor that floats monthly but is currently approximately 4 percent.
Unfortunately, the combination of Buyer and Target is not successful. Target and the combined group operate at a breakeven basis, and Target's NOL carryover expires in 2015 without ever having been used. In 2017, Buyer sells the stock of Target for $10 million, which is exactly what Buyer originally paid for the Target stock in 2011.
Buyer expects to report no taxable gain or loss as a result of the sale, having bought and sold Target's stock for $10 million. Unfortunately, Buyer has run afoul of the consolidated-return basis adjustment described above. When Target's NOL expired in 2015, Buyer was required to reduce the basis in its Target stock by $50 million representing the expired NOL carryover. This created an excess loss account with respect to the Target stock of $40 million. When Buyer sold the Target stock in 2017, this excess loss account was triggered. Buyer would be treated for tax purposes as if it had sold an asset with a $40 million negative basis. Buyer would generate taxable income of $50 million in 2017, representing the $10 million of cash it received plus the $40 million negative basis in the Target stock.
This result is clearly unfair. When Buyer purchased Target's stock, Buyer was aware that the acquisition would trigger the NOL limitations of Section 382. Knowing that it could generally utilize only about $400,000 of Target's NOL carryover each year, Buyer ascribed no separate value to Target's NOL in the purchase price negotiations and may not have even devoted much due diligence effort to determining the total size or expiration dates for Target's NOL carryover.
There are a number of steps that Buyer could have taken in a situation like this, but all require that Buyer focus on the issue. At the time of the original acquisition of Target, Buyer can elect to treat all or a portion of Target's NOL carryover as expiring immediately prior to the acquisition. This election is made on the consolidated return for the year that Buyer acquires the Target stock. This means that Buyer is forced to make the election before it knows how well the combined operation will function and how much of Target's NOL carryover can actually be used before the expiration date.
Without the election, Buyer would need to think about how to deal with the excess loss account that would be created in 2015 when the NOLs expire. Buyer might consider liquidating Target into Buyer or merging Target into Buyer. Either of these transactions would eliminate the excess loss account, but there may be a number of tax and nontax reasons for not doing so.
Buyer might also consider restructuring the sale of Target. Instead of selling Target's stock, Buyer could consider selling Target's assets. This is also not a totally desirable solution, however, because for nontax reasons it is often preferable to sell stock rather than assets.
One solution to bridge the gap might be to convert Target to a single-member LLC immediately prior to the sale. The conversion of Target from a corporation into an LLC would be treated for tax purposes as a liquidation of Target. This is typically a tax-free transaction that would eliminate the excess loss account problem. Following the conversion, Buyer could sell 100 percent of the membership interests in Target. While such a sale of membership interests would not be quite as simple as a stock sale, it would be substantially easier than a true asset sale.
Surprisingly enough, another "solution" might be to ignore the problem. As long as Buyer and Target stay together in the same consolidated group, the fact that Buyer has an excess loss account with respect to its Target stock is largely irrelevant. However, there is a big difference between ignoring a problem and not being aware that a problem exists.
The takeaway point is that Target's NOL carryovers require scrutiny in an M&A setting, even if they will never be utilized. If Target has substantial NOLs that could expire before being completely used, the NOL carryovers need to be carefully evaluated to be sure they do not eventually turn into a nasty tax surprise.