Taxpayers looking to utilize net operating losses (NOLs), excess interest carryovers and certain other tax attributes need to be cognizant of the rules that could limit or eliminate them, including section 382.¹ Section 382 requires a corporation to limit the amount of its federal taxable income that can be offset by NOLs if the corporation has undergone an "ownership change." Section 382 and the Treasury Regulations promulgated thereunder require that a loss corporation calculate increases in the percentage of stock ownership of its 5 percent shareholders to determine whether an ownership change occurred on a testing date. An ownership change will occur if one or more 5 percent shareholders increase their ownership, in the aggregate, by more than 50 percentage points during a testing period. The key is a 50 percentage point shift, rather than a 50 percent increase in ownership. Under section 382(g)(2), the shift is determined by looking at all the shareholders who own at least 5 percent of the corporation based on the value of their stock and certain other groups of shareholders who are treated as 5 percent shareholders under these rules. However, to the extent that there is a decrease in the ownership of a 5 percent shareholder, section 382 does not take such decreases into account. The amount of the loss that can be used after an ownership change is generally limited to the value of the corporation immediately before the ownership change multiplied by the "long-term tax-exempt rate."

Five Percent Filers

The first step to apply the rules of section 382 is to determine which shareholders to track. After a loss, a corporation will utilize documents such as capitalization tables and SEC filings to identity its 5 percent shareholders and the percentage ownership of each 5 percent shareholder in the company on each testing date, and then compare each 5 percent shareholder’s percentage ownership of company stock on each testing date to determine if an ownership shift of 50 percentage points or more occurred.

A loss corporation’s 5 percent shareholders include individuals or public groups that own, directly or indirectly, 5 percent or more of the stock of the loss corporation. Two or more persons can be combined into a deemed "entity" for section 382 purposes when these persons have a formal or informal understanding among themselves to make a "coordinated acquisition" of stock. In addition, two or more persons who are the economic owners of stock in a loss corporation may join together to report the combined beneficial interest on a single Schedule 13D or Schedule 13G filing with the SEC. If the Schedule 13D or Schedule 13G filing does not affirm the existence of a "group" for SEC purposes under section 13(d)(3) of the Exchange Act, then the two or more economic owners do not constitute an "entity" making a coordinated acquisition of stock for section 382 purposes.

Two or more economic owners should not be treated as an entity or as a shareholder making a coordinated acquisition for section 382 purposes merely because they share the same officers, directors and/or investment advisors. Thus, two or more economic owners should be treated as separate and independent shareholders in the loss corporation unless they affirm the existence of a "group" for SEC purposes or unless the loss corporation has actual knowledge that the owners joined together in a coordinated acquisition.

Based on the above principles, a loss corporation must interpret the company’s SEC Schedule 13D or Schedule 13G filings based on the following key disclosures in each respective Schedule 13D or Schedule 13G filing:

1. whether the filer indicated that it is an investment advisor and specifically disclaimed "economic" ownership of the reported shares
2. whether the filer indicated that any other person is the 5 percent shareholder of an "economic" interest in the company through the filer’s reported interest
3. whether the filer affirmed the existence of a group under section 13(d)(3) of the Exchange Act.

Private Letter Ruling 201902022

The IRS addressed the identification of 5 percent shareholders in its recently released PLR 201902022 (Feb. 8, 2019). In the PLR, the taxpayer had charter restrictions on its common stock that limit new acquisitions to persons who are less than 5 percent shareholders. Additionally, the taxpayer’s wholly owned subsidiary was in a state-regulated industry that requires any investors that own a certain percentage to file an information statement with the state. In the PLR, three separate investment advisors held the taxpayer’s stock in either managed accounts or funds.

Advisor A filed a Schedule 13G that reported ownership of more than 5 percent of the taxpayer’s stock. In the Schedule 13 filing, Advisor A did not confirm the existence of a group. Advisors B and C were indexed funds that owned less than 5 percent of the taxpayer. Each, however, had contacted the taxpayer to increase its reported common stock holdings above 5 percent, but neither filed a Schedule 13D or a Schedule 13G with the SEC with respect to the taxpayer’s stock.² In connection with the letter ruling request, Advisors B and C were contacted by the taxpayer regarding their ownership, and each confirmed that it had procedures in place to comply with the state regulatory reporting if required. The taxpayer made several representations with respect to each advisor, including that it had no knowledge of a formal or informal understanding to make a coordinated acquisition of its stock and that each advisor’s activities were those of an investment advisor. The taxpayer also represented that it had no knowledge of any individual or entity that would own more than 5 percent of the taxpayer directly or indirectly, including through attribution under section 318.

The IRS ruled that an individual or entity that has the economic ownership of the stock (right to receive dividends and sales proceeds) was the owner for section 382 purposes and that the investment advisors’ power to vote the shares did not mean they have economic ownership. Additionally, the managed funds and accounts of each advisor were not collectively considered an entity for section 382 purposes.

Pepper Perspective

While there are other private letter rulings that also separate the SEC reporting of 5 percent shareholders from the substance of being a section 382 5 percent shareholder, PLR 201902022 serves as good guideline of the type of representations that are needed to count as 5 percent shareholders. This is a very fact-intensive analysis and often requires reaching out to individual shareholders. In the case of a public company, we strongly advise the loss corporation’s tax preparers to use caution in gathering this information as it is a communication between the company and one shareholder. Taxpayers in this situation may want to seek counsel or have an intermediary contact the entity filing with the SEC.

Endnotes