Whether startup stock issuances caused a section 382 ownership change

Plain-English summary

Chief Counsel analyzed whether several early stock issuances by a startup loss corporation should be treated separately or integrated as part of its initial capitalization for § 382. Treating the later issuance as a separate testing date would produce an ownership change on a subsequent financing date; integrating it with the first issuance would not. Because the answer was fact-dependent, the memorandum discussed the governing rules, factual development, and litigation hazards without making a final recommendation.

Ruling snapshot

• Question: Did the startup loss corporation experience a § 382 ownership change on the later financing date?
• Outcome: Advice given. The result depended on whether early stock issuances were separate testing dates or an integrated initial capitalization.
• Key authorities: IRC § 382; Treas. Reg. §§ 1.382-2 and 1.382-2T

Full text (IRS public release)

     Office of Chief Counsel
     Internal Revenue Service
     Memorandum
     Number: 201432015
     Release Date: 8/8/2014
     CC:CORP:B03 ------------------                   Third Party Communication: None
     POSTF-138950-13                                  Date of Communication: Not Applicable

UILC: 382.00-00

date: April 21, 2014

to: Saima Ghafoor
(LB&I:HMP:E:10420)

from: Mark Jennings
Branch Chief, Branch 1, (Corporate)

     --------------------
     Attorney, Branch 3 (Corporate)


     LEGEND

     LossCo        =       ----------------------------------------

     Date 1        =       ------------------

     Date 2        =       ------------------

     Date 3        =       ----------------

     Date 4        =       ------------------

     Date 5           =    ----------------------

     First Investors =     -----------------------------------------------------------------------------
                           ------------------------------------------------------------------------------------------
                           ------------------

     Investor 1        =    --------

     Investor 2        =    ------------------------------

     Investor 3        =    --------------------

Investor 4 = ------------------------------------------------------------------------

a = --------------

b = -----------

c = -------------

d = ----------

e = -------------

f = -------------

g = ---------------

h = --------------

i = ---------------

This memorandum responds to your request for assistance in the above named case.
This advice is based on the facts that you have previously sent to us and may not all be
reproduced here. This advice may not be used or cited as precedent.

SUMMARY

Since LossCo was a loss corporation at the end of its first taxable year after formation, it
is subject to the loss limitation rules of section 382 in that year. In that year,
acquisitions of LossCo stock occurred on Date 1, Date 2, Date 3, and Date 4. The
regulations count all stock acquisitions after the first one as a testing date from which to
measure the amount of the percentage of owner shift (measured by value) caused by
the stock acquisition. LossCo argues that its first three stock acquisitions should be
integrated and treated as one acquisition because they were part of a plan to provide
the initial capitalization for LossCo and they occurred before LossCo engaged in any
business activity. (LossCo agrees that Date 4 was after the start of business activity.)
The change of ownership of 5 percent shareholders from each stock acquisition in this
case, is such that, if the acquisition on Date 3 is treated separately from those on Dates
1 and 2, Date 3 will be a testing date within the testing period of Date 5, and LossCo will
have an ownership change on Date 5. But, if the stock acquisitions on the three dates
are treated as one acquisition, Date 3 will not be a testing date, and so Date 3 will not
be within the testing period of Date 5, and LossCo will not have had an ownership
change on Date 5.

ISSUES

Did LossCo experience an ownership change on Date 5 under section 382?

CONCLUSIONS

This memorandum discusses the relevant provisions of section 382, its legislative
history, and its regulations, as well as other relevant law. The memorandum also
provides guidance as to relevant factual development and litigation hazards. The
memorandum does not make a final recommendation as the inquiry involved is fact
dependent.

FACTS

On Date 1, prior to the issuance of any LossCo stock, LossCo entered into an
agreement (“the Agreement”) with First Investors to sell them convertible preferred
stock. This convertible preferred stock was issued on Date 1 for $a. This amount was
deposited in a money market account the next day. The Agreement gave Investor 1
and Investor 2 an option to purchase convertible preferred stock.

On Date 2, LossCo issued restricted common stock to four employees/consultants
pursuant to employment agreements entered into three to four weeks before Date 1.
These four individuals are unrelated to the First Investors and not involved in the
Agreement. (Date 2 will not be mentioned hereafter since the relative value of the
common stock to the convertible preferred stock is so low; it turned out to have had no
effect on when LossCo had an ownership change.)

On Date 3, pursuant to the option in the Agreement, LossCo issued b shares of
convertible preferred stock to Investor 1 in exchange for $c. If Investor 1 had not
exercised its option to purchase convertible preferred stock then the First Investors
would have been obligated to purchase 75 percent of the amount of stock Investor 1
purchased on Date 3.

On Date 4, pursuant to the option in the Agreement, Investor 2 purchased d shares for
$e.

LossCo was a “loss” corporation for the tax year that included Date 1 through Date 4.
LossCo claims that Date 3 was the date it commenced business operations.

On Date 5, f shares of convertible preferred stock were issued to new or existing 5
percent shareholders for $g. Investor 3 and Investor 4, two new 5 percent
shareholders, purchased h shares of this total for $i.

LAW AND ANALYSIS

Section 382(a) generally limits the amount (the “section 382 limitation”) of a loss
corporation's loss carryovers and built-in losses that can be offset against the
corporation's taxable income in years after an “ownership change.” The “section 382
limitation” is defined by section 382(b) as the loss corporation's value (before the
ownership change) multiplied by the applicable long-term tax-exempt bond rate (defined
in section 382(f)). A “loss corporation” is defined by section 382(k)(1) as a corporation
with a net operating loss or “net unrealized built-in loss” (as defined by section
382(h)(3)).

The pivotal event that triggers the operation of section 382 is an “ownership change,”
which occurs under section 382(g) whenever, immediately after (i) an owner shift
involving a 5 percent shareholder or (ii) any equity structure shift, the percentage of
stock of the loss corporation owned by one or more 5 percent shareholders has
increased by more than 50 percentage points over the lowest percentage of stock of the
loss corporation (or any predecessor corporation) owned by such shareholders at any
time during the testing period. Under section 382(k)(6)(A), preferred stock which is
convertible into another class is considered stock for purposed of section 382. As
provided in section 382(k)(6)(C), determinations of the percentage of stock held by any
person is made on the basis of value. Under section 382(i), the testing period is
generally the three-year period ending on the day of any owner shift involving a 5
percent shareholder or equity structure shift.

For an ownership change to occur there must be an increase of 50 percentage points
by one or more 5 percent shareholders. The increase of each 5 percent shareholder is
determined separately, comparing the 5 percent shareholder’s percentage of stock
ownership immediately after the close of the testing date with that shareholder’s lowest
percentage ownership during the testing period. All increases during the testing period
are aggregated to determine whether the 50 percentage point increase has occurred
during the testing period. Treas. Reg. § 1.382-2T(c)(1).

Section 382(i)(3) states that a testing period shall not begin before the earlier of the first
day of either the first taxable year from which there is a carryforward of a loss (or of an
excess credit) to the first post-change year, or the taxable year in which the transaction
being tested occurs. Similarly, Treas. Reg. § 1.382-2T(d)(3) states that the testing
period may begin on the first day of the first year in which a loss occurs. Under Treas.
Reg. § 1.382-2(a)(4)(i), a loss corporation is required to determine whether an
ownership change has occurred immediately after any owner shift, or issuance or
transfer. Each date on which a loss corporation is required to make a determination of
whether an ownership change has occurred is referred to as a testing date. All
computations of increases in percentage ownership are to be made as of the close of
the testing date.

Under these facts, convertible preferred stock was first issued on Date 1 and convertible

preferred stock was issued on Date 3 and other dates up to and including Date 5. If
Date 3 is a testing date because it is viewed separately from Date 1, (which would mean
the testing period for Date 5 would include Date 3) an ownership change will have
occurred on Date 5. If instead Date 3 is not a testing date, because it is viewed as
integrated with Date 1 as part of the initial capitalization of LossCo, then the integrated
transaction could not be either an owner shift or equity structure shift as defined in
Treas. Reg. § 1.382-2T(e)(1), because at the beginning of the transaction LossCo had
no 5 percent shareholders from which to measure whether a 50 percent increase in
percentage of stock ownership had occurred. Thus, the testing period for Date 5 would
not include Date 3 and LossCo would not have an ownership change on Date 5.

For example, assume stock of a start-up was issued on two different dates two months
apart by a loss corporation where both issuances of stock were part of the initial
capitalization of the loss corporation, and they both occurred before business activity
had started. These facts do not present the abuse of trafficking in net operating loss
carryovers, that section 382 was designed to prevent. Congress was concerned with
situations where the shareholders who bore the economic burden of NOLs no longer
hold a controlling interest in the corporation. H. Rept. 99-426, at 256 (1985), 1986-3
C.B. (Vol. 2) 1, 256. In this example, the shareholders who purchased stock on the two
different dates were both the initial investors under the taxpayer’s plan for the
corporation’s initial capitalization and both equally bore the economic burden of the
NOLs arising after business activity commenced. The purpose of the statute would not
have been served by treating the second acquisition as a testing date within the testing
period of a subsequent testing date.

LITIGATION HAZARDS

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