Pepper Hamilton LLP: Section 382 Ruling Could Provide Venture Startups Relief When Doing Recapitalizations

Pepper Hamilton LLP: Section 382 Ruling Could Provide Venture Startups Relief When Doing Recapitalizations

By Todd B. Reinstein

A common fact pattern for many start-up companies is to issue multiple rounds of convertible preferred stock to venture capitalists to develop new products until a stream of revenue can be developed. This leaves these companies with a large net operating loss carryforward (NOL) for federal income tax purposes. Over a period of time, the NOL can become a large asset on the books of these companies and preserving its value can be difficult due to the onerous rules of Section 382.

Section 382 generally limits a loss corporation's ability to utilize its net operating losses against taxable income when the loss corporation undergoes an ownership change. An ownership change occurs when the loss corporation's 5-percent shareholders increase their ownership in the loss corporation by more than 50 percent. Thus, loss corporations that issue convertible stock usually create a testing date each time there is an issuance to determine if there have been ownershifts that aggregate toward the 50 percent limitation. The IRS recently released a private letter ruling (PLR) that addressed the Section 382 treatment of multiple recapitalizations of convertible preferred stock that could have a significant impact on how venture-backed companies evaluate the tax impact of a recapitalization.

PLR 2010390131

In the PLR, the loss corporation completed a private issuance of Series 1 convertible preferred stock to a group (Group A). At a later date, the loss corporation issued Series 2 convertible preferred stock to direct public groups of the loss corporation. The convertible preferred shares in both Series 1 and Series 2 were convertible at a set conversion price, subject to certain adjustments.

Following the Series 2 issuance, the conversion price for the Series 1 convertible preferred stock was reset under the terms of an anti-dilution adjustment mechanism in the investor agreements (Reset). In connection with this Reset, the loss corporation exchanged shares of the originally issued Series 1 convertible preferred stock for an equal number of shares of New Series 1 convertible preferred stock. Except for the reset conversion price with identical terms and conditions, the New Series 1 preferred shares had the same terms and conditions as the old Series 1 convertible shares.

The loss corporation then issued newly created Security A and a warrant to acquire shares of common stock in exchange for all of the shares of New Series 1 preferred stock held by Group A (the Series 1 Exchange) on a future date with Security A generally having the same voting rights as the common stock. The loss corporation issued shares of common stock in exchange for shares of Series 2 convertible preferred stock and shares of certain other preferred stock (the Series 2 Exchange). Unlike the Series 1 and Series 2 convertible preferred stock offerings, the preferred stock received in the Series 2 Exchange was not considered stock for purposes of Section 382 purposes under Section 382(k)(6)(A).2 In the final date of the PLR, the Security A held by Group A was converted into shares of loss corporation common stock pursuant to the terms of Security A (the Conversion).3

The IRS held that the shares issued in the Reset, Series 1 Exchange, Series 2 Exchange and the Conversion transactions would be allocated to the loss corporation's direct public groups in the same proportion as each group's ownership of the tendered instruments. Although the exact effect of this is not described in the PLR, this likely had a favorable result for the loss corporation on measuring the cumulative ownershift for purposes of Section 382.

Pepper Perspective

Because of the lack of Treasury Regulations or other guidance on many issues that arise in a Section 382 analysis, significant weight is often accorded to PLRs to get a sense of the IRS's position on the issue. The best authority for a particular taxpayer with these issues would be a private letter ruling issued to their specific events. If that is not possible, however, it is helpful to apply the reasoning provided to other taxpayers on similar issues when determining a specific resolution.


1 PLR 201039013 (October 1, 2010). A PLR may not be cited as authority by a taxpayer, but it does evidence an IRS position on the matter.

2 Presumably, the preferred stock met the requirements of Section 1504(a)(4).

3 The loss corporation in the Reset, Series 1 Exchange, Series 2 Exchange and the Conversion treated these transactions as tax free under Section 368(a)(i)(E).

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

This article is republished with permission of Pepper Hamilton LLP. Further duplication without the permission of Pepper Hamilton LLP is prohibited. All rights reserved.


Discover the features and benefits of LexisNexis® Tax Center

For quality Tax & Accounting research resources, visit the LexisNexis® Store

For more information about LexisNexis products and solutions connect with us through our corporate site.