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Introduction, Notice 2010-50
The Internal Revenue Service (IRS) released Notice 2010-50 on June 11, 2010, which provides guidance on fluctuations in value between different classes of corporate stock when measuring owner shifts for Section 382 purposes. The notice outlines two separate methods for applying the Section 382(l)(3)(C) "fluctuation in value" rules.
Section 382, In General
Congress enacted Section 382 to prevent "trafficking" in federal tax net operating losses (NOL). Section 382 generally limits a loss corporation's ability to use its historic NOLs against future taxable income if such loss corporation undergoes an "ownership change." An ownership change occurs when one or more of the loss corporation's 5-percent shareholders increase their interest in the loss corporation by more than 50 percentage points.
Section 382(l)(3)(C), Fluctuation in Value Statute
Section 382(l)(3)(C) states that "[e]xcept as provided in regulations, any change in proportionate ownership which is attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account." For many years controversy has existed as to how to interpret the "fluctuation in value" rules found in Section 382(l)(3)(C), with respect to determining how much of the ownership percentage is carried by each class of stock on each testing date, in order to determine if an ownership change has occurred under Section 382.
Without this special rule, a loss company could presumably undergo an ownership change as its fortunes gradually changed for the worse and the preferential terms of preferred classes of stock kick in to cause the preferred stock to represent a larger portion of the overall equity of the loss company, as compared to the common stock. Given that the policy behind Section 382 focuses on not allowing new shareholders to benefit from the losses of the company that were accumulated before they were owners, there is no reason to cause an ownership change and impose a limitation when no shareholders change and no equity changes hands.
While the IRS has issued rulings to specific taxpayers over the past few years clarifying how Section 382(l)(3)(C) should be interpreted for the taxpayer's situation,1 Notice 2010-50 provides more general guidance that will be helpful to loss companies that do not obtain a private letter ruling on their specific facts.
Two Methods of Application
In interpreting the fluctuation in value rules, Notice 2010-50 adopts two methodologies with one methodology allowing for two alternative approaches.
FVM - Full Value Methodology
The first methodology is the "Full Value Methodology" (FVM), which is close to a strict interpretation of the statutory language. Under the FVM the ownership interest of each shareholder is determined on a pure valuation approach on each testing date, regardless of whether a particular shareholder or group of shareholders does anything to affect their equity ownership. For example, if a testing date is triggered because of the issuance of stock under an employee stock purchase plan, then each class of stock of the loss corporation is valued and compared to the overall value of the loss corporation. The FVM approach would require the loss corporation to take into account any fluctuations in value that occurred since the loss company's last testing date in determining the percentage ownership shifts among the 5-percent shareholders. The notice provides that the FVM is essentially a "mark-to-market" approach for all shares on each testing date. Under this approach, there would be no "mark-to-market" until an equity event occurred to trigger a testing date.
HCP - Hold Constant Principle
The second methodology is more complicated. The "Hold Constant Principle" (HCP) is the approach taken by the IRS in several recent private letter rulings.2 The HCP essentially allows the relative value of each class of stock to be set at the time the stock is issued by "holding constant" the value of the new class of stock compared to the existing classes of stock at the issuance relative value for purposes of valuing such stock on subsequent testing dates. The HCP is applied by issuance and by shareholder. In addition, dilutive adjustments are made for subsequent issuances and accretive adjustments are made for subsequent redemptions. HCP, nevertheless, takes into account value fluctuation for actual acquisitions of stock.
Notice 2010-50 includes an example of the Hold Constant Principle. In the example in the notice, on Date 1 Shareholder A purchased one share of preferred stock for $20 and Shareholder B purchased two shares of common stock for $80 (80 percent). Two years later the common stock of X is worth $2.50 a share and the preferred stock is worth $20. B sells one share of common stock to C. For purposes of determining whether X has an ownership change, the percentage changes will be calculated as follows:
Testing Date %
% Change Increase
Thus, only a 10-percent increase in percentage ownership has occurred because of this sale.
The IRS will not challenge a taxpayer's application of the HCP (or the FVM) as long as such method is reasonable and applied consistently. Specifically, the IRS mentions two separate alternatives that can be used to apply the HCP, and that both of the described HCP alternatives are considered reasonable.
Alternative one calculates the percentage interest represented by a tested share on a testing date beginning with the value of such share on the testing date and then adjusting such percentage of value based upon changes in the relative value of the subject share to other stock of the loss corporation that has changed in value since the tested share's acquisition date. Once a particular shareholder sells its stock, the percentage owned by him is adjusted to take the disposition into account. Thus, it appears that in order to take advantage of the HCP, the relevant shareholder cannot have participated in any transaction in its stock that adjusted the value or percentage interest in the tested shares, or sold or disposed of the relevant shares in a transaction occurring on a testing date. Therefore, if the shareholder "holds constant," there is no percentage change adjustment with respect to his particular ownership percentage.
Under the second alternative in the HCP approach, the percentage interest in the loss corporation that is represented by the tested share is determined on its date of issuance, adjusting for subsequent dispositions and for the subsequent issuances or redemption of other stock. If the holder of these shares does not buy or sell additional stock, their percentage increase in the loss corporation associated with the stock will not increase because of another shareholder's actions, except for redemptions by the corporation. The IRS observes that alternative two may result in fewer calculations by the loss corporation on subsequent testing dates.
Because of the timed approach of the HCP methodology, dispositions of shares held by shareholders that acquired their stock at various points in time may create differing percentage ownerships. In determining which shares are being disposed of on a particular disposition date, the loss corporation may take the shares pro rata from all owned shares or use a LIFO method or FIFO method to determine which shares must be taken into account in calculating the percentage interest that is being transferred. Whichever methodology is chosen must be applied consistently by the loss corporation on subsequent testing dates.
The IRS will not treat certain methods as "reasonable" under Notice 2010-50. For example, the notice states that "the IRS intends to challenge a methodology that fixes the relative fair market value of a class of preferred stock to common stock on the issue date of the preferred stock, regardless of the actual value of either class on the subsequent date that a shareholder whose percentage ownership is being computed acquires a share of either such class of stock." Thus, a corporation taxpayer may not "freeze" the relative values of common and preferred classes of stock notwithstanding fluctuations in value and additional transactions in such stock.
Reliance on Notice 2010-50
As mentioned above, Notice 2010-50 specifically allows loss corporations and their shareholders to apply reasonable methods of measuring increases in ownership where fluctuations in value of various classes of stock are present. In this regard, the IRS will not challenge any reasonable application of either an FVM or an HCP, provided that a single methodology (i.e., if using HCP applying LIFO conventions for share dispositions, etc.) is applied consistently as required in the notice. The IRS believes that both alternative one and alternative two of the HCP methodology are reasonable applications of HCP.
Taxpayers may rely on Notice 2010-50 prospectively until additional guidance is issued under Section 382(l)(3)(C). In addition, taxpayers may apply the notice retroactively to any past tax year that is still an "open year" not barred by the statute of limitations. Notwithstanding this permitted retroactive application, taxpayers may not employ a methodology under the notice for an open year if employing such methodology for that open year would have changed the taxpayer's federal income tax liability for a "closed year" barred by the statute of limitations.
These rules represent an administrative acknowledgement of a ruling position that has been consistently applied by the IRS over the past few years and provides welcome operating procedures for taxpayers seeking to apply the fluctuation in value rules of Section 382(l)(3)(C). It cannot be used, however, to change a tax liability in a closed tax year or to nullify the effects and stock values from actual sales or dispositions of the loss corporation stock. In addition, the IRS states that it intends to issue regulations under Section 382(l)(3)(C) and would like comments on the approach these regulations should take given the approaches sanctioned in the notice and the overall policy and administrable concerns underlying Section 382 in general. Thus, as is the case with most Section 382 issues, the benefits of the FVM or the HCP methodologies will require significant information gathering on historical pricing, terms, and sales and other dispositions of the loss corporation stock over a significant period of time. Without these factual records the methodologies available to address fluctuation in value issues may not be as beneficial. In addition, a modeling exercise also will likely be required to determine the more optimal outcome using either methodology.
1 See e.g., PLR 201017004 (January 11, 2010); PLR 201017003 (January 11, 2010); PLR 201017002 (January 11, 2010); PLR 201015023 (December 30, 2009); PLR 201010009 (December 4, 2009); PLR 201005019 (October 27, 2009); PLR 200952004 (September 23, 2009).
The material in this publication is based on laws, court decisions, administrative rulings, and congressional materials, 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. Internal Revenue service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
This article is republished with permission of Pepper Hamilton, LLP. Further duplication without the permission of Pepper Hamilton, LLP is prohibited. All rights reserved.
RELATED LINKS: For further discussion of IRC Sec. 382 limitations, see:
LexisNexis Tax Advisor -- Federal Topical § 1D:15.04(8)