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