The short answer to the question of whether a capital raise can jeopardize your tax assets is yes. In the wake of the worst financial crisis in decades, many financial institutions are still looking for capital to satisfy regulatory demands and improve their balance sheets. But this new capital might come with a price - namely, loss of deferred tax assets due to Internal Revenue Code Section 382.
Section 382 in a Nutshell
In simple terms, Section 382 prevents corporations from trafficking in unused tax losses and credits. Take, for example, a hypothetical money-losing corporation that has been struggling for several years and has accumulated tax losses of $20 million, which at a 40 percent tax rate represent an $8 million tax benefit, or deferred tax asset. The money-losing corporation is nearly insolvent, with bleak prospects of generating future profit and, absent these tax benefits, almost zero value to a prospective buyer. Enter a hypothetical profitable corporation, which might be willing to pay $4 million for the stock of the money-losing corporation in order to use the $20 million of tax losses to offset its future taxable income and reap the $8 million benefit.
Not so fast, according to Section 382. While the $20 million in tax losses technically are available to the profitable corporation, Section 382 limits how much of those losses can be used in any one year to an amount equal to the value of the money-losing corporation immediately before the deal—let’s say that is $50,000—multiplied by a specific rate published monthly by the IRS, which currently stands at less than 3 percent. Based on these facts, the annual limit is only $1,500 ($50,000 x 3 percent). Because unused tax losses expire in 20 years (earlier in some states), at best $30,000 of the losses could be used ($1,500 annual limit x 20 years), providing a tax benefit of roughly $12,000 at a 40 percent rate. That is hardly worth a $4 million price tag.
In the previous example, we assumed a 100 percent turnover in ownership of the money-losing corporation. However, Section 382 applies any time there is a greater than 50 percentage point increase by major shareholders in their ownership of a money-losing corporation’s stock during, typically, a three-year period. Therefore, even a corporation raising capital from new or existing shareholders can run afoul of Section 382 and trigger substantial limitations on the use of its existing unused tax losses and credits, and even on the use of what is known as built-in losses.
Section 382 and Built-In Losses
Let’s take another simple example. A hypothetical bank raises capital via the issuance of new common stock and triggers a Section 382 ownership change. At the time of the ownership change, the bank has no unused tax losses or tax credits, but it has total assets with a fair market value of $200 million and a tax basis of $225 million. The tax basis in excess of fair market value, or $25 million, is a built-in loss. If the bank sells any of these assets during a five-year window (beginning from the date of the ownership change) and generates a loss from the sale, Section 382 may limit the deductibility of that loss. In addition, Section 382 also could limit the deduction of loan charge-offs claimed within a one-year period following the ownership change.
Planning for Section 382
What can be done to avoid the onerous results of a Section 382 ownership change? Planning is the key. Here are some ideas that might help avoid an ownership change altogether or mitigate its consequences:
- Raise capital from both new and existing shareholders.
- Execute a tax benefits preservation plan to guard against future stock acquisitions that might trigger an ownership change.
- Issue stock for cash, versus converting existing debt to stock, due to specific Section 382 provisions on the deemed allocation of cash-issued shares to existing shareholders.
- Dispose of certain assets in advance of an ownership change, or accelerate recognition of taxable income to potentially reduce losses subject to the Section 382 limitation.
If any of this seems confusing, that’s because it is. Section 382 is complex, but it must be considered in any capital-raising scenario where a corporation has unused tax losses, unused tax credits, or built-in losses. While it might not always be possible to structure a capital raise to avoid the limitations of Section 382, a methodical, well-thought-out strategy could preserve some or all of your tax assets.