Tax News
An agreement between a NOL target and a group of investment funds triggers the Section 382 five-percent shareholder rule
April 17, 2012
Administrative Actions
Section 382 generally limits the availability of NOLs for post-acquisition periods if there is a 5% shareholder ownership change in the target company.  This provision is particularly important to both vulture investment funds and the target bankrupt companies the funds are acquiring.  NOLs are often priced in the deal and the parties to the acquisition go to great lengths to make sure that the Section 382 rule is not triggered by the fund’s investment.  If the rule is triggered, the utility of the NOLs is lost and the fund’s future cash flows are less than anticipated.

In PRESP-102473-11 the Office of Chief Counsel (Corporate) had to decide whether a group of investment funds should be considered as a single entity for purposes of the 5% shareholder rule of Section 382. This issue is very important because if the funds are considered as a single entity, potentially, the acquisition of stock in the target could evaporate all of the target’s NOLs.  In this ruling the funds had varying amounts of overlapping beneficial ownership and were managed by a common group of individuals that acted through several entities and LLC.  The bankrupt target was concerned that the investment funds could be viewed as a single acquirer, and thus, trigger Section 382. The target and the funds entered into an agreement whereby the funds could acquire additional shares in the target, provided each fund would own Y shares or less, and the ownership of each fund would be treated separately and not aggregated for Section 382 purposes. If the ownership were aggregated for Section 382 purposes, however, the agreement treated the acquisition by the funds in excess of Y as void ab initio.

The IRS reasoned that an entity for purposes of the 5% ownership rule includes a group of persons who have a formal or informal understanding among themselves to make a coordinated acquisition of stock. A principal element in determining if such an understanding exists is whether the investment decision of each member of a group is based upon the investment decisions of one or more other members.  Then the Service pointed out that based on the agreement between the funds and the target, no fund had its own acquisition limit within which to operate. To avoid exceeding the maximum ownership limit in the agreement, each fund had to know how much target common stock the other funds were acquiring. The failure of each fund to calculate its own, separate, ownership limit made coordination between the funds regarding the acquisition of target common stock necessary.

 The facts in the ruling are scant and the IRS’ reasoning based on the stated facts is somewhat confusing. For example, the facts state that each fund had a limit of Y but the IRS based its decision on the fact that no fund had its own acquisition limit within which to operate. Nonetheless, I thought that the ruling is important for the following reasons. It shows that the IRS would consider Section 382 agreements between a target and a group of funds as a factor in determining whether the funds as a group should be treated as one owner for purposes of the 5% shareholder rule. More importantly, however, the ruling gives a clear bright red alert that any such agreements should set separate stock acquisition limits for each fund and that those limits should be computed independently without factoring in the maximum ownership of the group of funds as a whole and without referencing the ownership of any of the other funds. In other words, any such agreements should not give an indication that the investment decision of one fund is based upon the investment decisions of another fund. Drafting agreements to the contrary could lead to treating the group of funds as one entity, which seems counterproductive considering that the agreements between the acquirer and target are usually designed to deal with the Section 382 five percent shareholder issue in the first place.
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Tags: 5% shareholder, five percent shareholder, net operating losses, NOLs, Section 382