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Stock Options May Trigger Unexpected Loss Carryforward Limitation

January 1989

Corporations with net operating loss carryforwards should be aware of the very complex (and sometimes surprising) rules implemented by the 1986 Tax Reform Act which can severely limit the deduction of net operating loss carryforwards by corporations undergoing changes in stock ownership. Although the policy underlying these rules is to prevent corporations from avoiding tax liabilities by acquiring companies with substantial loss carryforwards, they also can have an impact on corporations which have not been acquired or sold in the everyday sense in which those terms are understood.

In general, limitations will apply if shareholders increase their ownership in a loss corporation by more than one-half of the value of all of the outstanding securities of the corporation (a “50 percent point” change) over a defined testing period of up to three years. As a worst case example, if such an ownership change were to occur, a corporation with a $1,000,000 loss carryforward would be able to use only a very small portion of that loss to offset income in the current tax year. The remainder would be carried forward to later years (up to a maximum of 15) and the amount of the usable carryforward would be recalculated each year with similarly disadvantageous results.

In determining whether the limitation will apply, corporations should be aware that any stock options which are outstanding on the date of a stock transfer will be deemed to be exercised and will be added to the computation of the ownership change. Ignoring this rule could result in the inadvertent and severe limitation of loss carryforwards triggered by even a small change in ownership.

The issue arises under long-awaited temporary regulations issued by the I.R.S. which explain the application of the 1986 rules, the treatment of stock options and the computation of the limitation. Very generally, these regulations provide that a corporation must determining if the limitation applies whenever a shareholder, or certain groups of shareholders, who own over 5% of the corporation’s stock, either increase or decrease an ownership interest. At that point, called an “owner shift,” the percentages of stock of the corporation owned by all of the 5% shareholders must be added together to determine if there has been an aggregate increase of over 50 percentage points over the lowest percentage held by the same shareholders during the testing period. If the increase is over 50 percentage points, an “ownership change” has occurred, and the corporation’s deduction for a net operating loss carryover in the current year is limited to the value of the stock of the company prior to the ownership change multiplied by the current federal long-term tax exempt rate.

As noted, the determination of whether the limitation applies is further complicated by the rules applying to the issuance and transfer of stock options themselves. In most cases, the issuance or transfer of an option to a 5% shareholder constitutes an owner shift. If a loss corporation has options outstanding on the date of an owner shift, or if an owner shift is created by the issuance or transfer of options, the options are deemed to be exercised if such exercise would result in an ownership change of over 50 percentage points.

As a practical matter, corporations will usually not be able to avoid this rule by issuing other types of stock rights, since the definition of “options” includes stock warrants, stock rights, convertible debt instruments, some types of convertible stock and contracts to acquire stock. In addition, unlike stock transfers, there is no limit on the testing period for options. This rule, called the “evergreen effect,” means that an unexercised option must be tracked for its entire existence whenever there is an owner shift by a 5% shareholder. However, once an option has been deemed exercised for purposes of imposing the limitation on one occasion, it will be disregarded for purposes of determining if there is an ownership change at later testing dates or on the date of the option’s actual exercise.

There is an exception to these rules for corporations with relatively small net operating loss carryforwards. In addition, a few types of options are excluded from the rules (e.g., under certain circumstances, options with respect to stock actively traded on an established securities market). Finally, corporations are required to maintain records to determine if there has been an ownership change and to file a statement with their tax return disclosing owner shifts and other information.

TLB Comment : Corporations with valuable loss carryforwards would be well advised to consult their accountant or attorney before issuing any securities of any type, since their utilization of these losses can be drastically curtailed by deceptively insignificant transactions.