Thirteenth century Persian poet Rumi once said: "Don't grieve. Anything you lose comes round in another form." So it goes sometimes with net operating losses (NOLs). When the owners of a corporation with NOLs look to sell all or part of the company, the NOLs may be one of the principal components of value. If one assumes a combined federal and state tax rate of 40%, a $5 million NOL has an ostensible value of $2 million. In order to prevent corporations from trafficking in tax losses, Congress enacted section 382 of the Internal Revenue Code, a section whose complexity would make Hegel's head swim, but distilled to its basics says that if new owners acquire more than half of a corporation's stock, then the ability to use its NOLs going forward is severely restricted.
 
This, as one might guess, has lead to a closet industry in how to best preserve NOLs in corporate acquisitions and recapitalizations. Similarly, what happens when a profitable corporation is sold, but after the sale the corporation generates NOLs that could be carried back to obtain refunds? The Seller might argue that it owned the corporation when the taxes were paid so it should be entitled to the refund. The Buyer, of course, would argue that it owns the corporation and any tax attributes. Not surprisingly, the IRS has weighed in on this issue.
 
In a recent situation addressed by the IRS Chief Counsel's office (CCA 201310039), one Parent corporation of a consolidated group sold two subsidiaries to a Parent of a different consolidated group. At the time of the sale, the parties agreed that Buyer would waive the right to carry back any NOLs after the acquisition was complete. Lo and behold, the Targets started losing money, and the crafty Buyer approached the Seller again and proposed that they split the tax refunds. The parties agreed, and the Seller applied for the refund (as it arose during the years that the Targets were part of Seller's consolidated group). Seller then paid a portion of the refund to Buyer. Everyone was happy. And then the IRS showed up.
 
The IRS addressed whether the refund was taxable to the Seller, and whether Seller was entitled to a deduction for the portion of the refund paid to the Buyer. The IRS started from the premise that a federal tax refund is not taxable to the recipient, as it is essentially a return of taxes paid that were never owed. In this case, the Target "owned" the tax refund, under both the consolidated return rules and under state law, as it generated the NOLs that entitled it to the refund. Under the consolidated return rules, Seller was simply Target's agent in applying for and receiving the refund. Because Seller had no independent right to receive the refund, the IRS treated the refund (net of the amount paid to the Buyer) as the Seller's sales price for entering into the post-closing NOL Agreement.   Although Seller was only required to report the net amount as consideration for the NOL Agreement, the IRS made it clear that Seller was entitled to no deduction for the amount of the refund paid to the Buyer.
 
At least, everyone knows what the rules are now. Except the IRS ruled on almost the exact same fact pattern as recently as 2005 and came up with a diametrically different answer. In PLR 200518014, the IRS held that the Seller's payment to Buyer was ordinary income to the Buyer and the Seller was entitled to an ordinary deduction on the payment. Although not addressed specifically in the ruling, it appears that the IRS treated the receipt of the refund by Seller as tax free.
 
The 2005 ruling, although a much longer and more complete analysis than the Chief Counsel Advice, was generally scorned by the commentators, and the new ruling is closer to the way the commentators would have addressed the issue. But the two rulings illustrate the complexity of this area of law, and demonstrate the need for careful and thoughtful tax planning in any transaction involving sales, capital infusions or other combinations of businesses. Contact your CBIZ MHM tax advisor well in advance of any contemplated transaction to help guide you through the potential pitfalls.
 

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