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Partners and S corporation shareholders have three hurdles to overcome before they’re permitted to deduct the losses allocated to them on Schedule K-1. First, they’ve got to have adequate basis, under either I.R.C. § 704 or I.R.C. § 1366. On the back end, they’ve got the passive activity rules of I.R.C. § 469 to deal with. Stuck in the middle of the two limitations lay the oft-misunderstood at-risk rules of I.R.C. § 465.

When an individual is engaged in certain activities,  I.R.C. § 465(a) limits the losses that an individual may claim as deductions to the amount for which the individual is “at risk” in the activity. Section 465(b)(1) provides that a taxpayer is considered at risk for an activity with respect to the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity and for certain amounts borrowed with respect to the activity. Section 465(b)(2) provides that a taxpayer shall be considered at risk with respect to amounts borrowed for use in an activity to the extent that he is personally liable for the repayment of such amounts.

While the statutory language under I.R.C. § 465 serves mainly to cause confusion, the concepts therein can be clearly explained through real life examples, as evidenced by the Tax Court’s decision today in Zeluck v. Commissioner, T.C. Memo 2012-98 (April 3, 2012).

Roy Zeluck (Zeluck) invested $310,000 in an oil and gas partnership in 2001; $110,000 was contributed in cash, and $200,000 was contributed in the form of a note maturing Dec. 31, 2009. The partnership in turn used Zeluck’s and other investors’ notes as security on a note it wrote to a drilling company. Zeluck signed an assumption agreement which made him personally liable on the partnership note up to the amount of his $200,000 liability to the partnership. This guarantee made Zeluck “at-risk” to the extent of the $200,000 loan, which when added to his $110,000 cash contribution, gave Zeluck total at-risk basis of $310,000.

In 2001 and 2002, Zeluck was allocated losses from the partnership which reduced his at-risk basis from $310,000 to $32,407. In 2003 the partnership terminated and distributed $32,407 to Zeluck, zeroing out his at-risk basist. Zeluck had not made payments of principal on the $200,000 note and failed to make certain required interest payments as well.

The IRS issued a notice of deficiency stating that Zeluck ceased to be at-risk for the $200,000 note in 2003 when the partnership liquidated. The IRS argued that Zeluck’s guarantee of the partnership’s debt to the drilling company became meaningless in 2003 after the liquidation of the partnership. As a result, Zeluck’s at-risk basis in the partnership had to be reduced from zero to a negative $200,000, requiring Zeluck to recapture $200,000 of income in 2003 under I.R.C. § 465(e):

Section 465(e) provides that if zero exceeds the amount for which the taxpayer is at risk in any activity at the close of any taxable year the taxpayer shall include in his gross income for such taxable year an amount equal to the excess.

Countering the IRS, Zeluck argued that the $200,000 debt to the partnership was genuine in 2001, 2002, and 2003, because even after the partnership liquidated, Zeluck continued to owe the drilling company for the $200,000 of debt he had previously guaranteed.

To determine whether Zeluck  had a valid debt to the drilling company for his guaranteed liability, the Tax Court examined the following factors:

(1) whether the promise to repay is evidenced by a note or other instrument;

(2) whether interest was charged;

(3) whether a fixed schedule for repayments was established;

(4) whether collateral was given to secure payment;

(5) whether repayments were made;

(6) whether the borrower had a reasonable prospect of repaying the debt; and

(7) whether the parties conducted themselves as if the debt was genuine.

After an examination of the factors, the Tax Court held that Zeluck’s note payable to the partnership was valid in 2002, but ceased to be valid in 2003:

We find that the…liabilities were genuine debts in 2002 but were not genuine debts in 2003. Our conclusion turns primarily on the lack of payments made and enforcement sought after the termination and liquidation of the partnership at the beginning of 2003. No demand for payment was made by any party upon the notes maturity date of December 31, 2009, and petitioner had made no arrangements to pay the balance due as of the time of trial, even though the amount due was allegedly accruing interest at 15%. It also appears that petitioner would not be able to pay the balance due under the note as of the time of trial, testifying that it “would be a ridiculously large check” for him to write.

Having concluded that no valid debt existed in 2003 between Zeluck and the partnership or Zeluck and the drilling company, the Tax Court applied Section 465(e) and required Zeluck to recapture $200,000 of previous losses as income.

Illustrating the principles of I.R.C. § 465 throughout Zeluck’s tenure in the partnership, he began with an at-risk amount of $310,000: $110,000 in cash invested and $200,000 in guaranteed partnership debt to the drilling company. In 2001 and 2002, Zeluck was allocated losses totaling approximately $270,000, which reduced his at-risk basis to $32,000. In 2003, the partnership terminated, and Zeluck’s at-risk basis was further reduced by the $32,000 liquidating distribution to zero.

Also upon the liquidation, Zeluck’s guarantee of the partnership debt ceased to bear consequence, as the court concluded the debt was no longer valid after the partnership’s liquidation. This drove Zeluck’s at-risk basis from $0 to negative $200,000, triggering Section 465(e) and the recapture of $200,000 of previously deducted losses.

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Today is March 15th, which means the last thing we should be writing about is a corporate tax issue. But let’s be honest, many of the more complex corporate returns get extended until September 15th, meaning the corporate filing season is really just starting as opposed to coming to an end.  

As tax-paying entities, C corporations present many issues that are unique when compared to the flow-through regimes of Subchapters K (partnerships) and S (S corporations). When these issues are not properly identified and addressed, the result is often real dollars to clients in the form of a tax deficiency assessed by the IRS.

One of the issues that causes confusion among even the most experienced of advisers is the limitation on net operating losses for certain C corporations that have undergone an ownership shift under the meaning of I.R.C. § 382.

Q: Why is Section 382 important?

A: Because over the next six months, it will simply be reflexive to offset any federal corporate taxable income for 2011 with available net operating loss carryforwards. Should a Section 382 change have occurred under your nose, however, those losses may well be limited in their usefulness.

Q: Why does Section 382 exist? What’s the point?

A: Section 382 exists predominately for two reasons.

1. In the context of an outright sale of corporate stock to new owners, Congress believes the new owners should not be able to “traffic” in NOLs and acquire losses that can be used to offset income previously earned by the buyer.

2. In the context of a change in corporate ownership created by the issuance of stock to new investors, Congress believes that new “controlling” owners should not have unfettered access to losses that were generated by the previous controlling shareholders

Q: OK, makes sense. So when does a corporation have a Section 382 change?

A: A Section 382 ownership change occurs when a loss corporation undergoes an ownership shift in which the stock ownership percentage (by value) of 5-percent shareholders has increased by more than 50 percentage points over such shareholders’ lowest ownership percentages within the testing period.

Q: I recognize all the words you just wrote, but I have no idea what that sentence means. Can we approach this differently?

A: Sure. There are a lot of moving parts in that definition, so breaking it down into its components is essential to developing an understanding of the mechanics of Section 382. Fire away.  

Q: What’s a loss corporation?

A: A loss corporation is any corporation entitled to use a NOL or generating an NOL for the tax year in which an ownership shift occurs. If a corporation is currently not generating a NOL and has no NOL carryforwards, then it can have all the ownership turnover in the world and Section 382 is not an issue.

Q: What is an ownership shift?

A:  Ownership shifts can take the form of sales of stock by existing shareholders, or issuances of new stock from the corporation to new or existing shareholders. Without ownership shifts, a corporation can generate unlimited NOLs without risk of Section 382 applying.

Q: Got it. So I need a corporation with losses and changes in the shareholders’ ownership. What if I have a bunch of shareholders with tiny interests?

A: The transfers of stock your concerned with involve 5-percent shareholders. While this definition can become confusing when evaluating public companies, in general a 5% shareholder is any shareholder that owns — directly or indirectly through attribution — 5% of the stock of the loss corporation. All of the shareholders who own less than 5% in a corporation are aggregated together and treated as one 5% shareholder.[i]

Q: Do I have to test every time a 5% shareholder buys, sells, or is issued additional stock?

A: Yes. However, the transfers of stock involving 5% shareholders must only be evaluated throughout a testing period. The testing period is the shorter of 1) three years, 2) the period of time since the corporation became a loss corporation, or 3) the period of time since a previous Section 382 change occurred.

Q: You lost me there. Can you show me what you mean?

A: Example: X Co. generated NOLs from 2003 through 2011. Thus, X Co. is a loss corporation. X Co. previously underwent a Section 382 change on May 3, 2008. On December 1, 2010, A, who owns 70% of X Co.’s stock, sells his stock to B, who was  not  previously a shareholder.

A is a 5-percent shareholder, and his sale of stock to B constitutes an ownership shift. X Co. must test its cumulative changes during the testing period. The testing period ends on December 1, 2010, and begins on the later of 1) December 1, 2007 (three years prior to the ownership shift); 2) January 1, 2003 (the date X Co. became a loss corporation); or 3) May 3, 2008 (the date of X Co.’s most recent Section 382 change resulting in a limitation). Thus, the testing period is from May 3, 2008-December 1, 2010.

Q: OK, but what exactly am I testing for?

A: To have an ownership change that limits your NOLs, there needs to be a cumulative increase in the ownership interest of 5-percent shareholders of at least 50 percent during the testing period. There are three common misconceptions surrounding this requirement that often result in inaccurate Section 382 computations:

  • The 50-percent increase is based on absolute values. If A’s ownership increases from 20% to 40%, even though his ownership interest has increased by 100% over his previous interest, it is not an absolute 50% increase. If ,however, A’s ownership increases from 20% to 75%, then A’s ownership has increased by 55-percent for purposes of Section 382.
  • The measure of the change is based on value, rather than pure percentage of stock held. This complicates matters greatly, as the value of the corporation must be known at each testing date in order to determine each 5-percent shareholder’s share of the total value. For a publicly traded corporation, value can be determined by merely glancing at the stock ticker. But for all other corporations, particularly those that may have multiple classes of stock outstanding with varying liquidation rights, the determination of the total enterprise value — and each 5-percent shareholder’s piece of that value on the testing date — often presents the biggest hurdle in measuring whether a Section 382 change has occurred.
  • The 50-percent increase is measured by comparing the percentage of value held by a 5-percent shareholder on a testing date to the lowest percentage owned by the shareholder throughout the testing period. Thus, if during a testing period A’s ownership of X Co. goes from 20% to 30%, and then from 30% to 45%, A’s increase for the second change is 25% (45% compared to 20%), rather than 15%. Even worse, the cumulative increases of the 5-percent shareholders are not offset by any decreases in interest by a 5-percent shareholder.

Q: Once I’ve confirmed I have a 50-percent change, what do I do next?

A: Once it has been determined that a Section 382 change has in fact occurred, an annual limitation must be determined on the utilization of the pre-change losses against taxable income. The limitation is generally equal to the long-term tax exempt rate in place during the month of change (issued by the IRS every month) multiplied by the value of the corporation immediately prior to the ownership change. The resulting amount represents the maximum amount of taxable income the corporation may offset in a post-change year with pre-change NOLs.

Example: X Co. underwent a Section 382 change on December 31, 2011. The value of the corporation was $1,000,000 prior to the change, and the long-term tax exempt rate was 5%. Thus, X Co.’s Section 382 limitation is $50,000. If X Co. recognizes $200,000 of taxable income in 2012, it may only use $50,000 of its pre-change NOLs to offset the $200,000 of taxable income.

Q: So I pretty much only need to be worried about big stock sales, right?

A: You weren’t listening, were you? A Section 382 change will not always be the result of an obvious 100% sale of a corporation’s stock; rather, they often are the end result of creeping changes over a period of time, or even situations where no new shareholders acquire interests in the corporation, but rather an existing shareholder greatly increases his ownership.

Example: A, B, C, and D each own 25% of X Co., a loss corporation. On January 10, 2009, A buys 10% of X Co. stock from D. On March 4, 2009, A buys all of B’s stock. Finally, on January 20, 2010, X Co. buys 20% of X Co. stock from C. An ownership change has occurred, because during the testing period ending January 20, 2010, A has increased his ownership in X Co. from 25% to 80%, a 55% increase. A’s increase is not offset by B, C, and D’s decrease in stock ownership.  

Q: I think I understand, thanks to your thoughtful explanation. You clearly deserve a large raise.

A: That’s’ really not a question, but thank you, I appreciate that. Truth be told, simply understanding that Section 382 exists is half the battle. Many tax advisers miss the issue entirely and utilize an NOL regardless of an underlying ownership change, inviting scrutiny from the IRS. While the hard part — the calculation — doesn’t begin until you’ve identified that your corporate client may be subject to Section 382, by simply undertaking the calculation, you’ve helped minimize risk for your clients.  


[i] If a 5-percent owner is an entity (i.e., a corporation, partnership or trust), the loss corporation is required to look through the entity (and through any higher-tier entity) in order to determine which owners of the entity are indirectly 5-percent shareholders of the loss corporation. It is the ownership of these ultimate 5-percent shareholders, including public groups, that is considered when determining whether a greater than 50 percentage point increase has occurred.

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