Net Operating Losses in Bankruptcy

Author: David J. Warner

COVID-19 is having an immeasurable effect on our lives—both personal and professional. The economic effect of this pandemic has affected businesses large and small. Many businesses have sought bankruptcy protection, including high-profile companies like JCPenney, J. Crew, Neiman Marcus, Hertz, and 24 Hour Fitness.

However, many corporations are unaware that their most substantial asset in a bankruptcy might be a loss.

Net Operating Losses (NOL)

If a corporation’s expenses exceed its income for any year, the business has a net operating loss for tax purposes. See Internal Revenue Code (I.R.C.) § 172(c). A corporation may be able to carry back a net operating loss to a previous tax year and forward indefinitely to future tax years. If a corporation earns a profit in a future tax year, this net operating loss can offset 80% of the corporation’s taxable income for that year. I.R.C. § 172(a)(2)(B)(ii). This deduction could potentially save corporations hundreds of thousands or even millions of dollars in taxes.

When a corporation is in financial trouble, it might generate losses for several years in a row. In this situation, the corporation cannot use its net operating losses because it does not have any taxable income to offset. However, a profitable corporation may want to “purchase” these net operating losses.

Limitation on Transferring Net Operating Losses: I.R.C. § 382

Congress was concerned that a corporation might try to “sell” its net operating losses to a profitable corporation. To prevent this situation, Congress enacted I.R.C. § 382. This section applies if there has been an “ownership change.” An “ownership change” involves a >50% change in stock ownership over a 3-year period. I.R.C. § 382(g).

If there has been an ownership change, then a corporation’s ability to deduct net operating losses may be limited. A corporation’s NOL is limited to the fair market value of the corporation (before the ownership change) times an interest rate set by the IRS. Here is an example:

Corporation’s Fair Market Value$20,000,000
July 2020 Interest Rate (set by IRS)0.89%
Limited Annual NOL Deduction$178,000
Corporation’s Total Net Operating Loss$10,000,000
Number of Years to Deduct Full NOL57 Years

With interest rates below 1%, corporations with ownership changes might need decades or longer to deduct the full amount of net operating losses.

Net Operating Losses and Bankruptcy: I.R.C. § 382(l)(5)

Inside of bankruptcy, I.R.C. § 382(l)(5) relaxes these strict rules, if a corporation can meet the following requirements:

  1. The corporation is in bankruptcy;
  2. Existing shareholders and “qualified creditors” own 50% of the stock of the reorganized corporation; and
  3. The reorganized corporation carries on at least a portion of the old corporation’s business.

If a corporation meets these requirements, then there is no limitation on the corporation’s net operating losses deduction.

However, these rules are subject to two major caveats. First, the total net operating loss is reduced by certain interest payments from prior years (the “interest chargeback”). I.R.C. § 382(l)(5)(B). Second, if there is another ownership change within 2 years after the bankruptcy reorganization, then the old net operating losses are reduced to zero. I.R.C. § 382(l)(5)(D).

Sears recently attempted to use § 385(l)(5) to its benefit. Sears filed for bankruptcy and estimated it had $5 Billion in net operating losses. Sears sought for one of its primary creditors to acquire Sears’ stock in a bankruptcy restructuring. This deal allowed Sears to emerge from bankruptcy with its debt restructured, new ownership, and net operating losses to use going forward.

Is your company considering bankruptcy but concerned about the tax implications? Does your business owe taxes to the IRS or State of California, and you are unsure what would happen in bankruptcy?

Former IRS Attorneys of Holtz, Slavett & Drabkin, APLC advise clients on the tax issues related to bankruptcy, as well as representing clients in sensitive domestic and international tax examinations, employment tax cases, and difficult tax collection matters. David J. Warner is a former IRS Attorney and former Special Assistant U.S. Attorney for the Department of Justice who represented the IRS and the United States in bankruptcy court. David also taught bankruptcy taxation at Loyola Law School. Please contact David at (949) 999-6606 to schedule a consultation.