NOL also known as net operating loss, occurs when total tax expenditure in a given taxable year exceeds taxable income gain, according to the U.S. federal income tax. A person entitled to pay tax is subjected during profitable periods without having tax relief during net operating loss results to tax burden debts. However, Congress offer solutions to such situations by allowing the tax payers to use losses obtained in one year to offset gains of the following year. This process is commonly referred to as carry forward and carry back of the net operating loss depending on prevailing corporation condition.
The main purpose of net operating loss is to ensure that bankruptcy of any given corporation is avoided. It also enables the involved system to plan for the following financial year having cleared all taxes. Context in this work will be extracted from different section of the internal revenue service (IRS) with respect to the U.S. federal income tax.
However, it should be noted that some sections are ambiguous and provides contradicting information involving tax rules. Courts have counter attacked such clauses by delivering a ruling which either dismisses such sections or recommending amendment of such section to the Congress. Different parties have also gone to seek clarity of such clause from the court.
Net operating loss has different goals depending on the audit conducted by a given organization. However, the most common objective of internal revenue service is analyzing prevailing conditions such as earning profit, expenditure as well as loss incurred by the organization, after the ownership change of corporation happens (Section 382 (h) in the internal revenue code) (Internal Revenue Bulletin, 2003).
In section 382, guidelines are provided on how change of ownership of a corporation affects loss and taxable income incurred by the corporation. Internal code service also outlines relevant guidelines which identifies built in terms and opens ground for suggestions. Gain and loss resulting from sale is extensively described under section 382 (h) (2) (A) and (B) (Willens, 2006d).
Federal internal service approaches
There are several approaches which try to explain different sections of internal federal revenue service. These approaches try to give different interpretation of tax rules as well as defining the meaning of various terminologies used in this field.
This approach defines section 1374 (d) among others in tax laws in the calculation of NUBIG (net unrealized built in gain) as well as NULBIL (net unrealized built in). Approach 1374 also identifies RBIG (recognized built in gain) and RBIL (recognized built unit in loss)
NUBIG and NULBIL is total accumulation of loss or profit which is recognizable under hypothetical sale of capital in form of assets. Basically, they are both calculated by establishing the amount that would be discovered just before ownership change loss corporation sells out all its capital in an open market. Calculating RBIG and RBIL with respect to exchange of assets involves the total cost of gain or loss discovered during the period of exchange. RBIG sum involves addition of asset which can not exceed the undiscovered built in profit or loss of the asset during the time of change.
In terms of item of income and deductions, this approach includes income which is portrayed as subtractions allowed during the discovering period is inclusive if only the taxpaying method is would have accommodated the item in income (Willens, 2007c).
Section 382 limitation
Ownership change of section 382 limitation is activated in this change. It dictates that new loss corporation taxable earnings in any given after change year may be settled by its losses before the change. This limitation is calculated by multiplying the value of old loss corporation just before the ownership is changed by long lasting tax rate. In general, this section states that loss corporation value is stock present just before the change of ownership, where stocks explained in section 1504(a) are involved.
When it comes to income generated by built-in gains asset, this (approach 1374) ignores the probability of income being included in RBIG since it counts not before ownership change date. It also departs tax rule and regulations in handling of amounts termed as depreciation, amortization and deductions made during the recognition period.
Approach 1374 allows the comparison of amortization with the deductions that would have been allowed in loss corporation bought in an open market. It should be noted that the amount of precise amortization subtractions should not exceed total hypothetical amortization collected amount.
When it comes to the question of discharge of indebtness income and debt deductions, approach 1374 tends to treat RBIG or RBIG as COD income. Loss corporation at the start of recognition period is also included in COD income. However, under section 382(h) reduction of tax is not connected to loss corporations NUBIL or NUBIG (Willens, 2006c).
Under this approach, items of RBIG and RBIL are identified through a comparison of loss corporation of the initial items of income, profit, expenditure and loss which tends to result after an election is carried out under section 338. However, calculation of NUBIG or NUBIL is similar to 1374 approach.
The above approaches enable taxpayers to apply section 382 when ownership change scenarios have occurred. IRS intends to stick to pre-existing rules and regulations, by sticking to the approaches outlined above. However, IRS intends to publish proposed amendments following the interpretation of the courts under their jurisdiction and understanding the law. This tax regulating body has also invited more suggestion form all quotas so as to come up with effective tax rules. Details have also been provided on the mechanism of comment submission where contacts have been provided.
Carry forward and NOL illustrations
Lucent Net Operating Loss Carry forward Likely Valuable to Alcatel despite ownership change in companies’ contemplated transaction
A clear subsidiary merge indicates that NOL equation looks like it’s nearly $10 billion insinuating that net operating loss of the company is in excess of $3.5 billion. This implicates that Lucent NOL can dictate the necessity of paying federal income taxes considering earned taxable profit in the future. If Lucent is acquired by this company, in a carry forward merger, the transaction would qualify to explain the reorganization of section 368(a).
However, the same might be termed as a reverse triangular absorption whereby Alcatel under new ownership is absorbed in Lucent. Similar businesses would be reflected to Lucent’s shareholders if a threshold of at least 80% is achieved, putting Alcatel choosing stock into consideration. Lucent’s shareholders of the stock for this corporation is governed by section 368(a) as long as they do not end up holding more than half percentage of Alcatel’s savings by the casting votes.
Considering Loss Corporation, ownership change happens when the total amount of income entitled to tax can settle carried tax burdens in any given final taxable income. This is calculated by multiplying a long-term tax rate by the loss corporation savings. This is clearly indicated under section 382 limitations. The main aim of odd limitation is to reinforce NOL. It simply prevents a company to operate in losses by ensuring that the company is not in a position to utilize net operating loss (Willens, 2009).
Segregation rules are applicable to some transactions such as those explained in section 381(a) (2). These rules are also applicable in other clauses, for instance during the transfer of stocks when a corporation incurs a loss. When they apply, all transactions applied are segregated, by treating pre-existing public group separately from a direct public group, which acquires stocks in businesses conducted afterwards.
In conclusion of Lucent net operating loss of Alcatel, its NOL should remain valuable, despite the fact that all transactions of Lucent and Alcatel ownership change will result to a change in the favor of Lucent (Willens, 2006b).
Family Values’ and the Right to Unfettered Use of Net Operating Losses
Governing law of this clause (section 382) tends to limit the amount of savings or in other words stock of the former loss of a given organization just before the ownership is changed. This clause is also affected by the prevailing conditions such as long term tax exempt rate. As such, “ownership change can occur if a certain percentage is owned by an individual or shareholders have increased by more than 50%”(Willens, 2005, p.1). Subsequent ownership also affects net operating loss. Ownership becomes effective when limits are carried forward to a new loss corporation’s capacity to utilize NOL which happened by old loss corporation.
Constructive ownership rules are dictated by section 318 in reference to of tax section 382. In summary, individual family members including children, parents, grandchildren and marriage partners are stipulated in this section. In differing views of family aggregation principles implies that brotherhood does not affect ownership rules since they belong to the same family. As such, a reference is made to either parents or grandparents.
In efforts of further understanding of section 382, the court ruled that when the question of siblings, grandchildren and distance relatives arises, inclusive mechanism measures must be included. However, Congress decision to make such change went viral with courts as it would not understand why such changes were made without attracting special attention. “Expanding the scope of exempting sales to involved significance range” (Tax Reform Act of 1986) was the clause that was revised by the congress (Willens, 2005, p.1).
In the question of shareholder of Loss Corporation, the court came to a consensus that the Congress main intentions were to apply to family aggregation principle from an individual who owns shares in a loss corporation. Therefore, when it comes to an individual under ownership change rule affecting the family members, if the there are no parents, grandchildren or even siblings are under spotlight during transaction period (Willens, 2005).
IRS Classification of ‘Sub-Prime’ Losses Could Prevent Their Utilization as NOL
Sub-prime lenders’ problems are not new in the world of net loss operation. This is due to the fact that such loans are now worthless and still tax deduction are still made on the same loans. Such deductions might not be enough to create NOL. Same NOL can be carried back or forth up to two taxable years. If by any chance NOLs are not fully settled, by several carry back wards, the same can be carried forth up to 20 taxable years following the year during which NOL was held continuously (Willens, 2007a).
Losses arising from such loans are directly proportional to capital assets. As such, if any capital assets are termed as worthless in a taxable year, the same is reflected to corporation’s earnings as a loss. It is only in the banks where security is not considered as capital asset. The same clause goes ahead to disqualify a sub-prime lender as a financial institution (Section 582 (c)).
Under section 1221, capital asset is defined as a property held by an individual entitled to tax. However, accounts acquired from normal businesses are not inclusive in the word ‘property’ such properties acquired from ordinary businesses are defined under section 1221(a) (4).
On the other hand, internal revenue service IRS does not agree with such definitions. If the IRS does not act swiftly, sustained losses may be incurred by sub-prime lenders having in mind worthless debt arising from these loans. This situation may also result to the loss of capital assets (Willens, 2007b).
Recent Ruling Illustrates Scenario Where ‘Ownership Change’ Can Be Reversed
In the recent past, there have been various contradictions surrounding the clause involving change of ownership. This clearly indicates that ownership of a company can be reversed in case a complaint is raised after ownership has been changed. This can also happen if the company is able to sustain its debts and profits in a full taxable financial year.
Ownership can be reversed in case of an owner shift touching one or more than 5% of the shareholders, a loss corporation of more than 5% shareholders has increased by more than 50% points or voting power relevant to the least percentage of stock at any given time during the testing period. (Willens, 2011, p.1055.
Testing period is usually less than 3 years after the ownership has been changed. At this juncture, a person having 5% is still under the corporation stock until the testing period is over. A 5% is critical as it can be used to establish whether the ownership change has taken place or not. Exchange of the loss corporation’s savings between shareholders who have less than 5% shares does not count during the owner shift (Willens, 2011).
Apart from ownership reversing, a corporation can avoid ownership change as stipulated by section 382 limitation. Recognition built in gain allows the corporation to retain a certain portion of Post Exchange taxable income. However, this goal is not easily met, as the corporation can easily be declared bankrupt by bank court.
Ownership of loss corporation can be threatened as a result of imposing Entity A’s activities (Willens, 2006a).
There are taxpayers friendly approaches which tend to harmonies the RBIGs. This has been adopted and implemented by internal revenue service to incorporate assets which are not disposable during the testing or recognition period. This section covers overflowing cost and also recovers amount loss corporation amount which would otherwise been incurred over the initial cost recovered from loss corporation. Under the same section, ownership change bankruptcy is exempted under court’s jurisdiction.
This can also be determined by the voting power whereby shareholders are entitled to vote. Exact amount of NOL is entitled to reduction by interest refunded during a certain period. Section 382 offers an explanation of how bankruptcy can be exempted in cases where ownership can change more than once during the testing period. Various companies have come up with a mechanism to protect ownership change before the testing period is over, putting into consideration prevailing stock (Willens, 2007d).
Constructive ownership rules are dictated by section 318 in reference to of tax section 382. In summary, individual family members including children, parents, grandchildren and marriage partners are stipulated in this section. In differing views of family aggregation principles implies that brotherhood does not affect ownership rules since they belong to the same family.
As such, a reference is made to either parents or grandparents. In efforts of further understanding of section 382, the court ruled that when the question of siblings, grandchildren and distance relatives arises, inclusive mechanism measures must be included. However, Congress decision to make such change went viral with courts as it would not understand why such changes were made without attracting special attention. Considering Loss Corporation, ownership change happens when the total amount of income entitled to tax can settle carried tax burdens in any given final taxable income.
This is calculated by multiplying a long-term tax rate by the loss corporation savings. This is clearly indicated under section 382 limitations. The main aim of odd limitation is to reinforce NOL. It simply prevents a company to operate in losses by ensuring that the company is not in a position to utilize net operating loss. IRS intends to stick to pre-existing rules and regulations, by sticking to the approaches outlined above. This tax regulating body has also invited more suggestion form all quotas so as to come up with effective tax rules.
The internal revenue should come up with measures to solve various conflicts arising from different sections governing taxes. This will ensure harmony in the business world. Due to their ambiguity, the court should offer clear definitions of various sections and rules. This can play a very important role to ensure that neither the government nor citizens are exploited by these regulations. Congress must always involve a section of legal teams like courts when making major decisions.
This allows healthy criticism from all taxpayers’ quotas where they can present their recommendations and wishes according to their understanding of the law. This tend to motivate taxpayers and hence increasing the overall national production as citizens are governed according to their wishes.
Clauses such as those governing the sub-prime loans should be amended to prevent law from providing contradicting information. Apart from the government, various corporations must ensure that they clear all tax burdens to prevent them from being declared bankruptcy. Each company must conduct financial audit annually to establish whether the company is moving forward.
It is the responsible of the government and all corporations to educate all shareholders both tax laws, terms and conditions applied in sharing of both losses and gains. Incase some sections are not clear, seeking legal advice from the courts is very important. This is because court decisions do not only offer solution of the issue at hand, but also leads to documentation of court’s interpretation, which can be used in future during tax section amendments. Taxpayers should also read and understand all laws governing tax payments. This enables them to understand tax expenditures and the reason for being taxed.
As a result of contracting rulings delivered by the courts, all ownership governing clauses should be reviewed to avoid such cases. This will not only save time but also resources for both the taxpayers and the government.
As concluded, there are some sections which need to be either revised or completely changed. Congress should debate and propose a new set of tax laws. This is to incorporate new businesses so as to ensure loss corporation governing sections are not abused. Awareness should be created so as to inform all taxpayers on the open forum whereby they are expected to pass comments and suggestions which might be considered during the reorganization of tax rules.
Courts should fully exercise their mandate by offering fair interpretation of laws governing tax deductions. Tax relief governing rules should be observed to the later in order to ensure all citizens re treated equally and fairly. Notice 2003-65 should be amended accordingly putting into consideration to peoples opinions.
Internal Revenue Bulletin. (2003). NOLs IRS Notice 2003-65 on Identification of Built-In Gain and Loss Recognized by Loss Corporation Following Ownership Change. Web.
Willens, R. (2005). ‘Family Values’ and the Right to Unfettered Use of Net Operating Losses. Daily Tax Report: News Archive, pp. 1-5.
Willens, R. (2006a). Conseco’s Worthless Stock Loss Appears to Withstand Scrutiny. Daily Tax Report: News Archive, pp. 1-5. Web.
Willens, R. (2006b). Lucent Net Operating Loss Carryforward Likely Valuable to Alcatel Despite Ownership Change in Companies’ Contemplated Transaction. Daily Tax Report: News Archive, pp. 1-5. Web.
Willens, R. (2006c). Eddie Bauer’s Net Operating Losses—A Textbook Bankruptcy Case. Daily Tax Report: News Archive, pp. 1-5. Web.
Willens, R. (2006d). What Becomes of Cablevision’s Net Operating Losses? Tax Notes, pp.847-849. Web.
Willens, R. (2007a). Competing Restructuring Plans for Delta: Effect on the NOLs. Tax Notes, pp.797-800. Web.
Willens, R. (2007b). IRS Classification of ‘Sub-Prime’ Losses Could Prevent Their Utilization as NOLs. Daily Tax Report: News Archive, pp. 1-5. Web.
Willens, R. (2007c). Recent Ruling Illustrates Scenario Where ‘Ownership Change’ Can Be Reversed. Daily Tax Report: News Archive, pp. 1-5. Web.
Willens, R. (2007d). Avoiding an Ownership Change Essential to Preserving Value of Infospace NOLs. Daily Tax Report: News Archive, pp. 1-5. Web.
Willens, R. (2009). Sirius XM Radio’s NOL Status. Tax Notes, pp.1509- 1511.
Willens, R. (2011). Closing Agreement Does Not Preclude Use of Notice 2003-65. Tax Notes, pp. 1055-1057.