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The net operating loss is a type of tax relief that allows a business to set off profits from one tax year with losses from another, and it’s an important tax planning tool. Generally, a corporation’s net operating losses (NOLs) can be carried forward for up to 20 years after the date of the loss.
However, NOL use is limited if a Chapter 11 reorganization plan results in a change of ownership. It’s important to be aware of limits on NOL use, and keep them in mind when making business plans.
Change of Ownership
The tax laws limit a corporate debtor’s ability to use NOL carryforwards if it undergoes an ownership change. An ownership change takes place when 50 percent or more of the corporation’s stock changes hands. An ownership change may take place where there has been a merger, for example.
If an ownership change happens, only part of the NOLs from before the change can be carried forward. This limit is equal to the value of the stock of a corporation immediately before the ownership change, multiplied by the long-term tax-exempt rate.
Bankruptcy Exception to Limitation
There’s a bankruptcy exception to the carryforward limit for corporations that have changed ownership. The limitation doesn’t apply if the shareholders and certain qualified creditors own at least 50 percent of the stock of the reorganized bankrupt company. This is called the continuity of ownership test.
Only stock received by qualified creditors is counted to see if the test is met. Stock received by shareholders or creditors in return for new investments isn’t included.
Qualified Creditors as New Owners
A qualified creditor is one who receives stock in the reorganized company as payment for a pre-existing debt owed to it. The debt has to be held at least 18 months before the start of the bankruptcy case. The debt must have arisen in the ordinary course of the corporation’s business, and it must have been held by the same creditor at all times.
The bankruptcy exception can be a good alternative in the right situation. Bankrupt corporations almost always have large NOLs. So, the use of this exception can allow the reorganized corporation to offset income taxes for many years. Creditors, who otherwise might not be paid, can receive equity in a business with potential growth.
Questions for Your Attorney
- If NOL carryforward limits will apply to my business, can I amend recent tax returns to use these NOLs?
- Are there ever disputes on issues involving qualified creditors?
- If a qualified creditor receives stock and there’s an NOL issue, does the creditor have to keep the stock for any minimum period before selling it?