Ownership changes under the new Sec. 382 segregation rules.

In certain circumstances, loss corporations previously subject to a Sec. 382 limitation due to an ownership change may retroactively elect that the ownership change did not occur.

On Oct. 4, 1993, the IRS issued final regulations relating to the Sec. 382 segregation rules. These regulations modified proposed regulations published in November 1992, which had been reserved in the 1987 temporary regulations. This six-year process culminated in final regulations more lenient to loss corporations.

The final regulations provide for two exceptions to the segregation rules: a small issuance exception and a stock for cash exception. Although the exceptions do not apply to most equity structure shifts, the small issue exception will apply if the issuance is pursuant to a type E recapitalization. In addition, transitory ownership of stock by an underwriter is not taken into account in determining an ownership change.

Most importantly, these exceptions can be applied retroactively at the election of the loss corporation to undo a previously reported ownership change.

Exceptions

Small issuance: An issuance of stock will not create a new public group if the amount of stock issued, when aggregated with all other issuances during a corporation's tax year, does not exceed the small issue limitation. Instead, the stock is considered as acquired by the existing public group(s). At the loss corporation's election, this limitation may be calculated in either of two ways: 1. 10% of the total value of all the corporation's outstanding stock at the beginning of the tax year, or 2. 10% of the number of shares of the class of stock issued at the beginning of the tax year. (This option is not available, if more than one class of stock is issued in a single issuance.) This limitation is prorated for loss corporations issuing stock in short tax years.

Example 1: Loss corporation L is a calendar-year corporation with 1,000 outstanding shares of ordinary common stock - its only class of stock. These 1,000 shares are owned by Public L, and no one shareholder owns 5% of the stock. During 1994 L sells newly issued common shares to its employees: 35 in April and 75 in November. No employee becomes a 5% shareholder as a result of this issuance.

Under the temporary regulations, L would be considered as having three public groups: Public L with 1,000 shares, "New Public 1" with 35 shares and "New Public 2" with 75 shares. This results in a 9.91% change in ownership.

Under the final regulations, the change in ownership is 0.9%. If L applies the class-by-class method, all of the first issuance (35 shares) will qualify as a small issuance (less than 10% of 1,000 shares). In addition, 65 shares (100 - 35) issued in November will also qualify as a small issuance. Public L is considered as acquiring 100 shares and New Public 1 is considered as acquiring 10 shares.

Since L has only one class of stock outstanding, the "value" method (option 1) would yield the same result.

As seen below, even this change can be mitigated by exception 2 - stock for cash.

Stock for cash: If a loss corporation issues stock solely for cash, a fraction of that stock is considered as acquired by the existing public group(s). This fraction is determined under the following formula: Stock owned by public group before Stock x 50% = /issuance issued/ Total stock owned by all public groups before issuance

In Example 1, 10 shares of the November stock were not "covered" by the small issuance exception. Since Public L was the only public group (owning 1,035 shares prior to November), five shares are also considered as acquired by Public L (10 x 0.50 x (1,035/1,035)). As a result, Public L is considered as owning 1,105 shares (1,000 + 35 + 65 + 5) and New Public 1 is considered as owning five shares. The ownership change is now only 0.45%.

To qualify for the stock for cash exception, the stock must be acquired solely for cash - no strings attached. If the buyer is required to purchase additional shares for consideration other than cash, the entire issue will not qualify. Additionally, if acquired on the exercise of an option that was not issued solely for cash, the stock will not be considered as acquired solely for cash.

The total amount of stock considered as acquired by the existing public groups, under both exceptions, cannot exceed the total amount of stock issued in the issuance less the amount of stock acquired by a 5% shareholder (other than the public group) immediately after the issuance.

Operating rules

Proportionate acquisition: To the extent the loss corporation has more than one public group, any stock not considered as acquired by a new public group, because of either exception, is considered as acquired by all existing public groups proportionately. In the original example, if L had two public groups owning 500 shares each, each would be considered as acquiring 17 1/2 shares (500/1,000 x 35) of the April issuance and 35 shares (500/1,000 x (75 - 5)) of the November issuance.

Actual ownership: If the loss corporation has actual knowledge that a direct public group acquired more than the stock it is considered as acquiring by reason of these exceptions, it can rely on the actual acquisition instead of the "deemed" acquisition. In Example 1, of the 110 shares issued during 1994, 105 were considered as acquired by Public L. If L had actual knowledge that all 110 shares were acquired by Public L, a new public group does not exist and there is no change in ownership.

Related issuances: Two or more issuances will be treated as one if they occur at approximately the same time pursuant to the same plan or arrangement or if their principal purpose is to minimize or avoid an owner shift. However, for purposes of the stock for cash exception, closely timed issuances will not be combined unless the purpose is to avoid an owner shift.

Example 2: Loss corporation L has 1,000 shares outstanding, all owned by Public L. On May 1, 1994, L offers 500 shares to the public. Under the stock for cash exception, 250 shares are considered as acquired by Public L and 250 acquired by New Public L. On May 2, 1994, L issues 501 more shares to corporation P shareholders in exchange for 50 P shares. The fact that the two May transactions occur shortly after one another will not, in and of itself, require the issuances to be combined. Instead, if the principal purpose of the transaction is to avoid an owner shift, the May transactions will be combined, resulting in a 50.02% ownership change.

Exercise of options: The final regulations also clarify the treatment of stock issued on the exercise of an option. The Treasury's intent was to treat options considered as acquired by existing public groups in a manner similar to stock. As a result, if options are considered as acquired by a public group and are subsequently exercised, the actual knowledge rules can be used - on the exercise of the option - to attribute more stock to one public group.

In other words, if 100 out of a total 500 options are considered acquired by an existing public group, but the loss corporation has actual knowledge that 200 options were exercised by members of that existing public group, that group will be considered as acquiring 200 shares.

Effective dates

The effective dates of these rules can provide a tremendous opportunity for loss corporations that thought they had a more-than-50% ownership change in a prior year.

Although generally effective for issuances or deemed issuances of stock in tax years beginning on or after Nov. 4, 1992 (for stock acquired via the exercise of an option, the rules apply to options issued before May 4, 1993 if they were disclosed in a registration statement with the Securities and Exchange Commission before Nov. 4, 1992), a loss corporation can elect to apply these regulations retroactively to all issuances before Nov. 4, 1992. The election must be made with the loss corporation's first tax return filed more than 60 days after Oct. 4, 1993. The return must contain the amended returns for the prior years, revised calculations of the ownership change and the statement "THIS IS AN ELECTION TO APPLY SECTION 1.382-3(j) RETROACTIVELY."

Opportunities/considerations

Any loss corporation with stock/option issuances that qualify for either exception should recalculate its change in ownership under the new regulations. Even if there was no 50% change, the retroactive application of the final regulations would lower the cumulative percentage change, thereby providing more room for future transactions. Any transaction that created new public groups should be revisited. These can include stock/options issued to banks for financing agreements; underwriters for offerings; employees under stock option plans or deferred compensation arrangements; certain recapitalizations, etc.

These new rules also provide opportunities for loss corporations to transfer stock to their employees. Issuances to employee benefit plans can be structured to qualify on an annual basis as small issuances. Outright purchases by employees can also be offered as part of the plan.

Presumably, a loss corporation can redeem stock from its existing public group and issue new stock to its employees without having an increase in its percentage change of ownership, if done within the boundaries of the exceptions.

There are, however, some loose ends among the temporary, proposed and final regulations. For example, in the temporary regulations, an option is considered exercised if its exercise would result in a more-than-50% ownership change. Under proposed regulations, that option is only considered exercised if it was issued for an abusive principal purpose. The criteria for determining an abusive principal purpose are also contained in the proposed regulations. In addition, the definition of when a related issuance was made for the principal purpose of avoiding or minimizing an owner shift was left undefined in the final regulations. Presumably, this "abusive" standard will be clarified in the future.

There are other questions still to be dealt with. If a loss corporation issues stock for cash, but the cash is below the trading value of the stock, is the issuance still considered solely for cash? Is there an "imputed" noncash consideration? What if stock is issued to a creditor for cash while the loss corporation is refinancing its debt? Is the issuance solely for cash, or does it include debt forgiveness? When the value of an issuance determines whether it qualifies as a small issuance, is any minority discount applied to the newly issued stock?

Although these matters need to be addressed, the final regulations provided good news and a window of opportunity to some loss corporations.