State tax treatment of net operating loss carryovers in corporate acquisitions.

Introduction

Many state tax statutes, unlike their federal counterpart, do not provide for the transfer of net operating loss carryovers (NOLs) from one corporation to another in an acquisition. These statutes typically provide that NOLs can be carried forward by a "taxpayer" and can be applied against the taxpayer's income over a specified period of years, but they say nothing about the use of NOLs against the income of any other taxpayer. The courts have had to address the question of the extent to which an acquiring corporation in a merger or other acquisition should be treated as the same "taxpayer" as the target corporation for purposes of these provisions. Although the word "taxpayer" typically applies only to a particular individual or entity, an argument can be made that in the context of the NOL provisions it should be given a broader reading in order to avoid distortion of income.

Some state tax departments and courts have read the statutory language literally, preventing the transfer of NOLs under any circumstances or only in limited circumstances. Other courts have read the statutory language more expansively.

Some themes are beginning to emerge in the cases and one of the interesting phenomena has been the reappearance of the continuity-of-business approach that was applied by the federal courts to taxable years before the Internal Revenue Code of 1954, when the federal statute was similar to the state statutes under discussion. The state courts have often looked to the old federal case law for guidance, reaffirming the proposition that state tax law cannot be practiced in a vacuum without regard to federal tax principles.

The Federal Statutory Scheme

1. NOLs Generally

It would be hard for a tax system based on net income to function without the use of a fiscal period. If income taxes were imposed on gross receipts, taxes could be paid to the government as income was received and the timing of income and expenses would be immaterial. If the tax is imposed on a net figure after subtracting the cost of earning income (and such other items that the legislature chooses to subsidize), however, a fiscal period is an administrative necessity. The system requires that there be a specified time frame in which income and deductions can be matched and a net figure computed. Although it would theoretically be possible for taxpayers to pay taxes whenever they received income and claim refunds whenever they incurred deductible expenses, such a system would be unworkable. Congress and the States have chosen a period of a year to be the fiscal period for income tax purposes, but there is no reason in tax policy or otherwise why this should necessarily be the case.

The annual accounting system can create distortions if a corporation loses money in one taxable year and has profits in another. If a corporation had an operating loss of $100,000 in year l and taxable income of $100,000 in year 2, its net income for the two years would be zero and natural law and logic would dictate that it should not have to pay income taxes for the two-year period. Some adjustment to the annual accounting concept must be made to produce this result, because otherwise the corporation would have a tax liability for the profitable year. One possibility would be for the government to pay a negative tax (that is, a refund) to a corporation for a year in which it incurred losses based on that year's tax rates. Hence, a corporation would be entitled to a cash subsidy from the government for every loss year, even if it never had profits. Congress has never adopted this approach. Although the negative income tax has been discussed as an alternative to the present welfare system for individuals (and appears to a limited extent in the present earned income tax credit), it has not been used to help indigent corporations. Instead, Congress has adopted a system under which operating losses can be carried back and forward to other years of the taxpayer. Under this system, a corporation that never makes profits does not benefit from its losses, although its shareholders may to the extent that they realize capital losses when they dispose of their stock. The corporation benefits from operating losses only if has taxable income in other years not too far removed from the loss year. Moreover, the tax benefit from the loss is based on the tax rates in effect during the profitable years to which it is carried and not on the rates in effect during the years in which the loss is sustained.

Under present law, NOLs must be carried back to the three immediately preceding taxable years (unless the carryback is waived). To the extent that they are not used up by profits in those years, they can be carried forward 15 years.(1)

2. NOLs in Acquisitions

Until the passage of the Internal Revenue Code of 1954, the federal statutory provisions allowed NOLs to be used only by the "taxpayer" that sustained them. The 1954 Code introduced express statutory rules for the transfer of tax attributes, including NOLs, from one corporation to another. Under section 381 of the Code, operating rules were provided for the transfer of corporate tax attributes in many transactions, including tax-free reorganizations under sections 368(a)(1)(A), (C), and (F) of the Code. If a transaction failed to qualify as a reorganization for technical reasons, the NOL did not move to the acquiring corporation and if the loss corporation was liquidated the NOL disappeared. Since the provision applied only to transfers of corporate tax attributes, it did not affect the acquisition of a profitable corporation by a loss corporation in which the NOLs stayed where they were.

The post-acquisition use of NOLs is subject to certain restrictions under federal law. Under section 269 of the Code, a taxpayer that acquires control of another corporation (defined in terms of 50 percent ownership of voting power or value) or a corporation that acquires another corporation's property in certain transactions for the principal purpose of securing the benefit of certain tax attributes, including NOLs, cannot use them.

Under section 382 of the Code, a corporation's use of its NOLs is restricted if in general more than 50 percent of its stock is acquired by new shareholders. The NOLs are not extinguished, but the income each year against which the NOLs can be applied after the acquisition is limited to a percentage of the value of the loss corporation on the date of the acquisition equal to the return that federal long-term bonds could be expected to yield if their interest were exempt from tax. The theory is that the use of the NOLs in the hands of the buyer (or in the hands of the target now owned by the buyer) should be limited to the use that the loss company could have made of them if the acquisition had not occurred. It is assumed that the loss company would have earned income each year equal to a reasonable return on its value and, further, that the return is reflected by the federal long-term tax-exempt bond rate.

Even if the use of a loss company's NOLs is not restricted or eliminated by sections 269 and 382, the federal consolidated return regulations provide that, if the loss company remains a separate corporation in the hands of the buyer and files a consolidated return with the acquiring corporation, its post-acquisition losses within the consolidated return group can be applied only against its own income and not against that of other members of the group.(2)

State Statutory Provisions

1. NOLs Generally

The States vary considerably in the extent to which they allow NOLs to be carried forward and back. Some States incorporate the federal 15-year carryforward and 3-year carryback periods.(3) Other States allow the 15-year federal carryforward but allow no carryback, apparently being reluctant to allow a corporation that sustains losses to request an immediate refund with respect to prior years.(4) Other States allow shorter carryforward periods.(5)

All States have some mechanism for limiting carryforwards and carrybacks to NOLs attributable to the State. The most common approach is to apply the State's apportionment formula to taxable income determined by taking the NOL into account.(6) Other States limit NOLs to losses actually sustained in the State.(7) Some States require the corporation to have been a taxpayer in the State for the year in which the loss was sustained.(8)

Some States have limited the use of carryforwards and carrybacks in order to raise revenue. Sometimes, these limitations apply only to carrybacks.(9) In other cases, they apply to carryforwards.(10) Some States have even suspended the use of NOLs on a temporary basis.(11)

The implication of these special rules for tax planning purposes is that corporations contemplating acquiring another corporation with NOLs should not assume that NOLs that are available for federal tax purposes will also be available for state tax purposes.

2. NOLs in Acquisitions

Many States allow the transfer of NOLs from one corporation to another in certain acquisitions in the same manner as does the federal tax law. Some state statutes expressly adopt section 381 of the Internal Revenue Code.(12) Other States adopt section 381 implicitly under their federal/state conformity provisions because no express variance from federal law is provided.(13)

Other States, however, have no provision for the transfer of NOLs in corporate acquisitions. These statutes typically provide that a "taxpayer" can apply NOLs from one year against the income of another year but no mechanism is provided for the movement of an NOL from one corporation to another in an acquisition, even if the acquisition is a statutory merger or other form of tax-free reorganization.

Survival of NOLs in States Lacking Statutory Provisions for Their Transfer

The remainder of this article focuses on the extent to which NOLs survive a corporate acquisition in States that lack express statutory authorization for their transfer from one corporation to another. The courts of these States have had to wrestle with the question of how broadly to interpret the statutory reference to the "taxpayer" that can use NOLs from one year against income in another year. A literal reading of the statutes, giving words their everyday meaning, would lead to a conclusion that NOLs cannot be transferred from one corporation to another. In some States, however, the courts have allowed the surviving corporation in a merger to use the pre-merger NOLs of the merged corporation under some circumstances.

Federal Case Law

1. Transfer of NOLs in Acquisitions

Before the enactment of the Internal Revenue Code of 1954, the federal tax statutes did not provide for the transfer of NOLs in corporate acquisitions. The federal statutes provided simply that an NOL could be used by the "taxpayer" that sustained it.

A series of federal tax cases addressed the question of when, if ever, the acquiring corporation in an acquisition could be treated as the same "taxpayer" as the target corporation for purposes of the NOL provisions. Although these cases are now of only academic interest to federal tax practitioners, they are of considerable interest to their state and local tax counterparts because the state courts, faced with a relative lack of state authorities in point, have turned to the old federal cases for guidance.

In New Colonial Ice Co. v. Helvering, the Supreme Court held that the NOLs of a corporation did not survive a transaction in which the corporation's assets and liabilities were transferred to a new corporation that was owned by the same shareholders in a transaction that was not a statutory merger under state law.(14) The old corporation remained in existence as an empty shell for about 16 months after the transfer. The transferor had been formed for the purpose of producing and selling ice. It ran into financial difficulties before its equipment was fully installed and at a time when its plant was operating at only 40 percent of capacity. A creditors' committee and shareholders committee were formed and all parties agreed that it would be necessary to form a new corporation to take over the assets and liabilities of the old one. Although the shareholders of the new corporation were the same as the shareholders of the old one, the Court held that it was a different taxpayer and that its separate identity could not be disregarded. It said that the NOLs of the old corporation were "personal...and not transferable to or usable by another."(15)

In Helvering u. Metropolitan Edison Co., the Supreme Court held that the surviving corporation in what it concluded was a statutory merger under Pennsylvania law could deduct unamortized discount and expenses with respect to bonds issued by the transferor and retired by the surviving corporation.(16) The Internal Revenue Service conceded that the deductions would be available if the transaction qualified as a statutory merger under state law and the only issue before the Court was the nature of the underlying transaction. The case is of interest principally because the court said, in describing the nature of a merger, that "the corporate personality of the transferor is drowned in that of the transferee."(17) This language has been cited by many taxpayers and some courts in arguing that the merged corporation's NOLs as well as its "personality" passed to the surviving corporation in a merger.

In a case more directly in point, the court in Stanton Brewery, Inc. v. Commissioner held that the surviving corporation in a merger could apply unused excess profits tax credits of the merged corporation against its post-merger income.(18) The case involved the statutory merger of a wholly owned subsidiary into its parent corporation. The parent had been a holding company and the merged subsidiary had been an operating company that had unused excess profits credits (generally 95 percent of average base period net income). The credit was a mechanism for ensuring that the excess profits tax was imposed only on excess profits and not on all profits. Thus, Stanton did not involve NOLs. The court relied on an analysis of the nature of corporate mergers. It said that the surviving corporation in a merger was "the union of component corporations into an all-embracing whole which absorbs the rights and privileges, as well as the obligations, of its constituents."(19) It appears that the surviving parent corporation was a mere holding company all of the assets of which consisted of the stock of the operating company. This being the case, the assets of the subsidiary that generated the credit were the same assets that produced the post-merger income and, hence, a continuity-of-business analysis would lead to an allowance of the credit after the merger. Nevertheless, the court rested its conclusion on its view of the nature of a statutory merger, which would have led to the same result even if the parent had conducted a separate active business before and after the merger and, presumably, even if the subsidiary's former assets had not generated income after the merger.(20) The court cited Metropolitan Edison's "drowning" metaphor.

In a case involving NOLs, the court in Newmarket Manufacturing Co. v. United States allowed the surviving corporation in a merger to carry back NOLs to offset the pre-merger income of the merged corporation.(21) Newmarket involved a simple reincorporation in another State. A Massachusetts corporation merged downstream into its Delaware subsidiary, which had been formed two months before, carried on no business, had no liabilities, and had assets consisting of a nominal amount of cash. The purpose of the merger was to reincorporate the parent company in Delaware to avoid certain Massachusetts tax liabilities. The surviving corporation was in all respects identical to the merged corporation, except that it was organized under the laws of a different State. Although the surviving corporation was a different legal entity from the merged corporation, the court said that they should be treated as one "taxpayer":

When, as here, everything in the business remains

the same, except for the change of corporate domicile 

from Massachusetts to Delaware, the answer

as an a priori matter seems easy: Income-tax-wise,

there is no more reason why the Congress should

choose to attach crucial significance to a mere

change of corporate domicile than it would to a

change of an individual taxpayer's domicile from

Massachusetts to Delaware.(22)

The court noted that only a single business was involved and that, unlike the facts in Libson Shops, Inc. v. Koehler (which had been decided by the U.S. Court of Appeals for the Eighth Circuit but not yet by the Supreme Court), the merger did not have the result of allowing the use of an NOL against income that would not have happened if the merger had not occurred.(23) The court noted that under the 1954 Code (which had been enacted but which did not apply to the years at issue) the merger would have been treated as a reorganization under section 368(a)(1)(F) of the Code and the carryback would clearly have been allowed. Although the legislative history to the 1954 Code specifically stated that it should not be viewed as guidance in interpreting the 1939 Code, the court believed that it was significant that when Congress focused specifically on the problem before the court it concluded that the carryback privilege should not be lost.

The court cited Metropolitan Edison for its discussion of the nature of a statutory merger, saying "that the transferee in a statutory merger should be deemed to be continuing in itself the corporate life of the now-defunct component, and that it followed from this conceptual identity that the two corporate entities were to be treated for a substantive purpose in the income tax as the same taxpayer."(124)

The court's language in Newmarket was broad enough to encompass any merger, even one involving corporations conducting different businesses. Nevertheless, its distinguishing Libson Shops on the ground that Libson Shops involved the use of NOLs that could not have been used had the merger not occurred suggests that Newmarket should have been confined to the facts of the case before it -- involving a mere reincorporation of a business in another State with the surviving corporation being identical with the merged corporation but for the new corporate domicile.

The Supreme Court finally addressed the issue head-on when the Libson Shops case came up from the Eighth Circuit. In Libson Shops, Inc. v. Koehler, the Court held that a corporation resulting from the merger of 17 corporations that had filed separate income tax returns could not carry over and deduct pre-merger NOLs of three of the merged corporations against post-merger income attributable to the businesses of the other corporations.(25) All of the corporations were owned by the same individuals in the same proportions. Sixteen of them sold women's clothing at retail and one, the surviving corporation, provided management services for the other sixteen. Three of the corporations had NOLs attributable to pre-merger years.

The IRS argued that the surviving corporation could not use the NOLs of the merged corporations because it was not the same legal entity that sustained the losses and there was no mechanism in the 1939 Code for transferring the losses to the surviving corporation in a merger. The Supreme Court did not base its decision on this argument because it accepted the IRS's alternative contention that the same "taxpayer" that sustained the loss was not involved "since the income against which the offset is claimed was not produced by substantially the same businesses which incurred the losses."(26) The loss corporations continued to sustain losses after the merger and the Court noted that if there had been no merger there would have been no opportunity to use their pre-merger losses in the taxable year at issue because they did not generate income in that year.

It seems clear that in Libson Shops all of the corporations were involved in the same business in that they were all selling women's clothing at retail and they were linked by common ownership with a management service corporation that served them all. It seems likely that they would have been viewed as operating a "unitary business" as that term has generally been applied in state combined report tax litigation. Thus, what the Court really seems to have been saying is not that the losses must be matched against the income of the same business but, rather, that they must be matched against the post-merger income produced by the same assets that had produced the pre-merger losses. The Court's reasoning seems to have been asset-oriented rather than business-oriented. The Court distinguished Newmarket on the ground that in Newmarket the old corporation would have been entitled to a carryback if the merger had not occurred because the post-merger income was generated by the same operation that had produced the pre-merger loss. The reference to the filing of separate returns by the constituent corporations suggests that the Court might have reached a different conclusion if they had filed consolidated returns, in which case the merger would not have afforded an opportunity to use losses that would not have been available without the merger.

The first case decided after Libson Shops was a First Circuit decision in which the court expanded the scope of its holding in Newmarket, holding that the surviving corporation in a reorganization could carry back post-reorganization losses against the pre-reorganization income of the absorbed corporation even where the two corporations conducted separate businesses. In F.C. Donovan, Inc. v. United States, a parent corporation conducted a leather business and its wholly owned subsidiary conducted a plastics business.(27) The subsidiary was liquidated into the parent in a transaction that was not a statutory merger.(28) The two businesses continued to be conducted by the parent after the liquidation and separate records were kept showing the income and expenses of each. After the liquidation, the plastics division, which operated the business previously conducted by the subsidiary, sustained losses. The court held that they could be carried back and applied against the pre-liquidation income of the subsidiary. Noting that a carryback of the losses against the same income would have been allowed if the liquidation had not occurred, the court read Libson Shops as conditioning the availability of the carryback on the continuation of the same business and not on legal formalities. Thus, the carryback should be allowed even though the transaction was effected by a liquidation, which was tax-free under the Internal Revenue Code, and not as a statutory merger.

The IRS then reconsidered its position. In Revenue Ruling 59-395, it announced that in the wake of Libson Shops it would allow NOLs to be transferred in a merger or consolidation under the following circumstances.(29) Pre-merger NOLs of a merged corporation could be transferred to the surviving corporation and used against income generated by the loss corporation's assets after the merger. NOLs generated after the merger by the surviving corporation from assets of the merged corporation could be carried back to offset pre-merger income of the merged corporation. If a group of corporations before a merger had filed consolidated returns, the companies would be treated in the aggregate as one business and one group of assets in applying these principles. The IRS said that the transfer of NOLs under these circumstances would be allowed only in statutory mergers and consolidations and not in other types of tax-free reorganizations.

The IRS's concession did not end the litigation, since it was limited to rather narrow circumstances. In Westinghouse Air Brake Co. v. United States, the Court of Claims held that a parent's pre-merger excess profits credit carryovers could not be used against the post-merger income of its subsidiary after the parent merged down-stream into the subsidiary.(30) The claimed credit exceeded the income that was produced after the merger by the business unit formally operated by the parent. The court said that allowing the credit under these circumstances would violate the continuity-of-business principle of Libson Shops. Although recognizing that the continuity-of-business principle could involve difficult accounting issues because of the need to trace the activities of the former merged corporation within the corporate shell of the surviving corporation, the court said that was not a problem in the case before it because the surviving corporation had accounted for these activities as a separate division.

This represented a shift in the Claims Court's position In a pre-Libson Shops case, Koppers Co. v. United States, the court had allowed the surviving corporation in a merger to carry back excess profits credits against the pre-merger income of the constituent corporations.(31) In that case, the court had based its analysis on the nature of a statutory merger, indicating that the surviving corporation represented the continuation of the pre-merger rights and obligations of the merged corporation, citing Stanton Brewery and Metropolitan Edison. After Libson Shops, the court concluded that the proper mode of analysis was to focus on continuity of business rather than on continuity of corporate identity.

2. Pre-Merger Losses of Surviving Corporation

Although Libson Shops involved the application of NOLs of one corporation against the income of another, it was perhaps inevitable that the Court's emphasis on continuity of business would lead to an extension of the principle to situations in which a single corporation tried to apply pre-merger NOLs against post-merger income of an acquired business. In Julius Garfinckel & Co. v. Commissioner, the court held that a corporation could not apply its pre-merger NOLs against the income of a business that it acquired from another corporation in a merger.(32) A single shareholder owned 58 percent of the loss corporation and 100 percent of the profitable corporation during the period in which the losses were generated. After the profitable corporation merged into the loss corporation, the shareholder owned 95 percent of the loss corporation. Both corporations conducted a retail clothing business, but the post-merger profits against which pre-merger losses were attempted to be applied were from the operations previously conducted by the merged corporation. The surviving corporation had discontinued the operation that had generated the losses. The court concluded, applying Libson Shops, that the corporation should not be allowed to apply its old losses against its new income because the income was generated by assets other than those that had produced the losses. It recognized that the Supreme Court in a footnote in Libson Shops had said that it was not passing on situations involving a single corporation that changed the nature of its business, but it concluded that the principle of Libson Shops should be extended to that kind of case.

3. NOLs of a Single Corporation That Has a Change in Shareholdings and Business

In the years before Libson Shops, the IRS had tried several times to disallow NOLs of a single corporation where there was a change in shareholdings and business even though the same legal entity continued. The IRS argued that the change in the corporation's ownership and business meant that it should be treated as a different "taxpayer," even though the corporate entity remained the same. The courts rejected these attempts, holding that there was no statutory basis for treating the corporation as a new taxpayer notwithstanding the change in its personality, if not in its identity.(33)

Libson Shops changed the landscape, however, and the IRS had more success in applying the same theory after the Supreme Court had spoken. In Mill Ridge Coal Co. v. Patterson, the court held that a corporation that was engaged in the coal mining business could not carry over its NOLs after its stock was sold to new shareholders, the coal business was discontinued and its assets were sold, and the corporation began to conduct an oil transportation business.(34) The court said that the principle of Libson Shops should apply to a single corporation that had a change of shareholders and a change of business. The changes meant that the corporation should not be viewed as the same "taxpayer" within the meaning of the NOL carryforward provisions.

Similarly, in Commissioner v. Virginia Metal Products, Inc., a corporation bought the stock of a corporation with NOLs from unrelated shareholders. It caused the loss corporation to sell its assets and then transferred a business previously operated by the corporate buyer into the loss corporation's shell. The court held that there had been a change of both business and shareholdings and that under Libson Shops the use of the NOLs against the income of the business contributed by the new shareholder should be disallowed.(35)

A similar result was reached in J.G. Dudley Co. v. Commissioner.(36) The court found that the NOLs should be disallowed under the predecessor of section 269 because the new shareholders had acquired the corporation's stock with the principal purpose of using its NOLs, but as an alternative ground it cited Libson Shops. Although the case before it involved only a single corporation and not the merger of a number of corporations, the court read Libson Shops and later cases to mean that "the continuity of the same business rather than the continuity of the same corporate structure is the test of the right of a taxpayer to deduct losses incurred in a previous year."(37)

In a clarification of its position, the IRS announced in Revenue Ruling 63-40 that it would not rely on the rationale of Libson Shops where a loss corporation purchased a profitable business so long as there was no significant change in the loss corporation's stock ownership.(38)

State Authorities

1. Regulatory Interpretations

The tax administrators in several States have taken a hard-line position with respect to the statutory language, concluding that the word "taxpayer" should be narrowly construed and that NOLs should not pass from one corporation to another under any circumstances, even where the merger involves a simple reincorporation from one State to another State with no change in the corporation's assets, liabilities, business, or shareholders.(39)

Massachusetts follows a more liberal approach. Although generally NOLs will not pass from one corporation to another in a merger, an exception is made if the merger qualifies as a mere change in form under section 368(a)(1)(F) of the Internal Revenue Code.(40) The North Carolina authorities are somewhat more restrictive, allowing NOLs to pass to the surviving corporation in a merger only if the surviving corporation is an empty shell before the merger so that it becomes identical in all respects to the merged corporation after the merger.(41)

2. State Court Cases

The courts in several States have rejected the restrictive approach of the state tax administrators, applying continuity-of-business principles and determining whether a corporation after an acquisition or a change in its business was the same "taxpayer" that incurred the losses before the change. The state courts have often looked to the federal precedents for guidance, although with the increase in state tax litigation they have increasingly looked to cases in other States as well. The application of continuity-of-business concepts by the state courts has been unsystematic, however, and has left many unresolved questions.

The North Carolina statute has been a fruitful source of litigation. The statute does not expressly provide for the transfer of NOLs in a corporate acquisition and the courts have generally taken a restrictive approach to the survival of NOLs in corporate transactions.

In Distributors v. Shaw, three separate corporations were each engaged in distributing religious books in different territories. They were owned by the same shareholders. Two of the corporations were merged into the third. The court said that the record before it was incomplete and did not address the nature of the businesses that the three corporations had carried on before the merger or what business the surviving corporation conducted after the merger. It similarly did not indicate which group of assets had produced the post-merger income. The court said that on this bare record it had no basis for applying the continuity-of-business principle of Libson Shops and it remanded the case for further proceedings.(42)

On remand, in Good Will Distributors (Northern), Inc. v. Currie, the court held that the surviving corporation could not use the pre-merger NOLs of one of the merged corporations.(43) The court said that the continuity of business required by Libson Shops was not present because, as a result of the merger --

a larger and more expanded business came into

being and included all of the former income producing

businesses. There was no continuity of the

business of either of the constituent corporations.

By reason of the merger a new and more extensive

enterprise has emerged. This new enterprise did

not suffer the loss and cannot claim a deduction 

therefor.(44)

Under this approach, the post-merger use of pre-merger NOLs would be prohibited in almost all cases where one of the corporations was not an empty shell. There was no suggestion in Good Will that the merged enterprise was larger and different from the sum of the constituent parts. It was simply a combination of those parts and that by itself was enough to extinguish the loss. There was no suggestion that the combination of the three corporations had enabled the business to expand, to change, or to do things that it could not have done if the corporations had remained separate.

Holly Farms Poultry Industries v. Clayton involved a similar situation.(45) Three corporations, all of which were wholly-owned subsidiaries of a common parent, merged. The surviving corporation was engaged before the merger solely in the business of manufacturing feed for farm animals, primarily for poultry. As a result of the merger, it acquired the "feed out" chicken business of one of the merged corporations and the experimental farm operation of the other merged corporation. Its net worth increased by a0 percent as a result of the transaction. The court held that the surviving corporation could not use the pre-merger NOLs of the merged corporations. Its business was "substantially enlarged and materially affected" by the merger and the requisite continuity of business was, thus, not present.(46 There is no indication whether the operations that had previously been conducted by the merged loss corporations generated taxable income after the merger. Under the court's analysis, that would not have been relevant because in the court's view the expansion of the surviving corporation's business as a result of the merger was enough to prevent the use of the NOLs. As in Good Will, there was no showing of whether the assets of the loss corporation produced income after the merger.

In Fieldcrest Mills, Inc. v. Coble, a parent corporation was not allowed to use the pre-merger NOLs of its wholly-owned subsidiary after the subsidiary merged into it.(47) Before the merger the corporations operated as independent entities, although they had dealings with each other. Some of the subsidiary's management personnel were employees of the parent, but the parent charged the subsidiary an arms-length amount for their salaries. The court adopted a more analytical approach than had the courts in Good will and Holly Farms, examining the nature of the operations of the constituent corporations. It noted that in the first year after the merger the operations previously conducted by the subsidiary had continued to generate losses so that an allowance of its NOLs against the overall taxable income of the parent would result in their application against income generated by assets that had not produced the losses. The court analyzed the development of the federal case law before and after Libson Shops and concluded that the general principle to be derived from those cases was that the pre-merger loss of a merged corporation could be used by the surviving corporation but only to the extent that the income was generated by the same business or assets that had produced the loss before the merger. The corporations had filed consolidated federal income tax returns before the merger but they had filed separate North Carolina returns so they could not be viewed as a single enterprise before the merger. The court noted that the state legislature had convened several times in the years since the Distributors and Good Will cases and that it had on occasion amended the NOL provisions. The court reasoned that if the legislature had disapproved of the results in those cases it would have reversed them by statute.

The most recent development in North Carolina is a rather curious one arising in a county court. In Bellsouth Telecommunications, Inc. v. North Carolina Department of Revenue, the surviving corporation was allowed to use the merged corporation's pre-merger NOLs after a merger despite its failure to prove that the merged corporation's old assets generated post-merger income.(48) The court noted that the merged corporation was the surviving corporation's wholly-owned subsidiary and the surviving corporation had been required to form it by an order of the Federal Communications Commission. But for that order, it would have conducted the target's operations, and sustained its losses, itself. The two corporations were engaged in substantially the same business. It is not clear whether the decision in Bellsouth will stand up on appeal or be approved in later cases. It seems inconsistent with other decisions of higher courts in the State and, in any event, it is likely to be limited to the unique circumstance in which the merged corporation was required to be formed by regulators.

Although the North Carolina courts appear to have taken a restrictive position with respect to the survival of NOLs in mergers, the analysis of the source of losses and income by the court in Fieldcrest may offer some hope to taxpayers. If it can be shown that the assets that generated the pre-merger loss generated income after the merger in the hands of the surviving corporation, the use of the NOLs against that income may be permitted.

Courts in several other States have read the word "taxpayer" more expansively. In Bracy Development Co. v. Milam, the surviving corporation was allowed to use pre-merger losses of a merged corporation.(49) Bracy Realty, Inc. and Bracy Development Co. were separate corporations with the same principal place of business and the same officers. They both were engaged in the business of constructing public housing projects. The opinion does not indicate their stock ownership, but they were obviously related. Realty accumulated a substantial NOL and was near financial collapse when it merged into Development. The taxpayer pointed to the state merger statute, which provided that the surviving corporation inherited all of the merged corporation's assets and liabilities. The court said that both corporations were engaged in the same type of business even though they were not identical and that the conduct of business by the surviving corporation after the merger was merely a continuation of the business that both corporations had previously conducted. Interestingly the opinion does not state whether the post-merger income of Development was generated by the old Development assets or by the old Realty assets. The implication is that they were probably generated by the old Development assets, because nothing in the opinion indicates that a turnaround was effected or even attempted. The court apparently did not believe that the source of the losses and income made a difference; it was enough that the two corporations had engaged in the same business.

Chilivis v. Studebaker Worthington, Inc. involved slightly more complicated facts, but the court viewed it as being a simple reincorporation.(50) Two subsidiaries of a common parent transferred all of their assets and liabilities to new subsidiaries of the same parent that were incorporated in different States and were then liquidated into those corporations. The transactions did not involve statutory mergers, but they were treated as tax-free reorganizations under section 368(a)(1)(C) of the Internal Revenue Code. One of the corporations had NOLs, and the court held that its successor corporation could apply those NOLs against its post-reorganization income. The court looked to the federal case law, including Libson Shops, for guidance and held that the successor corporation was virtually identical to the old corporation. Unlike the taxpayer in Good Will, which the court cited, the corporation continued the same operation that its predecessor had conducted and was not "a larger and more expanded business."(51)

An Arizona court failed to allow the use of pre-merger losses of the merged corporation against post-merger income of the surviving corporation in State Tax Commission v. Oliver's Laundry & Dry Cleaning, Co.(52) In Oliver's, two individuals owned all the stock of a corporation that was engaged in a laundry and dry cleaning business. They bought the stock of another corporation that was engaged in the same type of business but had a different location with different employees, physical plant, and accounts. The two corporations were operated as separate entities. One corporation provided laundry and administrative services for the other but charged a fee for the services. One of the corporations, New Cascade, incurred NOLs. It was then merged into the other corporation, Oliver's. After the merger the New Cascade operation was discontinued. One of the shareholders testified that if New Cascade had continued in business it would have continued to lose money. The court held that it was improper to allow the surviving corporation to benefit from the pre-merger NOLs of the merged corporation. The taxpayer argued that the two corporations were engaged in the same business and that therefore the transfer of the pre-merger NOLs was proper, but the court rejected this argument, adopting an assets approach. It noted that the constituent corporations in Libson Shops had been engaged in the same type of business but the Supreme Court had refused to allow the NOLs of some of the retail stores in that case to be applied against post-merger income of the other stores. In Oliver's, the operation that had generated the losses had been discontinued and that prevented the use of the pre-merger NOLs against the post-merger income of the other operation, even though the operations were of the same type.

In Richard's Auto City, Inc. v. Director, Division of Taxation, the New Jersey Supreme Court held that pre-merger losses of the merged corporation could not be used by the surviving corporation after the merger.(53) This case involved a merger of two corporations that were engaged in an integrated unitary business. Richards Auto City was an automobile dealership. Catena, Inc. was a leasing company that provided lease financing for Auto City's customers. Initially, Richard Catena was the sole shareholder of each corporation. In January 1984 he transferred all of the shares of Catena to Auto City, making Catena a wholly-owned subsidiary of Auto City. During the next few years, Catena incurred substantial NOLs. In late 1986 Catena merged into Auto City in a transaction that was treated as a tax-free liquidation under section 332 of the Internal Revenue Code.

The New Jersey Tax Court held that Catena's losses could not be applied against Auto City's income.(54) The Appellate Division reversed, basing its analysis on the state corporate merger statute, which provided generally that the surviving corporation in a merger succeeded to the assets, liabilities, and business of the merged corporation.(55) The Supreme Court reversed, holding that the statute was ambiguous and did not clearly authorize the surviving corporation in a merger to use the pre-merger NOLs of the merged corporation. There was therefore a strong presumption in favor of the validity of the Division of Taxation's Regulations, which provided that under no circumstances could a merged corporation's NOLs pass to the surviving corporation.(56) The court noted that the state legislature knew of the existence of section 381 of the Internal Revenue Code when it enacted New Jersey's NOL provisions and it could have enacted a comparable provision if it had wanted to. It found support for its decision in Libson Shops, noting that while the corporations were engaged in related businesses those businesses were not identical. It also noted that New Jersey did not allow combined reports and concluded that this reflected a judgment that two corporations, even if they were engaged in a unitary business, should be treated as separate taxable entities.

An application of the continuity-of-business test to the facts in Richards might have led to a conclusion that the corporations were engaged in a singled integrated unitary business and that this might have been relevant. Unlike the situation in Oliver's, where the two corporations conducted the same kind of business but in separate unrelated operations, in Richards, they were part of a single integrated business with Catena providing financing for Auto City's customers. On the other hand, there was no showing in Richards that the assets that generated the loss produced income after the merger and it is therefore not clear whether an assets analysis would have produced a different result.

Recent cases in Connecticut have shown some novel approaches to the problem. Although the Connecticut statute generally cross-references the Internal Revenue Code in computing net income, it does not incorporate section 381 and the courts have viewed it as not providing a mechanism for the transfer of NOLs.(57)

Initially, the Connecticut Supreme Court adopted a restrictive approach to the transfer of NOLs in mergers. In Golf Digest/Tennis, Inc. v. Dubno, the court did not allow pre-merger NOLs to pass to the surviving corporation in a merger.(58) Golf Digest, Inc. and Tennis Features, Inc. were separate Illinois corporations that were consolidated into Golf Digest/Tennis, Inc., a Delaware corporation. Tennis had a preconsolidation NOL and it continued to operate at a loss after the consolidation as a division of the surviving corporation. The court noted the existence of the Libson Shops line of cases, but it stopped short of adopting a continuity-of-business test. It said that the Connecticut statute did not specifically provide for a carryover of NOLs in a merger and that, since deductions were a matter of legislative grace and were construed against the taxpayer, the burden was on the taxpayer to show that the statute --

clearly and unambiguously authorizes a surviving

corporation to claim a deduction for the operating

losses that had been incurred by an acquired corporation

prior to the consolidation.(59)

The taxpayer failed to meet this burden of persuasion. The court said in dictum that because the "business unit" that had sustained the pre-consolidation losses continued to operate at a loss after the consolidation those losses would not have been available to the surviving corporation after the consolidation even if the court had adopted a continuity-of-business test.

Nevertheless, the seeds of a continuity-of-business approach were planted in Golf Digest/Tennis, and the principle was adopted in rather surprising circumstances in Thermatool Corp. v. Department of Revenue Services.(60) In Thermatool, a corporation, Industries, had two wholly owned subsidiaries: Thermatool 1 and Inductotherm. Thermatool 1 had NOLs. In order to apply these NOLs against Inductotherm's income, Thermatool 1 merged into Inductotherm.(61) The taxpayer conceded that Inductotherm could not use Thermatool 1's losses on its Connecticut returns under the principle of the Golf Digest case. After the NOLs had been used for federal tax purposes, the business that had been previously conducted by Thermatool 1 and then conducted as a separate division by Inductotherm was transferred to a new wholly owned subsidiary of Inductotherm, Thermatool 2. The stock of Thermatool 2 was promptly spun off to Industries, the common parent. As a result, the corporate structure after the transactions was identical to the corporate structure before the transactions began except that the Thermatool business was now being conducted by Thermatool 2: Thermatool 1 had disappeared, but Thermatool 2 was a carbon copy of it, with the same assets, liabilities, business, customers, and employees.

The court held that Thermatool 2 was the same "taxpayer" as Thermatool 1 had been for purposes of the Connecticut statute and that therefore it could use Thermatool 1's old NOLs, which had been dormant and which had not been available to Inductotherm during the time that the Thermatool 1 business had been conducted as a division of Inductotherm. The Department of Revenue Services argued that Thermatool 2 was a different corporation from Thermatool 1 and therefore could not be treated as the same "taxpayer," but the court rejected this argument. Tracing the evolution of pre-1954 Code federal cases, it said that the proper approach was functional rather than formalistic and that Thermatool 2 and Thermatool 1 were "for all practical purposes, the same business enterprise."(62)

The generous approach of the court in Thermatool surfaced again in Grade A Market, Inc. v. Commissioner of Revenue Services.(63) The court held that the surviving corporation in a statutory merger could deduct pre-merger NOLs of the merged corporations because it represented a continuation of the pre-merger business enterprise. In Grade A Market, the Cingari family owned and operated three retail supermarkets. Grade A Market, Inc. operated a supermarket in Stamford, Grade A Market of Darien, Inc. operated a supermarket in Darien; and Grade A Market of Newfield, Inc. operated a supermarket in the Newfield section of Stamford. The corporations had identical officers, directors, and shareholders. The court found that the three corporations were operated in effect as three divisions of a single integrated business. Although each corporation had a separate bank account, at the end of every business day the receipts were swept into a single account. The payroll for all three corporations was paid from a single account and vendors to all three corporations were paid from a single account. Employees were interchangeable and might be assigned to different corporations on different days. All employees were covered by the same fringe benefit plans and all corporations used the same accounting staff and management. Family members were assigned functions for all three corporations. For example, one individual was in charge of the grocery department of all three corporations.

In 1985, two of the corporations, Newfield and Darien, were merged into the third, and oldest, corporation, Market. The purpose of the merger was to reduce administrative costs. Each of the merged corporations had NOLs that predated the merger, and the issue was whether those NOLs could be used against the income of the surviving corporation after the merger.

The Commissioner of Revenue Services argued that only the corporate entity that incurred a loss could deduct that loss from its income in a later year. He described his theory as an "entity theory." The taxpayer argued what the court described as a "functional" theory under which pre-merger losses should be applied against post-merger income if the same business was continued.

The court accepted the taxpayer's argument and held that the survival of NOLs in a merger should be governed by continuity-of-business principles. It said that a four-factor test should apply:

1. Has the surviving corporation retained the same corporate identity of the pre-merger corporations?

2. Has the business enterprise that produced the loss been continued in the surviving corporation?

3. Has there been a substantial change in the ownership of the surviving corporation's stock?

4. Was the income-producing business of the surviving corporation altered, enlarged, or materially affected by the merger?

The court said that the four-factor test was met and that the surviving corporation should be entitled to use the pre-merger NOLs of the merged corporations. It said that the old corporations continued their same identity but as divisions of the surviving corporation, the enterprise that produced the losses was continued, and the old business continued exactly as it had been conducted before. The vendors and customers were unaware of the merger and there had been no change in shareholdings. The court noted that the three corporations before the merger did not operate functionally as separate corporations; the shareholders had effectively treated them as a single corporation.

The court distinguished Golf Digest because there the corporations had functioned as separate corporations before the merger. The court purported to adopt the continuity-of-business test of Libson Shops, but it stated that test in terms of whether the assets that produced the loss continued to be used in the same business in the surviving corporation. Referring to the North Carolina cases of Good Will and Holly Farms, the court said that the business in Grade A Market had not been altered, enlarged, or materially affected by the merger. This arguably misconstrues the North Carolina cases, because in those cases the aggregate combined business of the constituent corporations had not similarly been altered or enlarged or materially affected. The North Carolina courts, in preventing the transfer of NOLs, had held that the business of the surviving corporation had been altered and enlarged by the merger, and that was clearly the case also in Grade A Market because Grade A Market, Inc. after the merger was operating three supermarkets instead of just one.

Moreover, in Grade A Market the merger did make a difference in the use of NOLs. Darien, which had NOLs before the merger, continued to lose money in the first year after the merger, which was the year before the court. The court's decision enabled those losses to be applied against the post-merger income of Newfield. Thus, if the court had applied an asset-oriented continuity-of-business test, the use of Darien's NOLs against Newfield's post-merger income would not have been allowed.

The facts in Grade A Market were highly unusual, because the court seemed influenced by the fact that the shareholders had ignored the separate corporate entities of the three corporations before the merger and had treated them in effect as a single corporation. Even if the decision is upheld on appeal, it is likely that the case will be interpreted in the future as being confined to its rather narrow factual situation.

Analysis

Courts in States the statutes of which do not provide for a transfer of NOLs in acquisitions have struggled with situations in which a literal application of the statutory language was viewed as inconsistent with their notion of fairness. Ironically, the continuity-of-business doctrine, which was viewed by the Supreme Court initially as a means of limiting the use of NOLs, has developed in the state context into a means of expanding their use. The courts have on occasion allowed the post-merger use by the surviving corporation of pre-merger NOLs of the merged corporation to offset income of the same business. The courts have had to be somewhat creative in doing this because of the statutory language that authorizes the use of NOLs only by the "taxpayer" that incurred them. The issue has been whether the word "taxpayer" should be applied to a legal entity or to a business. Since the "taxpayer" that files a tax return is ordinarily a legal entity, the entity approach is more in keeping with traditional legal concepts. Nevertheless, defining "taxpayer" for this purpose in terms of a business or a group of assets makes more sense as a matter of economics and tax policy.

The simplest and most compelling case for the transfer of NOLs is a statutory merger that is intended simply to reincorporate a corporation in another State. The paradigmatic case is one in which the management of a corporation that is incorporated under the laws of, say, New Jersey decides that the corporation should be incorporated in Delaware because the corporate laws of Delaware are more hospitable. The most common way to do this is to form a new corporation in Delaware and to merge the old corporation into the new corporation. Unfortunately, state law does not simply permit a corporation to sign a document saying that it is now a Delaware corporation. The assets, liabilities, and businesses of the New Jersey corporation are transferred to the Delaware corporation automatically by operation of law. After the transaction, the Delaware corporation is in all respects identical to the New Jersey corporation, with the same assets, liabilities, and shareholders. The only difference is that it is now incorporated under the laws of Delaware.

The transfer is a tax-free reorganization under section 368(a)( 1)(F) of the Internal Revenue Code. It is treated for all purposes under the federal tax laws as a non-event. For example, although ordinarily the taxable year of a corporation ends when it merges out of existence, in an "F" reorganization of the type hypothesized the corporation is regarded as a single continuing corporation and its taxable year does not end on the date of the merger.(64) In fact, the Delaware corporation can even use the old taxpayer identification number of the New Jersey corporation.(65)

Under these circumstances, it would be absurd to suggest that the Delaware corporation is not the same "taxpayer" as was the New Jersey corporation. It is hard to imagine a tax administrator who would not contend that the Delaware corporation was liable for back-tax liabilities of the New Jersey corporation primarily and not merely as a transferee. Although some States explicitly provide that a corporation that reincorporates in another State loses its NOLs. such a position is indefensible.(66) The few courts that have been called upon to address the issue have properly held that the NOLs were available to the surviving corporation.(67) Other courts are likely to follow suit. In fact, state tax administrators should not even press the point. If they litigate these cases, it is likely that the courts, in rejecting their position, will use continuity-of-business language that could be expanded to apply to other situations where the merger involved the combination of two or more active business corporations.

If the States accept the proposition that a mere reincorporation in another State does not result in a change of "taxpayer" so that the merged corporation's NOLs survive the merger, what happens if the facts are varied slightly? Would the result be the same, for example, if the stock of a minority shareholder was surrendered in exchange for cash or if a new person became a shareholder through a capital contribution as part of the same transaction? The IRS has sent out conflicting signals on whether such a transaction is an "F" reorganization under these circumstances. In Revenue Ruling 75-561, it said that there must be "complete identity of shareholders and their proprietary interests in the transferor and acquiring corporations" for a transaction to be an "F" reorganization.(68) In other situations, however, the IRS has suggested that changes in shareholdings would not necessarily destroy "F" reorganization status.(69) More recently, the IRS ruled in Revenue Ruling 96-29 that a public offering occurring immediately after a reincorporation or a merger occurring immediately before would not affect the status of the reincorporation as an "F" reorganization.(70) The better view is that reflected in Revenue Ruling 96-29. The reincorporation transaction should be viewed as separate from changes in shareholdings that occur simultaneously and changes in shareholdings should be given the same tax treatment as if they were isolated transactions. In the NOL context, the right result is that a simple reincorporation in another State should have no effect on the corporation's NOLs. If there are concomitant changes in the corporation's shareholdings and business, those changes should be viewed apart from the merger and their effect on NOLs, if any, should be based on continuity-of-business principles.

An easy case on the other side of the spectrum is that in which in connection with a merger the merged corporation s business is discontinued and its assets are sold. Here, not only is the surviving corporation a different legal entity but the post-merger income is attributable to a different group of assets than those generating the loss. It is hard to discern any justification for extending the concept of "taxpayer" across entity lines under these circumstances.

The treatment of a combination of two or more businesses where the surviving corporation is not the mere alter-ego of the merged corporation and where the business of the merged corporation is continued by the surviving corporation presents a tougher case. One approach is to read the statute literally, apply the word "taxpayer" on an entity basis, and not allow the NOLs to move to the surviving corporation. This would be a permissible reading of the statutory language because of the traditional way in which the word "taxpayer" is generally applied. This approach is exemplified by the decision of the New Jersey Supreme Court in Richards Auto City, Inc. On the other hand, this produces a harsh result. As a matter of tax policy, it is hard to see an abuse in a situation in which the assets that produced a loss generate income after the merger. Had there been no merger, the NOLs would have been offset against the income in question. Should a merger, which is supposed to involve a combination of corporations and not a sale, result in a loss of the NOLs? The force of this argument might be weakened where a substantial part of the consideration received by the merged corporation's shareholders is cash or property other than stock of the acquiring corporation, but an argument can still be made that the surviving corporation in a merger represents an amalgamation of the constituent corporations regardless of the consideration that is issued.

One can argue that state legislatures should be presumed to be aware of section 381 of the Internal Revenue Code and to have made a conscious decision not to have adopted it, as the New Jersey Supreme Court in Richards Auto City reasoned. This may, however, give state legislatures too much credit for presumed tax expertise.

Another approach is the "pool of assets" approach, which is reflected in the North Carolina opinions. Under this view, the merged corporation's NOLs should be available after a merger only for use against income produced by the assets that generated the loss before the merger. In effect, the assets are treated as the "taxpayer." This is consistent with the continuity-of-business approach that has been developed in the federal cases. It has an analog in the separate return limitation year (SRLY) rules of the federal consolidated return regulations under which NOLs of a corporation that joins an existing consolidated return group are used only against post-acquisition income of that corporation.(71) Although the SRLY rules are entity-based and not asset-based, the principle of treating one component of a corporate structure as independent for purposes of applying past losses against future income is common to both approaches.

Under a strict asset approach, it would not be necessary that the assets be used in the same business after the merger. Inasmuch as any transfer of NOLs to a new entity (other than an absolute alter ego of the transferor, as in the reincorporation situation) might be viewed as something of a stretch of the statutory language, however, it would not be improper to suggest that the income must be produced by the same assets as part of the same business.

A continuity-of-assets or a pool-of-assets concept would have to be developed under an asset-oriented test. It would not be proper to require that the very same assets continue to be used forever. For example, replacement of manufacturing equipment or furniture in the normal course of business should not destroy an NOL even though this might result in the assets five years after the merger being different from the assets at the time of the merger.

Once one accepts the concept of replacement of assets in the ordinary course of business, line-drawing problems emerge. Should continuity of business be defeated if a manufacturing plant in one location is sold and the proceeds are used to buy a plant in a new location to produce the same product? What if some but not all of the employees are transferred to the new location? Should it matter that the plant comprises 90 percent of the business's assets? What if it comprises only one percent of the business's assets?

Most of the litigation in this area has involved taxable years immediately after the merger. If the surviving corporation continues the merged corporation's business intact for three years after the merger and then there is a wholesale change in the business's assets, should any continuing NOLs be affected at that time? The most sensible approach for both tax policy and administrability purposes is to treat as separate independent occurrences any changes that were not an integral part of the merger transaction. In other words, if major changes in the surviving corporation's business involving the assets received in the merger occur several years later as a result of new circumstances, those changes should not affect the transfer of NOLs in the merger. They should be addressed separately and their effect, if any, on NOLs should be determined without regard to the fact that the assets were acquired in a merger a few years before.

The most generous approach from the standpoint of taxpayers would be to allow the use of pre-merger losses against post-merger income of the same business even if that income is not necessarily produced by the same assets. This approach was expressly rejected in the North Carolina cases, which held that the expansion of the surviving corporation's operations resulting from the addition of the merged corporation's operations was enough to defeat the transfer of the NOLs even if the two corporations had been engaged in the same business. The approach was accepted by the Arkansas court in Bracy and, arguably, by the Connecticut court in Grade A Market, although Grade A Market might be limited to situations in which the corporations before the merger operated in effect as one entity without regard to corporate boundary lines.

Under a business-oriented approach, NOLs can be used by the surviving corporation after a merger even if it cannot be shown that the same operation that generated the loss before the merger is now generating income after the merger. This approach was arguably rejected by the Supreme Court in Libson Shops. Although the Court there spoke in terms of continuity of business, it is clear that all of the constituent corporations in that case were engaged in the same business and the problem was that the taxpayer was trying to apply the pre-merger losses of some of the stores in the business against the post-merger income generated by other stores in the same business.

Applying a strict continuity-of-business test can be difficult when the business changes. Identifying a "business" is not always easy. It is a rare merger in which an absorbed business is continued without change in personnel. If a corporation conducting a retailing operation with 20 stores merges into another corporation and 5 of the stores are closed after the merger, as would not be at all uncommon, can one say that the "business" has survived? What if five new stores are added? What if they are in different parts of the country?

The difficulty in some cases of tracing a business in the hands of a surviving corporation should not be a reason for rejecting the continuity-of-business concept. The taxpayer has the burden of proving its case and if separate accounting is not followed the loss can be denied on the theory that the taxpayer has failed to meet its burden of proof.

A tougher question is presented under the continuity-of-business test when the business that generated the loss is continued by the surviving corporation but it continues to produce losses. There, the issue is whether the pre-merger losses of the merged corporation can be applied against post-merger income of the surviving corporation from operations other than that which generated the loss. One can argue that there is no particular equitable case for allowing such use.

A still more generous approach for taxpayers is to apply a continuity-of-business approach on a unitary business basis. Under this view, pre-merger NOLs could be applied against post-merger income of any part of a unitary business into which the merged corporation was integrated after the merger, even if it was not the same business as that in which the merged corporation was engaged.

Conclusion

Reasonable arguments can be brought to bear in support of each of the approaches outlined in this article. The author believes that a strict entity approach, reflected in the Montana and New Jersey regulations, under which NOLs can never be transferred to the surviving corporation in a merger even in the paradigm reincorporation in another State case where the surviving corporation is identical in all respects to the merged corporation is improper. Extending transfers of NOLs to transactions that go beyond that case raises serious questions of statutory interpretation. Although it would not be unreasonable to deny a transfer of NOLs in these situations, the author believes that in the context of the NOL provisions it would be reasonable to allow the use of pre-merger NOLs against post-merger income generated by the same pool of assets that produced the loss. Requiring that they be used in the same business would not be improper. On the other hand if those assets continue to generate losses after the merger, it is harder to justify applying the pre-merger losses to income produced by other assets of the surviving corporation even if those assets are used in the same business. Ultimately, the solution to the problem lies in persuading the legislatures of the States to adopt the principles of section 381 of the Internal Revenue Code. Aside from the administrative benefits of conformity with the federal system, allowing the transfer of NOLs in tax-free reorganizations is consistent with the nature of those transactions. Putting it another way, if a state legislature recognizes those transactions as being tax-free for income tax purposes with a carryover basis of assets, it should also allow the transfer of tax attributes, including NOLs.

(*) Footnotes are printed beginning on page 309.

Notes

(1) I.R.C. [sections] 172(b)(1). The periods vary for certain types of taxpayers and certain types of losses. (2) Treas. Reg. [sections] 1.1502-21. (3) See, e.g., D.C. Code [sections] 47-1803.3(a)(14), Haw. Rev. Stats. [sections] 235. 7(d):Ill. Rev. Stats. [sections] 2-207; Ia. Code [sections] 422 35.13; Utah Rev. and Tax Code [sections] 59-7-110(2)(b) (for losses from taxable years, starting after 1993). Some States, such as New York, incorporate the federal rules automatically under their conformity provisions. (4) See, e.g., Col. Rev. Stats. [subsections] 39-22-504(1), (3); Minn. Stats. [sections] 290.095.1(a), N.M. Stats. Ann. [sections] 7-2A-2(1), Oh. Rev. Code [sections] 5,33.04(I)(1), Or. Rev. Stats. [sections] 317.476; R.I. Gen. Laws [sections] 44-11-11(b); S.C. Code [sections] 12-7-430(d)(2); Wis. Stats. [sections] 71.26(4). (5) 5 years: (Ark. Code Ann. [sections] 26-51-427(1) (B) Ariz. Rev. Stats. [sections] 43-1123.B; Cal. Rev. and Tax Code [subsections] 24116(b) and (e) (reduced from 15 years for taxable years starting after 1993); Conn. Gen. Stats. [sections] 12-217(a); N.C. Gen. Stats. [sections] 105-130. 10 years: (Id. Code [sections] 63-3022(d)(1); Kans. Stats. Ann. [sections] 79-32,143(a); Mich. Comp. Laws [sections] 208.23(e)). (6) See. e.g., Col. Rev. Stats. [sections] 39-22-504(1). Colorado does not allow an NOL to be carried to a year in which a different apportionment method is used from that used in the year in which the loss was sustained. Rev. Stats. [sections] 39-22-504(5). The Department of Revenue w ill allow a NOL sustained in a two-factor year to be carried forward to any other two-factor year in the carryforward period regardless of the number of intervening years. Letter of September 17, 1988, cited in CCH Colorado State Tax Reporter at [paragraph] 10-440.55. (7) See, e.g., Miss. Regs. [sections] 506. (8) See, e.g., Ga. Code [sections] 48-7-21(b)(3); Id. Code [sections] 63-3022(d)(2); Miss. Regs. [sections] 506 (loss must have been reported on a return); Mo. Regs. 12-CSR [sections] 10-2 165(3), R.I. Gen. Laws [sections] 44-11-11(b), Utah Code Ann. [sections] 59-7-108(14j(g); Wis. Stats. [sections] 71.26(4). (9) See, e.g., Id. Code [sections] 63-3022(d)(1) (maximum of $100,000 from any taxable year); N.Y. Tax Law [sections] 208.9(f)(5) (maximum of $10,000 from any taxable year); Vt. Stats. Ann. [sections] 5888 (refund from carrybacks cannot exceed $10,000 for any loss year ending before April 30, 1991; 0 for years ending after April 29, 1991, and beginning before 1993; and $5,000 for years beginning in 1993 and 1994). (10) California limits carryforwards to 50 percent of the NOL (except for certain small businesses). Rev. and Tax Code [sections] 24416(b). (11) See, e.g, Cal. Rev. and Tax Code [sections] 24416.3 (no losses carried into 1991 or 1992); Pa. Tax Reform Code [sections] 401(3)(M) (repeal of use of carryovers for years starting after 1990; NOLs restored beginning in 1995, but only to the extent of $500,000 per year; the constitutionality of the repeal has been upheld, Garofolo, Curtiss, Lambert & MacLean, Inc. v. Commonwealth, 167 Pa. Commw. 672, 648 A.2d 1329 (1994), CCH Pennsylvania State Tax Reporter [paragraph] 202-581. (12) See, e.g., Ala. Code [sections] 40-18-35.1(6); Cal. Rev. and Tax Code [sections] 24591; Minn. Stats. [sections] 290.095(3)(e); Wis. Stats. [sections] 71.26(3)(n). (13) See, e.g., Delaware, Illinois, Kansas, New York. (14) 292 U.S. 435 (1934) (15) 292 U.S. at 440. (16) 306 U.S. 522 (1939). (17) 306 U.S. at 529. (18) 176 F.2d 573 (2d Cir. 1949). (19) 176 F.2d at 575. (20) Stanton Brewery was followed in E. & J Gallo Winery v. Commissioner, 227 F.2d 699 (9th Cir. 1955). (21) 233 F.2d 493 (1st Cir. 1956), cert. denied, 353 U.S. 983 (1957). (22) 233 F.2d at 497 (23) Libson Shops, Inc. v. Koehler, 229 F.2d 220 (8th Cir. 1956). (24) 233 F.2d at 499. (25) 353 U.S. 382. Although decided in 1957, the case involved taxable years under the 1939 Code. (26) 353 U.S. at 390 (27) 261 F.2d 470 (1st Cir. 1958). (28) The subsidiary's corporate existence continued for about a year after the transaction, when it was dissolved. (29) 1959-2 C.B. 475. (30) 342 F.2d 68 (Cl. Ct. 1965). (31) 134 F. Supp. 290 (Cl. Ct. 1955). (32) 335 F.2d 744 (2d Cir. 1964), cert. denied, 379 U.S. 962 (1965). (33) See, e.g, Northway Securities Co. v. Commissioner, 23 B.T.A. 532 (1931); Alprosa Watch Corp. v. Commissioner, 11 T.C. 240 (1948); A.B. & Container Corp. v. Commissioner, 14 T.C. 842 (1950); WA G E, Inc. v. Commissioner, 19 T.C. 249 (1952). (34) 264 F.2d 713 (5th Cir. 1959). (35) 290 F.2d 675 (3d Cir. 1961). (36) 298 F.2d 750 (4th Cir. 1962). (37) 298 F.2d at 754. See also Federal Cement Tile Co. v. Commissioner, 338 F.2d 691 (7th Cir. 1964). (38) 1963-1 C.B. 46. (39) See Montana (Regs. ARM [sections] 42.23.415); New Jersey (Regs. [sections] 18:75.13(b)); Tennessee (Rule [sections] 1320-6.21(2)(d)); Texas (Ruling of Comptroller of Public Accounts, Microfiche No. 9406L1315804 (1994)). (40) Regs. [sections] 63.30.2(11)(a); Letter Ruling 95-4, CCH Massachusetts State Tax Reporter [paragraph] 400-209. (41) Letter of Corporate Income and Franchise Tax Division of November 9, 1964, cited at CCH North Carolina State Tax Reporter at [paragraph] 10-320.51. (42) 247 N.C. 157, 100 S.E.2d 334 (1957). (43) 251 N.C. 120, 110 S.E.2d 880 (1959). (44) 251 N.C. at 127. (45) 9 N.C. App. 345, 176 S.E.2d 367 (1970). (46) 9 N C. App. at 351. (47) 290 N.C. 586, 227 S.E.2d 562 (1976). (48) 95-CVS-1982 (Mecklenburg Ct. Sup. Ct. 1996). (49) 252 Ark. 268, 478 S.W.2d 765 (1972). (50) 137 Ga. App. 337, 223 S.E.2d 747 (Ct. App. 1976). (51) 137 Ga. App. at 343. (52) 19 Ariz. App. 442, 508 P.2d 107 (1973). (53) 140 N.J. 523, 659 A.2d 1360 (1995). (54) 12 N.J. Tax 619 (1992). (55) 270 N.J. Super. 92 (App. Div. 1994) (56) Regs. [sections] 18:7-5 13(b) (57) Conn. Gen. Stat. [sections] 12-217. (58) 203 Conn. 455, 525 A.2d 106 (1987). (59) 203 Conn. at 465. (60) 43 Conn. Supp. 260, 651 A.2d 763 (1994). (61) Although the primary purpose of the merger was to give Inductotherm the benefit of Thermatool 1's NOLs, the transaction was not subject to section 269 of the Internal Revenue Code because section 269(a)(2), which is the provision that applies to mergers, does not apply when the corporations have a common owner. It is unclear whether the corporations were filing consolidated federal returns. It is possible that they were but that the Thermatool 1 losses were separate return limitation year (SRLY) losses that could not be used against the income of other members of the consolidated return group. Treas. Reg. [sections] 1.1502-21. (62) 651 A.2d at 770. (63) No. CV-91-0398721S (Cone. Super. Ct. 1996), reported at CCH Connecticut State Tax Reporter [paragraph] 400-140. (64) I.R.C. [sections] 381(b)(1); Rev. Rul. 66-284, 1966-2 C.B. 115. (65) Rev. Rul. 73-526, 1973-2 C.B. 404. (66) See, e.g., Montana Regs. ARM [sections] 42.23.415; New Jersey Regs. [sections] 18:7-5.13(b). (67) See, e.g, Chilivis u. Studebaker Worthington, Inc., 137 Ga. App. 337, 223 S.E.2d 747 (Ct. App. 19761: Newmarket Manufacturing Co. v. United States, 233 F.2d 493 (1st Cir. 1956), cert. denied, 353 U.S. 983 (1957). (68) Rev. Rul. 75-561, 1975-2 C.B. 129. (69) Rev. Rul. 79-250, 1979-2 C.B. 156; Rev. Rul. 80-105, 1980-1 C.B. 78; See also Aetna Casualty & Life v. United States. 568 F.2d 811 (2d Cir. 1976). (70) 1996-24 .I.R.B 1. For a critique of the ruling (with which this writer disagrees), see Lee Sheppard, One Small Step for the Step Transaction Doctrine, Tax Notes, May 27, 1996, at 1135. (71) Treas. Reg. [sections] 1.1502-21.

PETER L. FABER is a partner in the New York City law offices of McDermott, Will & Emery. He has served as chair of the American Bar Association's Section of Taxation and as chair of the New York State Bar Association's Tax Section. He is a frequent lecturer on tax topics and has written numerous articles on a variety of tax subjects.