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Final Sec. 382 Regs. on distributions from qualified trusts.

While Sec. 382 is extremely complicated, there has been a level of certitude for practitioners that, if all the provisions applicable to a Sec. 382 analysis are properly taken into account (no easy feat), a taxpayer should know its cumulative ownership shift when determining whether it has experienced an "ownership change" under Sec. 382(g). However, recently enacted final regulations reshape this theory when distributions from certain qualified trusts (mainly pensions) are involved.

See. 382 Generally

Sec. 382 limits a corporation's ability to use its net operating losses (NOLs) and other attributes after an ownership change. An ownership change occurs when there is a greater-than-50% shift in ownership among "5% shareholders." The determination of 5% shareholders allows for the computation of cumulative ownership shifts. A cumulative computation of the ownership shift is required on each "testing date." The regulations specify various events (e.g., stock issuances, redemptions and stock sales) that give rise to a testing date. Ordinarily, on each testing date, a taxpayer either has an ownership change (in which case the process is stopped, a limit is determined and the analysis is reset) or merely notes the cumulative shift and moves on to the next testing date.

On June 28, 2006, TD 9269 was released, finalizing regulations under Regs. Sec. 1.382-10, which provides special rules on distributions from qualified trusts. The reason for the new regulations was a concern that, absent a special rule, a distribution from such a trust could cause an ownership change. The regulations apply only to qualified trusts as defined in Sec. 401(a) (i.e., pensions and profit-sharing and stock-bonus plans).

The general rule under Sec. 382(1)(3) is that, when determining stock ownership for Sec. 382 purposes, the Sec. 318 constructive ownership rules apply. Thus, if 10 individuals each own 10% of a partnership, which in turn owns 50% of the loss corporation being analyzed, the attribution rules will treat each individual as a 5% owner (and shareholder) of the loss corporation for Sec. 382 purposes; see Sec. 318(a)(2)(A). If the partnership were to dissolve and distribute its assets, there would be no ownership-shift effect with respect to each such individual, because Sec. 382 has already acknowledged them as 5% shareholders.

Trusts: This holds true for most trusts as well. However, the attribution rules explicitly do not apply to trusts described under Sec. 401(a). Thus, if individual X owns 10% of a pension that owns 50% of a loss corporation, X will not be treated as a 5% shareholder for Sec. 382 purposes. Because there is no attribution, the pension is treated as an individual 5% shareholder that owns 50% of the loss corporation; see, e.g., Temp. Kegs. Sec. 1.382-2T(h)(2)(iii) (B). If the pension thereafter were to distribute its stock in the loss corporation, X would be treated as a new 5% shareholder for Sec. 382 purposes. The ownership shift would be 5%, their current interest over their lowest ownership interest during the three-year testing period (which was 0%). Thus, the answer differs, depending on whether the first-tier entity is a partnership or a Sec. 401(a) trust such as a pension.

Final Regs.

The final regulations seek to correct the apparent iniquity between these two treatments. Kegs. Sec. 1.382-10(a) (1) applies to distributions from qualified trusts under Sec. 401(a). It provides that if such a trust "distributes an ownership interest in an entity ..., then for testing dates on or after the date of the distribution, the distributed ownership interest is treated as having been acquired by the distributee on the date and in the manner acquired by the trust and not as having been acquired or disposed of by the trust." In other words, the later action of distribution will have the effect of treating the holder of the distributed interest as having owned the stock all along. Thus, under the previous facts, X would be treated as having been the original owner of the interest in the pension, just as was the case when a partnership was involved. The pension's distribution of the loss corporation's stock to X would result in a 0% ownership change. Kegs. Sec. 1.382-10(a)(1) indicates that the act of distribution, however, is not a testing date (as it is neither an ownership nor an equity structure shift). However, unlike the partnership context, this is a later change to the ownership analysis (as the Sec. 318 attribution rules still do not apply to Sec. 401(a) trusts). Thus, can the final regulations affect prior determinations of whether there has been an ownership change for Sec. 382 purposes?

The preamble to the temporary regulations states, "[b]ecause the rule applies only for testing dates on or after the date of the distribution, a distribution does not retroactively cause (or undo) an owner shift that would (or would not) have occurred if the distributee had actually acquired the ownership interest on the date and in the manner acquired by the trust"; see TD 9063 (6/26/03). The final regulations adopt the temporary regulations with no substantive changes. Thus, it appears that, even though the regulations treat the distributed interest as having been acquired on the date the qualified trust acquired such interest, there will be no retroactive application that could either cause or undo an ownership shift or change on those prior testing dates. Yet, the rules can have a profound effect going forward.

In determining which ownership interests have been distributed by the Sec. 401(a) qualified trust, the final regulations provide further guidance. They state that the loss corporation must either specifically identify the ownership interest so distributed by the Sec. 401(a) qualified trust or use a FIFO methodology.

Example 1: X, Y and Z have each owned an equal interest in Loss Co. since its formation on Jan. 1, 2005. Loss Co. has 90 shares of common stock issued and outstanding; each of the three individuals owns 30 shares. On June 1, 2006, Pension (a qualified trust under Sec. 401(a)) purchased 18 shares (20%) of Loss Co. pro rata from X, Y and Z. On Dec. 1, 2006, Pension distributed all 18 shares to X, Y and Z (six shares each). On March 1, 2007, Loss Co. issues 60 new shares of common stock to investor A.

June 1, 2006 was a testing date, because Pension acquired Loss Co. stock and became a 5% shareholder. On that date, Pension's ownership was 20%. Its lowest percentage of ownership of Loss Co. stock at any time within the testing period (Jan. 1, 2005-June 1, 2006) is 0%, resulting in a 20% shift. X, Y and Z each owned 24 shares on June 1, 2006, representing approximately 26.7% ownership apiece, which is also the lowest percentage ownership for all three within the testing period, resulting in a 0% shift for each individual. Thus, the cumulative ownership shift on June 1,2006 was 20%.

Dec. 1, 2006 was not a testing date, as the only transaction was Pension's distribution of 18 shares. Under Kegs. Sec. 1.381-10, X, Y and Z will each be deemed to have owned their six distributed shares from June 1, 2006 forward. Thus, for all future testing dates, they will be treated as having owned 30 shares each from June 1, 2006 forward.

March 1, 2007 is a testing date, because A was issued Loss Co. stock and became a 5% shareholder. On that date, A's ownership is 40%, and A's lowest percentage of ownership of Loss Co. stock at any time within the testing period (Jan. 1, 2005--March 1, 2007) is 0%, resulting in a 40% shift. X,Y and Z have each owned 24 shares outright since Jan. 1,2005. In addition, they actually owned six shares apiece from Jan. 1, 2005--June 1,2006, and have been deemed to own such shares from June 1,2006--March 1, 2007. Each owns 20% of Loss Co., which is also the lowest percentage ownership for all three within the testing period, resulting in a 0% shift for each individual. Thus, the cumulative ownership shift on March 1,2007 is 40%.

Example 2: X, Y and Z have each owned an equal interest in Loss Co. since its formation on Jan. 1, 2005. Loss Co. has 90 shams of common stock issued and outstanding; each of the three individuals owns 30 shams. On June 1,2006, Pension, a qualified trust under Sec. 401(a), purchased 18 shams, or 20% of Loss Co., pro rata from X, Y and Z. On Dec. 1, 2006, Loss Co. issued 60 new shares of common stock to A. On March 15, 2007, Pension distributes all 18 shares to X, Y and Z (six shares each). Note: Example 2 is the same as Example 1, except the new issuance and pension distributions are reversed in timing.

For June 1,2006, the analysis is the same as in Example 1; thus, the cumulative ownership shift on that date was 20%.

Dec. 1, 2006 was also a testing date, because A was issued Loss Co. stock and became a 5% shareholder. On that date, A's ownership was 40%. A's lowest percentage of ownership of Loss Co. stock at any time within the testing period (Jan. 1, 2005-Dec. 1,2006) was 0%, resulting in a 40% shift. X, Y and Z each own 24 shares, or 16%, of Loss Co., which is also the lowest percentage ownership for all three within the testing period, resulting in a 0% shift for each individual. Pension owns 18 shares, or 12% of Loss Co. Its lowest percentage of ownership within the testing period is 0%, resulting in a 12% ownership shift. Thus, the cumulative ownership shift on Dec. 1, 2006 was 52%. Loss Co. experienced an ownership change within the meaning of Sec. 382(g) on that date and its pre-ownership-change NOL carryovers will be appropriately limited.

March 1,2007 is not a testing date, as the only transaction is Pension's distribution of 18 shares. Under Regs. Sec. 1.381-10, X, Y and Z will each be deemed to have owned their six distributed shares from June 1,2006 forward. However, this will not operate to eliminate the Sec. 382 ownership change on Dec. 1,2006.

Conclusion

These examples help illustrate potential pitfalls in dealing with distributions from Sec. 401(a) qualified trusts. Practitioners in this area should pay special heed when one of the owners of a loss corporation is a qualified trust. In sum, the:

* Sec. 318 attribution rules do not apply to qualified trusts. This is an important exception to the general entity attribution rules.

* New final regulations operate to treat distributions from qualified trusts as having been so acquired at the time and in the manner acquired by the qualified trust.

* Effect of the final regulations applies only for current and future testing dates, and cannot affect past determinations.

FROM GREG A. FAIRBANKS, J.D., LL.M., WASHINGTON, DC
COPYRIGHT 2007 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:CORPORATIONS & SHAREHOLDERS
Author:Fairbanks, Greg A.
Publication:The Tax Adviser
Date:Feb 1, 2007
Words:1836
Previous Article:Filing season tax minimization ideas.
Next Article:Automatic enrollment in Secs. 401(k) and 403(b) plans.


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