Protecting and preserving net operating losses.
A net operating loss is also important to an entity in bankruptcy. In an effort to protect net operating losses, the bankruptcy court applies several provisions in the bankruptcy code (Title 11 of the U.S. Code) to curb or restrict the conduct of a third party. The courts say that the net operating loss is property of the bankruptcy estate (11 USC section 541[a]) and property of the estate comes under the protection of the automatic stay (11 USC section 362[a]).
Net Operating Loss
The term net operating loss is defined in section 172 of the Internal Revenue Code as "the excess of deductions allowed by this chapter over gross income." In other words, a net operating loss occurs, for tax purposes, in a year when tax-deductible expenses exceed taxable revenues.
IRC section 172 permits a company to use a net operating loss incurred in the current year to offset profits from a different year. In general, this is accomplished by either carrying back the loss (up to two years) or by carrying it forward (up to 20 years). When electing to carry back a loss, a company is permitted to use the loss to offset income of the prior year, file an amended return, and obtain a refund of taxes previously paid. The alternative is to carry forward the net operating loss and use it to offset income earned in a subsequent period, up to 20 years into the future.
A company must elect to waive its right to carry back a net operating loss. In the year in which the net operating loss occurs, the taxpayer must attach a statement to the return indicating that the company is relinquishing the entire carryback period. Once made, this election is irrevocable. If the company is in bankruptcy, however, there is an exception to the irrevocable nature of the election to forgo the carryback of a net operating loss. A bankruptcy trustee can avoid this election under the fraudulent transfer provisions of 11 USC section 548.
In U.S.A. v. Sims (218 F.3d 948 [Ninth Circuit 2000]), the taxpayer filed a return for the 1993 tax year reflecting a net operating loss of $972,000. Under IRC section 172, the taxpayer had the option of carrying back the loss or electing to revoke carryback treatment and carry the net operating loss forward. Five months later, the taxpayer filed for bankruptcy under Chapter 7.
The Chapter 7 trustee filed amended income tax returns, utilizing the carryback provisions of IRC section 172, and requested refunds totaling $287,000 for 1990 and 1991. The IRS disallowed the refund requests, claiming the taxpayer made an irrevocable election not to carry back the net operating loss incurred in 1993. The trustee, in an adversary proceeding brought against the IRS, claimed the irrevocable election made by the taxpayer under IRC section 172 was a fraudulent transfer under 11 USC section 548. Under section 548, the trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred within one year before the date the bankruptcy petition was filed. The IRS argued that the irrevocable election was beyond the reach of the trustee.
The Court of Appeals for the Ninth Circuit agreed with the trustee. The court agreed that the election to waive the carryback of the net operating loss is irrevocable for the taxpayer; however, the trustee is not constrained to act solely as the debtor (taxpayer) could. The trustee has a duty to maximize the recoverable assets of the bankruptcy estate on behalf of creditors.
The Discharge of Indebtedness
The creation of indebtedness and the subsequent repayment of the debt have not generally been viewed as events that give rise to the realization of gain, because anything gained by the debtor from the loan proceeds has been correspondingly lost by the repayment of the loan (Richard C. McQueen and Jack F. Williams, Tax Aspects of Bankruptcy Law and Practice, Third Edition, Clark, Boardman, Callaghan, 1997). A different result occurs, however, when the debt is cancelled or reduced.
In United States v. Kirby Lumber Co. (284 U.S. 1, 76 L. Ed. 131, 52 S. Ct. 4 ), the U.S. Supreme Court held that the cancellation of indebtedness constituted a taxable event. The rule from Kirby can be stated as follows: When a debt is reduced or cancelled, a taxable gain is created in favor of the debtor equal in amount to the difference between the amount of the original debt obligation and the consideration paid for its discharge or reduction. If no consideration passes, the entire amount of the indebtedness is treated as taxable gain.
The cancellation of debt can be a major source of income in insolvency and bankruptcy cases (Grant W. Newton, Corporate Bankruptcy: Tools, Strategies, and Alternatives, John Wiley & Sons Inc., 2003). IRC section 61 lists discharge of debt as something that must be included in gross income and thus subject to income tax.
There are two situations where the discharge of indebtedness does not result in gross income:
* The discharge occurs in a Title 11 (bankruptcy) case, and
* The discharge occurs when the debtor is insolvent.
For a company in insolvency, the exclusion from income arising from the discharge of indebtedness is limited. The amount excluded cannot exceed the amount by which the debtor is insolvent. For example, if a company has assets of $15 million and debt of $20 million, it may discharge up to $5 million without creating taxable income.
For a company in bankruptcy, there is no limit on the amount of the discharge. While no taxable income results from the amount of the discharge of indebtedness, there is a different price to pay. Under IRC section 108(b), the company's tax attributes, including any net operating loss, are reduced by the amount of the debt discharged. The forgiveness of indebtedness does not affect the ability of the corporation to carry forward net operating losses.
Restrictions on the Transfer of Entities
Because of the power that net operating losses possess--to offset future or past income or reduce or eliminate debt on a tax-free basis--there is the potential for abuse. As a result, the IRC sets limits and restrictions on the transferability of entities having net operating losses. These rules are extremely complex and are not discussed in detail here.
Simply stated, IRC section 382 contains special rules governing the preservation of net operating losses for entities in bankruptcy. A net operating loss can be substantially reduced or eliminated entirely if these rules are violated. IRC section 382 restricts transfers where there has been change in corporate ownership of more than 50%. These changes in ownership are either the result of stock sales or corporate reorganization.
Property of the Estate
It is accepted practice to treat net operating losses as property of the bankruptcy estate. The bankruptcy code provides for the creation of an estate upon the filing of a petition in bankruptcy court. This estate is composed of all property owned by the debtor, including all legal or equitable interests in property, wherever located, at the commencement of the case.
The description of property that is included in the bankruptcy estate is quite broad (Michael J. Holleran, Donna Larsen Holleran, John D. Mickle, and John B. Corr, Bankruptcy Code Manual, 2005-2006 Edition, Thomson West, 2005). In enacting the statute governing property of the estate, Congress intended to define such property as broadly as possible, consistent with the desire to give the debtor a meaningful opportunity to reorganize and obtain a fresh start (In re: Hunter, 201 B.R. 959 [Bankr. E.D. Ark. 1996]). Property of the estate is defined broadly to include any property to which the estate has some right (Dalton Hydro LLC v. Town of Dalton, 889 A.2d. 24 [N.H. 2005]).
The definition of property included in the estate is so important that it was adjudicated by the U.S. Supreme Court in Segal v. Rochelle (U.S. 375, 86 S. Ct. ). In Segal, two individuals and their partnership each filed for bankruptcy in 1961. The partnership sustained a pre-petition tax loss (net operating loss) for that year. Each partner used the net operating loss by utilizing the carryback provisions of IRC section 172. Each partner filed amended personal tax returns for 1959 and 1960 entitling them to tax refunds for each year. The bankruptcy trustee argued that the individuals were not entitled to the refunds because they were property of the estate.
Both the Fifth Circuit Court of Appeals and the U.S. Supreme Court agreed with the trustee. Both courts held that the loss carryback and the refund claims were property of the estate and transferrable at the time the bankruptcy petition was filed.
Segal is an old case but it is still good law. The Court's decision in Segal dealt only with the issue of net operating loss carrybacks. The Court did acknowledge that loss carry-forwards might be worthy of different treatment: "We are told that if this loss carryback refund claim is 'property,' that label must also attach to loss carryovers, that is the application of pre-bankruptcy losses to earnings in future years. Without ruling in any way on a question not before us, it is enough to say that a carryover into post bankruptcy years can be distinguished conceptually as well as practically."
Another important case dealing with the treatment of net operating losses is In re: Prudential Lines Inc. (928 F.2d. 565 [2nd Cir. 1991]). In Prudential Lines, there were two corporations; the parent (PSS) and the subsidiary (PLI). Over time, PLI had accumulated net operating losses of $74 million. Creditors commenced involuntary bankruptcy proceedings against PLI under the reorganization provisions of Chapter 11 of the bankruptcy code. PSS was informed by its tax counsel and accountants that it could take a worthless stock deduction on its PLI stock. In so doing, however, any net operating loss carryfoward would be lost under the change of ownership rules contained in IRC section 382.
PSS attempted to use this as leverage in its negotiations with its creditors. In response, the creditors commenced an adversary proceeding in the bankruptcy court to have PSS enjoined from taking the worthless stock deduction. The creditors committee alleged, among other things, that the loss carryfoward was property of the bankruptcy estate and that by taking the worthless stock deduction, PSS would be violating the automatic stay. The Second Circuit agreed and permanently enjoined PSS from taking the deduction.
In a more recent case, the trustee of United Airlines' employee stock ownership plan (ESOP), was barred from selling its UAL stock because to do so might cause UAL to lose its net operating loss, an asset significant to its reorganization (In the Matter of UAL Corporation, 412 F.3d 775 [7th Cir. 2005]).
The ESOP owned approximately 51% of the UAL stock. UAL was concerned that by distributing the shares to the individual members of the ESOP it would violate the change of ownership rules in IRC section 382 and therefore risk losing the net operating loss (estimated to be between $2 billion and $3 billion).
The bankruptcy court granted UAL's injunction, and the U.S. District Court for the Northern District of Illinois affirmed the bankruptcy court's decision.
The trustee of the ESOP eventually obtained permission to distribute the shares; however, in the time it took to obtain approval, the price of the shares dropped nearly 30%. The trustee then appealed to the Seventh Circuit Court of Appeals to recover the damages sustained by ESOP members as a result in the drop in value of the shares. The Seventh Circuit held that the ESOP members could not recover damages, but it was not pleased with the legal reasoning employed by the lower courts.
The Seventh Circuit said that the bankruptcy judge's order not allowing members to sell their stock "imposed an inevitable injury" to the stockholders. It stated: "Requiring investors to bear the costs of illiquidity and underdiversification was both imprudent and unnecessary." United was attempting to preserve the value of its net operating loss, which only has worth if the company were to return to profitability. The court said there is no reason why investors who need liquidity should be sacrificed so that other investors (the debt holders) who will own UAL after it emerges from bankruptcy can reap a benefit.
In light of the issues raised in UAL, it will be interesting to see how the next major case involving net operating loss is decided.
Andrew J. DeJoseph, JD, LLM, CPA, is an instructor in the accounting and business administration department at Nassau Community College in Garden City, N.Y. This article is adapted from the thesis the author presented as part of the LLM program in bankruptcy law at St. John's University School of Law. The author is also a member of the Society's Bankruptcy and Financial Reorganizations Committee.
|Printer friendly Cite/link Email Feedback|
|Author:||DeJoseph, Andrew J.|
|Publication:||The CPA Journal|
|Date:||Dec 1, 2009|
|Previous Article:||Audit committee material weaknesses in smaller reporting companies.|
|Next Article:||Proposed changes in revenue recognition under U.S. GAAP and IFRS.|