Section 382 of the Internal Revenue Code generally requires a corporation to limit the amount of its income in future years that can be offset by historic net operating losses (NOLs) once that corporation has undergone an "ownership change." An important factor in determining whether or not an ownership change has occurred, and therefore whether or not a limitation is required, is determining the changes in the equity holdings of a corporation's 5-percent shareholders. A 5-percent shareholder, for purposes of Section 382, includes individuals, entities, and "public groups." Once a loss corporation's 5-percent shareholders have been identified, each such 5-percent shareholder's "interest in the loss corporation" must be measured.  This measurement is based upon each 5-percent shareholder's proportionate interest in the stock of the loss corporation as compared with all other holders of stock. Thus, if a loss corporation has issued multiple classes of stock, a relative value must be assigned to each class of stock to determine the percentage ownership interest held by each shareholder and the identity of each 5-percent shareholder of the loss corporation.
When a private equity group acquires a loss corporation, these issues can be difficult to resolve in a manner that provides all parties with a level of confidence that can be relied upon for both financial statement and tax return position purposes as to what the limitation may be on the NOLs as a result of this change or prior changes. For example, assume that a loss corporation (LossCo) was formed 10 years ago. Upon its formation it had three shareholders. Over the next five to six years LossCo issued various rounds of preferred stock, bringing in new cash and new investors each time.
In year seven LossCo did an IPO and became a public company and converted all the series preferred stock to common. Then, in year 10, PE (a private equity group) proposes to "take LossCo private." In a typical private equity going private transaction, private equity funds advised by the PE firm will contribute cash in exchange for stock to a newly formed "holding company." The new holding company may also borrow cash from an unrelated lender. In addition, this type of transaction often involves a partial rollover of certain key shareholders through the issuance of new common stock of the new holding company, usually to certain key managers or shareholders of LossCo, in exchange for the contribution of their LossCo shares to the new holding company. The transaction may involve the issuance of new preferred stock and possibly convertible debt, or just straight debt. The holding company's new cash is used to buy the stock of LossCo from the public and other selling shareholders in a tender offer. The remaining shareholders that did not sell their shares in the tender offer are generally "squeezed out" in a reverse cash merger whereby the new holding company causes a newly formed transitory acquisition subsidiary to merge with and into LossCo, with LossCo surviving.
Phase I—Threshold Diligence Issues
In this typical structure, a private equity buyer will have various due diligence items on its checklist to determine their potential ability to use the historic losses of LossCo, including items such as the following:
Generally, these documents will enable the PE firm to ascertain LossCo's previous equity shifts. The PE firm's next challenge is to estimate the value of each class of equity by looking at all issuance and transfer information with comparative value facts in evidence. Thus, in performing this inquiry, if the rounds of preferred stock have identical conversion ratios—say one-to-one into common—then the PE firm will need to look to other indicators of value by class, including: (i) whether adjustments have been made to the liquidation preference upon each round of preferred; (ii) whether the voting power increases; (iii) whether there are adjustments to other equity instruments, like options or restricted stock, as a result of the dilutive effect of later rounds of preferred with stronger preferences that effectively grant the holders a greater percentage of ownership in LossCo upon liquidation or other corporate transaction; and (iv) whether the rules relating to fluctuations in value should or could be applied to limit the percentage changes upon new issuances of stock. 
This inquiry into the equity shifts of LossCo must be performed back to the first day of the first tax year when LossCo had an NOL, built-in loss, or other similar tax attribute. Thus, a PE firm performing this analysis would start at year one, and "roll-forward" the equity shifts, testing date-by-testing date,  to determine whether LossCo had an ownership change on any testing date within any three-year testing period. As a practical matter, the analysis must generally begin on the first day of LossCo's first tax year (i.e., the PE firm cannot just go back three years from the present date of inquiry) because of the definition of a testing period and the requirement to look back three years on each testing date. If an ownership change occurs on any testing date, subsequent testing periods only look back to the shorter of three years or the prior ownership change.
Phase II—Valuing the NOLs
All of the information gathering and due diligence that is done is performed to determine whether LossCo has undergone an ownership change and if so, what amount of the LossCo NOLs and other tax attributes are subject to limitation (the "382 limitation"). In order to determine the amount of the Section 382 limitation, the PE firm must calculate the value of LossCo immediately before the ownership change and multiply that value by the long-term tax-exempt rate as published in the Federal Register for the time period during which the ownership change occurs. The value of LossCo is the tricky part of this calculation. In general, value is determined by adding up the fair market value of all classes of equity (including Section 1504(a)(4) "plain vanilla" preferred stock, even though such preferred stock does not count in calculating whether or not an ownership change has occurred). Special rules require the LossCo to subtract from value certain amounts attributable to excess cash or capital contributions made within a short period of time prior to the ownership change, or significant sales of assets or redemptions prior to the ownership change. In addition, if the purchase transaction requires assets of the LossCo to be used as part of the acquisition transaction (e.g., a leveraged buy-out), the value of the LossCo can be reduced as a result of this corporate contraction.
The value does not include any amounts received by LossCo as part of the transaction that caused the ownership change, as value determinations must be made immediately prior to the ownership change. Thus, in a typical PE acquisition, the value of LossCo cannot be increased by new money, or, in general, by amounts paid into capital very close in time to the ownership change date. Once LossCo has determined that a Section 382 limitation is imposed upon a pool of NOLs, LossCo will only be able to offset its pre-change NOLs against income earned in post-change years up to the amount of the 382 limitation.
Impact of Successive Ownership Changes
It is possible and very common to have a pool of NOLs subject to more than one Section 382 limitation. If this occurs, the lowest limitation must be applied to that pool of NOLs. As a diligence and planning matter, the identification of multiple subsequent Section 382 limitations is important to the preparation of projections with respect to NOL utilization or future amortization  amounts that can be used to offset projected income in post-acquisition tax years. Several ameliorative rules can be used to increase the Section 382 limitation in post-change years, however, such rules generally depend upon having built-in gain assets on the date of the ownership change, or an ability to accumulate the unused 382 limitation in post-change years because LossCo continues to operate at a loss and then uses these "refreshed" NOLs in later years when LossCo becomes profitable.
Pepper Perspective: A PE buyer must carefully review all of the information relevant to an analysis under Section 382 if it is to assign any transaction value to a pool of NOLs at a LossCo target company. While it may seem tantalizing to a buyer to see $100 million in NOLs on the books of a potential target company, it will take a significant amount of due diligence and analysis to assess whether those NOLs will have value to a private equity buyer.
 A "loss corporation" is any corporation that has an NOL, tax loss, tax credit, built-in loss assets, and similar tax attributes on any testing date.
 See Notice 2010-50.
 A "testing date" is any date on which an equity event occurs for Section 382 purposes and can include any issuance of stock, options, convertible stock, convertible debt, agreement to acquire stock, warrants, or similar interests. For this purpose, a redemption of stock is also an event that triggers a testing date under these rules.
 In certain cases in which LossCo has depreciable assets with a tax basis in excess of the value of such assets on the change date and LossCo is otherwise in a net unrealized loss position (as defined in Section 382(h)) on the change date, a portion of the amortization or depreciation associated with those built-in loss assets will be treated as if it was a pre-change NOL and will thus be subject to the 382 limitation.
Annette M. Ahlers
Pepper Hamilton LLP
Pepper Hamilton LLP (www.pepperlaw.com) is a multi-practice law firm with more than 500 lawyers nationally. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world.
Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Pepper Hamilton LLP. This work reflects the law at the time of writing.