IRS sets net operating loss (NOL) limits on corporate equity reduction transactions (CERTS)

The IRS issued long-awaited proposed regulations on the limitations on net operating losses (NOL) for excess interest deductions. The limitations apply when a corporation engages in a corporate equity reduction transaction (CERT) that generates or increases an NOL because of an excess interest deduction. The provision prevents the excess NOL from being carried back over the normal carryback period and generating a refund.

Congress enacted the limitations in 1989, but the IRS had never issued regulations. Congress wanted to limit the ability of taxpayers purchasing corporations to use debt to obtain refunds from carrying back NOLs attributable to interest on the debt. The application of the limitations has resurfaced because taxpayers were carrying back NOLs from 2008 and 2009 with an interest component. The issue is now being seen on returns audited for those years.

Although the regulations are proposed to apply only when published as final regulations, the IRS requested comments on transition issues, such as the application of the regulations to transactions occurring in years before the IRS issues final regulations.

A CERT is either a major stock acquisition (the acquisition of at least 50 percent of the stock in another corporation) or an excess distribution (the distributions made on stock during the year, compared to the average distributions over the three immediately preceding years). A CERT can arise from either a taxable or a tax-free transaction. For example, the law requires the testing of a Code Sec. 355 spinoff, a Code Sec. 351 reorganization, and a Code Sec. 368 stock acquisition. Practitioners have warned that this is a broad provision that will require an additional layer of analysis for many corporate transactions.

The regulations explain when a CERT has occurred, the computation of the excess NOL, and the treatment of successor corporations. The regulations provide that an integrated plan of stock acquisition with multiple steps will be tested as a potential CERT.

The regulations also discuss the treatment of consolidated groups, which must be treated as a single taxpayer. The regulations address: the group's average interest paid or accrued in the three years preceding the CERT; the effect if a corporation participating in a CERT becomes a member of a consolidated group; the effect if a group member deconsolidates after the group participated in a CERT; and apportionment of the excess loss to members of the group for carryback or carryover to separate return years.