Rev. Rul. 77-227

Advice has been requested whether, under the circumstances described below, the net operating loss carryover of a corporation acquired in a reorganization to which section 381(a)(2) of the Internal Revenue Code of 1954 applies will be reduced under section 382(b) (prior to its amendment by the Tax Reform Act of 1976).

H and W, husband and wife, each owned 50 of the 100 shares of corporation Y common stock. W owned all of the 200 shares of corporation X common stock. X and Y had no other stock outstanding. The fair market values of the net assets of X and Y were 90x dollars and 10x dollars, respectively. Y had a net operating loss carryover of 2x dollars.

X wanted to acquire Y in a merger that would qualify as a reorganization defined in section 368(a)(1)(A) of the Code and to succeed to the entire net operating loss carryover of Y under section 381. Therefore, X issued to W 500 shares of newly authorized nonvoting, nonconvertible preferred stock worth 50x dollars as a nontaxable dividend under section 305(a), and Y merged into X, with X issuing 50 shares of its common stock to H and W in exchange for their 100 shares of Y common stock. The purpose of the preferred stock dividend was to reduce the value of the X common stock outstanding before the merger to such an extent that the fair market value of the X common stock to be issued to H and W in exchange for their Y common stock would be 20 percent of the fair market value of all X common stock outstanding after the merger, thus rendering inapplicable the net operating loss carryover limitation of section 382(b). W will hold the new preferred stock indefinitely. The new preferred stock is "section 306 stock" within the meaning of section 306(c).

Section 381(a)(2) of the Code provides, in part, that in the case of the acquisition of assets of a corporation by another corporation in certain transfers to which section 361 applies (including a statutory merger defined in section 368(a)(1)(A)), the acquiring corporation shall succeed to and take into account, as of the close of the day of distribution or transfer, the items (including net operating loss carryovers) described in section 381(c) of the transferor corporation, subject to the conditions and limitations specified in section 381(b) and (c).

Section 382(b)(1) of the Code provides that if, in a reorganization specified in section 381(a)(2), the transferor corporation or the acquiring corporation has a net operating loss that is a net operating loss carryover to the first taxable year of the acquiring corporation ending after the date of transfer and the shareholders (immediately before the reorganization) of the loss corporation, as the result of owning stock of the loss corporation, own (immediately after the reorganization) less than 20 percent of the fair market value of the outstanding stock of the acquiring corporation, the total net operating loss carryover from prior taxable years of the loss corporation to the first taxable year of the acquiring corporation ending after the date of transfer shall be reduced by the percentage determined under section 382(b)(2).

Section 382(b)(2) of the Code provides that the reduction of the net operating loss applicable under section 382(b)(1) shall be the percentage determined by subtracting from 100 percent the percent of the fair market value of the outstanding stock of the acquiring corporation owned (immediately after the reorganization) by the shareholders (immediately before the reorganization) of the loss corporation, as a result of owning stock of the loss corporation, multiplied by five.

Section 382(c) of the Code defines the term "stock" as all shares except nonvoting stock that is limited and preferred as to dividends.

The issue in this case is whether the issuance by X of the preferred stock to W will be recognized for purposes of section 382(b) of the Code.

In this case, the issuance of the preferred stock permanently reduced the value of the X stock (as defined in section 382(c) of the Code) outstanding before the merger of X and Y. See Rev. Rul. 76-223, 1976-1 C.B. 103, wherein the "control" requirement of section 368(a)(1)(B) was held satisfied, even though voting rights were added to the nonvoting preferred stock for the sole purpose of satisfying the control requirement, because the voting rights were a permanent change in the rights of the preferred shareholders. Furthermore, the recognition of the issuance of the preferred stock is consistent with the stated purpose of the statute, that is, to prevent one corporation from acquiring the total net operating loss carryovers of another corporation without giving up at least 20 percent of its stock to the shareholders of the loss corporation. See S. Rep. No. 1622, 83d Cong., 2d Sess. 284 (1954).

Since H and W received 50 shares of X common stock in exchange for their 100 shares of Y common stock, H and W owned, immediately after the reorganization, 20 percent of the fair market value of the X stock (50 shares of the total of 250 shares of X common stock) as the result of owning stock of Y immediately before the reorganization.

Accordingly, the net operating loss carryover from Y will not be reduced under section 382(b) of the Code.

The holding of this ruling is not affected by the Tax Reform Act of 1976. Although the Act will change the relevant percentage and the method of computing the reduction of net operating loss carryovers, a percentage test will remain so the principle of the proposed ruling will be applicable even after the effective date of the amendment.