Introduction
Net operating losses (NOLs) allow companies with business difficulties to reduce taxes and, as a result, maintain the organization’s financial stability. However, some business owners have begun to take advantage of this opportunity to evade taxes. Consequently, the government proposed to apply limitations to NOL. In particular, these restrictions apply to owner shifts of more than 5% and the transfer of more than 50% of company ownership to another owner.
Limitations on Ownership Changes
Owner shift can occur under various circumstances and includes any change in percentage between shareholders. An example of a situation leading to an owner shift is the sale or purchase of shares in a losing company. At the same time, limitations are imposed only if the share of the new owner is more than 5%. Immediately after a company’s ownership change, its assets are assessed to determine what percentage the new shareholders receive.
In addition, it is possible to reduce the number of tax liabilities for a company only if it has demonstrated more than two years of continuous operation without a change in ownership and shares. For example, suppose a company owner sells part of the company’s shares to other owners every year. In that case, the organization will not be able to take advantage of the opportunity to reduce tax until two years have passed since the last change in interest between shareholders.
Factors Influencing Ownership Assessment
Moreover, when assessing whether there has been a change in the ownership of a company, it is necessary to consider some factors directly related to the shareholders. For example, all family members are considered one shareholder, and the shareholders own all shares owned by a corporation. Accounting for these factors often helps to identify the lack of ownership change.
Furthermore, some preferred shares may be ignored when determining a change in ownership. However, these shares are included in the corporation’s total value for the annual limitation. In addition, if the rights to stock, warrants, or convertible debt expire, the company may receive a tax refund. Separately, cases are considered when shares go to a new owner against their will, for example, due to death or divorce. In such a case, a trial period of 2 years of continuous operation for the company does not apply.
Bankruptcy-Related NOL Restrictions
Regarding restrictions associated with the company’s bankruptcy, there are also specific nuances. First, interest on debt is not considered when calculating net operating losses. That applies to any debt the company pays within four years before the change of ownership.
Secondly, the creditors covering the company’s debts become its stockholders to reduce their losses. Thirdly, in the event of bankruptcy, the rule of two years of continuous operation of the company continues to apply. It means that if another change of owners occurs during the testing period, all previous NOL accruals will be canceled. However, these exceptions do not apply when a company’s shares are exchanged for debt.
Treatment of Built-In Gains and Losses
In addition, when setting limitations, built-in gains and losses are considered. They are the difference between the market and the real value of the company’s assets. Built-in gains are restricted, and the company must sell them soon. Furthermore, taxes are offset by an increase in usable carryovers if the company receives built-in gains. On the other hand, limits on built-in losses only apply if the company has a net unrealized built-in loss.
Conclusion
Thus, the Tax Reform Act changes and sets clear corporate rules and restrictions. That applies to the change of owners of the company, its bankruptcy, and the use of tax carryovers. In addition, the changes introduced a testing period rule for companies for two years. These restrictions are necessary to establish a taxation system and reduce the number of incidents of tax avoidance.