Worthless Stock Deduction May Trigger Section 382 Limitations
October 17, 2014
Friday Morning Dealmakers Column
Did you know claiming a worthless stock deduction on a portfolio company could trigger an unintended section 382 limitation on that investment?
A corporation's ability to use net operating losses (NOLs) and built-in losses, such as depreciation, amortization and depletion deductions, may be limited following certain ownership changes, which is known as a section 382 limitation. An ownership change is often a conspicuous event where shareholders exchange stock, the loss corporation issues shares or a combination of the two. The loss company is generally aware of such stock changes and can address the impact of the changes, including an attempt to avoid incurring a change.
However, a trap for the unwary exists when a shareholder—such as a private equity fund—owning 50% or more of a corporation writes off its investment by taking a worthless stock deduction to accelerate loss recognition, yet continues to hold such shares. The PE fund is treated as disposing and reacquiring those shares on Day One of the following tax year, potentially triggering an unintended 382 limitation and thereby disallowing use of not only NOLs but also current deductions such as amortization and depreciation for the next five years.
If you’re intending to claim a worthlessness stock deduction on a portfolio company while still retaining ownership of that investment, carefully consider all of the tax consequences to the fund and the portfolio company, and consult with your tax advisor.
Read more about how a worthless stock deduction can trigger section 382 limitations.