Gulp! A Tax Play that Uses a Poison Pill

Companies are taking a page from the bankruptcy playbook to shield future tax benefits from impairment.

It is unusual for a solvent company to threaten to swallow a poison pill to protect its tax rebates. But that is exactly what Hovnanian Enterprises did this week, in announcing its adoption of a shareholder rights plan to preserve tax benefits related to its net operating losses.

The tactic, which up until now has been used mainly by companies in bankruptcy, gives companies some assurance that recent losses can still be used to offset future gains and ultimately lower future tax bills. That’s relatively good news for the myriad companies now being pummeled by the subprime mortgage crisis, and as a result posting significant NOLs.

The tax benefit at risk is an income offset linked to NOLs. The Internal Revenue Service allows companies that have posted an NOL to save up to two years’ worth of the losses, and use them to offset income that is generated over the next 20 years. By applying the NOLs to future periods, a company’s taxable income is decreased, and the corporation pays less to Uncle Sam. Essentially, the rule takes some of the sting out of current losses.

There is a catch, however. Under the tax code (Section 382) a change in ownership at the company could wipe out a big chunk of the NOL offset. The rule is harsh, says tax guru Robert Willens. He explains that if a corporation undergoes an ownership change, the IRS limits the amount of income that NOLs can offset in any year after the change — regardless of how much income a company earns.

The income ceiling is calculated by multiplying the company’s market capitalization by the long-term tax exempt rate, currently 4.71 percent. That would mean that a company with a $1-billion market cap on the day of an ownership change would be able to use NOL offsets against only $47 million of income for any subsequent years.

In addition to the straightforward calculation, the IRS forces companies to make other adjustments to the base amount to limit the tax benefit when there is a change in ownership. For example, financing cash has to be backed-out of income if the capital was raised as a way of increasing the Section 382 limitation. In the same way, proceeds from options issues are also disregarded.

The modern version of the rule was issued in 1986, to prevent “the trafficking of losses,” Willens asserts. In essence, the IRS didn’t want the primary reason for an acquisition to be NOLs. That is, the government didn’t like the idea that a financially fit company could snatch up loss companies just to make use of the target company’s offsets. “The rule makes NOLs neutral in an acquisition,” Willens says.

Hovnanian wasn’t the first solvent company this year to use the tactic. In May, the board of Stamps.com, an Internet postage retailer, changed the company’s articles of incorporation to thwart any change of ownership. According to Stamps.com CFO Kyle Huebner, the company has $250 million worth of federal NOLs and $150 million of state NOLs stemming from losses the company took on in 2000 and 2001 when the Internet bubble burst. Heubner says the federal NOLs won’t expire until 2020, while the state NOL expiration dates range from 2012 to 2014.

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