Looking at Historic Businesses Through an NOL Lens

As companies emerge from the financial crisis and begin to consider applying NOLs against taxable income, two older court rulings seem more relevant than ever.

When a corporation with net losses undergoes an ownership change, within the meaning of the tax code’s Section 382(g), limits are imposed on the amount of taxable income1 that may be offset by the company’s prechange losses. This limit is known as the “Section 382 limitation” and it is calculated by multiplying the fair-market value of the loss corporation’s stock, immediately before the ownership change, by the long-term tax-exempt rate.

However, under Section 382(c), if the new loss corporation (the loss corporation in its postownership change state) does not continue the business enterprise of the old loss corporation (the loss corporation in its prechange state) at all times during the two-year period beginning on the change date, the Section 382 limitation for any postchange year is zero. Accordingly, no amount of postchange income — except to the extent of recognized built-in gains — can be offset by the prechange losses in cases where, in connection with an ownership change, the so-called continuity of business enterprise (COBE) requirement is not met.

One issue that has arisen, and has been resolved favorably, is whether the business enterprise that the new loss corporation must continue is the business enterprise that produced the losses that will be used to offset otherwise taxable income. That’s what is at issue in Exel Corp. v. United States, 451 F.2d 80 (8th Cir. 1971).

In that case, the taxpayer, Eclipse Lumber Co., had operated a chain of retail lumber yards from 1902 through April 1959. On May 1, 1959, Eclipse sold all of its assets to another company — H.B. Pearl — for $2,275,000 in cash. The sale produced a net operating loss (NOL) of $1,089,358, a portion of which was carried back to taxable years preceding the year in which the NOL arose.

The proceeds of the sale were invested by Eclipse in “short-term government securities.” As a result, the only income against which the NOL was claimed arose out of income generated by the investment of the proceeds of the sale of Eclipse’s operating assets.

In October 1960, by virtue of the redemption of more than 50% of its outstanding stock, Eclipse experienced an ownership change. It was the position of the Internal Revenue Service that “old” Section 382 (the version in place from 1954 through 1986) barred the use of Eclipse’s NOL carryover. The IRS contended that the statute — in which COBE was and remains an indispensable element — should be interpreted to mean that the business enterprise that must be continued is the one that produced the loss.

WillensFinal“Can an investment business function as the loss corporation’s historic business? The answer would appear to be yes.” — Robert Willens

The court disagreed. It noted there is no language in the statute that (1) expressly states or (2) fairly implies that the business that produced the loss must be continued. Under the 1939 Internal Revenue Code, as interpreted by the Supreme Court in Libson Shops v. Koehler, 353 US 382 (1957), the loss carryover was allowable only if the income against which the offset was claimed was produced by “substantially the same business” that produced the loss. However, by enacting the 1954 Code, Congress destroyed the precedential value of Libson Shops. The court stated that Libson Shops “is no longer the law.”


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