In an Internal Revenue Service ruling released last year, the IRS took a suprisingly liberal stance on a question in which toughness might have been expected: At what point can an acquirer deduct a loss on business that the acquired company continued to conduct both before and after the acquisition?
During an initial three-year period, the company in question, which we’ll call LossCo, was engaged in “business development,” according to the ruling (LTR 201015024) released on April 16, 2010. During those first three years, LossCo developed a new technology and method for one aspect of its business, applied for and received patents, created a product, and brought that product to the commercial market.
In the second year of the three-year period, LossCo underwent an “ownership change” within the meaning of Section 382(g) of the Internal Revenue Code. Under the section, an ownership change occurs if there’s a difference of more than 50 percentage points between the aggregate ownership of all 5% shareholders during the testing period and the ownership of all 5% shareholders immediately after the testing event.
In the third year, an established LossCo competitor “undertook vigorous action to compete” with LossCo’s commercial marketing of its product. As a result, LossCo sold the part of its business that dealt with the commercial marketing of its product. At the same time, however, LossCo retained its research department, its patents and patent applications, and lawsuits or potential lawsuits. In the year following the initial three-year period, LossCo sold its research and development activities.
In the second year following the initial period, LossCo received a settlement payment (against which it sought to use its prechange net operating losses) for patent infringement and antitrust lawsuits it had mounted and for the right to the future use of its patents.
The IRS ruled that after LossCo sold its marketing operations within the initial three-year period, its activity in developing and perfecting new technology, applying for and/or perfecting patents, and negotiating with and litigating against its competitor constituted the proper use of “historic business assets” by the company. Moreover, the historic business assets with respect to which LossCo received the settlement payment constituted a “significant portion” of its postasset sale historic business assets — another prerequisite for deductibility by the acquirer.
Further, the settlement payment income derived by LossCo was eligible to be offset by LossCo’s preownership change net operating losses. Thus, the acquirer of LossCo was able to get credit for its acquisition’s prior loss costs.
Robert Willens, founder and principal of
Robert Willens LLC,
writes a weekly tax column for CFO.com.