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Ed Harris requested our tax advice for Patriot Inc., how to deal with the issues arising from filing for Chapter 11 Bankruptcy, and best method in dealing with the treatment of cancellation of debt and preserving the NOL carryovers. After much deliberation I have provided a recommendation for the tax treatment of these issues.
During April of 2012 Patriot, Inc. a filed for Chapter 11 bankruptcy protection and worked out a re-organization plan that was accepted by the Bankruptcy Court and the creditors' committee. Under the plan, the note holders (a venture capital firm that financed the business) with notes payable of $105,000,000 will receive new common stock; the old common stock will be cancelled. The new Whaoo, Inc emerged from bankruptcy on October 31, 2012.
Ed Harries will continue as the CEO and will own 2% of the stock which came from a conversion of liabilities that corporation owed him.
The corporation had debt cancelled under chapter 11 Bankruptcy of $105,000,000. It had Net Operating Loss (NOL) carryfowards of $65,000,000 from 2009, $45,000,000 in 2010, and $30,000,000 from 2011.
The fair market value of Patriot, Inc. at date of emergence from bankruptcy $150,000,000. Its Property and equipment had a value of $450,000,000 and accumulated depreciation on these assets of $200,000,000. The adjusted basis for the assets was $250,000,000. Patriot Inc., had intangible assets worth $250,000,000 with accumulated amortization of $100,000,000, giving it an adjusted basis of $150,000,000.
Ed Harris anticaptes the new corporation making an acquisition withing six months which will increase revenue 15% and profits by 12%.
The first issue relates to Section 382 of the Internal Revenue code and its impact on the company's future use of NOL carryfowards.
The second issue relates to "cancellation of debt income" and reduction of tax attributes under the Internal Revenue code 108. Some consideration for this issue are the company being in a chapter 11 bankruptcy, and that Wahoo, Inc. would like to be able to keep their NOL carryovers to offset future taxable income
Internal Revenue Code sets forth a limitation of NOL carryforward for a company that goes through an ownership change. Patriot, Inc. according the Internal Revenue Code did have an ownership change, which would give the company an NOL limitation equal to the value of the 'old loss corporation'. This value is equal to the fair market value of Patrio, Inc. at the date of emergence from bankruptcy ($150,000,000)
The NOL loss limitation per year for the company is $4,515,000. Which is computed using the long-term tax-exempt rate of 3.01% (Revenue Ruling 2012-28), multiplied by the $150,000,000 (old loss corporation). The NOL loss limitation for 2012 is $754,562 ((61/365)*4,515,000), due to limitation only covering November and December.
Assuming that Wahoo, Inc has taxable income above NOL limitation amount each year, there will be approximately $53,462,500 of unused NOL carryforward. For the next twenty years the aggregate NOL limitations is $86,538,000, after 2011.
Section 382(I)(5) gives the company the option to elect not to have the loss limitation apply because Wahoo, Inc. (new loss corporation) was involved in a title 11 bankruptcy case and the creditors of Patriot, Inc. (old loss corporation) own the at least 50% of the total value of Whoo, Inc. (new loss corporation) stock. This is computed by taking debt canceled under chapter 11 bankruptcy divided by the fair market value of patriot, Inc. at date of emergence from bankruptcy ($105,000,000/$150,000,000). We are assuming that the debt arose in the normal course of the business or that the creditors had held the debt for at least 18 months before the bankruptcy proceeding.
The company may elect not to have the NOL loss limitations apply by reducing the NOL carry forwards by the interest deductions in the current and three prior years related to the debt that was converted into equity. Further information is needed from the company to calculate what the reduction in the NOL would be.
The company should also consider the effects of the proposed acquisition and how it will increase revenues and profits in the future, as well as the negative consequence of changing ownership. Section 283(I)(5)(D) says "if, during the two-year period immediately following an ownership change to which this paragraph applies section 382(I)(5), an ownership change of the new loss corporation occurs, this paragraph shall not apply and the section 382 limitation with respect to the second ownership change for any post-change year ending after the change date of the second ownership change shall be zero". If Wahoo, Inc acquisition causes another ownership change for the corporation in the next two years preceding the bankruptcy the NOL carryforward will be reduced to zero.
Internal Revenue Code section 108 helps lay out the options for companies for the cancellation of debt income of the company. According to section 108(a)(1)(A), "gross income does not include any mount which would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs in a title 11 case". The company $105,000,000 should not be included in computation of gross income because the company filed for chapter 11 bankruptcy.
There are two options facing the corporation which include using the cancellation of debt income to reduce the basis in its depreciable property or use the cancellation of debt income to reduce the NOL carryforward. The Internal Revenue Code sections 108(b)(1), 108(2)(A), 108(b)(3)(A), and 108(b)(4)(B) says that if the company choose the option to reduce their NOL, they first must reduce the NOL for the current year and work back from oldest to newest NOL carryover. The reduction should be applied dollar for dollar with an exception for the $105,000,000 (cancelled debt).
To completely evaluate this problem more efficiently we would require more information, specially the current year NOL. With out a current year NOL, the reduction would go as follows: the NOL from 2009 ($65,000,000) would be completely eliminated, it would then reduce the 2010 NOL by $40,000,000. This would leave $5,000,000 NOL for 2010, and would allow the company to keep its entire 2011 NOL ($30,000,000).
Section 108(b)(5), a company may elect to reduce the basis in its depreciable property, but it may not reduce any other attributes. By choosing this option the company will reduce the depreciable assets basis from $250,000,000 to $145,000,000.
To provide a more complete analysis of this situation we require Ed Harris provide information that includes whether or not the proposed acquisition will result in an ownership change, the amount of the interest deduction related to the debt conversion into equity, the asset lives of the depreciable assets.
Based on the current information, and the fact that Mr. Harris would like to preserve the NOL's, we recommend that the company choose to reduce the basis of the depreciable property instead of reducing the NOL's. If the assets are comprised of long-lived assets and the company expects to be profitable over the next twenty years, this is the best option available.
The profitability of the company, the dollar for dollar amount of interest deduction related to the debt conversion into equity, and whether or not an ownership change will occur within two year window will ultimately effect the best option for the company. If the company chooses to use its NOL's it will be limited to $86,538,000 of the $140,000,000 NOL carryforwads.
If the the difference between NOL ($140,000,000) and the maximum aggregate NOL limitation of (486,500,000) is less than the interest deduction then the company should choose not use the NOL limitations, which is contingent on the company being able to provide a clause in the bankruptcy plan that would require creditors and stockholder to maintain ownership for the required two year holding period outline in the Internal Revenue Code. The other option would be for the company to use the current NOL limitations and lose a portion of the NOL carryovers instead of the entire amount.