The COVID-19 pandemic has had an enormous impact on the economy, but different types of businesses have been affected differently. Some businesses — such as restaurants, bars, entertainment venues, airlines and other transportation companies — have suffered significant losses as a result of lockdowns, travel restrictions and other disruptions. Others — such as health care providers, technology firms and e-commerce companies — have flourished. Still others have seen little or modest impact on their performance. Visit our COVID-19 news page for related articles.

As the struggles continue, many corporations have found themselves with net operating losses (NOLs) and other tax benefits they won’t be able to use in the foreseeable future, while others have enjoyed unusually high profit levels. One potential strategy for these corporations is to combine through a merger or acquisition, so that one corporation’s losses can be offset against the other company’s profits. If the strategy is successful, it allows one corporation to take advantage of tax benefits that might otherwise go unused, while reducing the other company’s tax liability.

If you’re contemplating such a transaction, careful planning is critical. The tax code authorizes the IRS to disallow tax benefits associated with an acquisition that’s motivated primarily by tax evasion or avoidance. So, to preserve these benefits, the parties must be able to demonstrate one or more legitimate business purposes for the combination.

Beware IRC Section 269

Internal Revenue Code (IRC) Section 269, “Acquisitions made to evade or avoid income tax,” states that the U.S. Secretary of the Treasury may disallow a deduction, credit or other allowance obtained through an acquisition if the principal purpose of that acquisition is to evade or avoid tax. An acquisition subject to Sec. 269 happens when “any person or persons acquire, directly or indirectly, control of a corporation.” It also includes certain asset transfers. “Control” is defined as ownership of stock possessing at least 50% of the total combined voting power of all classes of stock entitled to vote, or at least 50% of the total value of shares of all classes of stock.

Significantly, Sec. 269 doesn’t disallow all tax benefits obtained through acquisition. It applies if tax avoidance is the only principal purpose of the transaction. The term “principal purpose” is subject to interpretation, but, in general, the more “legitimate” business purposes the parties can offer for joining forces the more likely it is that NOLs or other tax benefits will be allowed.

Potential legitimate business purposes include:

  • Expanding
  • Diversifying
  • Increasing borrowing capacity
  • Limiting liability or reducing risk
  • Obtaining new distribution channels
  • Securing control of the supply chain or otherwise gaining the benefits of vertical integration
  • Achieving economies of scale
  • Reducing administrative expenses

Keep in mind that even if you clear the hurdle imposed by Sec. 269, other tax code provisions may limit your ability to use tax benefits after an acquisition. For example, IRC Sec. 382 places limits on NOL carryforwards and certain other loss deductions following an ownership change.

Weigh your options

If your company generated NOLs in 2020, the first option to consider is carrying them back to offset gains in previous years and claiming a refund. The CARES Act allows you to carry back NOLs generated in 2018, 2019 and 2020 for up to five years. If that isn’t an option, being acquired by a profitable corporation might be worth considering. If you are planning a merger and need assistance, our team is ready to help.

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