TIP on Tax:
New rules may ease burden for small
shareholders in tech acquisitions
This is the fourth installment of TIP on Tax, a series
from Grant Thornton LLP’s Technology Industry
Practice (TIP). The series introduces key tax issues for
dynamic technology companies.
In our first article, we explored strategies for managing
net operating losses (NOLs) generated in the startup
phase. Our second article offered insights into the
effective use of NOLs resulting from acquisitions of
loss-making businesses. The third article addressed
accounting for NOLs. This article focuses on new rules
put out by the IRS that could ease compliance burdens
for small shareholders of those loss-making businesses.
Introduction
The super-hot tech M&A market can be good news
for smaller technology companies seeking to be
acquired and — perhaps more importantly — for
their shareholders. Yet many of those companies
remain in a tax loss position following years spent in
not-yet-profitable R&D, or trying — often at a loss
— to expand business profitability. Section 382 of the
Internal Revenue Code generally limits the amount
of NOLs a new buyer can use after acquisition, to
prevent so-called “loss trafficking.”
Beginning in 1986, the IRS and Treasury Department
began putting into place an extremely complicated
set of rules under section 382 to prevent such loss
trafficking. One major fallout from those rules is a high
degree of complexity and compliance burden, coupled
with a system that might imply an ownership change
has occurred (limiting the use of NOLs) when, to a
layperson, it doesn’t appear there was a loss trafficking
transaction. Fortunately, new IRS regulations are
trying to address some of those concerns.
Loss limitations, generally
When a technology company undergoes an ownership
change, its ability to use its NOLs becomes limited.
An ownership change occurs when one or more 5%
shareholders increase their ownership, in aggregate,
by more than 50 percentage points over a three-year
period. Congress decided to create this limitation to
prevent profitable companies from purchasing those
in a loss position purely to use those losses to offset
future profits.
Greg Fairbanks, Senior Manager and Corporate Tax Specialist, Grant Thornton LLP
Section 382 of the Internal Revenue Code generally limits the
amount of NOLs a new buyer can use after acquisition, to prevent
so-called “loss trafficking.”

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Aggregation and segregation
Under previous rules, direct and indirect small
shareholders (those owning less than 5% of the target
loss company) were aggregated and treated as a 5%
shareholder (called a “public group,” even if these
were shareholders of a private company) upon starting
a section 382 analysis. The rules then required the
creation of an additional public group every time a
person who owned 5% or more of the corporation
sold stock to small shareholders (i.e., less than 5%).
These aggregation and segregation rules caused
problems for many shareholders, especially when
stock was frequently purchased and sold. And the
rules often caused or hastened ownership changes
when there was no intent or motive of loss trafficking.
In October 2013, the IRS and Treasury Department
changed their regulations to address the unintended
consequences of these complex rules by creating three
exceptions to the general rule of segregation for some
transactions involving a loss corporation and 5%
shareholders:
• Secondary transfer exception
• Small redemption exception
• General exception to segregation rules for 5%
entities and shareholders
Secondary transfer exception
Under this exception, the segregation rules don’t
apply with respect to transfers of loss corporation
stock to small shareholders from 5% shareholders or
entities. They also wouldn’t apply to transfers of 5%
entity stock to small shareholders.
Small redemption exception
Under this exception, the loss corporation doesn’t
segregate into a new direct public group redemptions
of stock that are “small” and fall within rules
governing this exception. The rules are a mirror of the
small issuance exceptions and exempt from segregation
up to 10%, by class or by fair market value, of the
stock redeemed within a tax year.
Suppose a corporation was owned 100% by small
shareholders, and the company undertook a tender
offer to redeem 10% of the shares. Under the old
rules, the 10% would be segregated from the 90%
that continue as shareholders. After the redemption,
the continuing shareholders own 100%, with a 10%
cumulative shift occurring. Under the new rules,
no such segregation takes place and the company is
treated as owned 100% by small shareholders both
immediately before and after the tender offer, resulting
in a 0% shift.
TIP on Tax: New rules may ease burden for small shareholders in tech acquisitions
Example:
LossCo is owned 20% by X and 80% by small
shareholders aggregated as a public group. On
successive dates within a three-year period, X sells
its stock to small shareholders, and Y then purchases
20% from the public. Under the old law, X’s sale
would create a new public group with 20% ownership
of LossCo, and the historic public owning 80%. The
purchase by Y comes pro rata from both groups, with
the end result being Y owning 20%, historic public
64%, and new public (from X’s sale) 16%. The total
ownership shift is 36% because both Y and the new
public are new, non-historic shareholders. Under the
new law, X’s sale goes back to the historic public and
Y buys from such historic public. The end result is that
Y owns 20% and the historic public 80%, for a total
ownership shift of only 20%.

General exception to segregation rules for
5% entities and shareholders
The final regulations also provide relief for indirect
shifts for first-tier entities that own 5–10% of a
corporation’s stock. Prior to the new law, corporations
were obligated to look through and track indirect
shifts for any entity that owned 5% or more of the
corporation’s stock. That means indirect issuances
and redemptions could create indirect shifts. This
also resulted in a high compliance burden for the
corporation, as it was difficult to obtain all the
information necessary to do such an analysis. The new
law prevents such segregation from taking place for
entities that own 10% or less, mitigating some of this
complexity.
TIP on Tax: New rules may ease burden for small shareholders in tech acquisitions
Note: In the previous example, if the LLC owned
15%, the new regulation would not apply and the
corporation would be in the same quandary as under
prior law.
Simpler application
These new regulations are meant to make life a little
easier for small shareholders and 5% shareholders
of loss corporations, and they’re here just in time.
For many tech companies that have gone through
initial funding and subsequent investment stages,
it’s entirely possible to have many different public
groups. And even if the company is still privately
held, a thriving secondary market for shares can
result in administrative burdens for those remaining
shareholders in the event of an acquisition.
The final rules are effective as of Oct. 22, 2013, and
may be permissively applied to dates before then, so
long as application of the final rules doesn’t result
in an ownership change occurring before Oct. 22.
The final regulations may not be applied to any date
on or before the date of an ownership change that
occurred before Oct. 22.
Though improved, these regulations are still
complicated, and there are myriad issues to consider.
Companies should consider consulting with tax
professionals to avoid unexpected surprises.
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Example:
A corporation is owned 10% by a limited liability
company (LLC) that has historically issued and
redeemed membership interests. However, the LLC,
which has historically been reluctant to share private
owner information, has no legal obligation to share
this information with the corporation. Prior to the new
law, the corporation was obligated to track and take
into account the effect of all those indirect issuances
and redemptions. Practically, this was an almost
impossible task that could result in potentially negative
results. The new law prevents such segregation
events from taking place, thereby obviating the need
to obtain such information.
Contacts
Paul Howell
Partner and National Technology
Industry Tax Leader
T 214.561.2314
E paul.howell@us.gt.com
Greg Fairbanks
Senior Manager and
Corporate Tax Specialist
T 202-521-1503
E greg.fairbanks@us.gt.com

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