Applying the 1.382-11 Small and Cash Issuance Exceptions

Section 382 of the Internal Revenue Code limits a company’s use of its past net operating losses (NOLs) after a significant “ownership change,” preventing corporations from being acquired solely for their tax benefits. An ownership change is triggered if shareholders owning 5% or more of the stock collectively increase their ownership by more than 50 percentage points over a three-year testing period. To ease the complex tracking burden this creates, Treasury Regulation § 1.382-3 provides exceptions for certain stock issuances that help companies manage their obligations more efficiently.

The Challenge of Tracking Ownership for Section 382

The main difficulty in complying with Section 382 comes from the “segregation rules.” These rules require a corporation to group its shareholders who own less than 5% of the stock into “public groups.” Each public group is treated as a single 5-percent shareholder for testing purposes, allowing the monitoring of ownership shifts among smaller investors.

Certain transactions, like a new public stock issuance, force the creation of a new public group from the shareholders acquiring the new stock. This new group is treated as a new 5-percent shareholder, which immediately increases its ownership from zero.

This process is especially challenging for companies that frequently raise capital. Each stock offering can create another public group that must be tracked separately. Over time, a company can accumulate many such groups, making ownership calculations complex and increasing the risk of an ownership change that would limit the use of its NOLs. The rules can capture simple capital-raising efforts, leading to unexpected consequences.

The Small Issuance Exception

The Small Issuance Exception allows a corporation to issue a modest amount of stock without creating a new public group. Instead of segregating the new shareholders, the company can treat the newly issued stock as being acquired proportionally by the public groups that existed before the issuance. This prevents an automatic ownership increase by a new shareholder group.

To qualify, an issuance must be “small” based on quantitative thresholds. A company can apply the exception to issuances during a tax year as long as the total stock issued does not exceed the limitation, which is calculated using the more favorable of two methods. The first method is based on value, applying to issuances up to 10% of the total fair market value of all the corporation’s stock at the beginning of the year.

The second method is based on shares. The limit is 10% of the total number of shares of the specific class being issued, measured against the shares of that class outstanding at the start of the year. A company cannot apply the exception to any single issuance that exceeds the entire 10% annual limitation.

For example, a company has 2,000,000 shares outstanding with a total fair market value of $40,000,000. Its small issuance limitation is the greater of 10% of the value ($4,000,000) or 10% of the shares (200,000). If the company issues 150,000 shares for $3,000,000, the issuance qualifies because it is below both limits, and no new public group is created.

The Cash Issuance Exception

The Cash Issuance Exception applies only to stock issued solely for cash and is often used for transactions too large for the Small Issuance Exception. Its primary feature is its interaction with the Small Issuance Exception. If an issuance exceeds the small issuance limit, the excess portion may be eligible for this exception.

The amount of stock exempted is equal to 50% of the aggregate percentage ownership held by all direct public groups immediately before the issuance. For instance, if a company’s stock is 100% owned by a single public group, the Cash Issuance Exception would exempt 50% of the qualifying stock from the segregation rules. The remaining portion would be segregated into a new public group.

Building on the previous example, imagine the company issues 400,000 new shares for cash, exceeding its 200,000-share small issuance limit. The first 200,000 shares are covered by the Small Issuance Exception. For the remaining 200,000 shares, the Cash Issuance Exception applies.

Since the existing public group owns 100% of the stock, 50% of the remaining 200,000 shares (100,000 shares) are exempted and treated as acquired by the existing group. The final 100,000 shares are segregated into a new public group.

Applying the Exceptions and Required Disclosures

To use these exceptions, a corporation must first gather specific data. This includes the fair market value of all outstanding stock and the number of shares outstanding for each class as of the first day of the taxable year. The company must also maintain a detailed log of all stock issuances throughout the year.

This log should include:

• The date of each issuance
• The number of shares issued
• The specific class of stock
• The type of consideration received (cash or other property)

Using the exceptions requires making a formal election by attaching a disclosure statement to the corporation’s federal income tax return for that year. The statement must identify the specific stock issuance(s) for which an exception is being claimed and state that the corporation is applying the relevant exception rules.