No Job Name · While tax plan-ning through net operating loss preservation has ... asks whether an...

Trafficking in Net OperatingLosses: What’s So Bad?

By Mark Hoenig

Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . 919II. NOLs — Why Do They Exist? . . . . . . . . . . 920

A. Statutory Framework . . . . . . . . . . . . . . 920B. The Rationale for Permitting NOL

Carryovers . . . . . . . . . . . . . . . . . . . . . . 921III. Trafficking in NOLs — A Problem

Emerges? . . . . . . . . . . . . . . . . . . . . . . . . . 922IV. Limits on NOL Use Following

Acquisitions . . . . . . . . . . . . . . . . . . . . . . 923A. Section 269 and Its Predecessor . . . . . . . 924B. The 1954 Code — Section 382 . . . . . . . . 925C. The Libson Shops Doctrine . . . . . . . . . . 926D. The Tax Reform Act of 1976 . . . . . . . . . 927E. The Tax Reform Act of 1986 . . . . . . . . . . 927F. Other Limitations . . . . . . . . . . . . . . . . . 929

V. Legislative Intent in Limiting NOL Use . . . 931A. Tax Avoidance . . . . . . . . . . . . . . . . . . . 931B. Same Person . . . . . . . . . . . . . . . . . . . . 933C. Inadequate Compensation . . . . . . . . . . . 934

D. Same Business . . . . . . . . . . . . . . . . . . . 935VI. Is There No Better Mousetrap? . . . . . . . . . 936

A. Lessons From the Past Century . . . . . . . 936B. Defining Goals . . . . . . . . . . . . . . . . . . . 936C. Where Do We Go From Here? . . . . . . . . 937

VII. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 939

On the loss carryover reform scene, we have a fullplate of alternatives, including, of course, the pos-sibility that we do nothing, on the grounds that atleast we’re reasonably familiar with what we cur-rently have under the existing regime. Nobody issure we can ever draft a statute that astute practi-tioners won’t be able to get around pretty quickly.At least, we’ve had the benefit of 30 years ofexperience with the present version. It’s far fromperfect, but it’s not the worst thing that couldhappen here.Written 30 years ago by professor James S. Eus-

tice,1 those words could just as well describe ourloss carryover scene today. Shortly after Eusticewrote those words, the rules governing loss carry-overs did in fact experience a seismic shift. And yet,his sentiments from long ago still resonate deeply.

I. IntroductionI have worked for over three decades on the

preservation of tax losses. In rare circumstances, aclient is laser-focused on — has as its principalmotive, we might say — just acquiring tax losses,and section 269 has never failed to serve its pur-pose. For the most part, however, my time in thisarea — and lots of it — has been spent navigatingthe maze of tax law constraints and limitations onthe use of tax losses in transactions with manyimportant commercial objectives. While tax plan-ning through net operating loss preservation hasbeen an important part of these transactions, it isfair to say, given what I do for a living, that taxplanning is an important part of any transaction onwhich I spend meaningful time.

My professional experiences in this arena haveoften been both puzzling and eye-opening. This isparticularly true of my earliest ones. Perhaps it wasjust my misfortune (or fortune) to enter the world oftax during the 1980s, a period during which the job

1Eustice, ‘‘Carryover of Corporate Tax Attributes,’’ 22 SanDiego L. Rev. 149 (1985).

Mark Hoenig

Mark Hoenig is a partnerwith Weil, Gotshal &Manges LLP. He gratefullyacknowledges the invalu-able contributions of MarkDundon and Eric Remijan,without whose many hoursand amazing dedication thisreport would not exist, andof his partner, Stuart Gol-dring, without whose input

and many years of collaboration this report wouldbe far less thoughtful.

Hoenig examines the almost century-long his-tory of Congress’s efforts to allow tax losses andlimit their transfer. He explores the rationale forthose efforts, assesses the system now in place, andasks whether an alternative set of rules might betterserve policy and the economy.

Copyright 2014 Mark Hoenig.All rights reserved.

tax notes™

SPECIAL REPORT

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of preserving tax losses presented extraordinarychallenges. During most of that decade, the prede-cessor of today’s section 382, a network of inconsis-tencies and traps, was a constant reminder of thedifficulties and risks of being a tax adviser. And in1986 (a little more than a year after Eustice wrote hispiece), the area was totally overhauled when Con-gress introduced what was then known as ‘‘newsection 382,’’ a framework that has endured andremains with us today. The new version of section382 offered fewer inconsistencies than its predeces-sor but, then and now, never seemed anchored to aunifying and overarching set of policy or fairnessprinciples other than ‘‘it works.’’

The lesson? For me, from early in my profes-sional development, it was a valuable lesson aboutthe somewhat unprincipled and occasionally evennonsensical way these tax loss limitation rules weredesigned. With no apparent comprehensive theoryor foundational policy, the rules seemed plainly toreward those fortunate enough to have clever taxcounselors (and some amount of luck). And sobegan my quest, trying to understand and rational-ize the tax law’s network of provisions all focusedon preventing something referred to as ‘‘traffick-ing’’ in tax losses.

The dictionary offers that trafficking (at least inthis context) means illegal or disreputable forms ofcommerce — like drug trafficking. This report ex-plores the almost century-long history of Con-gress’s efforts to allow tax losses and limit theirtransfer. It examines the rationale for those efforts,assesses the system we now have in place, and askswhether an alternative set of rules might betterserve policy principles and our economy.

II. NOLs — Why Do They Exist?

A. Statutory FrameworkUnder section 172, a taxpayer that incurs an

NOL2 in a tax year is permitted to carry back thatloss to the taxpayer’s two tax years immediatelypreceding the tax year in which the loss is incurred,or carry forward the loss to the taxpayer’s next 20tax years, in either case to be used as a deductionagainst the taxpayer’s taxable income in thoseyears.3 Any NOL that cannot be used by the tax-

payer during that period expires. Although theability to carry over losses from one tax year toanother now appears to be a permanent structuralfixture of the tax law,4 this benefit has not alwaysbeen provided to taxpayers.

Following the ratification of the 16th Amend-ment in 1913, Congress quickly enacted an incometax on both individuals and corporations.5 At thattime, net losses realized in any given tax year couldnot be carried over to an earlier or later tax periodto offset income and reduce tax liability. Thischanged in 1918 with the enactment of a temporarycongressional relief measure to aid manufacturersthat suffered losses as a result of decreased produc-tion following World War I.6 In 1921 Congressenacted a new form of deduction, an NOL deduc-tion, which permitted losses to be carried forwardfor two years.7 This provision was in effect until1932 when Congress limited the carryover period toone year. A year later, in 1933, given the massivelosses suffered during the Great Depression, Con-gress repealed the NOL deduction entirely to en-sure sufficient governmental revenue collection.8The allowance for taxpayers to carry over anddeduct losses was restored in 19399 and has re-mained in the tax code since then, although (asindicated above) the permitted periods for carry-backs and carryforwards have fluctuated overtime.10

One could envision a tax code in which a tax-payer simply tallied his items of income and deduc-tion for the applicable tax year and paid tax on anyresulting net income. If the taxpayer suffered a netloss during the tax year, he would owe nothing andpay nothing, and no carryover to earlier or lateryears would be permitted. The fairness of such a

2Section 172(c) defines an NOL as the excess of the deduc-tions allowed by the code over the taxpayer’s gross income.

3Section 172(a), (b)(1)(A). Throughout this report, the terms‘‘NOL carryover’’ or ‘‘loss carryover’’ (and derivatives thereof)refer to an NOL arising in one tax year that may be claimed asa deduction in a different tax year. The terms ‘‘carryback’’ and‘‘carryforward’’ refer to losses that may be claimed as a deduc-tion in a tax year preceding the loss year, or in a tax year afterthe loss year, respectively. In some cases, an NOL may be carriedback more than two years. These carryback and carryforward

periods have varied over the decades. For individual taxpayers,section 172 primarily applies to losses incurred in connectionwith the conduct of a trade or business, rather than lossesattributable to investments or personal items. Section 172(d)(4).Capital losses are subject to a separate limitations regime andtherefore are not addressed by section 172. See section 1212.

4References to the ‘‘tax law’’ are to the U.S. income tax law,meaning the Internal Revenue Code currently in effect or, as thecontext indicates, its predecessors, as well as authoritativeadministrative and judicial interpretations and applicationsthereof.

5Section II, Revenue Act of 1913.6Section 204, Revenue Act of 1918; S. Rep. No. 65-617 (1919).7See section 206(a), Revenue Act of 1924; section 206(a)(5),

Revenue Act of 1926; and section 117(a)(1), Revenue Act of 1928.8Section 117, 1932 Revenue Act; section 218(a), National

Industrial Recovery Act of 1933.9Section 211, Revenue Act of 1939.10Under prior versions of section 172, the carryback period

was three years and the carryforward period was five years fortax years beginning before 1975, and three years and 15 years,respectively, for later tax years beginning before August 6, 1997.

COMMENTARY / SPECIAL REPORT

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system could certainly be debated, but that is notthe focus of this report. Rather, this report focuseson the underpinnings and fairness of legislativelimitations on the breadth and extent of provisionspermitting loss carryovers to prior and later taxyears. Of course, it is the legislative permissiongiven to taxpayers to carry over net losses that setsthe stage for limiting those carryovers. Thus, tounderstand those limitations, it is important to firstunderstand the underpinnings of the tax loss carry-over allowance.

B. The Rationale for Permitting NOL Carryovers

The tax law raises revenues for the federal gov-ernment by taxing income.11 Both within and out-side the field of taxation, many economists haveattempted to define income. For purposes of devel-oping and refining tax policy and implementing taxlegislation, one widely accepted definition of in-come is the Haig-Simons definition.12 Under theHaig-Simons definition, income is equal to the sumof (1) the market value of the taxpayer’s consump-tion during the period and (2) the net increase in thetaxpayer’s wealth during the period (whether fromthe accumulations of savings or the increase in thevalue of property held).13 Under the Haig-Simonsdefinition, costs that are incurred to generate in-come are subtracted before coming to a calculationof income because those costs neither reflect per-sonal consumption nor represent an increase in thetaxpayer’s wealth.

The determination of taxable income under thetax law diverges from the Haig-Simons approach.The tax law first requires a taxpayer to determinehis gross income and then permits the taxpayer tosubtract specified costs or expenses incurred togenerate that gross income.14 The Supreme Courthas stated that the allowance for deductions forcosts incurred to earn income is not required by theU.S. Constitution;15 thus, the allowance reflects afundamental decision by Congress to tax net, rather

than gross, income.16 While the computational ap-proaches may vary, both the tax law and the Haig-Simons approach seek to tax income net of costsincurred to generate the income.

Once the decision has been made to tax netincome, there arises a decision regarding the propertime horizon over which to measure net income; asa matter of temporal proximity, which costs andexpenses should be allocated to which period indetermining net income of a given period?17 Forpurposes of their theory of economic income, whichwas not overly concerned with any arbitrary tem-poral cutoff date, Messrs. Haig and Simons werenot focused on an appropriate period for determin-ing tax liability.18 To the extent that an annualaccounting period was to be used, Simons thoughtit should be ‘‘tentative and provisional.’’19 From atheoretical perspective, the determination of anindividual’s economic income could (and probablyshould) be judged over an individual’s or a busi-ness entity’s lifetime, because it is only over thatperiod that economic income could be definitelymeasured and fixed. However, the crafters of ourincome tax law could not take such a long view,regardless of the compelling underlying argumentsto do so. For administrative purposes and to ensurethat the government has revenues to carry out itsfunctions, the tax code requires taxpayers to calcu-late and pay tax on their income annually.20

The tax code generally does not provide forpayments from the government to taxpayers whoexperience negative taxable income for a tax year.21

Consequently, the annual accounting period can

1116th Amendment (‘‘The Congress shall have power to layand collect taxes on incomes, from whatever source derived’’(emphasis added)); see also Eisner v. Macomber, 252 U.S. 189(1920); section 61; and section 62(a)(1).

12Boris I. Bittker and Lawrence Lokken, Federal Taxation ofIncome, Estates and Gifts, para. 3.1.1. This definition is named forAmerican economists Robert M. Haig and Henry C. Simons.

13Simons, Personal Income Taxation, 50, 61-62, 206 (1938).Because a corporate entity itself cannot consume, as meant forpurposes of this definition of income, its income would belimited to the increase in its savings during the period.

14Sections 61 and 62(a)(1).15White v. United States, 305 U.S. 281 (1938) (‘‘Moreover, every

deduction from gross income is allowed as a matter of legisla-tive grace’’); see also Bittker and Lokken, supra note 12, at para.20.1.1.

16Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).17To be sure, the decision to tax net income gives rise to or

affects several issues regarding time. For example, often (if notusually) costs are incurred well before the realization of associ-ated income, and so emerges the challenge of matching (or not)items of cost and income to determine the proper measure of netincome. Along these lines, questions arise about the proper timeof income and expense recognition. Accelerated expense recog-nition, such as through accelerated depreciation, tends to exac-erbate the mismatching of expense and associated income,while accelerated income recognition, such as through mark-to-market rules, tends to enhance the matching process. For thesake of discussion, this report assumes the validity of thosetiming rules through which NOLs emerge, and instead focuseson the legislative need and decision to create discrete taxperiods over which net income would be measured.

18Bittker, ‘‘A ‘Comprehensive Tax Base’ as a Goal of IncomeTax Reform,’’ 80 Harv. L. Rev. 925, 935 (1967).

19Simons, Federal Tax Reform 58-60 (1950).20Section 441.21Some, however, have argued that taxpayers who experi-

ence net losses in a tax period should be reimbursed for thoselosses in what essentially amounts to a negative income tax. See,e.g., Mark Campisano and Roberta Romano, ‘‘Recouping Losses:The Case for Full Loss Offsets,’’ 76 Nw. U. L. Rev. 709, 717 (1981).



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create disparities between the tax treatment of busi-nesses whose income is relatively constant versusbusinesses whose income fluctuates from year toyear.22 For example, consider two businesses: Busi-ness A earns $100 of net taxable income in both year1 and year 2, and Business B suffers a $100 nettaxable loss in year 1 and earns $300 of net taxableincome in year 2. At a 35 percent tax rate, BusinessA would pay $70 of total tax ($35 in both years 1and 2), but Business B would pay $105 of total tax($0 in year 1 and $105 in year 2). Although BusinessA and Business B both earn $200 of net taxableincome over the entire two-year period, Business Bpays more tax because of the annual accountingperiod. Given that the annual accounting period isan arbitrary convention devised and adoptedmerely to satisfy administrative and other govern-mental conveniences, the different results for Busi-ness A and Business B seem unjustifiable other thanto say, ‘‘Too bad, we had no other better choice.’’

This lack of symmetry between the taxation oftwo taxpayers that each enjoyed the exact sameaccession to wealth is at least partially alleviated bypermitting loss carryovers, which was the avowedpurpose for the enactment of the original NOLcarryover provision in 1921.23 Loss carryovers es-sentially enable a taxpayer to average its tax liabil-ity by recouping or reducing taxes paid in high-income years with the application of lossessustained in down years to reduce the amount ofincome taxed in the profitable years.

The conceptual foundation of this averaging so-lution is fairly straightforward in the context of anindividual taxpayer, but, at least in the view ofsome, becomes murkier when applied to corpora-tions. For federal income tax purposes, corporationsare treated as taxable entities separate from theirowners. As separate tax ‘‘persons,’’ corporationscalculate their taxable income on a stand-alonebasis and pay the resulting tax liabilities out of theirseparate corporate assets. Accordingly, under theaveraging concept embodied in the allowance tocarry over tax losses, if a corporation incurs netlosses during a tax year, it registers a loss carryoverthat can be used against the corporation’s futuretaxable income. And yet, some have observed thatcorporations are mere legal fictions without theability to consume; thus, corporations do not reapthe rewards of their success or suffer the economicconsequences of their losses. Those benefits andburdens are borne by their shareholders (and credi-tors).

This disconnect raises the question of how losscarryovers of a corporation should be treated underthe tax law, because the entity that possesses theloss carryover (the corporation) is not the sameperson who bore the corresponding economic loss(the corporation’s shareholders). This disconnecthas implications in any exploration of how andwhether corporate tax losses should be allowed andlimited.

III. Trafficking in NOLs — A Problem Emerges?A corporation with accumulated tax loss carry-

overs is more valuable than an otherwise similarlysituated corporation without loss carryovers, be-cause the loss carryovers can be used to offsetfuture tax liabilities. Assuming each of the twocorporations projects the same future stream ofpretax income, the corporation with loss carryoverswill anticipate higher after-tax yields. At least intheory, an acquirer should be willing to pay anadditional amount for the loss corporation up to thepresent value of the projected future tax savingsresulting from the anticipated use of loss carryoversto offset future income.

Is there anything wrong with that? Does anacquirer’s payment of incremental purchase pricefor this type of tax asset result in some distortion orunfairness that cannot be tolerated by our taxsystem? Are there important differences betweenthe purchase of a tax asset as compared with, say,the purchase of a machine or a parcel of real estate?

A review of the legislative history and relatedliterature over decades of congressional efforts tocurb trafficking in tax losses clearly reflects a wide-spread view that there is in fact a difference, a viewthat third parties should not be permitted to simplypurchase — ‘‘traffic in’’ — tax losses. The emergedwisdom among the tax community is that a losscorporation’s ability to use pre-acquisition loss car-ryovers should be limited to prevent so-called traf-ficking in loss corporations.

But why? Several rationales are offered. Traffick-ing is often presented as a self-evident evil, gener-ally defined by reference to a motive to engage in atransaction primarily to acquire a loss corporation’stax attributes. This, however, merely begs the ques-tion: Why is that bad? If it is acceptable for apurchaser to acquire a machine, for example, whynot a tax attribute?

One answer often provided: The tax law cannotabide by an acquisition undertaken solely with atax-driven motivation. The tax law, under this wayof thinking, cannot be driving transactions andshould ‘‘allow’’ only transactions that would havebeen undertaken even in the absence of tax losscarryovers. Under this view, a transaction whosesole result is a net decrease in tax revenue to the

22Bittker and Lokken, supra note 12, at para. 3.1.1.23H.R. Rep. No. 65-619, at 7 (1919).



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Treasury can have no place within our tax system.This violates the principle of tax neutrality, whichposits that tax implications should neither impedenor induce business transactions. As will be ex-plored below, not only are the ethical, moral, andpractical underpinnings of this principle unclear, itis even debatable whether this principle is followedwith sufficient consistency within the tax law tocloak it with respectability.

Another theory for limiting loss trafficking isbased on the principle that only the historic ownersof a loss corporation who have borne the underly-ing economic loss should be permitted to realize thetax benefit associated with that loss carryover.Again, however, this merely begs the question: Whyshould the tax benefit, unlike other assets, be usableexclusively by these shareholders? And why, evenunder this view that the shareholders who bore theeconomic loss should be able to enjoy the associatedtax benefit, should these shareholders be precludedfrom realizing that value through a sale of thebenefit?

Some have offered a corollary to the idea thatonly the historic owners should get the tax benefitassociated with having endured the economic loss:According to this notion, the reason to constraintrafficking in tax losses is to protect these historicowners from the eventuality that acquirers will notadequately compensate selling shareholders for thetax attribute. Under this theory, it is argued thatacquirers will discount their payment to account foruncertainty regarding the potential acquirer’s abil-ity to use a loss carryover, and so selling sharehold-ers will simply be unable to obtain adequatecompensation for the underlying tax benefit. Con-sequently, the selling shareholders would be under-paid and the acquirer might accede to a windfall ifit can use more of the loss carryover than it antici-pated at the time of the acquisition. This concern,further examined later, has the hallmarks of arationale concocted after the fact to explain a rulethat may simply have no good underlying purpose.

Finally, some object to the possibility that lossesincurred in one business line will be used to offsetprofits arising from another, unrelated business.This is a particularly strict application of the con-cept that loss carryovers are intended to facilitateincome averaging. This rationale at least presents avalid policy question: In our system of annualizedreporting, if we are to permit an averaging conven-tion across tax periods to smooth out profitableyears with loss years and thereby achieve greaterparity between similarly situated taxpayers, shouldthe averaging be done at the taxpayer level or thebusiness level?

These are the main rationales offered for our webof tax law provisions that constrain and penalize

trafficking in tax losses. They are explored later inthis report. At this point, it merits observation thatquite (if not most) often the tax community simplytakes for granted that trafficking in tax attributes isan evil that should be eliminated wherever possible,with no effort to articulate the ‘‘evil.’’ While somehave paused to examine a particular negative asso-ciated with trafficking, such as its potential toviolate the goal of tax neutrality, these efforts gen-erally fail to satisfactorily examine the potentialundesirable consequences resulting from the con-straints and limitations imposed or the lack ofconsistency or conformity with other areas of thetax law. Importantly, however, these are the ratio-nales and justifications that have, over all thesemany decades, been handed down and become our‘‘received wisdom’’ on the subject, a wisdom thathas frequently been invoked in both legislative andjudicial approaches to the treatment of loss carry-overs, and a wisdom that perhaps deserves a sec-ond look.

IV. Limits on NOL Use Following Acquisitions

As discussed earlier, a principal reason for per-mitting NOL carryovers was to enable averaging ofincome and losses across tax years so as to reduce atleast some of the unfairness resulting from adoptionof an annual accounting period to measure income.Initially, when confronting the case of corporatetaxpayers, courts applied this averaging conceptstrictly and permitted NOLs to be used only by thespecific corporate taxpayer that incurred the loss. InNew Colonial Ice Co. v. Helvering, the Supreme Courtheld that a corporation newly formed to acquire allthe assets and liabilities of an existing corporationcould not inherit the NOLs of the existing corpora-tion, even though the business conducted by theexisting corporation was continued in the newcorporation and the shareholders remained thesame.24 The taxpayer argued that the losses shouldbe transferred to, and available for use by, the newcorporation because after the transaction the stock-holders and creditors of the new corporation werethe same as the existing corporation. The Courtrejected the taxpayer’s argument because the twocorporations were in fact two distinct legal entitiesand the new corporation should not and could notbe viewed as the same entity for tax purposes.Consequently, the Court held that the new corpo-ration could not use the tax losses incurred by itspredecessor.

24292 U.S. 435, 437-438 (1934) (applying the two-year NOLcarryover allowed under the Revenue Act of 1921, ch. 136,section 204(b)).



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A few years later, in Helvering v. MetropolitanEdison Co.,25 the Court moved away from this strictentity approach and permitted the surviving corpo-ration in a merger to use the other corporation’sdeduction for unamortized bond discount, a favor-able tax attribute. The distinction between Metro-politan Edison and New Colonial Ice apparently wasthat the Metropolitan Edison transaction took theform of a merger rather than an actual sale of all ofone corporation’s assets to another. This formalisticdistinction enabled taxpayers to effect tax-motivated acquisitions of loss corporations so longas they were structured correctly.

A. Section 269 and Its PredecessorTo combat these tax-motivated transactions, Con-

gress enacted section 129 of the Revenue Act of 1943(the predecessor to current section 269), whichprovided that if any person acquired control of acorporation, or any corporation acquired the assetsof another corporation not controlled by the acquir-ing corporation before the acquisition, ‘‘and theprincipal purpose for which such acquisition wasmade is evasion or avoidance of Federal income orexcess profits tax by securing the benefit of adeduction, credit, or other allowance which suchperson or corporation would not otherwise enjoy,then such deduction, credit, or other allowanceshall not be allowed.’’26

Section 129 of the 1943 Act was intended ‘‘to putan end promptly to any market for, or dealings in,interests in corporations or property which have astheir objective the reduction through artifice of theincome or excess profits tax liability.’’27 It had cometo Congress’s attention that some corporations withlarge excess profits were purchasing corporationswith large current, past, or projected losses toreduce or offset those taxable profits. Congress tookaction to close this ‘‘loophole’’ so as not to under-mine the position of ‘‘honest’’ taxpayers.28 Thelegislative history in the Senate report also notesthat more specific (meaning less vague) statutorylanguage was considered but rejected in favor of thegeneral (meaning vague) principle because specificdescriptions place too much emphasis on the formand technical character of the tax avoidancescheme, rather than on the substance.29 Interest-ingly, the original House proposal would have

applied to a transaction if ‘‘one of the principalpurposes’’ was tax avoidance, but the Senate nar-rowed this statutory antiabuse rule to apply only if‘‘the principal purpose’’ was tax avoidance; theSenate Finance Committee thought that the provi-sion should be operative only if ‘‘the evasion oravoidance purpose outranks or exceeds in impor-tance, any other one purpose.’’30 However, in itsapplication, section 129 was not up to the task.

The inadequacy (real or perceived) of section 129was highlighted in dicta offered by the Tax Court inAlprosa Watch Corp. v. Commissioner,31 which fo-cused on a transaction that preceded the enactmentand effectiveness of section 129. In Alprosa Watch,the purchasers of the stock of a loss corporationwere able to preserve NOL carryovers even thoughthe corporation immediately disposed of its historicbusiness, changed the location of its place of busi-ness, and changed its name. The Tax Court, relyingon the principle that a corporation and its share-holders are separate entities for tax purposes, con-cluded that the change of ownership did not affectthe tax identity of the corporation, so the corpora-tion could continue to use its historic NOLs toreduce its taxable income following the ownershipchange.

Although the transaction in Alprosa Watch oc-curred before the effective date of section 129, theTax Court expressed ‘‘considerable doubt’’ that sec-tion 129 would have applied to the transactionbecause ‘‘that section would seem to prohibit theuse of a deduction, credit, or allowance only by theacquiring person or corporation and not their useby the corporation whose control was acquired.’’32

The Tax Court also stated that because the purchas-ing shareholders had a business purpose for thetransaction apart from any potential tax benefits,section 129 (had it been in effect for the transactionat issue) would not apply because tax avoidancewas not the dominating motive.

Thus, in Alprosa Watch, the Tax Court signaled aperceived deficiency of the subjective intent-basedapproach, an approach later and still relied on by

25306 U.S. 522 (1939).26Revenue Act of 1943, section 129. The triggering language

of current section 269(a) is virtually the same. The provision wasamended in 1963 to give the Treasury secretary discretion todisallow deductions or credits. Revenue Act of 1964, section235(c)(2).

27H.R. Rep. No. 78-871, at 49 (1944).28Id.29S. Rep. No. 78-627, at 49 (1944).

30Id. (emphasis added).3111 T.C. 240 (1948).32As indicated, the Tax Court actually said that the statutory

language of section 129 — the predecessor of section 269 —would disallow use of the tax losses by the acquirer but not bythe corporation in which the losses arose. This interpretation ofthe statute has been rejected by courts in subsequent cases, suchas in Commissioner v. British Motor Car Distribs. Ltd., 278 F.2d 392(9th Cir. 1960) (‘‘We should be closing our eyes to the realities ofthe situation were we to refuse to recognize that the personswho have acquired the corporation did so to secure for them-selves a very real tax benefit to be realized through the acquiredcorporation and which they could not otherwise have realized’’)(emphasis added).



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section 269. This statutory antiabuse rule reliesentirely on a taxpayer’s intention, which in the bestof circumstances is hard to determine, much lessprove. Thus, the emerging and later prevailing viewwas that a subjective antiabuse rule simply wouldnot suffice. As long as a taxpayer could demonstratea business purpose as a primary motivation for atransaction, this type of statutory constraint wouldnot serve as an effective limitation on trafficking inloss carryovers. Under this view, the IRS’s burdento prove a subjective primary intent of tax avoid-ance renders the provision too difficult to success-fully invoke in transactions if they are notcompletely devoid of economic substance.

B. The 1954 Code — Section 382And so, the legislative effort to address the

problem of trafficking in tax losses persisted. In1954 Congress completed a major overhaul of theInternal Revenue Code, and some of the changeshad a significant impact on the treatment of losscarryovers. First, section 381 was added, whichpermitted the carryover of specified corporate taxattributes, including NOL carryovers, for liquida-tions of 80 percent-owned corporate subsidiariesand other transactions that qualify as asset-typereorganizations under section 368.33 New section381 enabled a successor corporation to step into thetax shoes of the predecessor corporation eventhough it is not the same legal entity. Accordingly,new section 381 effectively overruled the holding ofNew Colonial Ice for tax-free asset reorganizationsand expanded the range of transactions in whichloss corporation shareholders could ‘‘transfer’’ losscarryovers.

To address loss trafficking, Congress concur-rently added section 382. Congress thought that thesubjective intent test of then-section 129 (the prede-cessor of section 269) increased the chance of litiga-tion and hampered a taxpayer’s ability to conductlegitimate business transactions.34 Accordingly, the1954 version of section 382 enumerated objectivecriteria in an attempt to add certainty to the deter-mination of when loss carryovers would be lim-ited.35

Newly enacted section 382 provided two sepa-rate sets of rules: one for purchases of stock of losscorporations (under then-section 382(a)) and onefor specified types of reorganizations involving losscorporations (under then-section 382(b)). Section382(a) provided that a loss carryover was disal-lowed in full if there was a 50 percent change ofstock ownership of a loss corporation within atwo-year period and the loss corporation did notcontinue its historic business. For purposes of thistest, only increases in stock ownership by the losscorporation’s 10 largest stockholders were consid-ered.36 Under section 382(b), following a reorgani-zation, the amount of a loss carryover was reducedproportionately, depending on the degree to whichthe shareholders of the loss corporation receivedless than 20 percent of the acquiring corporation’sstock in the reorganization.37

Many of the inconsistencies between the treat-ment of stock purchases on the one hand and thetreatment of reorganizations on the other wereunprincipled.38 For example, (1) the continuation ofa historic business was irrelevant for reorganiza-tions but required for stock purchases; (2) losscarryovers under the reorganization rules werepermitted in full following as much as an 80 percentownership change but were entirely eliminatedupon only a 50 percent ownership change under the

33Codified at current section 381(a). In reorganizationstreated as stock sales for U.S. federal income tax purposes, suchas B reorganizations, the target corporation remains in existenceand retains its tax attributes.

34See S. Rep. No. 83-1622, at 53 (1954) (section 269 ‘‘has beenso uncertain in its effects as to place a premium on litigation anda damper on valid business transactions’’).

35IRC of 1954, section 382(a)(1)(A) and (C). Cf. S. Rep. No.83-1622, at 53 (1954) (stating that the rule is to prevent the use ofNOL carryovers against the income of an unrelated businessand that the limitation will apply if ‘‘the corporation engages ina different type of business’’). Under the new provision, existing

loss carryovers would be eliminated if, in addition to changingownership beyond a specified threshold, the corporation didnot continue its historic business. Despite the articulated goal inthe Senate report, the statute clearly permitted complete sur-vival and use of the loss carryovers as long as some part of theold loss corporation business was continued, and it permittedthe use of those surviving losses to offset not only the historicbusiness’s income, but also to offset income from new busi-nesses. (The regulations prohibited more than a minor change inbusiness. Reg. section 1.382-1A(h)(7).) The statements in theSenate report — which did not appear to guide the actualformulation of the new statutory provisions — resemble theprinciple and holding later enunciated by the Supreme Court inLibson Shops Inc. v. Koehler, 353 U.S. 382, 382 (1957) (discussedbelow).

36IRC of 1954, section 382(a)(2) (repealed in 1986).37IRC of 1954, section 382(b) (repealed in 1986). If the loss

corporation shareholders owned less than 20 percent, the allow-able NOL carryover was reduced. IRC of 1954, section 382(b)(1)and (2). The continuing ownership taken into account for thispurpose was only that ownership which was attributable tointerests previously held in the loss corporation. IRC of 1954,section 382(b)(1)(B). The limitation on NOL carryovers follow-ing a tax-free reorganization extended to reorganizations towhich section 381 applied regardless of whether the loss corpo-ration was the acquired or surviving entity. IRC of 1954, section382(b)(1). The limitation on loss carryovers was not extended toB reorganizations, in which the loss corporation remains whollyintact (albeit owned by a new corporate shareholder).

38George K. Yin, ‘‘Of Diamonds and Coal: A RetrospectiveExamination of the Loss Carryover Controversy,’’ 2 NYU Pro-ceedings of the 48th Inst. on Fed. Tax’n, ch. 41 (1990).


(Footnote continued in next column.)


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stock purchase rules; and (3) reductions of the taxloss carryovers were proportionate under the reor-ganization rules but all-or-nothing for stock pur-chases. Further, the statute left important gaps. Forexample, many believed that neither the rules ap-plicable to stock purchases nor the rules applicableto reorganizations applied to B reorganizations orsection 351 transactions.

Interestingly, despite the perceived inadequacyof then-section 129 or the stated congressional con-cern regarding the tendency of section 129 to fosterexcessive litigation and hamper otherwise validcommercial transactions, Congress reenacted for-mer section 129 as section 269, which the legislativehistory made clear could be applied regardless ofwhether section 382 applied to a transaction.39

C. The Libson Shops DoctrineIn 1957 the Supreme Court again waded into the

discussion regarding NOL carryovers. Libson ShopsInc. v. Koehler40 involved the survival and transfer-ability of loss carryovers in a transaction that pre-ceded the enactment and effectiveness of the 1954legislation. The taxpayer, Libson Shops Inc., was thesurviving corporation in a transaction in which 16sales corporations were merged with and into it,with the shareholders of the 16 corporations receiv-ing stock in Libson Shops as consideration. Thesame persons who, directly or indirectly, ownedstock of the merged sales corporations owned thestock of Libson Shops in the same proportions as aresult of and following the mergers. Three of thesales corporations had historic NOLs before themerger, which the combined entity attempted toclaim against its combined taxable income in theyear following the merger. The applicable statuteprovided that ‘‘if for any taxable year beginningafter December 31, 1947, and before January 1, 1950,the taxpayer has a net operating loss, such netoperating loss shall be a net operating loss carry-over for each of the three succeeding taxableyears.’’41 The question presented was whether Lib-son Shops should be considered the taxpayer re-garding the pre-merger NOLs of the three losscorporations.

Based on the applicable (pre-1954 law) statutoryconstruct and judicial precedent, the Court facedseveral possible outcomes. The IRS relied heavilyon New Colonial Ice to argue that no carryovershould be permitted because Libson Shops had itsown corporate charter and therefore was not tech-

nically the same corporate taxpayer that incurredthe tax losses. The taxpayer in turn relied onMetropolitan Edison to argue that a surviving corpo-ration in a statutory merger should be treated as thesame taxpayer and therefore permitted to inheritand use the predecessor corporation’s tax loss car-ryovers. Further, it argued, the fact that the samepersons ultimately owned the loss corporations andLibson Shops in the same proportions could havebeen relied on to conclude that the losses should beinherited and usable by the surviving corporationin the mergers.

Ultimately, the Supreme Court decided that thesurviving entity, Libson Shops, could not use thepre-merger NOLs to offset post-merger income be-cause there was not a sufficient continuity of busi-ness enterprise between the activity that generatedthe loss and the income that Libson Shops sought tooffset with the NOLs. The Court found support fora continuity of business requirement in the legisla-tive history of the applicable NOL carryover provi-sions (section 122 of the IRC of 1939). Based on theCourt’s reading of the legislative history, the then-applicable provision allowing carryover of NOLswas enacted to remedy the ‘‘unduly drastic conse-quences of taxing income on an annual basis,’’ butthere was no indication that Congress intended forthat averaging to permit pre-merger losses of onebusiness to offset post-merger income of some otherbusiness that had previously been taxed sepa-rately.42 Finally, the Court noted that because thebusinesses of the three loss corporations that gen-erated the NOLs continued to generate losses on astand-alone basis after the merger, they would havebeen unable to use the NOLs (within the applicablethree-year carryforward period) absent themerger.43

The Supreme Court’s holding in Libson Shops hadthe potential to significantly affect the treatment ofloss carryovers in corporate acquisitions. However,because the transaction in Libson Shops occurredbefore the effective date of the 1954 code, there wasuncertainty whether the holding’s constraints onthe use of tax losses had been superseded by the1954 legislation, given that Congress had created astatute specifically addressing the treatment of losscarryovers in acquisition transactions.

The rationale underlying the Libson Shops hold-ing is consistent with the Senate’s stated purposefor enacting the continuity of business requirementfor stock purchases in section 382(a) of the 1954code. The Senate report stated, ‘‘Abuse has most

39See S. Rep. No. 83-1622, at 284 (1954) (stating that ‘‘the factthat a limitation under [IRC of 1954, section 382] does not applyshall have no effect upon whether section 269 applies’’).

40353 U.S. 382 (1957).41IRC of 1939, section 122(b)(2)(C) (emphasis added).

42353 U.S. at 386.43Before the merger, the 16 sales corporations had not elected

to file a consolidated return.



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often arisen [in] the purchase of the stock of acorporation with a history of losses for the purposeof using its loss carryovers to offset gains of abusiness unrelated to that which produced thelosses.’’44 The continuity of business requirementactually enacted in 1954, however, was less strin-gent than the holding in Libson Shops because it onlyrequired the loss corporation to continue ‘‘to carryon a trade or business substantially conducted’’ be-fore an ownership change in order to preserve itsloss carryovers.45 Thus, under the new legislation atthe time, a taxpayer with multiple lines of businesswas not required to continue conducting the tradeor business that generated the loss; rather, only oneof its historic lines of business needed to be contin-ued. Further, as long as any historic line of businesswas continued, the 1954 version of section 382 didnot prevent a loss corporation from using lossesagainst any of its income (even income attributableto a line of business that was acquired in thetransaction), which is exactly what the SupremeCourt proscribed in Libson Shops.46

For transactions occurring after the 1954 enact-ment of section 382, courts generally concluded thatthe holding in Libson Shops was superseded and thatpost-1954 transactions would be tested only undersection 382.47 The IRS, however, not yet willing tothrow in the towel and concede that Libson Shopswas no longer relevant, continued to assert thatLibson Shops could apply to transactions with simi-lar facts if section 382 did not impose a loss carry-over limitation.48

The ambiguity regarding the continued relevanceof the Libson Shops doctrine was not put to rest until1986 when Congress, in connection with its over-haul of section 382, affirmatively stated its intentthat the Libson Shops doctrine was no longer appli-cable. At long last, Libson Shops was, according toeveryone, ‘‘dead.’’

D. The Tax Reform Act of 1976In 1976 Congress again took up the issue of

constraining the ability to traffic in tax loss carry-overs. The Tax Reform Act of 1976 included adjust-

ments to section 382 intended to create bettersymmetry between the rules applicable to stockpurchases and those applicable to reorganizations.49

Under the proposed 1976 revisions (1) the businesscontinuation requirement was eliminated from sec-tion 382(a); (2) both sets of section 382 rules — forstock acquisitions and for reorganizations — wererevised so that there was no disallowance of losscarryovers until there was at least a 60 percentownership change; and (3) the loss use limitation,once triggered, effected only a partial disallowanceof carryovers under both provisions.50 The changesproposed under TRA 1976 were the subject of muchcriticism, in part because the amendments werehastily drafted and Congress did not permit anadequate opportunity for industry comment.51 Con-gress repeatedly delayed the effective date of the1976 changes; a portion of the 1976 changes finallybecame effective in 1984 only to be followed shortlyby a full repeal of the 1976 changes in 1986.52

E. The Tax Reform Act of 1986Persistent concerns with and criticism of the 1954

rules, together with the strong and vocal dissatis-faction with the (enacted but never fully effective)1976 revisions, compelled Congress to revisit thetreatment of tax loss carryovers in the 1980s. Ap-parently, given the long history of criticism anddissatisfaction, Congress was finally moved to lookat the entire set of rules through a different part ofthe prism, willing to address the problem — what-ever it was — by fashioning a brand-new approach,an approach unlike previous efforts. Hence, theoverhaul of section 382 in TRA 1986.

With the 1986 approach, Congress introducedseveral new concepts. As with the original section382, the new rules only applied following a largechange in the ownership of a loss corporation, butthe consequences of such an ownership changewere significantly altered. Instead of an ownershipchange resulting in the reduction of the pre-ownership change amount of loss carryovers, the

44S. Rep. No. 83-1622, at 53 (1954).45IRC of 1954, section 382(a)(1)(C) (emphasis added).46Also, section 382(b) did not specifically require a continuity

of business enterprise at all in a reorganization.47See Maxwell Hardware Co. v. Commissioner, 343 F.2d 713 (9th

Cir. 1965).48Indeed, while the courts generally signaled that Libson

Shops had no continuing relevance or application in the face ofIRS assertions to the contrary, the legislative branch did its partin keeping the intrigue alive; when Congress amended section382 in the Tax Reform Act of 1976, it specifically stated that itwas not superseding Libson Shops for tax years before theeffective date of the 1976 changes.

49Also, Congress sought to correct several technical deficien-cies with the prior statute.

50There were also several other minor changes, such asmeasuring an ownership change by reference to the 15 largestshareholders instead of 10, and over a three-year period ratherthan two years.

51See generally Eustice, ‘‘The Tax Reform Act of 1976: LossCarryovers and Other Corporate Changes,’’ 32 Tax L. Rev. 113(1977).

52TRA 1986, section 621(e). Because of a delay in the enact-ment of TRA 1986 until October 1986, some taxpayers maylegitimately have assumed that the 1976 amendments, due totake effect on January 1, 1986, actually went into effect. Congresswas aware of this potential problem and provided transitionalrelief by permitting application of the 1976 amendments insome cases. TRA 1986, section 621(f)(2).



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new provision generally left intact and unreducedthe amount of loss carryovers and instead imposeda limit on the amount of post-ownership changeincome of the loss corporation that could be offsetby its pre-change losses.53 The enunciated goal ofthe new rules was to limit use of loss carryoversfollowing an ownership change to the amount oflosses that would have been used by the losscorporation had no ownership change occurred.54

The basis for this new approach was a studyconducted by the American Law Institute and re-ported in 1982. The loss use limitation proposal inthe ALI report included several components, not allof which were adopted by Congress in new section382. The ALI report made two proposals, one formergers and one for purchases of shares. Bothproposals were based on a ‘‘pool of capital’’ con-cept: A loss corporation’s tax loss carryovers follow-ing an acquisition transaction should be allowed tooffset only income from that loss corporation’s poolof capital existing on the date of the acquisitiontransaction.

Under the ALI report’s primary proposal, appli-cable to mergers and some other business combina-tions, a loss corporation could apply its losses tooffset post-merger profits only to the extent ofprofits allocable to shares of the loss corporationoutstanding when the loss was incurred. For ex-ample, if in a merger the target loss corporation’sshareholders receive 10 percent of the total out-standing shares of acquirer common stock (suggest-ing that the loss corporation represents 10 percentof the combined entity), the tax loss carryovers ofthe loss corporation could be used to offset only 10percent of the acquiring corporation’s post-mergerearnings. This is consistent with the pool of capitalconcept because only the portion of the futureearnings attributable to the loss corporation can beoffset by the tax loss carryforward, with the per-centage of acquirer stock received by the loss cor-poration shareholder’s acting as a proxy for therelative value of the loss corporation. This first andprimary proposal offered by the ALI report alsorequired a proration of future earnings that couldbe offset by prior loss carryovers when sharehold-

ers make additional capital contributions to a losscorporation in exchange for new loss corporationstock.55

The ALI report proposal included a second com-ponent, a backup rule that would apply when stockof a loss corporation was purchased outside amerger. Under the primary rule, in a situation inwhich there is a purchase of loss corporation stock(involving no combination with any second corpo-ration), there would be no limit on the loss corpo-ration’s ability to use its loss carryforwards. In thatcase, under the arithmetic application of the pri-mary rule, there would have been no change in itspool of capital and thus no limitation. There wasconcern, however, that following such a stock ac-quisition, the new shareholders could make capitalcontributions to the loss corporation in a way thatcould thwart the intended operation of the primaryrule. Therefore, the proposal also included a sec-ondary purchase rule, which would limit the use ofany loss carryforwards following an acquisition ofloss corporation shares. Under this rule, loss usewould be limited to an objective rate of returnmultiplied by the price paid for the purchasedstock. This method was based on the theory that thevalue of the loss corporation’s equity — the value ofits outstanding stock at the relevant time — repre-sented a good measure of the pool of capitalamount. This purchase rule, intended as a backstop,would apply only if the primary rule did not apply.

In fashioning the 1986 version of section 382,Congress adopted the ALI report’s underlying poolof capital theory but chose to enact only the pur-chase rule. It felt that the primary rule was toocomplex. Section 382 of the 1986 code limits theamount of taxable income of the loss corporationthat may be offset by loss carryovers following anownership change. The ownership change triggerserves as a cliff; until the threshold is met there is nolimit on continued use of the tax loss carryovers,but once the ownership change threshold isreached, the loss limitation rule applies in full force.

Under the new 1986 formulation, an ownershipchange generally is any increase greater than 50percentage points in a corporation’s stock owner-ship over a three-year period by shareholders (orshareholder groups) who own 5 percent or more ofthe stock of the loss corporation. If an ownership53Under the 1986 version of section 382, Congress retained an

element of the prior law’s focus on tying the NOLs to the ‘‘samebusiness.’’ Under the new version (section 382(c)), a discontinu-ation of the loss corporation’s business within two years of theownership change would result in elimination of the NOLs (andnot merely a limitation on their use). This continuity of businessrequirement was, however, considerably more relaxed than thecontinuity required under the prior version of section 382.

54See also H.R. Rep. No. 99-426, at 257 (1985); S. Rep. No.99-313, at 232 (1986); and American Law Institute, ‘‘FederalIncome Tax Project — Subchapter C: Proposals on CorporateAcquisitions and Dispositions,’’ at 239-242 (1982) (ALI report).

55The ALI report allowed exclusions from this requirementto prorate future income for pro rata capital contributions aswell as contributions of preexisting debt (meaning debt alreadyin place when a loss was incurred) in exchange for losscorporation equity. The ALI report also contained special rulesfor situations in which the loss corporation shareholders receiveplain vanilla preferred stock or equity with characteristics ofboth common and plain vanilla preferred stock.



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change occurs, the amount of the limitation — theamount of income that can be offset each yearfollowing the ownership change — is generallyequal to the value of the loss corporation at the timeof the ownership change multiplied by the long-term tax-exempt interest rate (updated and pub-lished monthly by the IRS). The limitation formulais a rough attempt to impute a rate at which the losscorporation could have used its losses if the trans-action had not occurred and the corporation hadinstead sold all its assets and used the proceeds topurchase Treasury bonds. By limiting the amount ofthe tax benefit in this way, Congress hoped toeliminate any tax-motivated incentive for a thirdparty to acquire and gain the benefit of tax losses —at least any tax benefit exceeding what the losscorporation would itself enjoy in the hypotheticalliquidation scenario — in acquisitions of loss cor-porations.

Section 382 also was expanded to include a newconcept of built-in losses. In 1986, for the first time,Congress sought to curb not only acquisitions ofexisting loss carryovers but also acquisitions fo-cused on the existence of an overall built-in tax losswithin the target corporation, meaning assets thaton the whole have a tax basis in excess of theirvalue. This expanded focus even on built-in losseswas driven by a concern that the new section 382rules could be circumvented by a loss corporationthat timed sales of assets with built-in losses tooccur after an ownership change.56

F. Other LimitationsIn addition to sections 382 and 269, there are

rules in the code (and regulations) that can restrict aloss corporation or acquirer’s ability to use losscarryovers after corporate acquisitions.1. SRLY rules. Under the consolidated return rules,if a loss corporation is acquired by a corporationthat is a member of a group of corporations filing aconsolidated federal income tax return, the losscorporation’s tax losses (including its built-inlosses) are subject to the separate return limitationyear (SRLY) rules. Under the SRLY rules, the losscarryovers and recognized built-in losses may beapplied to offset consolidated taxable income onlyto the extent that the income is attributable to theloss corporation.57

Thus, the SRLY rules operate in a manner thatcalls to mind the Supreme Court’s holding andrationale in Libson Shops. Like Libson Shops, pre-transaction losses generally could be used to offsetincome only from the businesses conducted by theloss corporation before the transaction. Unlike Lib-son Shops, however, the SRLY rules permit (subjectto some antiabuse rules) the pre-acquisition losses(and built-in losses) to be applied against income ofthe acquired loss corporation even if generated byan entirely new business. Another difference fromthe Libson Shops concept is that in applying theSRLY limitations, the IRS has ruled that if a memberof a consolidated group acquires an unaffiliated losscorporation in an asset-type reorganization —meaning the assets or operations of the loss corpo-ration are themselves acquired by and held insidethe consolidated group member — the consolidatedgroup member that acquired the loss corporation istreated as the successor of the acquired corporation.The losses acquired by the successor (under section381) remain intact and available for use under theSRLY rules to offset income of the successor corpo-ration. Consequently, in that situation, the acquiredlosses may be applied against not only income ofthe acquired loss corporation but also income of theacquiring corporation (whether generated by theacquiring corporation’s historic business or — sub-ject to antiabuse rules — a new business).58

The SRLY rules reflect an effort to reconcilesingle- versus separate-entity treatment of consoli-dated group members regarding their losses whenthey join or leave a group, in addition to addressingloss trafficking concerns.59 The Supreme Court firstimposed a SRLY-like limitation in Woolford RealtyCo. v. Rose because it determined that Congresscould not have intended consolidated returns topermit manipulation of net taxable income throughthe absorption of separate return losses on a con-solidated basis.60 In his opinion, Justice Benjamin N.Cardozo stated:

Doubt, if there can be any, is not likely tosurvive a consideration of the mischief certainto be engendered by any other ruling. A dif-ferent ruling would mean that a prosperouscorporation could buy the shares of one thathad suffered heavy losses and wipe outthereby its own liability for taxes. The mindrebels against the notion that Congress in

56H.R. Conf. Rep. No. 99-841, at II-190 (1986).57Reg. section 1.1502-21(c)(1). To be sure, the SRLY rules

contain computational rules more complex than articulatedhere, which are beyond the scope of this report. Also, if an entiresubgroup is acquired, the SRLY rules are applied on a subgroupbasis (i.e., the losses of any subgroup member may be carriedforward to offset the income of any subgroup member). Reg.section 1.1502-21(c)(2).

58LTR 8851017.59Andrew J. Dubroff et al., 2 Federal Income Taxation of

Corporations Filing Consolidated Returns, section 42.02[1][a], at42-8 and section 42.02[1][d], at 42-36 (2012).

60286 U.S. 319 (1932); see also Planters Cotton Oil Co. v. Hopkins,286 U.S. 332 (1932) (same).



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permitting a consolidated return was willingto foster an opportunity for juggling so facileand so obvious.61

The consolidated return regulations first im-posed a limitation on the use of carryovers fromseparate return years for tax years beginning in1929. This first SRLY62 limitation was based on thecost or basis of the stock of the acquired losscorporation.63 Under this earliest articulation of theSRLY rule, a new member’s losses from pre-consolidation periods could be used only to theextent ‘‘of the cost or the aggregate basis of the stockof such [member] owned by the members of thegroup.’’64 The theory behind limiting the deduc-tions to the cost or value of the stock was toeliminate any incremental tax benefit associatedwith the purchase of stock of a corporation with taxloss carryforwards. The regulations were laterchanged to the current approach, which calculatesthe limitation based on the acquired loss corpora-tion’s separate income as a member, which is moreconsistent with preserving separate-entity treat-ment in determining the amount of the loss corpo-ration’s tax losses that could offset post-acquisitionincome.65

In cases in which both section 382 and the SRLYrules would apply, section 382 generally controlsand the SRLY rules do not apply.66 Under thisoverlap rule, if a loss corporation becomes a mem-ber of a consolidated group as part of a transactionthat results in an ownership change under section382, the SRLY rules will not apply. The rationalegiven for this rule is that section 382 is the morerestrictive of the two limitation regimes and so itmore comprehensively addresses the underlyingloss trafficking concern. As a result of the overlaprule and its underlying rationale, commentatorshave argued that the SRLY rules are superfluousand should be repealed.67 Others have argued thatthe SRLY rules should be preserved for non-overlaptransactions.68 For the time being, however, wemust deal with both of these somewhat duplicative

sets of rules. The legislative history of section 382clearly signals that SRLY principles will continue toapply even after the 1986 enactment of section 382.69

2. Section 384. Enacted in the Revenue Act of 1987,section 384 limits use of the loss carryovers andcertain built-in losses of one of the two corporationsto offset gain built into the assets of the other whenone corporation acquires another or one corpora-tion acquires the assets of another in an A, C, or Dreorganization. Under this statutory construct, thelimitation rules can apply whether the loss corpo-ration acquires the gain corporation or vice versa.70

In either situation, if the acquisition — either by theloss corporation or by the gain corporation —results in shifting ownership of the loss corporation,section 382 can apply as well.71

Once section 384 is triggered, the loss carryoversfrom pre-combination periods are not allowed to beused to offset gain on the disposition of assets forfive years if the assets were held by the gaincorporation on the date of the combination, and tothe extent the assets had built-in gain as of the dateof the combination. Unlike section 382, section 384is not limited to changes in ownership of the losscorporation. Rather, it is focused on the combina-tions of gain corporations and loss corporations inorder to prevent the blending of gain-corporationgain and loss-corporation losses to produce a com-bined tax liability lower than the aggregate taxliability of the two corporations absent the combi-nation.

But what problem, exactly, was section 384 ad-dressing? The legislative history indicates that Con-gress intended to prevent the losses of a losscorporation from sheltering the built-in gains of again corporation, such as phantom gains on prop-erty for which depreciation had been taken beforethe acquisition and the built-in income of a ‘‘burnt-out’’ leasing subsidiary whose property has a fairmarket value ‘‘less than the present value of thetaxes that would be due on the income associatedwith the property.’’72

Again, however, what is the underlying abuse orpolicy goal? The section 384 construct, which disal-lows use of the existing losses (and built-in losses)61Woolford Realty, 286 U.S. at 329.

62The term SRLY was not used until the 1966 regulations.New York State Bar Association Tax Section comment letter(Dec. 10, 1996) (summarizing the history of the SRLY rules).

63Reg. 75, Art. 41(c) (1929).64Id.65Reg. 102, Art. 31 (1938).66Reg. section 1.1502-21(g) (the overlap rule).67See, e.g., NYSBA tax section comment letter (Nov. 24, 1998);

Association of the Bar of the City of New York comment letter(June 5, 1997).

68See, e.g., Lee A. Sheppard, ‘‘The Camel’s Nose of PartialSRLY Repeal,’’ Tax Notes, June 21, 1999, p. 1678; Tax ExecutivesInstitute, comments on Notice 98-38 regarding SRLY (Apr. 15,1999).

69H.R. Conf. Rep. No. 99-841, at II-194 (1986).70Under section 384(b), the combination of a loss corporation

and a gain corporation that were part of the same controlledgroup (based on a 50 percent vote and value test) for five yearsbefore that combination will not trigger section 384(a).

71Sections 382 and 384 are meant to apply cumulatively, andpresumably section 382 applies first. Bittker and Eustice, FederalIncome Taxation of Corporations and Shareholders, para. 14.45. Thedetailed mechanics of section 384 are uncertain in many casesbecause no regulations have been promulgated thereunder.

72H.R. Conf. Rep. 100-3841 (1987).



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against income and gain built into the assets ofanother corporation, runs counter to the idea thatthe owners of the loss corporation who bore theeconomic loss should be able to benefit from theloss carryovers generated by those economic losses.And while section 384 on its surface seems like itseeks to limit the tax losses generated by a particu-lar business activity to that activity only — à laLibson Shops — the reality is that section 384 im-poses limitations considerably more sweeping thanwould be required under that principle. The legis-lative history hints that Congress may again havebeen targeting tax-motivated transactions,73 but sec-tion 384 is triggered with no ‘‘evil’’ tax-motivatedpurpose and certainly covers significantly moreground than transactions undertaken with taxavoidance as a driving (or even relevant) factor.Thus, the enactment of section 384 could be thoughtof as (yet another?) minor piece in a hodgepodge oflegislative lurches aimed at an uncertain target.

V. Legislative Intent in Limiting NOL UseAs mentioned above, the received wisdom is that

trafficking in tax losses must be curtailed to preventseveral ‘‘evils’’ — real, imagined, or manufactured.Over the many decades during which these legisla-tive, administrative, and judicial efforts to curbtrafficking have been undertaken, a variety of ratio-nales and objectives have been advanced. The fol-lowing are those most consistently or frequentlyoffered:

• tax law must not encourage or permit transac-tions that have no nontax purpose and aredriven entirely with a goal to reduce or elimi-nate tax liability (tax avoidance);

• the benefits that can be derived from tax lossesmust be enjoyed exclusively by the person thatsuffered the economic loss that gave rise to thebenefit (same person);

• if the tax law permitted the sale of tax losses,sellers would almost certainly be inadequatelycompensated (inadequate compensation); and

• the tax benefits that can be derived from taxlosses should be available only through offset-ting the income generated by the same busi-ness activity from which the underlying taxlosses arose in the first place (same business).

The discussion below examines whether and theextent to which these articulated concerns are in factcompelling. It also explores whether current law iseffective at achieving its stated goals and whetheralternative approaches might be better from a taxpolicy standpoint.

A. Tax AvoidanceAs enunciated in 1944, the primary factor driving

Congress’s effort to limit loss carryovers followingchanges in corporate ownership was that taxpayerswere buying shell companies solely to acquire andtake advantage of loss carryovers.74 Congress con-cluded that this so-called trafficking in losses hadno purpose other than tax reduction and shouldtherefore be restricted.75

At least theoretically, section 269 (or its predeces-sor) should have curtailed this type of tax-motivated transaction. However, because theapplication of section 269 requires a finding that ataxpayer engaged in a transaction with the princi-pal purpose of tax avoidance, it proved to havelimited effectiveness in practice. Taxpayers haveoften been and continue to be able to marshalevidence of a legitimate business purpose comple-menting the desire to acquire tax attributes. Thisperceived deficiency — the statute’s reliance on ataxpayer’s subjective state of mind — was a pri-mary driver for Congress when it enacted section382, anchored with its focus on objective triggers. Itis noteworthy, however, that section 382 clearlyapplies to a spectrum of transactions far broaderthan merely those undertaken with a tax avoidancemotive. Indeed, given the mechanics of section 382,it is difficult to believe that curbing tax avoidancewas even a significant consideration.

But what is wrong with transactions having astheir sole motivation the reduction of taxes? Wehave come to understand and acknowledge thattaxpayers are permitted to take steps to reducetaxes, that tax avoidance is not per se a bad thing.Courts have long held that a taxpayer ‘‘may arrangehis affairs so that his taxes shall be as low aspossible; he is not bound to choose that patternwhich best pays the treasury.’’76 Apparently, whilethere is nothing inherently objectionable aboutwhat we now commonly call ‘‘tax planning,’’ thatkind of planning becomes unacceptable if it is notsomehow connected with other objectives. Why?

The answer seems to be that purely tax-motivated transactions are undesirable becausethey violate the principle of tax neutrality, which

73Id. (‘‘No inference is intended that such situations are notsubject to section 269 of present law.’’)

74At the time, shareholders placed advertisements in news-papers touting their corporations as having nominal assets andsignificant losses. See Richard H. Nicholls, ‘‘Net Operating LossCarryovers and Section 382,’’ Tax Notes, Feb. 13, 1984, p. 609, atp. 610; and comment, ‘‘Net Operating Loss Carryovers andCorporate Adjustments: Retaining an Advantageous Tax His-tory Under Libson Shops and Sections 269, 381, and 382,’’ 69 YaleL.J. 1201 (1960).

75H.R. Rep. No. 83-1337, at 42 (1954).76Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293

U.S. 465 (1935).



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holds that the tax law should neither induce norimpede business transactions. On hearing this an-swer, a bit of skepticism takes hold and one istempted to list the many ways our tax law isintentionally and incontrovertibly designed to en-courage or discourage different types of activityand conduct, calling into severe question the valid-ity of any argument relying on this imagined prin-ciple of tax neutrality. However, this weakness inthe very premise of tax neutrality as a principle canbe significantly or fully discounted by merely ac-knowledging that there are in fact many situationsin which the tax law is clearly designed to cause orinhibit specified conduct, and that in the absence ofa congressional desire to cause or inhibit targetedconduct, the principle of tax neutrality fills thevacuum.

Thus, despite the many provisions within the taxlaw that reflect a spotty adherence to the principleof tax neutrality, we can accept as a given that thereexists a congressional view that unless there is somekind of legislative goal to be achieved, the tax lawsshould be designed to stay out of the way of‘‘normal’’ commercial conduct. We should remainmindful, however, that the mere articulation of thatview — ‘‘we need tax neutrality’’ — still fails toexplain the why: What is wrong with transactionspursued entirely to reduce taxes?

Congress’s century-long failure to answer thisquestion — which leaves us no clear explanation ofhow pursuit of and adherence to the principle of taxneutrality advances any important national interestor policy — invites us to explore whether clingingto this principle in the area of tax loss trafficking hasany negative consequences (unintended or other-wise).

The focus on tax neutrality in this context seemsto ignore other important considerations. Imagine aparticularly egregious example in which a profit-able corporation acquires a shell corporation withsignificant tax loss carryovers. The acquiring corpo-ration’s sole objective is to acquire the loss carry-overs to offset income from its own successfuloperations. Assume the shareholders of the losscorporation receive cash in exchange for their stock.In that transaction, the acquirer is paying anamount upfront for the ability to reduce future tax.The selling shareholders, who otherwise wouldhave been unable to benefit from the loss carry-overs, receive value for the tax losses from a partyable to make use of them. In this way, sellingshareholders who had suffered the economic lossand, through that loss gained ownership of a taxasset, would be permitted to realize at least someportion of the value of that asset.

If one believes that a loss corporation, and de-rivatively its shareholders, should be entitled to a

reduction in taxes because of the prior economiclosses, all that has occurred is that the shareholdershave received that benefit in the form of purchaseprice for their loss corporation shares. Some haveinsisted that this is actually a good result, the fairresult, asserting that the taxpayers who have suf-fered an economic loss should be permitted torecoup, through tax reduction or through the sale oftax benefits, some portion of that economic loss. Butwhy? Why is it fair to facilitate such a recoupment?

Recoupment proponents fall within (at least) twocamps. One camp focuses on the need to create, andthe societal benefit attendant on, a tax system thathelps those who have suffered loss or encounteredhardship.77 This is something of a welfare view ofour tax system, whose adherents stress our commu-nal obligation to prop up those less fortunate. Thesecond camp is less ‘‘socialist’’ (for lack of a betterword) and simply wants fairness within the fourcorners of the tax system. This group, recognizingthe completely arbitrary nature of our annual re-porting system, bristles at the notion that taxpayerswho (directly or indirectly) have net losses in agiven tax period might have paid tax in an earlierperiod or may pay tax in a future period with nooffset for those losses.

In our ‘‘egregious’’ scenario, the members ofthese two recoupment camps may have differingviews about the right answer. Perhaps one of therecoupment camps would argue that loss corpora-tion shareholders should be permitted to monetizevalue any way they can, and the other camp wouldcondition the ability to sell tax losses on a showingthat taxes were paid in the past or would be paid inthe future. Generally, however, the fact that thepayment came indirectly from a third party and notdirectly as a reduction of future taxes should notmatter to the members of either recoupment camp.

77Some commentators argue against recoupment on thegrounds that it merely subsidizes failure. See Daniel L. Sim-mons, ‘‘Net Operating Losses and Section 382: Searching for aLimitation on Loss Carryovers,’’ 63 Tul. L. Rev. 1068-1069 (1989):

The principal argument against a recoupment policy isthat the recoupment of losses is a government subsidy tofailing businesses. Free transferability of loss carryoversprovides a partial recoupment when the seller whoincurred the loss receives payment for the value of its losscarryover discounted for the risk that the purchaser willbe able to generate sufficient income to absorb the loss.The purchaser of loss carryovers is reimbursed withfuture tax reductions for its purchase price plus whateverprofit is negotiated in the transaction. The subsidy con-cept diverges significantly from the averaging rationalefor carryovers. Recoupment frees the loss corporationfrom the requirement that it produce income to offset itslosses in order to realize the benefit of net operating losscarryovers.



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But even proponents of recoupment would prob-ably pause in the case of a corporation and itsshareholders, asking whether the shareholdersought to be entitled to any form of recoupment atall. After all, the corporation is itself an entity, andso maybe the juridical entity only, and not itsowners, should be the focus of our recoupmentefforts. If (under either of the prevailing recoup-ment views) the benefit to the loss corporationshareholders must be in the form of reduced tax onfuture (or past) income of this particular corpora-tion, there need not be accommodation in the taxlaw to permit these shareholders to secure thebenefit of the tax losses through a sale of losscorporation stock.

Such a constricted view of how these sharehold-ers should be allowed to realize value from the taxlosses may be unduly harsh. The value of theshareholders’ stock is inextricably linked to thecorporation’s tax history and profile, which areharmed (in this case) by a tax system that — foradministrative convenience only — creates an arbi-trary annual cutoff for tax calculations. Arguably,then, it is simply unfair to hamstring the sharehold-ers’ ability to realize value as they dispose of theirinvestment. Permitting a loss corporation or itsshareholders to freely transfer loss carryovers there-fore enables that corporation’s shareholders to re-coup a reduction in value of their investmentresulting from the tax law’s annual accountingconvention.

Who loses in that scenario? The Treasury. In theabsence of this transaction, the government wouldhave otherwise collected tax from the profitableacquiring corporation in future tax years, while thetax losses would have ultimately expired unused atno cost to the government. Clearly, if tax policy isdriven by how to get the most tax dollars, the rulescurbing this type of transaction serve that goal. Butwe should recognize that even in this kind ofegregious transaction, the acquiring corporation issimply taking steps to reduce total tax paymentsand the seller is merely recouping at least somevalue from previously suffered economic losses.Evil? Hard to find any, unless you first define amotivation to reduce taxes as evil. There is noquestion, however, that the selling shareholdershere are hurt by a policy with questionable validityand no articulated underpinning.

B. Same PersonA prevailing rationale underlying the allowance

of loss carryovers is to permit a taxpayer to averageits tax liability over loss years and gain years. Giventhis underlying rationale for the very existence ofloss carryovers, some insist that the tax law shouldnot permit tax losses incurred by one taxpayer to beacquired and used by a different taxpayer.

For a corporation that incurs tax losses, this‘‘same person’’ principle is applied at the share-holder level. The shareholders of a corporation arethe parties who ultimately enjoy or suffer the cor-poration’s economic performance, and so, the argu-ment goes, it is a loss corporation’s shareholders atthe time the losses were incurred, and only thoseshareholders, who should be entitled or permittedto benefit (through the corporation’s use of thosetax losses) and thereby achieve the desired averag-ing.78 Thus, if and to the extent there has been asignificant change in a corporation’s ownershipbase, under this argument the corporation’s abilityto offset future income with loss carryovers —which would inure to the benefit of a differentgroup of shareholders — should be curtailed. Oth-erwise, the loss carryovers are not furthering thepurpose of averaging, because the shareholderswho bore the loss are not the ones receiving thecorresponding tax benefit.

Current section 382’s limit on the ability to offsetpost-change income with pre-change losses follow-ing a 50 percent ownership change partially ad-dresses this concern. After all, if a section 382ownership change occurs, the corporation’s taxlosses become subject to use limitation. In impor-tant respects, however, section 382 does not orcannot address the concern or achieve the same-person objective. For example, given the section 382rules that lump together small shareholders of apublic company and effectively ignore sales ofshares between these small shareholders, the own-ership of a publicly held loss corporation canchange dramatically with zero impact on the corpo-ration’s ability to use its tax losses. Arguably, de-signing a rule to achieve the same-person objectivein the context of ‘‘invisible’’ stock trading by smallshareholders of a public corporation is simply im-possible. So this example merely reflects an inabilityto fully realize the same-person objective, not thatthe objective is unworthy or that Congress wasn’tconcerned with it.

Section 382 has other elements inconsistent witha desire to pursue the same-person objective. Forexample, following a change of ownership undersection 382, the tax loss carryovers are limited, noteliminated. If the goal is to adhere to and pursue the

78‘‘As an equitable matter, the answer seems rather plain:When one looks past the legal fiction of corporate entity, hefinds human beings bearing corporate losses through decline invalue of their stock. As a number of courts have clearlyrecognized, the stockholders — not the business activity or theloss entity — deserve and need the averaging device, for theyare in the final analysis the true sufferers of the loss.’’ Michael R.Asimow, ‘‘Detriment and Benefit of Net Operating Losses: AUnifying Theory,’’ 24 Tax L. Rev. 4 (1968).



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same-person objective, why permit continued useof the tax losses? And why does section 382 includethe convention of a three-year testing period, whichallows new shareholders — meaning shareholderswho acquire shares of a loss corporation after theincurrence of tax losses — to be treated as oldshareholders after three years? How is that consis-tent with a goal to ensure the same-person objec-tive?

Clearly, current section 382 was not fashionedwith a singular or overarching focus on the same-person objective. Perhaps more likely, the same-person principle is only an ingredient in the mix, anadditional — but not primary or guiding — factordriving legislative efforts to curtail loss trafficking.Most likely, when invoked at all, the same-personprinciple serves as a backstop to the tax avoidanceconcern discussed above. If so, the plumbing ofsection 382 seems more rational: Congress waslargely (but not entirely) focused on stopping acqui-sitions having tax avoidance as their primary goal;it recognized that section 269, with its purely sub-jective test, never has and never will be sufficientlyeffective; and so crafted current section 382 with itsobjective test but also with allowances for situationsin which tax avoidance is almost certainly not atplay. In any event, this exploration of section 382clearly suggests that even assuming the same-person objective has any validity, it is not a prin-ciple that has driven or should drive legislativeaction without also balancing important counter-vailing considerations.

The argument that the same-person objectivesupports the imposition of tax legislation that pre-cludes or impedes transfers of loss corporationstock also appears to ignore (or remain indifferentto) the very outcome that is achieved by thatlegislation. As a result of the rules limiting ordisallowing transfers of loss carryovers, sharehold-ers of the loss corporation become unable or lessable to receive an incremental purchase price attrib-utable to the value of the tax loss carryovers andthereby are rendered unable to secure the very taxbenefit that the same-person proponents believe isand should be theirs. Allowing these shareholdersto realize value upon a sale of the loss corporationwould itself represent an indirect recoupment of thetax benefits attributable to the prior losses.

For example, assume that a loss corporation hasbusiness assets that are expected to generate futurecash flows with a present value equal to $1,000 andalso has a loss carryover of $200. Absent the losscarryover, a potential acquirer would be willing topay up to $1,000 to acquire the corporation. How-ever, if the loss carryover can be used post-acquisition, the acquirer would, at least in theory,pay a higher price based on its determination of the

ability to use the tax losses to reduce future taxliability. This additional purchase price would com-pensate the selling shareholders, at least in part, forthe tax benefit associated with their economic loss.

Oddly, then, the example presents a difficultchallenge for those who say the same-person objec-tive supports the curtailing of this type of traffick-ing. After all, if we imagine a case in which anacquirer pays 100 percent (discounted to take ac-count of present value considerations) of the ex-pected tax savings, only by allowing this kind oftransaction will the ‘‘same person’’ be in a positionto recoup the benefit associated with the economicloss. Why, then, should the tax law impede such atransaction?

C. Inadequate Compensation

Some have argued that loss carryovers shouldnot be freely transferable because selling sharehold-ers would not receive adequate compensation inexchange for those attributes.79 On its face, thisargument seems both overly paternalistic and fairlyarchaic. In today’s economic system, which permitsand encourages the sale of just about any kind ofasset — real or imagined, contingent or otherwise— it is difficult to understand a concern that theshareholders of the loss corporation won’t get paidenough for the transfer of their tax asset. Indeed,our economies and our sophisticated markets havelittle difficulty placing a value on just about any-thing; surely they could figure out a proper valuefor these tax assets.

Ironically, the fact that loss carryovers are notfreely transferable is probably the only real barrierprecluding an efficient system in which tax lossesare evaluated, bought, and sold with facility, a

79Robert P. Harrill, ‘‘The Limitations on Loss Carryovers:Hindering Legitimate Business Transactions,’’ 15 Tax Mgmt.Wkly. Rpt. 1410 (1996) (Congress believed ‘‘that the full value ofnet operating losses is never properly reflected in the purchaseprice of a loss corporation. A windfall is realized by theacquiring corporation when it obtains an asset worth muchmore than its purchase price. Congress believed that freetransferability of net operating losses would not solve thisproblem; buyers would continue to take advantage of superiorbargaining positions to negotiate a purchase price which did notadequately reflect the value of the attributes’’). See also JointCommittee on Taxation, ‘‘General Explanation of the Tax Re-form Act of 1986, 100th Cong., 1st Sess., Special Limitations onNet Operating Loss and Other Carryforwards,’’ at 294 (1987) (a‘‘prospective buyer of a loss corporation might be a less efficientoperator of the business than the current owner, but the abilityto use acquired losses could make the loss corporation morevaluable to the less efficient user and thereby encourage a sale’’).



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system in which shareholders selling a loss corpo-ration could realize full value for their loss corpo-ration shares.80 In today’s environment,encumbered by (among many things) tax law con-straints like sections 269 and 382, when a potentialacquirer is trying to determine the expected value ofa tax attribute, it must not only take into account theeconomics of the underlying businesses, but it alsomust sort through and analyze the overlay of taxlaw constraints on the ability to use the tax losses.Of course, to the extent that as a result of these taxlaw provisions the amount of a loss carryover isreduced or the amount of future income that a losscarryover can offset is capped, the tax loss carry-overs hold less or little value to the potentialacquirer and, consequently, the price offered to theselling shareholders is even lower than it wouldotherwise be. And so, ironically, a concern thatselling shareholders would receive inadequate con-sideration for the tax losses is offered to support asystem of rules that in the final analysis results in adiminution of the amount that an acquirer will payfor those very losses.

Finally, some have argued that selling sharehold-ers of loss corporations as a general matter have lessbargaining power than acquirers, which will resultin those selling shareholders receiving less thanthey should for tax attributes. Given that eachtransaction has its own particular dynamics, it isunclear why this would be the case and particularlydoubtful that this could be characterized as thenorm. Further, acquisition transactions are volun-tary, so if selling shareholders do not believe thatthey are receiving adequate value, they can alwaysdecide not to proceed with the sale transaction.

D. Same BusinessThe fourth main objection to trafficking is that

loss carryovers attributable to one particular line ofbusiness should be permitted to offset only incomefrom that same line of business. This reasoningformed the basis for the Supreme Court’s holding inLibson Shops; given that loss carryovers are only

permitted to facilitate the averaging of tax liability,use of the losses must be limited to the businessactivity that generated the loss. Under this theory,the averaging convention enabling the leveling ofnet profit years and net loss years was not contem-plated in the context of a corporate transaction inwhich pre-transaction losses would be used tooffset post-transaction income from a new line ofbusiness. This ‘‘same business’’ concern also seemsto represent the underpinning of the SRLY limita-tion,81 although the SRLY rules represent at best aloose adherence to this approach because theyapply on an entity-by-entity basis and do not limituse of an entity’s SRLY losses against income of thatsame entity from a different or even brand-newventure.

One significant shortcoming of this ‘‘same busi-ness’’ approach is that if our limitation rules actu-ally restricted use of tax losses to the same business,a loss corporation would be compelled (or at leastencouraged) to continue a losing business line inorder to realize value from its loss carryforwards,which is both economically inefficient and poor taxpolicy.

Moreover, the same-business principle is simplynot in any way a staple of our tax law. There aremany provisions within the code that explicitlypermit a taxpayer to average its tax liability acrossmultiple lines of business. For instance, a corporatetaxpayer calculates its net taxable income basedupon all of its activities, with losses generated inone line of business applied to reduce total netincome, effectively offsetting the losses from onebusiness against profits from another. Similarly, theability to file consolidated returns also allows aconsolidated tax group to calculate net taxableincome across all the members of the group, per-mitting losses from one business to offset profitsfrom another. Thus, the notion that use of tax losscarryovers must be limited to the very business inwhich the losses were generated is simply inconsis-tent with important elements of our existing taxsystem and, in that way alone, if applied in theanti-trafficking regime, would represent an arbi-trary and inappropriate delineation.

Further, if, as a policy matter, we do not want topermit taxpayers to offset income and loss acrossbusiness lines, the focus of our trafficking rulesshould shift away from ownership changes, whichdo not necessarily result in changes to the businessactivities of a loss corporation, and focus instead on

80It is not difficult to imagine a system — unencumbered bysections 269, 382, or other tax loss limitation provisions — inwhich acquirers would routinely assess a value on loss carry-overs embedded within a target corporation. An acquirer wouldproject the amount and timing of future income and calculatethe amount and timing of projected reductions in tax liability. Inthis way, an acquirer would set a value and be inclined to payfor the tax losses. One could expect discounting for time valueof money and for the risks of whether the assumptions concern-ing future income, tax rates, and other elements actually mate-rialize. This form of tax loss valuation occurs today in manyscenarios, so the process described here is hardly novel orfanciful. Ultimately, the price offered by the acquirer andaccepted by the seller would represent the truest measure of thevalue of the tax asset.

81See Dubroff, supra note 59, section 42.02[1][a] at 42-8 (2012)(stating that the SRLY rules represent an effort to reconcile thesingle- versus separate-entity treatment of consolidated groupmembers when a member join or leaves the group).



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the activities of the loss corporation. However, anysystem implementing that policy would be complexfrom an administrative and compliance standpoint.There would be a definitional question about whatactivities of a corporation should constitute a line ofbusiness; taxpayers would need to begin trackingtheir taxable income on a business-by-business ba-sis (rather than on an aggregate basis); and the IRSwould need to have some method to determinewhen a corporation with losses shifted its businesslines in a manner that should trigger a loss uselimitation. All in all, not only does the same-business approach lead to bad economic and taxpolicy, and not only is the approach inconsistentwith many other elements within our tax system,but the underlying goal would be quite difficult toachieve.

VI. Is There No Better Mousetrap?

A. Lessons From the Past CenturySo what have we learned? And what shall we do?

Looking back over just about 100 years, we candraw several conclusions:

• while there is a strong sense that there is aproblem — trafficking — that needs to beaddressed, there is no clear articulation of whatthe problem actually is;

• the legislative, judicial, and administrative ef-forts to curb trafficking in tax losses have beeninconsistent, jerky at times, and lacking a de-fining and fixed focus;

• the most prevalent reasons offered to curbtrafficking appear to be either superficial orflawed in important ways; and

• there has never been, as far as one can tell, agenuine effort to explore the benefits to oureconomy and to the perception of fairnesswithin our tax system that might result fromeliminating or drastically altering the rules thatdisallow or discourage so-called trafficking.

So what? Maybe, despite the fits and starts overthe decades and the absence of a unifying andcoherent focus, the network of loss limitation ruleswithin the tax law has finally gotten to an accept-able place. Perhaps the current version of section269 serves its purpose of discouraging the mostabusive transactions, and section 382 (along with anassist from the SRLY rules) establishes a set ofground rules that has created a now-familiar systemthat seems to work reasonably well — even if wecan’t necessarily determine whether there is an evilor a goal of some sort. Sure, we continue to adjustsection 382 around the edges, but it has enduredlargely intact now for almost 30 years and thereappears to be no major industry-based complaint or

effort at significant change or repeal. If that is ourstandard of successful tax law, maybe we haveachieved it.

Or maybe we should step back and reexamineour assumptions, question whether the receivedwisdom is flawed, and explore whether a clearerunderstanding of our desired goals might help theconceptualization and implementation of a bettersystem.

B. Defining GoalsIf we were to have a disciplined discussion to

figure out what our tax system should be achievingregarding the transfer of tax loss carryovers, whatwould we decide? I’m guessing we would havedifficulty finding common ground and that wewould all agree on just one principle: The tax lawshould not respect transactions that are withoutsubstance. If a purported transaction changes noth-ing, the tax implications should correspondingly benothing. This one principle already is a staple of ourtax law in the form of judicial constraints such asthe sham transaction, substance over form, and (tosome extent) step transaction doctrines. And morerecently, Congress, through its enactment of section7701(o), has added a legislative constraint on trans-actions having no economic substance. This hasgiven the IRS an additional tool to combat transac-tions with no substance.

Admittedly, these various tools are imperfect.The IRS’s battle to identify and undo or disregardtransactions without substance continues to be dif-ficult and often unsuccessful. But, if we all agreethat this is the principle that should be upheld, ourfocus ought to be on enhancing the effectiveness ofthese tools, not on creating different tools thataddress other, perhaps questionable, issues andobjectives. The legislative and judicial constraintson NOL trafficking are not targeted narrowly — ifat all — at addressing nonsubstantive transactions,and unquestionably apply to a broad range oftransactions that are quite ‘‘substantive.’’ Even sec-tion 269, with its focus on a taxpayer’s subjectiveintent, really has, at best, only an incidental rela-tionship with whether the underlying transactionhas substance.

Aside from our universally agreed principle thatdoing nothing should not change the tax landscape,are there any other principles we would all agreeon? I think not. Tax avoidance? Sure, many willreflexively say that transactions pursued entirelywith tax avoidance as a goal should not be re-spected. As discussed earlier, however, there reallyis no compelling rationale for this position, otherthan arguing that those transactions are unseemly.Our tax law at times ignores and sometimes evenencourages tax avoidance, so the real question iswhether the area of NOL trafficking is unique



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somehow, an area in which we should imposelimits? Is this kind of trafficking, unlike many otherareas within the tax law, simply an area of taxavoidance we won’t sanction? If so, why not?

Beyond tax avoidance, the ability to gain anykind of consensus on why and whether to limittransfers of NOL carryovers gets even more diffi-cult. We have identified at least three differentcamps, each with its own view on how to thinkabout NOL carryovers:

• The first camp, a subset of the recoupmentproponents, believes that our tax systemshould help those who are struggling, thosewho have suffered economic losses. This campwould (or should) argue in favor of free trans-ferability of NOL carryovers.

• The second camp, the other subset of therecoupment proponents, focuses on the arbi-trariness of our annual cutoff for determiningtax liability and believes that for our system tobe fair, it must ensure averaging of income andloss over long stretches of time, perhaps evenover the lifetime of a taxpayer. This campwould (or should) argue in favor of a systemdesigned to ensure that no taxpayer (perhapseven shareholders of a corporation, who indi-rectly pay the corporation’s taxes) involun-tarily loses the potential tax benefit ofeconomic losses to offset taxes paid in the pastor (ever) to be paid in the future.

• The third camp, less focused on the fairness orarbitrariness of our annual accounting conven-tion, appreciates that the system is set up as itis and will have winners and losers. This campis not moved to reimburse taxpayers for un-used tax losses or to facilitate taxpayers’ abilityto squeeze any value out of NOL carryovers.This camp would (or should) have no drivingprinciple for whether and when to permit NOLtrafficking, other than to insist that the ruleswork and that they don’t create other negativeconsequences.

C. Where Do We Go From Here?And so, as we consider whether and how to limit

transfers of NOL carryovers, we do so with nocollective agreement on goals. After setting asidesham transactions, there is no real agreement onwhat, if anything, needs to be accomplished orshould be avoided. Perhaps Eustice was right 30years ago: What we have seems to work wellenough, so why tinker?

Maybe we tinker because what we now haveappears to be a patchwork of provisions with nooverarching theory, no governing principle, and nosingular goal. This patchwork arguably impedesfree commerce and treats similarly situated taxpay-

ers differently — while costing the public andprivate sectors uncounted dollars to maintain,monitor, and navigate.

What would tinkering look like?1. Maybe we should retain section 269. At somelevel, one could argue that section 269 should be leftin place, complementing the judicial and now leg-islative doctrines and rules designed to disallownonsubstantive transactions. While some argue thatsection 269 is an imperfect tool, the reality may bethat the tool is difficult to actually use but largelyserves its purposes simply by existing.2. Or maybe we should repeal section 269. Recog-nizing that section 269 is not targeted at transac-tions lacking substance and plays no important rolein that arena, we might simply repeal (at long last)section 269 and instead permit the judicial andlegislative doctrines and rules that are genuinelyfocused on substance versus sham to serve theirintended function. Under this view, the tax lawshould not, in the absence of a compelling reason,disallow transactions with substance, even if moti-vated by a desire to reduce taxes. Thus, recognizingsection 269’s focus on tax avoidance and not on theeconomic substance of a given transaction, weshould repeal it.3. Maybe we should repeal section 382. Other thanits service as a backstop to section 269, section 382may have no purpose that most people wouldsupport. In its current form, section 382 is not in anyway tied to tax avoidance. It is largely a permuta-tion of the ‘‘same person’’ theory, a theory withquestionable validity and not widely embraced as acompelling policy objective. Section 382 also repre-sents, to a minor extent, a modest nod in thedirection of the ‘‘same business’’ theory, a theorydifficult to reconcile with important aspects of thetax law and a theory that has not been embracedwith consistency over the decades of judicial andlegislative activity in this area. If this is all true,maybe section 382 ought to be repealed.4. Or perhaps we should retain but amend section382. Alas, we seem to have an almost unbreakablebond with section 382, a bond that may be theproduct of the long and uncontested effort to con-vince ourselves (and the public at large) that there issomething wrong with NOL trafficking, somethingunseemly. Consequently, those who argue — evenwithout explaining why — that free transfer ofNOLs is unseemly could prevail and insist thatsection 382 serves an important purpose and shouldbe retained. Even in that case, however, we stillshould consider an element of current section 382that arguably is unfair.

Most or all of us would agree that a corporation’sinability to carry back NOLs more than two yearscan result in unfairness (when the corporation paid



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tax in those earlier tax periods), an unfairness bornof our arbitrary annual tax period convention. Innormal situations, the allowance to carry forwardNOLs to subsequent tax years reduces (but does noteliminate) this unfairness. Application of section382, however, can significantly reduce (or eveneliminate) the corporation’s ability to approach anaveraging through NOL carryforwards. In this way,the application of section 382 can stymie achievinggreater fairness within our tax system. Perhaps,then, section 382 could be amended to permit anextended carryback period when a corporation un-dergoes a section 382 change of ownership, therebymitigating this unfair result and permitting theshareholders who suffered the economic loss torecover at least some portion of the associated taxbenefit.

Such an amendment to section 382 would, how-ever, confront challenges. Allowing an extendedcarryback to secure otherwise unattainable tax re-funds from prior years only in situations in whichthere has been a section 382 change of ownershiplikely would create some odd, perhaps inappropri-ate, results: The owners of a loss corporation facinglittle or no prospect of ever making a profit (againstwhich its NOLs could be used) might be tempted tomanufacture a sale of the loss corporation just toallow the extended carryback period and to securetax refunds from earlier tax years otherwise out ofreach. Some would argue that this is an unaccept-able result. Further, allowing too long a carrybackperiod could be viewed as an administrative diffi-culty or impossibility for the IRS. Perhaps these andother challenges to amending section 382 to allow agreater opportunity for averaging could be over-come with a carefully tailored amendment, but onegets the sense that we would then be slipping downthe same type of slope that has gotten us to ourcurrent version of section 382.5. Maybe, then, we should retain section 382 as is.Some might argue that section 382 serves an impor-tant purpose simply as a revenue raiser and shouldtherefore be retained without substantial alteration.After all, in a tax system allowing unfettered trans-ferability of NOLs, it would be unlikely that anyNOL would expire unused. In that system, all ofcorporate America would be like a single taxpayer— something like one giant consolidated group —when it comes to making use of NOLs. If thecorporation that generates an NOL cannot use it,another corporation surely would pay for and makeuse of the NOL. As a result, Treasury would collectless revenue than under our existing system.

We can debate of course whether a system withno section 382, a system that allows all of corporateAmerica to be a single taxpayer when it comes tothe use of NOLs, would represent a distorted and

unacceptable expansion of the underlying goal ofaveraging to mitigate the unfairness of our annualaccounting convention. Many would argue that aninviolable rule of our system is that everyoneshould pay their fair share of taxes, that those of uswho earn or make profit should not be permitted tosimply staple our tax return to the tax return ofothers who’ve been less successful and therebyavoid paying taxes. Under this view, permitting allof corporate America to share NOLs would repre-sent an unacceptable expansion of the averagingprinciple. Others might argue that we find our-selves facing these difficult issues only because ourcurrent system picks and chooses when to respectthe separate existence of a corporate entity andthereby creates some unfair results that beg to beaddressed, perhaps even with this kind of expan-sion of the averaging principle.

Ultimately, then, we are back to a lack of consen-sus regarding which principles should prevail, andan appreciation that in the final analysis, the maindriver of tax policy is that the government mustestablish a revenue-raising system that appears fairwithin the prevailing economic, social, and politicalenvironment. In a system with no section 382, inwhich NOLs are freely transferred and all of corpo-rate America thereby shares NOLs, Treasury surelywould lose revenue it otherwise would have col-lected. If raising revenue is the reason to retainsection 382, then so be it, but we should say soopenly; at least an honest admission that revenue-raising is the goal of section 382 would properlyinform our focus on the proper application andmodifications of section 382.6. Maybe we should repeal section 384. Section 384can be broken into two categories: (1) limitationsimposed when a gain corporation acquires a losscompany; and (2) limitations imposed when a losscorporation acquires a gain company. Transactionsin the first category, involving an acquisition ofNOLs (or built-in losses), are and should be gov-erned (if at all) by other judicial and statutoryconstraints, with no need for a section 384 overlay.Judicial (and legislative) constraints on sham trans-actions, complemented if need be by sections 269and 382, really ought to be sufficient to cover thisground.

Thus, in assessing the need for section 384, ourfocus should turn to transactions in the secondcategory, involving an acquisition of built-in gainassets. The question becomes whether our tax lawshould permit a corporation with NOL carryovers(or anticipated tax losses) to use those losses tooffset income and gains that are built into acquiredassets. The underlying congressional concern re-lates to types of activity and assets for which thetransferor would unfairly escape long-delayed gain



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recognition. This seems like an issue that should notbe addressed by focusing on the acquiring corpora-tion or its tax attributes; instead, the focus should beon when and whether to tax the transferor of gainassets rather than allow a tax-free transfer with acarryover of the low tax basis. Section 384’s mis-placed focus on the loss corporation acquirer —particularly given the sweeping application of sec-tion 384 to acquisitions well outside the underlyinglegislative concern — arguably represents just an-other inappropriate roadblock, stifling a loss corpo-ration’s efforts to use its NOLs to regain its footingor achieve greater profitability. Therefore, seriousconsideration should be given to repealing section384 or at least significantly narrowing its applica-tion.

7. What about the SRLY limitations? Defining therole of the consolidated return rules in this one areaof loss limitations is well beyond the scope of thisreport. While there is little doubt that the SRLY rulesare somewhat subsumed by section 382, and thereremain questions regarding the validity of the ra-tionale underlying the continuation of the SRLYrules, one could argue that unique considerationspresent themselves in consolidated tax returns andthat the SRLY rules should therefore be examinedthrough a different prism. I defer to that notion,although I still maintain that a robust discussionconcerning what the tax law should (and shouldnot) seek to prevent or achieve would be a healthyfirst step in any such examination.

VII. ConclusionWhere to go from here? My vote would be to

permit free transfer of NOL carryovers as long asthe underlying transaction has substance. Doing sowould (1) allow the development of a rationalmarket for the sale and purchase of NOLs; (2)render unquestionably aboveboard the arena ofNOL preservation and use in corporate transac-tions; (3) permit greater fairness within a systemthat necessarily imposes arbitrary conventions; and(4) substantially reduce the high public and privatesector cost of navigating through a system that hasquestionable value at best. Thus, I would repealsections 269, 382, and 384. But after I retire, please.

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