Page 116 - Bankruptcy and Reorganization Services

1. Has the loss corporation experienced a more than 50% change of the value of its stock within a
three-year period (an ownership change)?

2. If the corporation is in bankruptcy, should it elect out of IRC Section 382(l)(5) and be subject to
the provisions of IRC Section 382(l)(6)?

3. What was the value of the loss corporation at the time of the ownership change?

The assessment of item (3) may result in a circular calculation because the annual limitations imposed
on the usage of the NOL may depend upon the fair market value of the loss corporation, but the fair
market value of the loss corporation may depend on the limitation imposed on the annual usage of the
NOL. Accordingly, the assessment of item (3) and the ultimate value estimate may need to be calculated
through an iterative process.

As a practical matter, it is typically preferable to calculate the value of the NOL separately from the val-
ue of the operations of the loss corporation. The utilization of the NOL will typically require an analysis
of the tax attributes of the company, including interest expense, which will be more detailed than the
taxable income assumptions used in the DCF. An example of the interaction between interest expense
and NOLs is presented in appendix 1. The utilization period for NOLs may also extend beyond the ex-
plicit forecast period of the projections prepared for the income approach. Calculating the NOL sepa-
rately from the value of the operating business avoids these differences. The value of the NOL can then
be added to the equity value before any required adjustments are made. The value of the NOL may also
be added to the equity value in the application of the capitalization of earnings method.

The discount rate used to present value the NOL should reflect the risks associated with realizing the tax
benefits of the NOL. Because an NOL can only be utilized if the business generates positive EBT (after
interest expense), an equity cost of capital is often considered to be appropriate. As discussed elsewhere
in this practice aid, the value of the NOL will be affected by the capital structure assumed for the reor-
ganized corporation.

It is also appropriate to calculate the value of the NOL separately from the value of operations when us-
ing the guideline company and guideline transaction methods. The value of the NOL will be specific to
the loss corporation and will not be reflected in the multiples of guideline companies.

The flow chart in appendix 2 summarizes the authors’ analysis regarding the use of net operating losses.

Tax on Cancellation of Debt Income

In many instances, the cancellation of debt can result in taxable events that generate sizeable levels of
taxable income for the debtor. Although careful tax planning can reduce the impact of such events, it is
frequently necessary to recognize cancellation of debt income in the context of a business reorganiza-
tion. The practitioner must give careful consideration to the impact of cancellation of debt income on the
entity’s NOL and estimated future tax bill. However, it is beyond the scope of this practice aid to pro-
vide further guidance on the subject of tax on cancellation of debt income. fn 8

fn 8 For a detailed discussion of tax on cancellation of debt income, see Grant Newton and Robert Liquerman, Bankruptcy and Insol-
vency Taxation, (New York: John Wiley & Sons, Inc. Updated annually).

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