Tennessee Issues Ruling on Survival of Net Operating Losses After Merger
When engaging in corporate mergers and acquisitions, including internal reorganizations, it is important for companies with state tax benefits, such as net operating losses, to be mindful of their treatment for state income tax purposes since not all states will permit those benefits to be used by the successor taxpayer.
By: Tina M. Chunn, SALT Senior Manager
State tax treatment of net operating losses (NOLs) does not always follow the federal treatment and may require separate computations and tracking of carryforward amounts. In addition, in the case of mergers and acquisitions, including internal reorganizations, some states restrict or limit the carryover of a pre-acquisition NOLs to the specific corporation or business that generated the loss. In such cases, if a loss corporation is merged into a profitable corporation, the loss corporation’s NOLs may disappear for state tax purposes.
For example, Tennessee’s statute provides that in the case of mergers, consolidations and similar transactions, a successor taxpayer is prohibited from using the loss carryforward incurred by a predecessor taxpayer prior to the merger. However, there is an exception to this rule if the taxpayer merges out of existence and into a successor corporation that has no income, expenses, assets, liabilities, equity or net worth (i.e., a shell corporation). On September 17, 2020, the Tennessee Department of Revenue (DOR) issued a revenue ruling addressing the survival of NOLs in two different transactions where multiple related corporations are merging out of existence.
The basic facts are that Corporations 1 and 3 have Tennessee NOL carryforwards and Corporation 2 does not have a Tennessee NOL carryforward. All three corporations are owned by a single shareholder. In Merger Transaction #1, Corporations 1, 2, and 3 merge out of existence and into newly created Corporation 4, which is wholly owned by the same shareholder. Immediately prior to Merger Transaction #1, Corporation 4 is a shell company with no income, assets, expenses, liabilities, equity, or net worth. Immediately following Merger Transaction #1, Corporation 4 holds the assets, liabilities, and equity of Corporations 1, 2 and 3.
Alternatively, in Merger Transaction #2, Corporation 2 and Corporation 3 merge out of existence and into Corporation 1. Immediately following Merger Transaction #2, Corporation 1 holds the assets, liabilities, and equity of Corporations 2 and 3.
For Merger Transaction #1, the DOR ruled that the exception does not apply to the entire transaction since it applies only to a single taxpayer that merges out of existence. In other words, the exception will apply only to the first corporation to merge into Corporation 4. After the first merger, all subsequent mergers will not come under the exception since at the time of those subsequent mergers, Corporation 4 will now have income, assets, expenses, liabilities, equity, or net worth (i.e., it is no longer a shell corporation).
For Merger Transaction #2, the DOR ruled that the exception does not apply at all because the successor corporation (Corporation 1) is not a shell company.
This ruling highlights that the structure and specific sequential steps of any reorganization can significantly impact the survival of NOLs in some states. Therefore, it is important to carefully consider the state’s NOL rules and the order of a multi-step reorganization. For example, in the situations above, choosing Merger Transaction #1 is preferable to Merger Transaction #2, and within Merger Transaction #1, it is crucial to merge the corporation with the largest Tennessee NOL carryforward amount since the other Tennessee NOLs will be lost. When preparing the legal merger documents, it may be prudent to state specifically an effective date AND time of the merger for the avoidance of any doubt as to which merger occurred first.
Aprio’s SALT team is experienced with reviewing these types of transactions and the state treatment of NOLs and other beneficial state tax attributes. Our team will help guide you in determining the impact of a proposed transaction and recommend the best approach to maximize the survival of any state tax benefits available based on the state’s tax laws. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the November/December 2020 SALT Newsletter.
 Tenn. Code Ann. Sec 67-4-2006(c).
 Tennessee Revenue Ruling No. 20-06, September 17, 2020.