Acquiring the tax benefits of a corporation

Avoid recharacterization or denial of tax losses in M&As.
By Ray A. Knight, CPA, J.D., and Lee G. Knight, Ph.D.

Acquiring the tax benefits of a corporation
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The lockdowns and disruptions of business operations from the COVID-19 pandemic have left many corporations with losses and other tax benefits they cannot use currently and perhaps not in the future. Some corporations, however, have increased their profits during the COVID-19 pandemic and perhaps their tax liability as well. Both types of corporations may be tempted to seek a win-win solution through a merger or acquisition and so net the losses of one corporation against the profits of the other.

As might be expected, however, the tax law does not look favorably on a transaction that is primarily motivated by tax avoidance. Sec. 269, under which the IRS can disallow the benefits of an acquisition made to evade or avoid tax, does not close the door on all mergers involving a loss corporation, but its requirements are rigid enough to force corporations to carefully consider how they can keep the IRS from applying it to disallow the use of these tax benefits. And, even if the corporations make it through the Sec. 269 provisions, the IRS could limit the annual amount of these benefits by applying the provisions of Sec. 382, which restricts net operating loss (NOL) carryforwards and certain built-in losses following an ownership change. In addition, the IRS may apply any of a variety of other statutory provisions to both corporate and noncorporate entities to disallow or recharacterize losses and other tax benefits.

This article discusses these provisions and provides planning points to help corporations navigate the narrow path available to reap the tax benefits both parties to the merger or acquisition envision.


Sec. 269(a) provides that any tax benefit, such as a deduction, credit, or other allowance, may be disallowed if it is obtained by a person or corporation acquiring control of another corporation with the principal purpose of avoiding or evading federal income tax. The meaning of "control" here is critical: ownership of stock possessing either (1) at least 50% of the total combined voting power of all classes of stock entitled to vote; or (2) at least 50% of the total value of shares of all classes of stock. Control, for this purpose, may be acquired indirectly, as when a company redeems its shares from other shareholders, leaving a shareholder with a controlling interest.

For Sec. 269 to apply, an acquisition of control of a corporation must occur. For example, the Fifth Circuit has held that Sec. 269 did not apply to the acquisition of nonvoting stock representing less than 50% of the corporation's value, where one shareholder held all voting stock before and after acquisition (Jackson Oldsmobile, Inc., 237 F. Supp. 779 (M.D. Ga. 1964), aff'd, 371 F.2d 808 (5th Cir. 1967)).

Also, although the percentage of voting stock owned by the acquiring person or corporation is generally the critical factor in determining voting power, record ownership is not the sole criterion for determining voting power where there is other evidence to the contrary and voting power is not merely the holding of voting stock shares. The Federal Court of Claims has stated that "the ultimate expression of voting power is the ability to approve or disapprove of fundamental changes in the corporate structure, and the ability to elect the corporation's board of directors" (Hermes Consol. Inc., 14 Cl. Ct. 398 (1988)).

An acquisition has not occurred for purposes of Sec. 269 where the taxpayer revives its own controlled dormant corporation for use in different circumstances, because control has not been broken (see The Challenger, Inc., T.C. Memo. 1964-338). Control must be in some way relinquished and reestablished for there to be a change. Under former Sec. 129, the predecessor of Sec. 269 in the Internal Revenue Code of 1939, "[a] mere shift in the form of control — from direct to indirect, from indirect to direct, or from one form of indirect to another form of indirect — cannot ... amount to the acquisition of control" (S. Rep't No. 627, 78th Cong., 1st Sess., 60 (1943)).

Tax avoidance as a 'principal purpose'

Tax avoidance is the principal purpose of a transaction if it "exceeds in importance any other purpose" (Regs. Sec. 1.269-3(a)). Some courts have interpreted the statute to require that the tax-avoidance purpose exceed all other purposes combined, not just any other single purpose (see U.S. Shelter Corp., 13 Cl. Ct. 606 (1987); Bobsee Corp., 411 F.2d 231 (5th Cir. 1969)). Valid legitimate business purposes for forming new corporations include limiting of liability, obtaining increased borrowing power, and simplifying reporting requirements. Tax planning may be a purpose as well, as long as evading or avoiding federal income tax does not exceed in importance any other purpose.

Former Sec. 129, the predecessor to Sec. 269, was enacted in 1943 to give the IRS a weapon to combat certain then-common tax-avoidance transactions, such as those where a corporation with large excess profits acquired a corporation with current, past, or prospective losses or other tax benefits for the purpose of reducing its own income and taxes. Most of the cases that have arisen under Sec. 269 and its predecessor "have dealt with the sale by one control group to another of a corporation with, typically, a net-operating loss carryover, and the efforts of the new control group to utilize this carryover by funneling otherwise taxable income to a point of alleged confluence with the carryover" (The Zanesville Investment Co., 335 F.2d 507, 509 (6th Cir. 1964)).

Thus, in a typical case, the courts apply Sec. 269 to restrict the use of preacquisition losses after an acquisition, regardless of whether the losses arose in the target or the acquiror (see Supreme Investment Corp., 468 F.2d 370, fn. 9 (5th Cir. 1972)). The courts, however, have not applied Sec. 269 to the use of post-acquisition losses against post-acquisition income (see The Zanesville Investment Co., 335 F.2d at 514; Herculite Protective Fabrics Corp., 387 F.2d 475 (3d Cir. 1968)). The few occasions where a court has applied Sec. 269 to post-acquisition losses involve situations where the acquired corporation had a history of incurring losses, and those losses continued to be incurred after the acquisition (see R.P. Collins & Co., 303 F.2d 142 (1st Cir. 1962); Hall Paving Co., 471 F.2d 261, 262 (5th Cir. 1973)). However, courts have compared the pre- and post-acquisition business activities of acquired corporations and have sometimes considered a lack of continuity as indicating that tax concerns may have predominated.

Example: J acquires all of the stock of H Corp., which has been engaged in the business of operating retail drugstores. At the time of the acquisition, H Corp. has NOL carryovers of $100,000, and its net worth is $100,000. After the acquisition, H continues to engage in the business of operating retail drugstores, but the profits attributable to the drugstores after acquisition are not sufficient to absorb a substantial portion of the NOL carryovers. Shortly after the acquisition, J facilitates the transfer of a hardware business that he controls to H Corp. The hardware business historically has generated profits that would substantially absorb the NOLs of H Corp. The transfer of the hardware business has the effect of using NOLs to offset the profits of a business unrelated to the business that produced the losses, indicating that the principal purpose of the acquisition was evasion or avoidance of federal income taxes.

A deferral of tax consequences will not meet the principal-purpose prong of Sec. 269. For example, in Rocco, 72 T.C. 140 (1979), the Tax Court rejected the IRS's attempt to deny the taxpayer the ability to use the cash method of accounting. The Tax Court stated that Sec. 269 applies to "deductions or credits, allowance of which would result in a permanent reduction of revenue" and noted that the IRS was "attempting to disallow a benefit which defers the tax but does not result ultimately in the avoidance or evasion of tax."

Creation of a corporation

As mentioned above, an acquisition for purposes of Sec. 269 can occur indirectly by a corporation's redemption of the stock of some shareholders, increasing another shareholder's relative degree of control. However, a substantial nontax business purpose for redemptions of other shareholders may prevent Sec. 269's application (see, e.g., Younker Bros., Inc., 318 F. Supp. 202 (S.D. Iowa 1970)).

Although the statute was aimed primarily at specific types of abuses, the Tax Court has stated that Sec. 269 is not limited to any particular form of transaction but is subject to a substance-over-form examination. Thus, the law was "broadly drafted to include any type of acquisition which constitutes a device by which one corporation secures a tax benefit to which it is not otherwise entitled" (Briarcliff Candy Corp., T.C. Memo. 1987-487). In Briarcliff Candy, the Tax Court held that Sec. 269 applied to a loss corporation's acquisition of a profitable subsidiary (but questions of material fact remained in the case as to whether the acquisition was undertaken for the principal purpose of evading or avoiding tax).

Under some circumstances, Sec. 269 has been held to apply to the creation of a new corporation. For example, former Sec. 11(c) (before amendment by the Revenue Act of 1978, P.L. 95-600) imposed (with certain exemptions) a surtax of 26% of corporations' taxable income over a certain amount. If a person organized two or more corporations instead of a single corporation to secure the benefit of multiple surtax exemptions, Sec. 269 was sometimes applied (see Regs. Sec. 1.269-3(b)(2); Concord Supply Corp., 37 T.C. 919 (1962)). More contemporaneously, Sec. 269 operates to disallow other tax benefits, including when a person with high-earning assets transfers them to a newly organized controlled corporation that retains assets producing NOLs (Regs. Sec. 1.269-3(b)(3)).

Generally, Sec. 269 has been held to apply to the creation of a new corporation based only on specific facts. In Coastal Oil Storage Co., 242 F.2d 396 (4th Cir. 1957), which also involved surtax exemptions, Sec. 269 was applied to the formation of a new corporation when the corporation's owner merely continued a preexisting business in the newly formed corporation. The Fourth Circuit agreed with the Tax Court that the disallowance was proper, holding that the parent corporation "acquired complete control" of the subsidiary and that the transfer had no "real purpose other than tax avoidance." In James Realty Co., 280 F.2d 394 (8th Cir. 1960), the court found no real business purpose for the creation of a new corporation in the same line of business as the controlling company that claimed a surtax exemption as well as a minimum excess profits tax credit under former Secs. 15(b) and 431.

Borge, 405 F.2d 673 (2d Cir. 1968), concerned entertainer Victor Borge's conduct of a poultry business. For several years, the unincorporated poultry business lost money that Borge offset against his entertainment income. Under Sec. 269, the IRS increased Borge's income taxes for prior years. The court held that Borge attempted to avoid a limitation on deductions by individuals during the tax years in question by incorporating the poultry business and then personally contracting with the new corporation to provide entertainment services. The new corporation offset the entertainment income with its losses from the poultry operation. The court held that the corporation was formed for the sole purpose of securing a tax benefit to Borge and applied Sec. 269 to deny the claimed benefit.

While Coastal Oil concerned splitting up an existing business solely to gain a tax benefit, Borge addressed incorporation of a loss-generating business for the tax benefit of the incorporator. In neither instance was the newly formed entity or entities established to pursue a separate and distinct business from that which previously existed; rather, a new form was adopted for an existing business solely to obtain tax benefits. In addition, the benefits sought by the taxpayers in Coastal Oil and Borge were available only if the enterprise was in corporate form. Sec. 269 is usually invoked when a taxpayer attempts to secure tax benefits from built-in or preexisting circumstances, as in the common example of when an NOL carryforward is present. Otherwise, where bona fide business purposes are present, the Tax Court observed in Cromwell Corp., 43 T.C. 313, 320—21 (1964), "the formation of a holding company to acquire another corporation is not an unusual procedure and is not a 'device' which would distort the income of ... the principals ... as comprehended by section 269."


Sec. 269 does not apply to disallow any deduction, credit, or other allowance resulting from an election by a corporation to be taxed as a small business corporation under Subchapter S (Rev. Rul. 76-363). Taxpayers can claim losses because of the operation of the rules of Subchapter S — passing through income, gains, losses, and deductions under Sec. 1366 and exercise of the right to treat the S corporation as if it had separate tax years before and following the redemption of any shares under Sec. 1377(a). Along with Rev. Rul. 76-363, courts have consistently recognized that S corporations possess a special tax status, and accordingly, Sec. 269 cannot be applied to deny the resulting tax benefits. For example, the Tax Court in Modern Home Fire & Casualty Insurance Co., 54 T.C. 839 (1970), stated Sec. 269 would not apply even if, as the IRS contended, the principal purpose had been to allow the shareholder to offset losses against an S corporation's income.


If Sec. 269 does not preclude a corporation from taking advantage of the tax benefits of a target corporation, Sec. 382 may limit the amount of NOLs and built-in losses that can be applied each year to post-acquisition or merger earnings. In very general terms, an "ownership change" for Sec. 382 purposes takes place if the percentage of stock of the corporation owned by one or more 5% shareholders increases by more than 50 percentage points over the lowest percentage of stock owned by these shareholders during a three-year testing period (Secs. 382(g) and (i)). An ownership change occurs where the loss corporation is acquired in either a taxable purchase or a tax-free transaction, including a tax-free asset reorganization described in Sec. 368(a)(1)(A), (C), or (D).

The amount of pre-change losses available under the annual Sec. 382 limitation equals the value of the old loss corporation immediately before the ownership change multiplied by the federal long-term tax-exempt rate. Sec. 382(k)(1) defines a loss corporation as a corporation entitled to use an NOL carryover or having an NOL for the tax year in which the ownership change occurs. A loss corporation also includes any corporation with a "net unrealized built-in loss." A corporation has a net unrealized built-in loss if, immediately before the date of the ownership change (the change date), the aggregate adjusted basis of the corporation's assets exceeds their fair market value (Sec. 382(h)(3)(A)).

If a corporation has net unrealized built-in losses on the change date, the acquiring corporation treats them as pre-change losses that can be offset against post-change income only to the extent of the Sec. 382 limitation (Sec. 382(h)(1)(B)). A recognized built-in loss is any loss recognized on the disposition of an asset during the five-year period beginning on the change date (except that the amount of recognized built-in losses treated as pre-change losses is limited to the amount of net unrealized built-in loss) (Sec. 382(h)(2)(B)).


The IRS may challenge the transaction using any of several other statutory grants of authority, such as the transfer-pricing rules of Sec. 482 or other common law doctrines or principles to recharacterize a corporate transaction. A transaction is given effect under the business-purpose doctrine if it is motivated by a valid business reason other than tax avoidance. A challenge may also be made under the principles or doctrines of economic substance, substance over form, sham transaction, or step transaction.


To avoid the application of Sec. 269, the acquiring corporation (or both corporations contemplating a merger) should consider the following points:

  • The acquiring corporation (or both corporations in a merger) should emphasize in a plan approved by the board(s) of directors the nontax business purposes for the merger or acquisition. Business purposes should offer stronger support for the merger or acquisition than gaining tax benefits. The number of business reasons supporting the merger or acquisition should exceed or at least equal the number of tax reasons supporting the transaction. Including this information in the plan should be useful in defending any subsequent challenge by the IRS.
  • Future profit expectations of the parties to the merger or acquisition should be clearly delineated in each corporation's preacquisition plan and the post-acquisition combined plan, including the tax benefits obtained in the merger or acquisition, for at least the next five years.
  • A profitable corporation acquiring or merging with a corporation that has consistently produced operating losses might not meet the business-purpose test in Sec. 269. If the losses occurred during the COVID-19 pandemic, however, the IRS may treat this situation as an exception to Sec. 269's general guidance.
  • A corporation merging with or acquiring a different line of business may have more difficulty showing the transaction was undertaken primarily for nontax business purposes. However, a corporation in such a case may have sound business reasons, such as securing its supply chain. These reasons should be stated in the preacquisition plan.


Gaining control of the tax benefits of a corporation through an acquisition or merger may sound worthwhile in a boardroom discussion. However, the risks of a possible disallowance of those tax benefits under Sec. 269 or 382 must be soundly analyzed and dealt with before going forward.

About the authors

Ray A. Knight, CPA, J.D., is a professor of accounting at Elon University in Elon, N.C., and Lee G. Knight, Ph.D., is a professor of accounting emerita at Wake Forest University in Winston-Salem, N.C. As co-authors, they are past winners of the JofA's annual Lawler Award for best article, in 2013, for "Tax Considerations When Dividing Property in Divorce."

To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at or 919-402-4434.

Learning resources

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Introduces you to the most common types of business acquisitions and equips you with necessary tax related skills.

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