Corporate Close-Up: Montana’s Disallowance of Pre-Merger NOLs Poses Trap for the Unwary


Sometimes it’s desirable for a corporation incorporated under the laws of a particular state to change its state of incorporation to a different jurisdiction such as Delaware, which may have more favorable corporate statutes. This change is often made by forming an empty shell corporation in the new state and merging the existing corporation into the new corporation. For federal tax purposes, the transaction generally qualifies as a tax-free reorganization under I.R.C. § 368(a)(1)(F) (an F reorganization), without adversely affecting the net operating losses (NOLs) of the existing corporation. See Treas. Reg. § 1.381(b)-1(a)(2). But significant adverse state tax consequences could arise from these reorganizations, particularly with respect to state tax attributes such as NOLs. Taxpayers contemplating a merger of a corporation engaged in business in Montana should consider the consequences of the special rule in Montana that disallows a deduction to the surviving corporation for any pre-merger Montana NOLs of the merged corporations.

Vincent G. Kalafat, a tax attorney and author of Bloomberg BNA’s Montana Corporate Income Tax Navigator, cautions that this special rule in Montana is a real trap for the unwary. Specifically, under Mont. Code Ann. § 15-31-119(8), in the case of a merger of corporations, the surviving corporation is not allowed an NOL deduction for any NOLs sustained by the merged corporations prior to the merger.While this special NOL disallowance rule may seem draconian, it has survived statutory and constitutional challenge.

In GBN, Inc. v. Montana Dept. of Rev., 815 P.2d 595 (Mont. 1991), the Montana Supreme Court found that the state’s statute expressly prohibited a deduction by the surviving corporation for the NOLs that each merged corporation sustained prior to the merger. GBN argued that although the statute refers to “merged corporations” in the plural, the legislature could have intended to prohibit the loss carry forward for the disappearing corporation only.

But the court was not persuaded. “Here, there is no basis for arguing legislative intent because the plain language of the statue clearly and unambiguously precludes pre-merger net operating loss deductions,” the court concluded. “The statute expressly prohibits the surviving corporation from carrying forward net operating losses incurred by corporations prior to merger,” the court held.

Other states, such as Arizona, limit post-merger NOLs by allowing the deduction to the extent that the NOLs are attributable to the same entity that incurred them. But Montana goes one step further by denying the pre-merger NOLs incurred by both the surviving and target corporations. Montana has stretched this NOL disallowance rule even further through administrative regulations, disallowing any pre-conversion NOLs of a corporation that has converted to a disregarded entity. See Mont. Admin. R. 42.23.804(3).

Returning to the state reincorporation transaction from above, we couldn’t help but ask whether Montana’s special pre-merger NOL rule applies even to an F reorganization effected through a state law merger. In GBN, the Montana Supreme Court recognized as policy reasons for this special pre-merger NOL disallowance rule the prevention of “larger, profitable corporations from gaining a tax advantage by acquiring another corporation’s losses” and encouraging “the continued existence of smaller corporations which have less ability than do large corporations to take advantage of substantial tax shelters and other means of avoiding taxation.”

Considering those policy reasons for Montana’s special rule, you might not think that the change of a state of jurisdiction of one corporation through a merger of an existing corporation into a new shell corporation should result in the disallowance of the existing corporation’s pre-merger NOLs. Indeed, as Kalafat comments, there would appear to be no “loss-trafficking, large corporation profiting” with a plain vanilla F reorganization merger to change a single corporation’s state of incorporation.

However, as Gertrude Stein wrote when Montana was still a young state, “Rose is a rose is a rose is a rose.” And it would appear difficult for taxpayers to argue that a “merger is not a merger is not a merger is not a merger” for purposes of this special rule in Montana disallowing pre-merger NOLs. As Kalafat observes, the term “merger” in this special rule is not defined in Montana’s tax statutes or administrative rules, nor is there any distinction in the special rule for a merger that qualifies as an F reorganization for federal tax purposes. In light of the Montana Supreme Court’s emphasis in GBN on interpreting the language of the special rule based on its plain meaning, Kalafat further observes that it would appear difficult for taxpayers to argue that a “merger” for purposes of this special rule in the tax statute does not include a “merger” under the state corporate statute, even if the merger effects an F reorganization for federal tax purposes.

It also doesn’t bode well for the argument that the Montana Supreme Court firmly dismissed an argument in GBN based on the disparate treatment of NOLs for Montana and federal tax purposes following a merger. In the words of the court, “Whether the net operating losses in question are deductible for federal purposes is irrelevant. Federal tax law does not preempt the area of state taxation; the fact that the Montana Legislature chooses not to classify an item in the same manner as Congress does not make the classification unreasonable.”

Perhaps it is time for the Montana Legislature to revisit this special rule for pre-merger NOLs, which appears to use a tax sledgehammer to crack an NOL nut. In the meantime, taxpayers should keep this tax trap in mind when contemplating any transaction (including an F reorganization for federal tax purposes) that involves a merger of any corporation that has a Montana NOL. 

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: What other dangers lurk for pre-merger NOLs at the state level?

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