On Sept. 10 the U.S. Department of the Treasury and the IRS issued proposed regulations that would change the current rules regarding treatment of items of income and deduction included in the calculation of built-in gains and losses under IRC Section 382. That section imposes an annual limitation on the use of prechange tax losses after a corporation with net operating losses (NOLs), capital losses, or certain credits (loss corporation) experiences an ownership change. In general, this limitation is based on the value of the loss corporation immediately before the ownership change, multiplied by the long-term tax-exempt rate.
In addition, under Section 382(h), if a loss corporation has net unrealized built-in gain (NUBIG) immediately before an ownership change, the Section 382 annual limitation for the recognition period (generally five years) is increased by the recognized built-in gain (RBIG) up to the amount of the NUBIG, reduced by NUBIG absorbed in prior years.
Under Section 382, if the loss corporation has net unrealized built-in loss (NUBIL) immediately before the ownership change, any recognized built-in loss (RBIL) for any tax year included in the recognition period is treated as a prechange loss for purposes of the Section 382 limitation, up to the amount of the NUBIL.
For 15 years, taxpayers have relied on Notice 2003-65, which provides two safe harbors to determine RBIG or RBIL: the Section 1374 method and the Section 338 method. The 1374 method generally relies on accrual method of accounting concepts used under Section 1374(d) to identify built-in income and deduction items. The Section 338 approach generally identifies items of RBIG and RBIL by comparing the loss corporation’s actual items of income, gain, deduction, and loss recognized during the recognition period with those that would have been recognized if a Section 338 election had been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation in the change date. For loss companies with NUBIG, the second safe harbor allows for RBIG for the depreciation and amortization that would have been deductible if a Section 338 election was made.
The proposed regulations reject the Section 338 method and adopt a modified version of the Section 1374 approach. For loss corporations in a NUBIG position, this change might reduce the amount of RBIG dramatically and thus limit the NOL usage.
Under Notice 2003-65, the fair market value of the loss company’s assets is determined as if the loss company had sold all of its assets, including goodwill, at fair market value to a third party that assumed all of the loss company’s liabilities. The proposed regulations modify this approach and require the bifurcation of the deemed sale between assets secured by nonrecourse debt and assets secured by recourse debt. The fair market value of the assets is the amount that would be realized if the loss corporation had surrendered its inadequately secured nonrecourse liabilities by conveying its assets to the nonrecourse lender plus the fair market value of its other assets.
The proposed regulations make a number of other significant changes to current guidance. Some of the changes include:
- All bad debt deductions during the recognition period are RBIL.
- Contingent liabilities are treated as RBIL up to the extent of estimated value as of the ownership change date.
- Special rules include built-in cancelation of indebtedness income in the NUBG/NUBIL calculation in certain cases.
- Disallowed Section 163(j) interest carryforwards are not treated as RBIL if the amounts were allowable as a deduction during the recognition period.
- Section 1248 dividends and global intangible low-taxed income received by a loss corporation are not treated as RBIG.
The proposed regulations generally are effective for ownership changes only after the date the regulations become final. Taxpayers have the option of relying on the proposed regulations to claim a refund if certain conditions are met.