Magazine article The CPA Journal

Post-Ownership Change Treatment of Built-In Gains and Losses

Magazine article The CPA Journal

Post-Ownership Change Treatment of Built-In Gains and Losses

Article excerpt

IRC Section 382 imposes restrictions on the use of a corporation's net operating losses (NOL) and other carryovers after an ownership change occurs. An ownership change is a greater than 50 percentage point increase by 5% shareholders during the testing period, which is generally three years. These restrictions limit the amount of a corporation's pre-change losses that can be used in a tax year. The annual limitation is equal to the value of the loss corporation immediately before the ownership change, multiplied by the long-term tax-exempt rate. The annual limitation is increased each year to the extent that there is an unused limitation in a prior year.

Built-in Gains and Losses

An exception to the general loss limitation rules of IRC section 382 occurs when a built-in gain or loss is recognized following an ownership change. The exceptions apply only if the loss company has a net unrealized built-in gain (NUBIG) or loss (NUBIL). A NUBIG or NUBIL is defined as "the amount by which the fair market value of the assets of such (loss) corporation is more or less, respectively, than the aggregate adjusted tax basis of such assets at such time." If the NUBIG or NUBIL does not exceed the threshold amount (the lesser of $ 10 million or 15% of the fair market value of the assets at the date of the ownership change), then it is considered zero. If the loss company has a NUBIG and a built-in gain is recognized (RBIG) during the recognition period, the section 382 limitation is increased by the amount of the RBIG for that year. If the loss company has a NUBIL and a built-in loss is recognized (RBIL) during the recognition period, that loss is subject to limitation as if it were a pre-change loss. The recognition period refers to the five-year period beginning on the change date.

An additional provision under IRC section 382 states that items of income or loss that are properly taken into account during the recognition period but are attributable to periods before the ownership change will be treated as RBIGs or RBILs. In determining whether the threshold amounts have been met, the amount of the NUBIG or NUBIL is adjusted for amounts that would be treated as built-in gains or losses if such amounts were properly taken into account during the recognition period.

Because regulations have not been written on the built-in gain and loss rules under IRC section 382(h), only limited guidance was available before the issuance of Notice 2003-65 in September 2003. The notice provides two safe harbor methods for computing built-in gains and losses: the IRC section 1374 approach and the IRC section 338 approach. The choice and implementalion of the proper method could have substantial impact on a taxpayer's ability to maximize the utilization of NOLs.

Section 1374 Approach

The IRC section 1374 approach is a direct asset sale approach and should be the preferred method for a loss company with a NUBIL. Under this approach, the NUBIG or NUBIL is the amount of gain or loss that would be recognized if the company had sold all of its assets immediately before the ownership change. Specifically, the NUBlG or NUBIL is computed by determining the following:

* The amount realized on a hypothetical sale of all the company's assets (including goodwill) for fair market value to a third party that assumed all of its liabilities; minus

* Any deductible liabilities that would be included in the amount realized; minus

* The corporation's adjusted basis in its assets; plus or minus

* Any section 481 adjustments that would be taken into account on a hypothetical sale; plus

* Any RBIL that would not be allowed as a deduction under IRC sections 382, 383, or 384 on the hypothetical sale.

This amount represents a NUBIG to the extent it is greater than zero. It is a NUBIL to the extent it is less than zero.

The section 1374 approach relies on the accrual method of accounting to identify income or deduction items as RBIG or RBIL. …

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