Post–Ownership Change Treatment of Built-in Gains and Losses

By Maureen McGetrick and Randy Schwartzman

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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 implementation 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 NUBIG 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. An accrual-basis taxpayer might not have any income or deduction items treated as RBIG or RBIL under this method, while a cash-basis taxpayer will. Items of income or deduction properly included in income during the recognition period are considered “attributable to periods before the change date” if an accrual method taxpayer would have included the item in income or been allowed a deduction for the item before the change date.

Under this approach, income from built-in gain assets (wasting assets) is not considered RBIG, because the income did not accrue prior to the change date. This approach departs from the tax accrual rule, however, in its treatment of depreciation and amortization deductions. In accordance with IRC section 382(h)(2)(B), depreciation and amortization deductions are treated as RBIL except to the extent that the loss company can establish that the deduction is not attributable to the excess of the tax basis of the assets over the fair market value (FMV) as of the change date. Other special exceptions to the accrual rule apply to cancellation of indebtedness (COD) income and bad debt deductions recognized during the first 12 months of the five-year recognition period. These items are treated as RBIG and RBIL, respectively, if the debt was held as of the beginning of the recognition period.

The following example from the proposed regulations illustrates how income from wasting assets is treated for purposes of the section 1374 approach:

Example: LossCo has a NUBIG of $300,000 that is attributable to several nonamortizable assets with an aggregate fair market value of $650,000 and an aggregate adjusted basis of $500,000, and a patent with a fair market value of $170,000 and an adjusted basis of $20,000. The patent is an amortizable section 197 intangible as defined in section 197(c). In Year 1 of the recognition period, LossCo has gross income of $75,000, $20,000 of which is attributable to royalties collected in connection with the license of the patent. No part of the $20,000 attributable to the royalties is RBIG in Year 1, because the income would not have been properly taken into account before the change date by an accrual method taxpayer. Accordingly, LossCo’s section 382 limitation for Year 1 is not increased by any part of that amount.
Comments: LossCo has a NUBIG because the net BIG of $300,000 is greater than 15% of the FMV of the assets ($650,000 x 0.15 = $97,500). If the patent were sold in the recognition period for a gain of $200,000, then $150,000 would be considered a RBIG (FMV minus the adjusted tax basis at the date of the ownership change).

Section 338 Approach

This approach determines whether a NUBIG or NUBIL exists by reference to the value of a company’s stock. If 100% of a company’s stock is acquired in a single transaction, the price in that acquisition should set the value of the company for the purposes of the annual IRC section 382 limitation as well as the value to be used in determining if a NUBIG or NUBIL exists under the IRC section 338 approach. When individuals or entities in the aggregate acquire greater than 50% of the stock in discrete transactions that involve minority blocks of stock, however, aggressive planning, supported by appraisals, can increase the annual limitation as well as the amount of NUBIG.

The IRC section 338 approach identifies items of RBIG and RBIL by comparing the loss corporation’s actual income and deductions with income and deductions that would result had the corporation made a section 338 election on a hypothetical sale of its stock on the date of the ownership change. As a result, certain assets may be treated as generating RBIG even if they are not disposed of during the recognition period (e.g., goodwill and other intangibles). This approach represents a significant departure from the section 1374 approach and presents significant planning opportunities.

Under the IRC section 338 approach, NUBIG or NUBIL is computed in the same manner as under the IRC section 1374 approach. Therefore, contingent consideration (including contingent liabilities) is taken into account in the initial calculation of NUBIG and NUBIL, rather than adjusted for later, as it would be in an actual section 338 election.

The IRC section 338 approach identifies RBIG and RBIL from sales and exchanges of assets by comparing the actual gain or loss with what would have resulted had the loss corporation made an IRC section 338 election with respect to a “hypothetical purchase” of all of its stock on the change date.

The major benefit of the section 338 approach is that a loss corporation with a NUBIG can treat income from “wasting” built-in gain assets as generating RBIG even if the assets are not disposed of during the recognition period. This approach assumes, for any given year, that the asset generates income equal to the cost recovery deduction that would have been allowed for the asset if a section 338 election had been made with respect to the hypothetical purchase. A valuation may be required to determine a proper value for the stock of the company and the hypothetical allocation of purchase price to the various wasting assets under the seven asset classes, using the methodology of section 338. The RBIG attributable to a wasting asset is determined as the excess of the cost recovery that would have been allowed had the section 338 election been made over the actual cost recovery deduction attributable to the asset.

The following example from the proposed regulations illustrates this principle:

Example: LossCo has a NUBIG of $300,000 that is attributable to various nonamortizable assets with an aggregate fair market value of $710,000 and an aggregate adjusted basis of $500,000, and a patent with a fair market value of $120,000 and an adjusted basis of $30,000. The patent is an amortizable section 197 intangible as defined in section 197(c), for which 10 years of tax depreciation remain. In Year 1 of the recognition period, LossCo has gross income of $75,000. In Year 1, $5,000 is RBIG attributable to the patent: the excess of the $8,000 amortization deduction that would have been allowed had a section 338 election been made with respect to a hypothetical purchase of all of the stock of LossCo ($120,000 FMV divided by 15, the amortization period), over $3,000 (the actual allowable amortization deduction). This $5,000 of RBIG increases LossCo’s section 382 limitation for Year 1.

Unfortunately, symmetry exists for a loss corporation with a NUBIL. In this situation, the 338 approach treats certain BIL assets as generating RBIL even if those assets are not disposed of during the recognition period. The IRC section 1374 approach will generally yield a more favorable result for a loss corporation with a NUBIL, while the IRC section 338 approach would yield a more favorable result for a loss corporation with a NUBIG.

Evaluating Options and Opportunities

Selecting the best approach under Notice 2003-65 for identifying BIG and BIL could have significant impact on a taxpayer’s ability to use its NOL. In particular, the acknowledgement by the IRS that income from a wasting asset can generate RBIG represents a significant planning opportunity for companies with significant goodwill and other appreciated assets that have undergone a change in ownership.

Taxpayers may rely on either of the two approaches set forth in Notice 2003-65 for purposes of applying the BIG and BIL rules to ownership changes that occurred prior to the issuance of this notice (limited to open years) or after the issuance of the notice (and prior to the effective date of temporary or final regulations to be issued in the future).