Corporations operating at a loss can utilize these losses in the future to offset taxable income – the net operating loss (NOL) carryover. But there may be limits to the tax benefits of these losses when a loss corporation is acquired by another entity. The limitations are outlined in Internal Revenue Code Section 382 (Section 382). For loss corporations, calculating the limitations of Section 382 seems relatively simple at first, but over the years this analysis has become somewhat complicated, as a recent Chief Counsel Advice demonstrates.
The IRS’s Chief Counsel Advice (CCA) issued guidance on a case that could have an impact on loss corporations calculating their built-in gain or loss when considering Section 382 limitations. All loss corporations and entities that acquire them should pay careful attention to the CCA ruling, as it affects cases where the loss corporation has deferred revenue obligations.
The Mechanics of Section 382
Analyzing the impact of the CCA decision starts with an understanding of the mechanics of Section 382.
Loss corporations, entities that have a NOL or built-in-gain or loss are eligible to use a NOL subject to Section 382. Section 382 is designed to prevent a company from being acquired solely for the use of tax benefits and looks to the substance of the transaction. It does this by establishing limitations on the tax benefits for losses that a loss corporation can take following a change in ownership.
For Section 382 purposes, a change in ownership occurs when there is a purchase, sale or reissuance of equity, and there is a 50 percent increase in ownership by 5 percent of the shareholders during a three-year testing period. After an ownership change occurs, loss corporations calculate the maximum amount of their pre-sale losses that can be utilized each year going forward (until expiration or utilization of the NOL).
This is accomplished by determining the loss corporation’s base limitation amount, which is the fair value of the pre-sale loss corporation multiplied by the federal long-term tax exempt rate. This amount is often referred to as the “382 limitation” but that is not the end of the story. Loss corporations are required to adjust the base limitation amount by the value of certain pre-sale built-in gains or losses. To do so requires consideration of whether the loss corporation has net unrealized built-in gains (NUBIG) or net unrealized built in losses (NUBIL) at the time of the sale. Notice 2003-65 provides an excellent outline of how this analysis is performed and applied.
The NUBIG or NUBIL is the difference between the fair market value of the loss corporation’s pre-change in ownership assets and the aggregate adjusted basis of the assets on the date of the ownership changes. The notice looks to the transaction as a fictitious asset sale and determines if there would be residual positive or negative value over the assets based on the purchase price.
Entities with NUBIG increase their Section 382 limitation by the amount recognized each year during the five-year period after the transaction. Entities with NUBIL must incorporate their recognized built-in loss in the Section 382 limitation calculation. If the NUBIG/NUBIL amount is lower than the lesser of $10 million or 15 percent of the fair market value of the loss corporation’s assets, then the loss corporation is deemed to not have NUBIG or NUBIL for Section 382 purposes.
For NUBIG, the adjustments include items of income or deductions that would be treated as realized built-in gains or losses during the period in which the ownership change took place. Deductions that are properly accounted for during the current period but attributable to periods before the change took place are considered realized built-in losses for Section 382. Items of income taken during the changeover period that are attributable to prior periods are classified as built-in gains. There are specific rules established in this area for treatment of certain items in this analysis. For example, rules specify that prepaid income arising from a customer’s prepayment of a service is not considered a realized built-in gain for Section 382.
Loss corporations can calculate their NUBIG/NUBIL and identify realized built-in gains or losses using either the Section 1374 approach or the Section 338 approach as outlined in Notice 2003-65. To calculate using the Section 1374 approach, loss corporations perform a hypothetical transaction:
- They take the amount they would have realized if they sold all of their assets at fair market value before the change in ownership (deemed asset sale) and the buyer assumed all liabilities.
- This figure is decreased by the sum of deductible liabilities that would be included in the hypothetical sale.
- This figure is decreased by the loss corporation’s aggregate adjusted basis in all its assets, increased or decreased by the items of income or deductions and increased by any realized built-in losses ineligible to be taken as deductions.
The amount over or under is the NUBIG or NUBIL, respectively.
Section 1374 Approach and the CCA
A loss corporation and the IRS disagreed over a loss corporation’s calculation using the deemed asset sale approach of Notice 2003-65 which employs a Section 1374 approach.
Prior to the change in ownership sale, the loss corporation had distributed prepaid cards to its customers for future use of a service. If the cards expired without the customer using them, the cards were nonrefundable. Based on these and other factors, payment for the cards constituted deferred revenue obligation liabilities required to be deferred until after the change in ownership date.
The loss corporation included the deferred revenue obligations as a liability that that buyer assumed during the transaction in its Section 1374 NUBIG/NUBIL calculation. It did not, however, reduce the amount the loss corporation would have realized in a deemed asset sale by the deferred revenue obligation liability to perform the services purchased with the presale cards. After completing the full NUBIG/NUBIL calculation, the loss corporation reported that it had a NUBIG that increased its Section 382 base limitation, which was calculated as $0 prior to any NUBIG consideration.
Disagreeing, the IRS argued that the loss corporation’s deferred revenue obligations constituted a deductible expense, and therefore its NUBIG should also be $0.
The CCA determined that Section 382 should not include deferred revenue obligations because neither Section 382 nor subsequent IRS guidance provides the authority to include it. As such, the correct calculation of the loss corporation’s NUBIG/NUBIL would put the adjustments at $0, which would mean the loss corporation could not use the acquired losses to offset future income.
Moral of the Story
Although the case involved a complex, nuanced situation between the IRS and a loss corporation, the CCA’s guidance provides an important lesson for loss corporations with deferred revenue obligations and careful consideration of these amounts should be taken when calculating the limitations pursuant to Section 382.
For more information on the proper application of Section 382, please contact us here.
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