Safe Harbors for Identifying Sec. 382 RBIG or RBIL

The Service intends to publish regulations on identifying built-in income and deduction items for Sec. 382(h) purposes. In the interim, Notice 2003-65 provides two alternative safe-harbor methods that loss corporations can rely on to identify such items, provided that either approach is consistently applied to an ownership change. The notice states that the two safe harbors are not the exclusive methods by which a taxpayer may identify built-in items; the merits of alternative approaches will be determined on a case-by-case basis.

Background

Under Sec. 382, after an ownership change, the amount of a loss corporations taxable income for any post-change year that may be offset by pre-change losses cannot exceed the Sec. 382 limit for that year. The Sec. 382 limit generally equals the fair market value (FMV) of the loss corporations stock multiplied by the long-term tax-exempt rate, although certain adjustments to the stocks FMV may be required.

Sec. 382(h) applies to loss corporations that have significant built-in gains (BIGs) or losses (BILs) at the time of an ownership change. If a loss corporation has a net unrealized built-in gain (NUBIG) (i.e., the gross FMV of its assets just before an ownership change exceeds such assets aggregate tax basis), it may offset recognition of such gain during the 60-month period following the ownership change with pre-change losses, without limit by Sec. 382. Conversely, if a loss corporation has a net unrealized built-in loss (NUBIL) (i.e., the aggregate tax basis in its assets exceeds the assets gross FMV just before an ownership change), any such loss recognized during the 60-month period following the ownership change is treated as a pre-change loss that can offset taxable income, to the extent of the Sec. 382 limit.

Under Sec. 382(h)(6)(A), any item of income properly taken into account during the recognition period is treated as recognized built-in gain (RBIG) if the item is attributable to periods before the change date. Likewise, Sec. 382(h)(6)(B) provides that any item of deduction allowable as a deduction during the recognition period is treated as recognized built-in loss (RBIL) if the item is attributable to periods before the change date. Also, allowable depreciation, amortization or depletion deductions are treated as RBIL except to the extent the loss corporation establishes that the amount of the deduction is not attributable to the assets built-in loss on the change date.

Notice 87-79 announced that the IRS anticipated that regulations under Sec. 382 would permit income from a cancellation of debt (COD) integrally related to a transaction resulting in an ownership change to be allocated to the pre-change period. Notice 90-27 stated that the IRS would promulgate regulations providing that BIG recognized on an installment sale occurring before or during the recognition period would be treated as RBIG, even if recognized after the recognition period.

1374 Approach

Under the 1374 approach, a loss corporations NUBIG or NUBIL generally equals the net gain or loss the loss corporation would have recognized had it sold all of its assets for FMV just before the ownership change to a purchaser that assumed all of the loss corporations liabilities. Based generally on Sec. 1374(d), this approach generally treats items as attributable to the pre-change period under Sec. 382(h)(6)(A) or (B) only if an accrual-method taxpayer would have included the item in income or been allowed a deduction for it before the change date. Because the approach restricts the scope of items treated as built-in, loss corporations with NUBILs generally will opt to apply it; loss corporations with NUBIGs generally will not derive significant benefit from its use.

Amortization: The 1374 approach departs from the tax-accrual rule and the Sec. 1374 regulations in its treatment of amounts allowable as depreciation, amortization or depletion during the recognition period. Except to the extent the loss corporation establishes that the amount is not attributable to the excess of an assets adjusted basis over its FMV on the change date, those amounts are treated as RBIL, regardless of whether they accrued for tax purposes before the change date. A loss corporation may use any reasonable method to establish that the amortization deduction is not attributable to an assets
BIL on the change date. One acceptable method is to compare actual amortization with hypothetical amortization (based on a hypothetical purchase of the BIL asset at FMV on the change date). Only the excess of actual amortization over hypothetical amortization is treated as RBIL for each recognition-period tax year.

COD income: The 1374 approach treats taxable COD income recognized during the first 12 months following the ownership change on debt outstanding on the change date as BIG, and treats a Sec. 166 deduction recognized during the first 12 months following the ownership change due to a creditor position held on the change date as BIL. Under Notice 2003-65, any reduction of tax basis under Secs. 108(b) and 1017 that occurs as a result of excluded COD income realized during the first 12 months following the ownership change is treated as if it occurred immediately before such change, so that a subsequent disposition of such asset may be treated as RBIG (although such basis reduction does not affect NUBIG or NUBIL). Taxpayers that otherwise use the 1374 approach may use Notice 87-79, rather than the above rules, for ownership changes occurring before Sept. 12, 2003.

338Approach

The 338 approach determines NUBIG or NUBIL in the same way as does the 1374 approach. However, it identifies RBIG and RBIL items by comparing a loss corporations actual items of income, gain, deduction and loss with those that would have resulted had a Sec. 338 election been made for a hypothetical purchase of all of the loss corporations outstanding stock on the change date. Essentially, the 338 approach treats a loss corporations BIG assets as generating RBIG, even if they are not disposed of during the recognition period. Specifically, the 338 approach assumes that, for any tax year, an asset that had BIG on the change date generates income equal to the difference between any allowable cost recovery deduction and the deduction that would have been allowed had a Sec. 338 election been made for the hypothetical purchase. This approach means that, in the case of an amortizable BIG asset with basis amortized over a relatively short remaining recovery period, the hypothetical amortization of the BIG calculated over a longer, new recovery period may not exceed the actual amortization.

Example: One of L Corp.s assets is a customer list whose FMV and basis on the change date are $150 and $50, respectively. The remaining Sec. 197 amortization period is five years. It might be expected that some part of the $100 of BIG in the customer list would generate built-in income during the recognition period. But the hypothetical amortization of $150 over 15 years (i.e., $10 per year) does not exceed the actual Sec. 197 amortization of the customer list over the remaining five years ($10 per year). Thus, the 338 approach provides no built-in income benefit for the customer list.

The excess of hypothetical over actual basis recovery is RBIG, regardless of the loss corporations gross income in any particular recognition-period tax year. Thus, even if the BIG assets do not actually generate income, and even if the loss corporation generates a loss for the year, the forgone amortization may still result in an increased Sec. 382 limit that carries forward unused to later post-change years.

Contingent liabilities: The notice provides that contingent liabilities (and other contingent consideration) are taken into account in the initial calculation of NUBIG or NUBIL, at their estimated amount. NUBIG or NUBIL is not later readjusted to reflect the resolution of the amount of the contingent liability. It is unclear whether the contingent liabilitys estimated amount takes into account discounts for time value and risk. For loss corporations with NUBIL, the 338 approach treats the payment of a contingent liability as a built-in deduction, to the extent of such liabilitys estimate on the change date. For loss corporations with NUBIG, the notice does not indicate whether contingent liabilities will give rise to additional BIG when they become fixed and determinable (as they would in the case of an actual Sec. 338 election).

COD income: In contrast to the 12-month rule under the 1374 approach, the 338 approach requires a hypothetical marking-to-market as of the change date of any debt discharged during the recognition period. Includible COD income is treated as built-in income only to the extent of the excess of the discharged debts adjusted issue price over its FMV on the change date. Any reduction of tax basis under Secs. 108(b) and 1017 that occurs as a result of excluded COD income realized during the recognition period is taken into account when measuring RBIG or RBIL, to the extent of the excess of the debts adjusted issue price over its FMV on the change date. However, the reduction of tax basis does not affect the measurement of overall NUBIG or NUBIL under Sec. 382(h)(3).

Other items: The notice provides that the 338 approach incorporates the Regs. Sec. 1.1374-4(i) rules on partnership items, to the extent those items are not already taken into account in the 338 methodology of comparing actual loss corporation items to those that would have resulted had a Sec. 338 election been made for the hypothetical purchase.

From Mark Yecies, Washington, DC