IRS Finalizes Regs. Addressing Limitations on Transfers of Built-In Losses

Editor: Michael Dell, CPA

Corporations & Shareholders

The IRS issued final regulations (T.D. 9633) under Sec. 362(e)(2) that provide guidance on the determination of the bases of assets (including stock) transferred in certain nonrecognition transactions to which Sec. 362(e)(2) limitations on built-in losses apply. The final regulations adopt, with a few minor changes, the proposed regulations issued in 2006 (REG-110405-05). The regulations are effective for transactions occurring after Sept. 3, 2013; however, taxpayers may apply the regulations to any transaction occurring after Oct. 22, 2004.

Background

Sec. 362(e)(2), enacted as part of the American Jobs Creation Act of 2004, P.L. 108-357, generally limits taxpayers’ ability to duplicate net losses in Sec. 351 contributions and capital contributions. Before Sec. 362(e)(2) was enacted, loss duplication could occur under the normal operation of the subchapter C basis rules—e.g., a transferor that contributes loss property to a transferee would generally take an exchanged basis in the stock of the transferee (which would reflect the loss in the property), and the transferee would take a carryover basis in the property contributed (which would continue to reflect the loss in the property).

Congress enacted Sec. 362(e)(2) because it viewed these transactions as potentially abusive. Sec. 362(e)(2) provides that, in the case of property that is transferred in a Sec. 351 transfer or capital contribution, which is not described in Sec. 362(e)(1) (addressing loss importation transactions), if the transferee’s aggregate basis in the property would (but for Sec. 362(e)(2)) exceed the property’s fair market value (FMV), then the transferee must reduce its basis in the property so the aggregate basis does not exceed its FMV. This rule has the effect of eliminating the built-in loss at the transferee level.

The aggregate basis reduction required under Sec. 362(e)(2) is allocated among the transferred built-in loss property in proportion to the respective built-in losses. The transferor and transferee may, however, jointly and irrevocably make an election under Sec. 362(e)(2)(C) to reduce the transferor’s basis in the stock received. The transferee is permitted to take a carryover basis in the property contributed, thereby eliminating the built-in loss at the transferor level. Until the issuance of final regulations, the primary guidance in this area had been Notice 2005-70, which provided interim guidance for making the Sec. 362(e)(2)(C) election, as well as the 2006 proposed regulations.

Final Regulations

The final regulations are substantially similar to the 2006 proposed regulations and generally adopt the rules set forth in Notice 2005-70 and render it obsolete. The final regulations also clarify a number of issues.

Importantly, the final regulations provide two exceptions to Sec. 362(e)(2). The first exception is—if a transfer is not relevant for U.S. federal income tax purposes at the time it occurs and it does not become relevant for U.S. federal income tax purposes at any time within two years of the transfer, Sec. 362(e)(2) does not apply. The second exception applies to the extent that the transferor distributes the stock received in the transaction and, in the distribution, no gain or loss was recognized and no person takes the stock or other property with a basis determined by reference to the transferor’s basis in the distributed stock—i.e., Sec. 362(e)(2) does not apply to reorganizations that also qualify as Sec. 351 contributions because there is no duplicated loss resulting from the transaction.

In addition, the final regulations provide that stock received in a transaction for which a Sec. 362(e)(2)(C) election is made is not subject to the basis-tracing provisions in Regs. Sec. 1.358-2. The final regulations also clarify that an assumption of liability has no effect on the application of Sec. 362(e)(2). This prevents the reduction of stock basis attributable to contingent liabilities associated with a trade or business, for which basis is specifically preserved under Sec. 358(h)(2)(A).

Furthermore, the final regulations also clarify a number of administrative and compliance matters. For instance, the final regulations provide that the transferor and transferee must execute a binding written agreement to make the Sec. 362(e)(2)(C) election and provide the manner for making the election in a variety of fact patterns. In addition, the final regulations state that controlled foreign partnerships (CFPs) should be treated the same as controlled foreign corporations (CFCs). Accordingly, a CFP’s U.S. partners have the same reporting requirements as the CFC’s controlling U.S. shareholders. The final regulations retain the rule excepting transactions wholly outside the U.S. tax system but do not presume that basis and value are equal; they instead simply exempt qualifying transactions.

Finally, further guidance on the interaction between Sec. 362(e)(2) and both subchapter K partnership rules and subchapter S corporation rules is offered in the final regulations. Specifically, if an S corporation or partnership is a transferor in a transaction in which a Sec. 362(e)(2)(C) election is made, the final regulations provide that the basis reduction in the transferee stock is an expenditure or expense of the transferor partnership or S corporation, thus resulting in a shareholder/partner-level basis reduction.

Implications

The final regulations are welcome guidance from the IRS, particularly the exception for Sec. 351/reorganization overlap transactions and the two-year rule for determining whether a transaction generally outside the U.S. tax net is “relevant” under Sec. 362(e)(2).

Although applied on a transferor-by-transferor basis, Sec. 362(e)(2) and the final regulations are concerned with whether, in the aggregate, there would be a net built-in loss acquired from any particular transferor. But the rules are implemented on an asset-by-asset basis. As a practical matter, the final regulations thus highlight the valuation challenge that taxpayers will face in identifying loss-duplication property and whether they have engaged in a loss-duplication transaction.

That is, while taxpayers may be more readily able to determine the aggregate basis in transferred assets, the regulations essentially require a valuation of each asset to identify a particular asset as loss-duplication property and to apply the required basis adjustments. Note that, even if an asset’s basis is marked down under the final regulations, the adjusted basis may still exceed the asset’s FMV, since the basis in built-in gain property also is taken into account in determining whether there is a loss-duplication transaction (see Example 1 of Regs. Sec. 1.362-4(h) in the final regulations).

Also, as noted, the final regulations provide that stock received in a transaction in which a Sec. 362(e)(2)(C) election is made is not subject to the basis-tracing provisions in Regs. Sec. 1.358-2. Thus, the effect upon transferee stock basis may form part of the calculus in determining whether to elect under Sec. 362(e)(2)(C) to reduce stock basis instead, where the transferred property is stock of another corporation, and the basis-tracing provisions of Regs. Sec. 1.358-2 would otherwise apply absent a Sec. 362(e)(2)(C) election.

Editor Notes

Michael Dell is a partner at Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.