Updates to Sec. 382 NUBIG and NUBIL safe harbors

Editor: Anthony S. Bakale, CPA   To prevent taxpayers from trafficking in tax attributes, Sec. 382 was enacted to limit the use of net-operating-loss (NOL) carryforwards and certain built-in losses following an ownership change. There is an ownership change subject to the limitations of Sec. 382 if, immediately after any owner shift involving a 5% shareholder or equity structure shift, the percentage of the loss corporation’s stock owned by one or more 5% shareholders has increased by more than 50% over the lowest percentage of stock of the loss corporation owned by the shareholders at any time during the three-year testing period.

All less-than-5% owners are considered to be part of one public group for purposes of measuring ownership changes. Once the taxpayer has determined it has had an ownership shift subject to Sec. 382 limitations, it must compute the limitations to its affected attributes. Basically, the Sec. 382 limit is the fair market value (FMV) of the loss corporation multiplied by the long-term tax-exempt rate at the time of the shift. Subject to certain limitations, a loss corporation can either increase its annual Sec. 382 limitations by its recognized built-in gain (RBIG) or decrease its limitations by its recognized built-in loss (RBIL).

To properly calculate this adjustment, a taxpayer must determine if it has either a net unrealized built-in gain (NUBIG) or a net unrealized built-in loss (NUBIL) at the time of an ownership change and how it affects the utilization of its NOLs after the change. The foregoing can be illustrated with this basic example:

Example 1: Loss Co., a C corporation, is owned 100% by Shareholder A and has an NOL carryforward of $5 million. If A sells all of Loss Co. stock for $5 million to B, the Sec. 382 limits will be triggered, since B’s ownership percentage has increased by more than 50% during the testing period. If it is further assumed that the long-term tax-exempt rate is 3%, the annual amount of an NOL that can be utilized is $150,000 before being either increased or decreased by the RBIG or RBIL adjustments.

Sec. 382(h) provides rules for the treatment of built-in gain or loss recognized with respect to assets owned by the loss corporation at the time of its ownership change. Sec. 382(h) states losses that offset built-in gain should not be subject to the Sec. 382 limitation merely because the gain is recognized after an ownership change. This is due to the fact that, if the gain were recognized before the ownership change, it would have been offset without limitation by the loss corporation’s NOL. Similarly, a built-in loss should not escape the Sec. 382 limitation merely because it is recognized after an ownership change because, if the loss had been recognized before the ownership change, it would be subject to the Sec. 382 limit.

Many calculations are necessary to correctly compute the limitation of the NOL under Sec. 382, and each step is complicated. Notice 2003-65 provided two safe harbors that allow taxpayers to calculate their NUBIG or NUBIL, which can either increase or decrease the Sec. 382 limit on the NOL if recognized. However, under Sec. 382(h)(3)(B), if a loss corporation’s NUBIG or NUBIL does not exceed a threshold amount, which is the lesser of $10 million or 15% of the FMV of its assets immediately before the ownership change, its NUBIG or NUBIL is zero.

Pursuant to Sec. 382(h)(3), a loss corporation’s NUBIG or NUBIL equals the amount by which the aggregate FMV of its assets immediately before an ownership shift is more or less than the assets’ aggregate adjusted basis at that time, adjusted by the amount of certain items of income or deduction described in Sec. 382(h)(6)(C). In the case of dispositions of assets during the five-year recognition period, Sec. 382(h)(2) places the burden on the loss corporation to establish that any gain recognized is RBIG and that any loss recognized is not RBIL. Sec. 382(h)(2)(A) defines RBIG as any gain recognized during the five-year recognition period on the disposition of any asset to the extent the new loss corporation establishes that (1) it held the asset on the change date and (2) the gain does not exceed the asset’s built-in gain on the change date. Furthermore, Sec. 382(h)(2)(B) defines RBIL as any loss recognized during the five-year recognition period on the disposition of any asset except to the extent the new loss corporation establishes that (1) it did not hold the asset on the change date or (2) the loss exceeds the asset’s built-in loss on the change date.

Sec. 382(h)(6) and Sec. 382(h)(2)(B) provide rules treating certain items of income or deduction as RBIG or RBIL. Basically, the rule states that any item of income properly taken into account during the recognition period is treated as RBIG if the item is attributable to periods before the change, and provides that any item of deduction allowable as a deduction during the recognition period is treated as RBIL if the item is attributable to periods before the change. Additionally, 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 asset’s built-in loss on the change date.

Notice 2003-65 outlines two safe harbors: (1) the Sec. 1374 approach and (2) the Sec. 338 approach. Under the Sec. 1374 approach, the starting point for the calculation is determining whether there is a NUBIG or a NUBIL under the Sec. 1374 approach, which incorporates the rules of Sec. 1374(d) and Regs. Secs. 1.1374-3, 1.1374-4, and 1.1374-7. Under the Sec. 1374 approach, NUBIG or NUBIL is the net amount of gain or loss that would be recognized in a hypothetical sale of the loss corporation’s assets immediately before the ownership change. NUBIG or NUBIL is calculated by determining the amount realized if, immediately before the ownership change, the loss corporation had sold all of its assets, including goodwill, at FMV to a third party that assumed all of its liabilities, decreased by the sum of any deductible liabilities of the loss corporation that would be included in the amount realized on the hypothetical sale and the loss corporation’s aggregate adjusted basis in all of its assets, increased or decreased by the loss corporation’s Sec. 481 adjustments that would be taken into account on a hypothetical sale, and increased by any RBIL that would not be allowed as a deduction under Sec. 382, 383, or 384 on the hypothetical sale. If this calculation exceeds zero, then the loss corporation has a NUBIG; if this calculation results in an amount less than zero, the result is the loss corporation’s NUBIL. The following examples from Notice 2003-65 illustrate the calculation of NUBIG and NUBIL using the Sec. 1374 approach:

Immediately before an ownership change, LossCo has one asset with a fair market value of $100 and an adjusted basis of $10, and a deductible liability of $30. Disregarding the threshold requirement of [Sec.] 382(h)(3)(B), LossCo has a NUBIG of $60 ($100, the amount LossCo would realize if it sold all of its assets to a third party that assumed all of its liabilities, decreased by $40, the sum of the deductible liability ($30) and the aggregate basis in the assets ($10)).

The facts are the same as [above] except that the asset has an adjusted basis of $90 instead of $10. Disregarding the threshold requirement of [Sec.] 382(h)(3)(B), LossCo has a NUBIL of $20 (the amount by which $0 exceeds —$20 ($100, the amount LossCo would realize if it sold all its assets to a third party that assumed all of its liabilities, decreased by $120, the sum of the deductible liability ($30) and the aggregate basis in the assets ($90))).

Under the Sec. 1374 approach, the amount of gain or loss recognized during the recognition period on the sale or exchange of an asset is RBIG or RBIL, respectively, subject to the limitations in Sec. 382(h)(2)(A) or (B). The sum of the RBIG or RBIL attributable to an asset cannot exceed the NUBIG or NUBIL in that asset on the change date. The Sec. 1374 approach departs from the tax-accrual rule and the regulations under Sec. 1374 in its treatment of amounts allowable as depreciation, amortization, or depletion deductions during the recognition period (collectively, these amounts are referred to as amortization).

Sec. 382(h)(2)(B) states that, except to the extent the loss corporation establishes that the amount is not attributable to the excess of an asset’s adjusted basis over its FMV on the change date, these 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 amount is not attributable to an asset’s built-in loss on the change date. One acceptable method is to compare the amount of amortization deduction actually allowed to the amount of the deduction that would have been allowed had the loss corporation purchased the asset for its FMV on the change date. The amount by which the actual amortization deduction does not exceed the amount of the hypothetical amortization deduction is not RBIL.

The foregoing can be illustrated by the following example, paraphrased from Notice 2003-65:

LossCo has a NUBIL of $300,000 that is attributable to several nonamortizable assets with an aggregate FMV of $500,000 and an aggregate adjusted basis of $650,000, and a patent that is amortizable under Sec. 197 with an FMV of $125,000 and an adjusted basis of $275,000. As of the change date, the patent has a remaining useful life for tax purposes of five years. On its tax return for year 1, LossCo claims a $55,000 amortization deduction for the patent. If LossCo had purchased the patent for its FMV on the change date, it would have been allowed an amortization deduction in the amount of $8,333 on that return. Accordingly, LossCo is able to establish that $8,333 of the amortization deduction for that tax year is not attributable to the patent’s built-in loss on the change date. Therefore, only $46,667 of the actual amount of amortization deduction in year 1 is RBIL. On the first day of year 2, LossCo sells the patent for $70,000 and recognizes $150,000 of loss. Of LossCo’s $150,000 loss from the sale, $103,333 is RBIL ($150,000 built-in loss on the change date decreased by the $46,667 deduction attributable to the patent previously treated as RBIL).

The second safe harbor in the notice is the Sec. 338 approach. It identifies items of RBIG and RBIL generally by comparing the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if a Sec. 338 election had been made with respect to a hypothetical purchase of all of the loss corporation’s outstanding stock on the change date. As a result, unlike under the Sec. 1374 approach, built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period, and deductions for liabilities that exist on the change date may be treated as RBIL.

Under the Sec. 338 approach, NUBIG or NUBIL is calculated in the same manner as under the Sec. 1374 approach. Contingent consideration is taken into account in the initial calculation of NUBIG or NUBIL, and no further adjustments are made to reflect subsequent changes in consideration.

For loss corporations with a NUBIG, the Sec. 338 approach treats certain built-in gain assets of the loss corporation as generating RBIG even if the assets are not disposed of during the recognition period. The Sec. 338 approach assumes that, for any tax year, an asset that had a built-in gain on the change date generates income equal to the cost-recovery deduction that would have been allowed for the asset under the applicable Code section if an election under Sec. 338 had been made with respect to the hypothetical purchase. Therefore, with respect to an asset that had a built-in gain on the change date, the Sec. 338 approach treats as RBIG an amount equal to the excess of the cost-recovery deduction that would have been allowable with respect to the asset had an election under Sec. 338 been made for the hypothetical purchase over the loss corporation’s actual allowable cost-recovery deduction.

The cost-recovery deduction that would have been allowed to the loss corporation had an election under Sec. 338 been made with respect to the hypothetical purchase is based on the asset’s FMV on the change date and a cost-recovery period that begins on the change date. The excess amount is RBIG regardless of the loss corporation’s gross income in any particular tax year during the recognition period.

The enactment of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, expanded Sec. 168(k) to allow for 100% bonus depreciation and to allow bonus depreciation on used assets. As a result, Notice 2018-30 was issued to address unintended consequences to the Sec. 1374 and Sec. 338 safe harbors outlined in Notice 2003-65. Notice 2018-30 modifies Notice 2003-65 to say that under the Sec. 338 approach, in determining RBIG or RBIL, the hypothetical cost-recovery deductions that would have been allowable had an election under Sec. 338 been made are determined without regard to Sec. 168(k). Additionally, the notice provides that under the Sec. 1374 approach, in computing the amount of cost-recovery deductions that are not attributable to an asset’s built-in loss on the change date, the hypothetical cost-recovery deductions that would have been allowable had the loss corporation purchased the assets for FMV on the change date is determined without regard to Sec. 168(k).

The TCJA reduction of the corporate tax rate to 21% and the 100% exclusion allowable under preexisting law for selling Sec. 1202 stock, among other factors, are resulting in more target stock acquisitions. With the increased use of stock acquisitions, buyers must correctly apply the Sec. 382 limitations, including the additional analysis required by Sec. 382(h) to determine the impact of NUBIG and NUBIL.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.