Prop. regs. would eliminate Sec. 338 safe harbor, modify calculations

By Andrew M. Herman, J.D., LL.M., Washington, D.C.; Amy J. Sargent, J.D., LL.M., Washington, D.C.; and Amy F. Ritz, CPA, J.D., LL.M., Los Angeles

Editor: Susan Minasian Grais, CPA, J.D., LL.M.

The IRS issued proposed regulations (REG-125710-18) on the items of income and deductions that are included in calculating built-in gains and losses under Sec. 382(h), and reflecting changes made to the Internal Revenue Code by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The proposed regulations would eliminate the so-called 338 approach, a safe-harbor method as set forth in Notice 2003-65. The proposed regulations would adopt as mandatory another safe-harbor method in Notice 2003-65, the "1374 approach," with certain modifications, particularly for cancellation-of-debt (COD) income and deductions for the payment of contingent liabilities. Other significant changes in the package include the rules related to consolidated groups and the rules related to some international tax provisions, including Secs. 951A and 1248.

This discussion provides an overview of the current Sec. 382 regime, and then discusses the significant changes in the proposed regulations and their implications.


Under Sec. 382, the amount of a loss corporation's taxable income that may be offset by prechange losses following an ownership change for any post-change year cannot exceed the Sec. 382 limitation for that year. The Sec. 382 limitation generally equals the fair market value (FMV) of the loss corporation's stock multiplied by the long-termtax-exempt rate, although certain adjustments to the stock's FMV may be required.

Special rules in Sec. 382(h) apply to loss corporations with significant built-in gains or losses at the time of an ownership change. If a loss corporation has a net unrealized built-in gain (NUBIG) — i.e., the FMV of its gross assets at the time of an ownership change exceeds the assets' aggregate tax basis — recognition of that gain during the 60 months following the ownership change is recognized built-in gain (RBIG) and may be offset by prechange losses without limitation 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 at the time of an ownership change, any such loss recognized during the 60 months following the ownership change is recognized built-in loss (RBIL) treated as prechange loss and, therefore, can offset taxable income only to the extent of the Sec. 382 limitation.

Notice 2003-65

Notice 2003-65 provides two alternative safe-harbor methods (the 1374 approach and the 338 approach) on which loss corporations can rely to identify built-in income and deduction items for purposes of Sec. 382(h), provided that either approach is consistently applied to an ownership change. In addition, Notice 2003-65 provides a single safe harbor for computing the NUBIG or NUBIL of a loss corporation, which (1) is based on the Sec. 1374 principles in calculating net recognized built-in gain for purposes of the tax imposed on C corporations that elect to be S corporations, and (2) analyzes a hypothetical sale or exchange of all assets of the loss corporation to a third party that assumed all of the loss corporation's liabilities.

Under the 1374 approach, a loss corporation's NUBIG or NUBIL generally equals the net amount of gain or loss that the loss corporation would have recognized if it had sold all of its assets for FMV to a purchaser that assumes all of the loss corporation's liabilities, generally relying upon accrual-method accounting principles to identify built-in income and deduction items at the time of the ownership change.

The 338 approach determines the amount of NUBIG or NUBIL in the same manner as the 1374 approach but provides a different method of determining built-in items. The 338 approach identifies those items by comparing a 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 for a hypothetical purchase of all the outstanding stock of the loss corporation on the change date.

Before Notice 2003-65, the IRS previously provided more limited guidance (Notice 87-79 and Notice 90-27) on determining built-in gains and losses. Notice 2018-30, which was issued following the TCJA, makes the Sec. 338 safe harbor of Notice 2003-65 unavailable when computing items arising from bonus depreciation under Sec. 168(k).

The 338 approach of Notice 2003-65 is generally favorable to loss corporations in a built-in gain position because it allows for a broad interpretation of built-in gain and income items, including "forgone" depreciation and amortization deductions during the five-year recognition period attributable to the asset basis being less than FMV at the time of the ownership change. This has permitted loss corporations to enhance their RBIG (and thus their 382 limitation) even without identifying actual items of income attributable to the NUBIG.

NUBIG/NUBIL safe harbor, modified 1374 approach, and elimination of the 338 approach

Regarding the computation of NUBIG and NUBIL, the proposed regulations would adopt and make mandatory the safe-harbor computation provided in Notice 2003-65 based on the Sec. 1374 principles, with some changes. Regarding the identification of RBIG and RBIL, the proposed regulations would eliminate the 338 approach and adopt and make mandatory the 1374 approach, with some changes.

Eliminating the 338 approach: The preamble of the proposed regulations lists several concerns that Treasury had with the 338 approach. First (in Treasury's view), the 338 approach is inconsistent with the text of Sec. 382(h) because depreciation and amortization deductions on certain built-in gain assets give rise to RBIG, even though no actual recognition of gain or income has occurred. Second, when the loss corporation owns a chain of subsidiaries, deemed-tiered Sec. 338 elections create significant complexity with respect to lower-tier controlled foreign corporations (CFCs) (the implication that tiered Sec. 338 elections are contemplated by the 338 approach is itself a noteworthy departure from the current thinking of some practitioners). Third, numerous complexities would arise from the interaction of the 338 approach and various TCJA provisions, including Secs. 168(k), 163(j), and 172 (the latter two provisions being limited by taxable income, which would be affected by a hypothetical 338 election, potentially creating iterative calculations).

COD income: The proposed regulations would also make significant changes to the rules regarding the treatment of COD income under the 1374 approach in Notice 2003-65 and would provide different treatment for includible and excludable COD income to prevent duplicating benefits under Sec. 382(h). Under the proposed regulations, nonrecourse debt generally would be reflected in NUBIG/NUBIL to the extent that the adjusted issue price of nonrecourse debt exceeds the basis of the assets that secure it (i.e., the nonrecourse COD is "built-in").

In contrast, recourse debt would generally not be reflected in NUBIG/NUBIL unless and until it is RBIG/RBIL, at which time there is a retroactive adjustment to the NUBIG/NUBIL calculation. The total amount of the recourse debt adjustment would be limited to (1) the debt discharged in the proceeding, in the case of a bankruptcy, and (2) the excess of the issue price of the debt over the FMV of assets (excluding assets that secure nonrecourse debt) in other cases.

For RBIG/RBIL, COD income recognized during the first year after the ownership change would be RBIG to the extent it is includible COD or excludable COD and reduces post-change attributes or basis in assets not held as of the ownership change. If excluded COD reduces basis in assets held immediately before the ownership change, that asset basis reduction would be retroactively taken into account in NUBIG/NUBIL and could become RBIG upon disposition of the asset during the recognition period.

Contingent liabilities: The proposed regulations would modify the treatment of contingent liabilities under the 1374 approach. Under the 1374 approach in Notice 2003-65, the estimated value of contingent liabilities (as of the change date) is included in NUBIG/NUBIL calculations but is not treated as RBIL. Under the proposed regulations, any deductible contingent liabilities would be treated as RBIL for the amount paid or accrued during the recognition period, to the extent of the estimated value of those liabilities on the change date.

Consolidated group rules

The proposed regulations would apply the principles of Regs. Sec. 1.1502-76(b) in determining NUBIG/NUBIL if a loss corporation enters or leaves a consolidated group on the date of an ownership change for purposes of Sec. 382. Under the proposed regulations, items that are includible, under Regs. Sec. 1.1502-76(b)(1)(ii)(A)'s end-of-day rule, in the tax year that ends due to a loss corporation's change in status would not be treated as recognized or taken into account during the recognition period for purposes of Sec. 382 and its regulations. Moreover, no such item is included in the determination of NUBIG/NUBIL.

Further, the determination of NUBIG/NUBIL would exclude the FMV and basis of any asset that is disposed of on the change date if the gain or loss from that asset were includible in the tax year that ends due to the loss corporation's change in status. In contrast, items that are includible, under Regs. Sec. 1.1502-76(b)(1)(ii)(B)'s next-day rule, in the tax year that begins as a result of a loss corporation's change in status would be treated as occurring in the recognition period, and those items (and the basis and FMV of any assets that generate those items) are among the amounts included in the determination of NUBIG/NUBIL.

International tax-related rules

In the international context, the proposed regulations also provide that dividends (including deemed dividends under Sec. 1248) and global intangible low-taxed income under Sec. 951A do not constitute RBIG.

Under the proposed regulations, gain recognized on the disposition of stock generally would be treated as RBIG. The preamble, however, notes that the deemed Sec. 1248 dividend generally gives rise to a deduction under Sec. 245A (i.e., a dividend-received deduction, or DRD), with no net income being generated. Therefore, the proposed regulations provide that the gain taxable as a dividend under Sec. 1248 should not give rise to RBIG. However, dividends and deemed dividends would not be RBIG even if the Sec. 245A DRD were not available, creating actual taxable income that is not available to unlock prechange losses.

The proposed regulations would apply to any ownership change occurring after the final regulations are published. Taxpayers may continue following the approaches in Notice 2003-65 until the proposed regulations are finalized.


If finalized in their current form, these proposed regulations would significantly change current practice for utilizing built-in gains or losses that are subject to the Sec. 382 limitation. The proposed approach would generally offer less-taxpayer-favorable determinations of RBIG, because the 338 approach — proposed to be eliminated — is favored by corporations with built-in gains, given their ability to treat forgone depreciation and amortization as RBIG, notwithstanding the lack of an actual item of income or gain.

In addition, the proposed changes with respect to the COD income would likely change the status of many loss corporations from a NUBIG to a NUBIL position. Unlike the approach taken by Notice 2003-65, built-in COD income on recourse debt would now only be reflected in NUBIG/NUBIL to the extent income from the cancellation of debt is ultimately recognized. In addition, the treatment of contingent liabilities as RBIL would also significantly expand the treatment of items that constitute RBIL.

For multinational U.S. groups, the proposed regulations would deny RBIG treatment for all dividends from a CFC, regardless of whether a DRD is claimed for that dividend under Sec. 245A (the proposed rule would apply to all dividends under Sec. 61(a)(7), not just to dividends from CFCs). But the proposed regulations do not address other issues relating to the ownership of CFCs, in which built-in income inside a CFC owned by the loss corporation is not reflected in NUBIG or RBIG, because the asset of the loss corporation is the CFC stock, not the CFC's assets.

Finally, consolidated return groups should keep in mind that Treasury is considering changes to the end-of-day rule and next-day rule of Regs. Sec. 1.1502-76(b). Taxpayers will need to evaluate those changes, when published, in conjunction with these proposed regulations to evaluate the treatment of loss corporations. Treasury had issued proposed changes to the end-of-day rule and next-day rule of Regs. Sec. 1.1502-76(b) in part to address a perceived abuse — taxpayers applying the next-day rule purportedly to avoid Sec. 382. The proposed Sec. 382(h) regulations appear to address Treasury's concern in this regard by treating the items to which the next-day rule applies as RBIG/RBIL.


Susan Minasian Grais, CPA, J.D., LL.M., is a managing director at Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact Ms. Grais at 202-327-8788 or

Contributors are members of or associated with Ernst & Young LLP. Versions of many of these items were previously published as Ernst & Young Tax Alerts.

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