Issues in allocating income under Sec. 384

Editor: Greg A. Fairbanks, J.D., LL.M.

Sec. 384 (limitation on use of preacquisition losses to offset built-in gains) was enacted in 1987 by the Omnibus Budget Reconciliation Act, P.L. 100-203, but despite its being in the Code for over 35 years, Treasury and the IRS have not promulgated any regulations for it. Although the IRS has addressed several issues in the application of Sec. 384 with letter rulings and other guidance, the Service has yet to come out with comprehensive regulations and, thus, has yet to address several issues with its application.

One issue that has not been formally addressed is how total taxable income of a corporation is allocated to recognized built-in gain (RBIG) on property that it acquired that is subject to Sec. 384, when it has other income or loss from other properties. Additionally, the IRS has yet to address the application of Sec. 384 when there is a sale of multiple properties with RBIG that are subject to different Sec. 384 limits.

Sec. 384 basic interpretation

Sec. 384 generally limits the use of preacquisition net operating losses (NOLs) of a corporation to offset gain recognized on property that the corporation acquired with a built-in gain. Sec. 384(a) provides that if a corporation acquires directly (or through one or more other corporations) control of another corporation, or if the assets of a corporation are acquired by another corporation in a reorganization under Sec. 368(a)(1)(A), (C), or (D), and either of the corporations is a “gain corporation,” income for any recognition period tax year, to the extent attributable to RBIG, is not offset by any preacquisition loss (other than a preacquisition loss of the gain corporation). Under Sec. 384(c)(3), a preacquisition loss includes any NOL carryforward to the tax year in which the acquisition date occurs, any NOL for that year to the extent the loss is allocable to the period in that year on or before the acquisition date, and any recognized built-in loss (RBIL).

Under Sec. 384(c)(4), a gain corporation is any corporation with a net unrealized builtin gain (NUBIG). In general, a corporation has a NUBIG if the fair market value (FMV) of its assets immediately before the acquisition date exceeds their aggregate adjusted bases. Under Sec. 384(c)(1)(A) an RBIG is any gain recognized during the recognition period on the disposition of any asset, except to the extent the gain corporation establishes that (1) the asset was not held by the gain corporation on the acquisition date, or (2) the gain exceeds the excess, if any, of the FMV of the asset on the acquisition date over its adjusted basis on that date.

The following example illustrates the application of Sec. 384 to a simple fact pattern:

Example 1: On Dec. 31, 2021, Corp A and Corp B each have NOLs of $25 million. Also on Dec. 31, 2021, Corp B merges into Corp A in a transaction that qualifies as a tax-free reorganization under Sec. 368(a)(1)(A). On Dec. 31, 2021, immediately before the merger, Corp B had property with an FMV of $100 million and a basis of $50 million (Property 1). In the tax year ending Dec. 31, 2022, the combined corporation sold Property 1 for $100 million, for a gain of $50 million. In the same tax year, the combined corporation had total income, including the gain from sale of Property 1, of $50 million (this example assumes that no Sec. 382 limit applies to the use of any of the NOLs).

Under Sec. 384, the combined corporation is not permitted to use preacquisition losses of Corp A to offset the gain from the sale of Property 1 to the extent that the gain was attributable to RBIG. Since the entire $50 million of gain was attributable to RBIG, the corporation is not permitted to use preacquisition losses except those from Corp B. Therefore, the combined corporation is not permitted to use the $25 million of NOLs from Corp A but is permitted to use the $25 million of NOLs that were acquired from Corp B. Thus, the corporation recognizes $25 million of gain in the tax year ended Dec. 31, 2022.

Complications interpreting ‘attributable to recognized built-in gains’

Although the most basic applications of Sec. 384 can be straightforward, what income “attributable to recognized built-in gains” means can be difficult to apply in more complicated fact patterns. The following example illustrates one of the difficulties in interpreting Sec. 384(a) when gain on the built-in gain property exceeds total income of the corporation during the year and some of the gain on the sale of the property is attributable to postacquisition appreciation:

Example 2: On Dec. 31, 2021, Corp C and Corp D each have NOLs of $25 million. On the same date, Corp D merges into Corp C in a transaction that qualifies as a tax-free reorganization under Sec. 368(a)(1)(A). At the time of the transaction, Corp C had one asset with an FMV of $100 million and basis of $100 million (Property 2), and Corp D had one asset with an FMV of $100 million, and a basis of $0 (Property 3). During the tax year ended Dec. 31, 2022, the new combined corporation sells Property 2 for $10 million, recognizing a loss of $90 million, and Property 3 for $150 million, recognizing a gain of $150 million. The combined corporation had $0 net income and loss in the year other than the sale of the properties so that the combined corporation had $60 million of gain in the year (this example assumes that no Sec. 382 limit applies to the use of any of the NOLs).

Sec. 384 provides that the gain (to the extent attributable to RBIG) is not offset by any preacquisition loss other than the preacquisition loss of the gain corporation (i.e., the corporation that held the built-in gain property). There was a $150 million gain on the sale of Property 3 but only a $60 million total gain in the tax year from the combined corporation that can be offset by NOLs. An issue of interpretation arises in determining whether the $60 million of income is “attributable to” the RBIG of Property 3. One interpretation would be that since there was $100 million of RBIG on the sale of Property 3, then all income of the combined corporation up to $100 million is attributable to the RBIG. Under this interpretation, the combined corporation would not be permitted to use any Corp C NOLs to offset the $60 million of income; therefore, only the $25 million of Corp D NOLs are permitted to be used, and the combined corporation must recognize $35 million of income.

A second interpretation could be that since $50 million of gain was attributable to post-acquisition appreciation, then $50 million of the total $60 million of income is not attributable to RBIG of Property 3. Therefore, the combined corporation would not be limited under Sec. 384 from using any of its NOLs, thus recognizing only $10 million of gain.

A third interpretation is that, of the $150 million of gain on the sale of Property 3, $100 million was attributable to RBIG and $50 million was attributable to post-acquisition appreciation so that two-thirds of the $60 million of net income ($40 million) was attributable to RBIG and onethird of the $60 million ($20 million) was attributable to post-acquisition appreciation. Therefore, the combined corporation would be permitted to use up to $20 million of Corp C’s NOLs (and the entire $25 million of Corp D’s NOLs). Thus, the combined corporation would recognize $15 million of income in the tax year ended Dec. 31, 2022.

The IRS has not indicated whether post-acquisition appreciation on the built-in gain property that is subject to Sec. 384 should be considered when determining the amount of income “attributable to” RBIG and whether it is appropriate to allocate some of the corporation’s income to that postacquisition appreciation. One commentor has briefly discussed a related issue regarding what it means to be “attributable to RBIG” in the context of RBIG triggered by a consolidated group member, where different members of the group generate income and loss.

While it does not directly relate to the issue of post-acquisition appreciation, and the example is in the context of the consolidated return rules, the commenter appears to interpret the Sec. 384 rules to require a proration of losses from another subsidiary in the group between the income that was “attributable to RBIG” and the rest of the income of the group (see the example in Dubroff, Federal Income Taxation of Corporations Filing Consolidated Returns (Matthew Bender, 2d ed.), in Chapter 42.06[1], where P is the parent of a consolidated group that includes S1, S2, and T, where S1 had $100 of income, S2 had a $100 loss, T had $100 of income attributable to RBIG, and Sec. 384 treats only $50 of the $100 net income of the consolidated group as being attributable to the RBIG of T).

Complications with multiple Sec. 384 limitations

Example 2 simply illustrates one issue that arises in interpreting “to the extent attributable to recognized built-in gain,” that of post-acquisition appreciation on the built-in gain property. Another issue arises when two separate Sec. 384 limits apply to different assets sold in the same tax year. See the following example:

Example 3: On Dec. 31, 2020, Corp E has $50 million of NOLs, and Corp F has $10 million of NOLs. On Dec. 31, 2020, Corp F merges into Corp E in a transaction that qualifies as a tax-free reorganization under Sec. 368(a)(1)(A). At the time of the transaction, Corp E had one asset with an FMV of $100 million and a basis of $0 (Property 4), and Corp F had one asset with an FMV of $150 million and a basis of $0 (Property 5). On Jan. 1, 2021, the combined corporation purchased a piece of property for $500 million in a taxable transaction, so that the property is acquired with $500 million of basis (Property 6). During the tax year ending Dec. 31, 2022, the new combined corporation sells both Property 4 and Property 5 for $250 million each and sells Property 6 for $50 million. Thus, the combined corporation recognizes gain on the sale of Property 4 of $250 million, gain on the sale of Property 5 of $250 million, and loss on the sale of Property 6 of $450 million. Therefore, the combined corporation has combined net income of $50 million for the tax year ended Dec. 31, 2022 (this example assumes that no Sec. 382 limit applies to the use of any of the NOLs).

In Example 3, the corporation recognized a $250 million gain on Property 4, $100 million of which was attributable to RBIG; a $250 million gain on Property 5, $150 million of which was attributable to RBIG; and a $450 million loss on Property 6, for total net income of $50 million for the tax year ending Dec. 31, 2022. This scenario seems to offer three potential interpretations of Sec. 384.

First, since there was $100 million of RBIG on Property 4 and only $50 million total income to offset with NOLs, there is an interpretation of Sec. 384 that the entire $50 million is attributable to the RBIG of Property 4, and, therefore, no preacquisition NOLs from Corp F could be used. In addition, the same interpretation would apply to the Sec. 384 limit on Property 5. Since there was $150 million of RBIG from Property 5, there is an interpretation of Sec. 384 that the entire $50 million of income is attributable to the RBIG of Property 5, and, therefore, no NOLs from Corp E could be used. Together, if interpreted this way, the two separate Sec. 384 limits, arguably, prevent the use of any of the combined corporation’s preacquisition NOLs so that the corporation would have to recognize the entire $50 million of gain. This interpretation appears inconsistent with the purpose of Sec. 384.

A second interpretation of Sec. 384 would be to prorate the income between the RBIG of Property 4 and Property 5. Since there was $100 million of RBIG on Property 4 and $150 million of RBIG on Property 5, this interpretation would treat $20 million of the total income as attributable to Property 4 RBIG, which cannot be offset by Corp F’s preacquisition NOLs, and $30 million of the income as attributable to Property 5 RBIG, which cannot be offset using Corp E’s preacquisition NOLs. Thus, the corporation would use $20 million of Corp E’s NOLs and the entire $10 million of Corp F’s NOLs, recognizing $20 million of income in the tax year ended Dec. 31, 2022.

A third interpretation of Sec. 384 is to prorate the net $50 million of gain between the RBIG of Property 4 and Property 5 and the post-transaction appreciation of both properties. Under this interpretation, there was $500 million of total gain on Property 4 and Property 5 — $100 million (20%) attributable to the RBIG of Property 4, $150 million (30%) attributable to post-transaction appreciation of Property 4, $150 million (30%) attributable to RBIG of Property 5, and $100 million (20%) attributable to posttransaction appreciation of Property 5. Under this interpretation, of the $50 million of income, $10 million is attributable to the RBIG of Property 4, $15 million is attributable to the RBIG of Property 5, and $25 million is attributable to post-transaction appreciation of Property 4 and Property 5.

Thus, Sec. 384 would work to prevent $10 million of the income from being offset using Corp F’s NOLs (only permitted to use Corp E’s NOLs to offset), $15 million from being offset by Corp E’s NOLs (only permitted to use Corp F’s NOLs to offset), and $25 million that can be offset by using either set of NOLs (in which case normal NOL ordering rules would apply). Therefore, since the corporation only has $10 million of Corp F’s NOLs and $15 million of income attributable to the RBIG of Property 5 (so that it can only be offset using Corp F’s preacquisition NOLs), $5 million of the net income cannot be offset using any NOLs. The corporation would then use all of Corp F’s preacquisition NOLs (to offset $10 million of the $15 million of income attributable to RBIG of Property 5) , and $35 million of Corp E’s preacquisition NOLs (offsetting the entire $10 million of income attributable to RBIG of Property 4 and the $25 million attributable to post-acquisition appreciation).

Therefore, the combined corporation would still recognize $5 million of income in the tax year ended Dec. 31, 2022, because there were insufficient Corp F NOLs to offset the entire $15 million of income that was attributable to the RBIG of Property 5. However, since some of the income was treated as attributable to post-acquisition appreciation, this interpretation still permits a greater use of preacquisition NOLs than the second interpretation.

While Sec. 384 has been in the Code for over 35 years, significant guidance is still needed in interpreting the provision. The IRS has addressed several specific issues in the application of Sec. 384 (see Letter Ruling 201806005, Technical Advice Memorandum 200447037, and Notice 90-27) but has yet to address one of the more fundamental issues: What does “to the extent attributable to recognized built-in gains” mean in the application of the Sec. 384 limit? As discussed above, there appear to be several logical interpretations of this phrase, and guidance from the IRS would be helpful to address what it means to be “attributable to RBIG” and the application of Sec. 384 when multiple Sec. 384 limits apply in the same tax year.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. Contributors are members of or associated with Grant Thornton LLP. For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.