Corporations with net operating losses (NOLs) and other tax attributes need to be cognizant of the limitations imposed by Sections 382 on the use of their attributes when an ownership change occurs. For purposes of Section 382, an ownership change occurs when there’s a purchase, sale, or equity structure shift (e.g., certain reorganizations), and the ownership of one or more 5-percent shareholders has increased by more than 50 percentage points during a three-year testing period.
Section 382 places an annual limitation on the amount of pre-change losses that can be used to offset taxable income in post-change years. The limitation is generally calculated as the fair market value of the corporation immediately before the ownership change multiplied by the long-term tax-exempt rate. If the annual Section 382 limitation is not entirely absorbed in a post-change year, the excess limitation amount is carried forward and will increase the Section 382 limitation for the next post-change year. It is also important to note that Section 382 contains a ‘continuity of business enterprise’ requirement. As defined in Section 382(c)(1), if the new corporation does not continue the business enterprise of the old corporation at all times during the two years beginning on the change date, the Section 382 limitation for any post-change year will be zero, with the exception for certain gains.
Regulation Section 1.383-1(d) contains ordering rules for the utilization of pre-change tax attributes for the absorption of the Section 382 limitation. If a corporation has multiple tax attribute carryovers, the amount of the annual Section 382 limitation is absorbed in the following order:
- Built-in capital losses recognized during the post-change year
- Pre-change capital loss carryovers into the year
- Built-in ordinary losses recognized during the post-change year
- Disallowed business interest expense
- Pre-change NOL carryovers into the year
- Pre-change foreign tax credit carryovers
- Pre-change general business credit carryovers
- Pre-change minimum tax credit carryovers
Impact of TCJA on Section 382
Section 163(j) as enacted under the Tax Cuts and Jobs Act of 2017, P.L. 115-97 (TCJA) limits the deductibility of business interest expense to the sum of (i) the taxpayer’s business interest income for the tax year; (ii) 30% of the taxpayer’s adjusted taxable income for the tax year; and (iii) the taxpayer’s floor plan financing interest expense. Any business interest expense not allowed to be deducted in the year incurred can be carried forward and deducted as a business interest expense in future years. This provision has, in effect, broadened the scope of Section 382 because a business interest expense carryforward is subject to the Section 382 limitation. As a result, corporations that have historically had taxable income will now also need to consider the applicability of Section 382.
Built-in Gains and Losses
Corporations subject to the Section 382 limitation might be required to adjust the base Section 382 limitation amount if they have certain pre-change net unrealized built-in gains (NUBIG) or net unrealized built-in losses (NUBIL). As provided in Section 382(h), if the corporation has a NUBIG at the time of the ownership change, a recognized built-in gain (RBIG) within five years of the ownership change will be fully offset by pre-change NOLs without consideration of the Section 382 limitation. Conversely, if the corporation has a NUBIL at the time of the ownership change, a recognized built-in loss (RBIL) within five years of the ownership change is also subject to the Section 382 limitation. The treatment of RBIG and RBIL is consistent with the notion that if built-in gains were recognized prior to the ownership change, they would have been offset by NOLs without a limitation. Similarly, if built-in losses had been recognized prior to the ownership change, they would have been part of the NOL carryover to post-change years. Section 382(h) also provides a de minimis threshold for the recognition of NUBIG or NUBIL. If the amount of the NUBIG or NUBIL does not exceed the lesser of $10 million or 15 percent of the corporation’s assets prior to the ownership change, then the corporation’s NUBIG or NUBIL is considered to be zero.
As provided within Notice 2003-65, there are two methods for calculating NUBIG and NUBIL – the section 1374 method and the Section 338 method. The Section 1374 method, which is considered as the favorable method for corporations with a NUBIL, generally only considers items that were accrued prior to the ownership change and recognized within the five-year recognition period. The Section 338 method, which is considered as the more favorable method for corporations with a NUBIG, compares items of income or loss recognized during the five-year recognition period with those that would have been recognized had the corporation made a Section 338 election.
On September 9, 2019, proposed regulations were issued under Section 382(h) that would eliminate the Section 338 approach and mandate the use of the Section 1374 approach for the calculation of built-in gains and losses. The proposed regulations address several other aspects of the calculation of the Section 382 limitation, including further guidance on the NUBIG/NUGIL calculation, treatment of cancellation of debt income, and others. Although taxpayers may rely on the proposed regulations if certain requirements are met, they are not considered effective until after the date final regulations are published.
Interaction of Section 382 with Financial Accounting
For financial reporting purposes under GAAP and SAP, corporations are required to record a deferred tax asset for their NOL carryforwards. When there’s a limitation on the use of NOLs and other tax attributes, management needs to make a determination of whether the NOLs are more likely than not to be realized prior to expiration and whether a valuation allowance is necessary. The TCJA changed the carryback and carryforward rules for NOLs. NOLs generated after December 31, 2017, by corporations other than property and casualty insurance companies have an indefinite carryover period, and no carryback is allowed. The indefinite carryforward period alleviates the tension on the realizability of NOLs generated after December 31, 2017; however, corporations will still need to make a valuation allowance assessment for NOLs generated under pre-TCJA law. The NOL carryforward and carryback rules for property and casualty insurance companies remain unchanged, whereby NOLs may be carried forward 20 years and carried back 20 years.
Section 382 has various nuances that need to be considered in the event of an ownership change. Determining whether an ownership change has occurred and calculating the Section 382 limitation will have implications on the company’s financial statements, tax returns, as well as transaction pricing with respect to a merger or acquisition.