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Focus on Taxation: Changes to Section 382 of the Internal Revenue Code

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The IRS recently published proposed regulations that would further reduce a corporation’s already-limited ability to utilize its net operating loss (NOL), credits and interest expense carryforwards after an ownership change.
October 7, 2019

The IRS recently published proposed regulations that would further reduce a corporation’s already-limited ability to utilize its net operating loss (NOL), credits and interest expense carryforwards after an ownership change. If adopted as final regulations, the rule change would have adverse consequences on many M&A transactions.

Section 382 of the Internal Revenue Code imposes a value-based limitation on a corporation’s use of its NOLs and other carryforwards if, during a three-year period, there is more than a 50% increase in the ownership of the corporation among one or more “5% shareholders.” In its simplest form, Section 382 prevents a corporation from trafficking in NOLs. To illustrate, assume X Co. purchases all of the stock of Y Co. from B for $1 million at a time when Y Co. has NOL carryforward of $10 million. On the date of the acquisition, X Co. becomes a 5% shareholder, and its ownership of Y Co. immediately increases from 0 to 100%. As a result, Y Co. has undergone an ownership shift, and thus X Co.’s ability to utilize the NOL of Y Co. is limited. In general, the limitation is based on the value of the Y Co. stock ($1 million in this example), multiplied by the long-term tax-exempt rate in place at that time. If that rate were 5%, for each year post acquisition, X Co. would generally be permitted to utilize only $50,000 of Y Co.’s NOL.

X Co.’s ability to utilize Y Co.’s NOL, however, may be increased by any “recognized built-in gain” within five years of the acquisition. Recognized built-in gains are those gains that were attributable to appreciation occurring in Y Co. prior to the acquisition, but that are triggered after the transaction. For example, if Y Co. were to sell an asset immediately after its acquisition by X Co. for a gain of $20,000, this $20,000 would increase X Co.’s Section 382 limitation for the year from $50,000 to $70,000.

For the past 15 years, following an ownership change a corporation could generate recognized built-in gain, and thus increase its annual Section 382 limitation, even in the absence of a formal disposal of its assets. Notice 2003-65 allows the target corporation to determine the unrealized gain inherit in all of its assets on the change date before then computing the hypothetical depreciation and amortization expense attributable to the fair market values of those assets, with a portion of those depreciation and amortization amounts representing “recognized built-in gain” for a period of five years, buoying the corporation’s ability to utilize its NOLs post-change.

Proposed regulations issued on September 10, 2019, however, would no longer allow for such a computation. This is not the only adverse change to be found under the proposed regulations, but it is the most significant. Taxpayers that are undergoing M&A activities as either an acquirer or target should reach out to our tax professionals at RubinBrown to ensure that the proposed regulations are properly considered as part of the deal. We are available to quantify the impact of the regulations on the ability of a target corporation to utilize its NOLs, credit and interest expense carryforwards after an ownership change, and to help both buyer and seller understand the ramifications of Section 382.


 

Readers should not act upon information presented without individual professional consultation.

Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.

 

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