When a significant number of tax groups and businesses comment on regulations, the IRS appears to listen. Six months ago, the IRS proposed regulations on computing built-in gains and losses for the Sec. 382 loss limitation that applies after a change in corporate ownership. After receiving comments from organizations such as the AICPA, the American Bar Association Tax Section and the American Investment Council, the IRS issued new proposed regulations that withdraw some of the earlier rules, delay the effective date and provide transition relief for pending transactions.
The comments expressed concern that the effective date would impose a significant burden on taxpayers due to the uncertainty about when transactions will close and when the proposed regulations would be finalized. Taxpayers and practitioners also noted that transition relief for binding agreements would be inadequate, because pending transactions regularly are modified or delayed prior to closing.
The IRS addressed these concerns in the new regulations, as described below.
Sec. 382 Loss Limitation Basics
To understand the changes, it is important to review how the Sec. 382 loss limitation works. To limit corporate takeovers done solely to acquire losses, Congress enacted Sec. 382, which limits a corporation from using net operating losses after an “ownership change.” An ownership change occurs if, immediately after any owner shift or any equity structure shift, there is a 50% increase in ownership by 5% shareholders during a three-year period.
How the Limitation is Calculated
When there is an ownership change, the amount of the loss limitation depends on whether the loss corporation has built-in gains or losses. If a loss corporation has net unrealized built-in gains immediately before an ownership change, the Sec. 382 limitation is increased. If the loss corporation has a net unrealized built-in loss immediately before an ownership change, any built-in loss recognized within five years after the ownership change date is subject to the loss limitation.
The limit on loss deductions is calculated for any post-ownership change year as the fair market value of the loss corporation immediately before the ownership change multiplied by the applicable long-term tax-exempt rate set by the IRS. For example, if a loss corporation has a value of $1,000,000 and the tax-exempt rate is 5.78%, the loss limitation would be $57,800.
Proposed Regulations: Effective Date Later than Adoption Date
The proposed regulations establish one method of determining net built-in gains and losses and recognized built-in gains and losses. These numbers affect both the net-operating loss limitation and the disallowed business interest expense under Code Sec. 163. The earlier regulations would have applied to ownership changes that occurred after the date the proposed rules were adopted as final. The new proposed regulations delay the applicability date of the rules until 30 days after the proposed rules are finalized.
The new rules also include transition relief for some transactions that are in progress before the delayed effective date. The final regulations will not apply to ownership changes that occur:
- Under a binding agreement in effect on or before the delayed applicability date and at all times thereafter;
- Pursuant to a specific transaction described in a public announcement made on or before the delayed applicability date;
- Pursuant to a specific transaction described in a filing with the Securities and Exchange Commission submitted on or before the delayed applicability date;
- By order of a court in a Title 11 or similar case bankruptcy case if the taxpayer was a debtor in the case on or before the delayed applicability date; or
- Pursuant to a transaction described in a private letter ruling request submitted to the IRS on or before the delayed applicability date.
The new regulations give corporations advance notice and some time to comply with the revised computation of built-in gains and losses. The rules also eliminate the possible duplicative application of Sec. 382 to some disallowed business interest expense carryforwards. Finally, the changes made by the IRS should cause less disruption in negotiations and transactions that are underway when the proposed rules become final.