BIGs and items of income under sec. 382.

The special rules for built-in gains (BIGs) under Sec. 382(h) must be considered when advising a corporation with net operating loss (NOL) carryovers that has experienced an ownership change within the meaning of Sec. 382. These rules apply when such a corporation has substantially appreciated assets or substantial accrued, but not yet recognized, income.

While the general rule for BIGs under Sec. 382(h) is relatively straightforward, the scope of the "item of income" in Sec. 382(h)(6)(A), added by Congress in 1988, remains unclear; little guidance is available beyond vague statutory language and the legislative history. The IRS has not issued regulations explaining BIGs or items of income for Sec. 382 purposes, nor are any being developed actively (according to informal discussions with the Service). However, several rulings provide guidance on the meaning of "item of income" under Sec. 382, including two noteworthy administrative releases last year. Note: There are parallel rules to the item of income and BIG rules that deal with built-in losses and deduction items. These equally important rules, which apply if a corperation has depreciated assets or significant accrued but unclaimed deductions at the time of an ownership change, are not addressed herein.

Statutory Overview

The purpose of Sec. 382 is to thwart "trafficking" of NOLs. The statute is based on the principle that tax-beneficial items should be a neutral factor in the decision to acquire a corporation with NOLs.

In general, Sec. 382 is triggered (i.e., an ownership change occurs) when more than 50% of a corporation with NOLs changes hands during a three-year period. Once this happens, Sec. 382 limits the amount of the loss corporation's taxable income for any subsequent year that can be offset by NOLs generated prior to the ownership change. The annual limit is the corporation's total equity value multiplied by a long-term tax-exempt rate published quarterly by the IRS. Thus, the Sec. 382 limit denies any incremental NOL benefit to new owners that did not bear the economic burden of the losses.

NUBIGs and RBIGs

Sometimes, an upward adjustment to the annual Sec. 382 limit is allowed for BIGs. If a corporation with NOLs has a net unrealized built-in gain (NUBIG) above a certain threshold and has an ownership change, it may increase its Sec. 382 limit for the five-year period after the ownership change to the extent of recognized built-in gain (RBIG).

NUBIG is the amount by which the fair market value (FMV) of the assets of a corporation with NOLs exceeds such assets' adjusted basis immediately before the ownership change. The rules do not apply unless the NUBIG exceeds the lesser of (1) 15% of the gross value of the corporation's assets other than cash or cash equivalents or (2) $10 million. RBIG is "any gain recognized during the [five-year] recognition period on the disposition of any asset," as long as the asset was held by the loss corporation before the ownership change. (Emphasis added.) The RBIG amount is limited to the excess of the FMV over the asset's basis on the change date.

Sec. 382, as substantially amended in 1986, limited an RBIG to situations in which there had been a post-ownership-change asset disposition. The rule was expanded in 1988 to include "any item of income which is properly taken into account during the recognition period but which is attributable to periods before the change date." RBIG treatment for income items (as well as parallel treatment for deductions treated as built-in loss items) is consistent with the neutrality principle and the notion that the Sec. 382 limit should only limit use of pre-change tax benefits to offset post-ownership-change earnings. The legislative history of Sec. 382(h)(6)(A) lists the following nonexelusive examples of income items: (1) post-ownership-change collections of pre-change receivables recognized by a cash-basis taxpayer, (2) post-ownership-change completion of a longterm contract by a taxpayer on the completed contract method of accounting and (3) pre-ownership-change income recognized after the change as a result of a Sec. 481 adjustment.

The Service has considered Sec. 382(h)(6)(A) in a variety of contexts to provide further guidance as to what constitutes an income item.

COD Income

The IRs has issued several letter rulings concluding that cancellation of debt (COD) income may be treated as RBIG under Sec. 382(h)(6)(A); see Letter Rulings 9328021, 9226026 and 9291040. The rulings generally provide that any COD income recognized after the date of an ownership change for debt discharged in connection with such change is treated as an income item attributable to the pre-change period under Sec. 382(h)(6)(A), and, therefore, as RBIG (assuming the threshold NUBIG is satisfied). Unfortunately, these letter rulings do not address whether COD income excluded under Sec. 108 (used or not used to reduce attributes) would be treated as RBIG.

These letter rulings shed some light on the Service's thinking. The IRs seems to have adopted a broad interpretation of when an income item is "attributable to" the prechange period by including income economically accrued before an ownership change. These rulings also offer guidance on how an income item that qualifies as RBIG is added to the overall NUBIG before application of the threshold calculation (as required by Sec. 382(h)(6)(C)).

Foreign-Source Dividends

Another category of income that arguably should qualify as an income item under Sec. 382(h)(6)(A) is post-ownership-change foreign-source dividends paid to a corporation with NOLs from a controlled foreign corporation (CFC) out of earnings shown to be generated before an ownership change.

Example: L, a corporation with NOLs, owns stock in a CFC, F, which has a large BIG with respect to its assets and substantial earnings and profits that have never been repatriated or subject to U.S. tax. L's ownership of F with built-in appreciation, combined with L's other assets, exceed the NUBIG threshold limit. Therefore, the appreciation in the F stock constitutes a BIG, and gain from the sale of such stock subsequent to the ownership change constitutes RBIG. If, instead, F were to sell all its assets and distribute the proceeds in a dividend, the transaction would be economically equivalent to a stock sale, and the dividend, arguably, should be treated as an item of income attributable to a pre-ownership change period under Sec. 382(h)(6)(A).

Unfortunately, the Service has cast some doubt on this position. In Letter Ruling 9122067, it stated that if a CFC's stock were sold, the resulting gain would be treated as RBIG, including any portion of income treated as a dividend under Sec. 1248. However, the Service also ruled that, if the CFC sold its assets and liquidated, the income (including gain recharacterized as a dividend under Sec. 1248) could be treated as BIG only if the shareholder elected not to include the "all earnings and profits amount" in gross income; the income would be treated as a BIG only if the liquidation was governed by Sec. 331 (which gives rise to the gain from the sale or exchange of the CFC's stock). This suggests that the foreign-source dividends would not be considered income "attributable to" prechange periods, even if clearly paid out of pre-change earnings.

Prepaid Service Income

In Letter Ruling (TAM) 9942003, the IRS ruled that service income earned and recognized after an ownership change (but prepaid before the ownership change) would not be treated as RBIG under Sec. 382(h)(6)(A).

The taxpayer in the TAM had received payment for services from customers before providing the services. The taxpayer elected to defer taxable income for such prepaid service income under Rev. Proc. 71-21, which allows accrual-basis taxpayers to defer reporting receipts as income until the services are performed. After receipt of the prepayments, the taxpayer experienced an ownership change under Sec. 382, and the prepaid amounts were reported as income on the return for the tax period immediately following the change date. The taxpayer also had a NUBIG that exceeded the threshold. In this case, however, the Service determined that the income would not constitute RBIG under Sec. 382(h)(b)(A) merely because the payments were received by the corporation with the NOLs before the ownership change.

In contrast to its unduly restrictive view of foreign-source dividends, it is difficult to criticize the IRS's rationale for denying RBIG treatment under Sec. 382(h)(6)(A), given Letter Ruling (TAM) 9942003. The conclusion in the TAM seems consistent with the economic accrual theory; the income item was not earned by the taxpayer or accrued in any economic sense before the ownership change.

Software Licensing Income

In Field Service Advice (FSA) 1998-415, the Service indicated that software licensing fees collected after an ownership change could be treated as an income item under Sec. 382(h)(6)(A). In the FSA, a corporation with NOLs resulting from software development costs experienced an ownership change when it was acquired in a tax-free reorganization. The IRS determined that software licensing income recognized after the ownership change could be treated as RBIG, even though such income could not be treated as a disposition of an asset under Sec. 382(h)(2). It based its analysis on the legislative history of Sec. 382(h)(6)(A) and the "flip side" treatment of depreciation as recognized built-in loss under Sec. 382(h)(2), so that a "reasonable argument" could be made for treating post-ownership-change software licensing income as RBIG.

In FSA 1998-415, the Service recommended not to challenge the taxpayer's position. Although the FSA is not precedent, the IRS National Office analysis provides some support for arguing that post-ownership-change income streams from identifiable, intangible assets may be treated as income items attributable to the preownership-change period within the meaning of Sec. 382(h)(6)(A).

Conclusion

Until regulations are published, uncertainty surrounding the definition of an income item under Sec. 382(h)(6)(A) may allow tax planning that may lead to an increase in a Sec. 382 limit. The statutory language and legislative history suggest an expansive view, which the Service has adopted in some circumstances; however, the IRS has not always been consistent, especially as to the treatment of foreign-source dividends after an ownership change. Finally, in addition to Sec. 382, a host of other rules should be considered for NOL limits, including Secs. 269 and 384 and the separate return limitation year rules. Although treating post-ownership-change income as an income item (and, therefore, an RBIG) can be beneficial under Sec. 382, this could have a negative effect in a different context (e.g., under Sec. 384).

FROM RICHARD F. MCMANUS, J.D., LL. M., WASHINGTON, DC

Robert Zarzar, CPA
Partner
Washington National Tax Services
PricewaterhouseCoopers
Washington, DC