Issues and pitfalls in Sec. 384 - limits on NOL use.

The Code includes numerous provisions that limit a taxpayer's ability to use net operating losses (NOLs) (e.g., Sees. 269,382 and 384 (as well as the consolidated return separate return limitation year rules)), each of which was enacted to prevent a perceived abuse. For example, Sec. 269 disallows tax benefits from certain transactions when tax avoidance is the principal purpose; Sec. 382 prevents taxpayers from trafficking in loss corporations.

Sec. 384 generally applies to transactions that combine a loss corporation with a gain corporation that has built-in gain (BIG) assets. Originally enacted in 1987, it restricts a taxpayer's ability to offset certain recognized BIGs (RBIGs) of the gain corporation with a loss corporation's pre-acquisition NOLs. Its effect may be significant and should not be overlooked.

Sec. 384 Mechanics

Several requirements must be met for Sec. 384 to apply. First, under Sec. 384(a)(1), one corporation must acquire either (1) "control" of another corporation or (2) the assets in an A, a C or a D reorganization. Sec. 384(c) (5) states that the Sec. 1504(a)(2) definition of control applies (i.e., 80% of vote and value). Next, at least one of the corporations must be a "gain corporation" (i.e., it must have a net unrealized BIG (NUBIG)). Sec. 384(c)(8) provides that, for these purposes, NUBIG generally has the same meaning as in Sec. 382(h). Finally, one of the corporations must have pre-acquisition NOLs.

Generally, under Sec. 384(a), the gain corporation's income during any "recognition period taxable year" (RPTY) cannot be offset by pre-acquisition NOLs (other than those of the gain corporation) to the extent such income is attributable to RBIG. Cross-referencing the Sec. 382(h)(7)(B) definition, an RPTY is any tax year that includes a portion of the 60-month period following the acquisition date (the recognition period).

Exceptions and Limits

There are exceptions to and limits on applying Sec. 384. For instance, under Sec. 384(c)(1)(C), the RBIG in any given RPTY cannot exceed the initial NUBIG, reduced by the RBIG from prior RPTYs. Thus, the potential loss limit is capped by the NUBIG at acquisition. Additionally, Sec. 384 does not prevent a gain corporation from using its own preacquisition NOLs to offset RBIGs arising during the recognition period. Similarly, Sec. 384 does not limit use of post-acquisition NOLs, nor apply to gains attributed to post-acquisition appreciation or recognized after the recognition period.

Finally, under Sec. 384(b), Sec. 384 does not apply if the loss and gain corporations were members of the same "controlled group" at all times during the five-year period (or the period either corporation was in existence, if shorter) ending on the acquisition date. Sec. 384(b)(2) states that, for this purpose, the Sec. 1563(a) definition of a controlled group applies, subject to certain modifications (e.g., a reduced, 50%ownership test).

Effect of the Lack of Guidance

No regulations interpreting Sec. 384 have been issued yet; thus, the proper application of the statute is not always clear, even for relatively basic computations. The following example demonstrates three alternatives for computing the Sec. 384 limit; each reaches a different result.

Example 1: L Corp., a loss corporation, acquired the assets of G Corp., a gain corporation, in an A reorganization on Jan. 1, 2004. For its 2004 tax year, L has a $10 deduction item, a $20 NOL carryforward, $15 of income and a $5 RBIG attributable to an asset acquired from G.

Alternative 1: Current-year income and deduction items are first netted, resulting in the $10 deduction offsetting $10 of income. Then, NOLs would offset the remaining $5 of income. Pre-acquisition NOLs may not offset the RBIG. Thus, L reports $5 taxable income and has a $15 NOL carryforward.

Alternative 2: Under this more aggressive approach, the RBIG is first offset by the current-year deduction. Current-year income is then offset by the remaining $5 deduction and $10 of NOLs. Thus, L reports no taxable income and has a $10 NOL carryforward.

Alternative 3: Total income is prorated to determine the portion of the current-year deduction that may be used to offset the RBIG. Accordingly, 25% ($5/($5 + $15)) of the total income is subject to the Sec. 384 limit, and 75% ($15/($5 + $15)) is not. Based on this ratio, 25% ($2.50) of the $10 current-year deduction could be used to offset the $5 RBIG (leaving $2.50 of RBIG); 75% ($7.50) could be used to offset current-year income. NOLs could offset the remaining current-year income. Thus, L reports $2.50 of taxable income and has a $12.50 NOL carryforward.

Overlap with Sec. 382

As noted above, Sec. 384 is but one of many of the Code's loss-limit provisions. These rules are generally not mutually exclusive; applying them concurrently can result in unexpected consequences. One potential pitfall is the overlap between Secs. 382 and 384.

Under Sec. 382(h) generally, a loss corporation that has a NUBIG at the time of an ownership change may increase its annual Sec. 382 limit to reflect RBIGs that arise during the recognition period. Often, inventory is such an RBIG item and would result in an increased Sec. 382 limit (and, thus, increased use of pre-change NOLs). However, Sec. 384 could also apply and reduce the benefit offered by Sec. 382(h). Thus, careful consideration should be given to Sec. 384's effect.

Example 2: Acquiring Corp. A has $400 of NOL carryforwards when it purchases 100% of target T's stock for $300. At acquisition, T's assets have a $600 NUBIG. T has $100 of NOL carryforwards.

Sec. 382 should apply, as T has NOL carryforwards at the time of the acquisition. If the Sec. 382 value of T is $300 and the long-term tax-exempt rate is 5% on the acquisition date, the annual post-acquisition use of T's NOLs should be limited to $15. T's NUBIG is related solely to its inventory; T sells the inventory in the year immediately following the acquisition. As T has a $600 RBIG, it should be allowed, under Sec. 382(h), to increase its annual $15 Sec. 382 limit by the RBIG. Thus, T should use its entire $100 NOL carryforward. Further, it may appear that A could use its $400 NOL carryforward against T's gain on the sale of its inventory, as Sec. 382 generally does not limit an acquiring corporation's use of NOL carryforwards. However, Sec. 384 prohibits use of any of A's NOL carryfoward, as T is a gain corporation that recognizes its NUBIG during the recognition period.

Summary

Sec. 384 is one of many Code provisions that limit a taxpayer's ability to use NOLs. It can apply concurrently with other NOL-limiting provisions and, in certain instances, remove benefits that a taxpayer receives when using other Code sections on NOLs. As a result, Sec. 384 should not be overlooked in analyzing the tax benefits associated with transactions that include NOLs.

FROM JOHN LEHRER, J.D., AND JAYANT HAKSAR, J.D., LL.M., WASHINGTON, DC