Limitation increase rule revoked by proposed regulations.

On Nov. 19, 1992, the IRS issued proposed regulations under Sec. 382 on the allocation of taxable income or loss to periods before and after a change date. The regulations provide a closing-of-the-books election that was contemplated in the legislative history of Sec. 382 and which has been allowed under Notice 87-79 by obtaining a letter ruling. The major difference between the election allowed under the proposed regulations and the election previously allowed under Notice 87-79 is the elimination of the taxpayer-favorable limitation increase rule. Not only is the limitation increase rule omitted from the proposed regulations but the preamble to the proposed regulations stated that the Service will no longer apply the rule in letter rulings issued under Notice 87-79 after Nov. 19, 1992.

Sec. 382 limits the amount of prechange losses that can be used to offset postchange income. Since ownership changes under Sec. 382 do not necessarily occur at the close of a tax year, Sec. 382(b)(3)(A) provides that generally taxable income or loss for the year is allocated ratably to each day of the year for a tax year that includes an ownership change date. If the taxpayer generates taxable income for the year, the income allocated to the prechange period can be offset by prechange losses without limitation; however, the income allocated to the postchange period can be offset only by prechange losses in an amount equal to the Sec. 382 limitation prorated for the short period. If the taxpayer generates taxable loss for the year, the loss allocated to the prechange period is subject to the Sec. 382 limitation, while the loss allocated to the postchange period is not limited (unless there is another ownership change).

Although ratable allocation may be convenient, it can give rise to distorted results if large taxable gains or losses occur in either the prechange or postchange period but are allocated pro rata within the year. In addition, allowing only ratable allocation of taxable income or loss could result in distorted treatment between a loss corporation whose tax year closes as a result of the ownership change transaction and a loss corporation whose year remains open. Congress recognized this potential problem and provided in the Conference Report that regulations should be promulgated that would allow the loss corporation to close its books at the change date. In response, the IRS issued Notice 87-79, which outlined the procedures for making a closing-of-the-books election prior to the publication of regulations.

Generally, a closing-of-the-books election is desirable if a disproportionate amount of taxable loss is recognized in the postchange period because such loss would not be subject to the Sec. 382 limitation while, under ratable allocation, some portion of the loss would be allocated to the prechange period and subject to limitation. However, the amount of taxable loss that can be allocated to the postchange period is limited by the amount of taxable loss for the year. Although not explicitly provided for in either the legislative history or Notice 87-79, the Service has allowed taxpayers to increase the Sec. 382 limitation for the year of change (to the extent that income recognized in the prechange period is offset by loss recognized in the postchange period). This rule was intended to provide similar results for taxpayers whose ownership change occurs during the tax year and taxpayers whose tax year closes on the change date. The example on this page illustrates the difference between a corporation that makes a closing-of-the-books election with and without the limitation increase rule and a corporation whose tax year ends as a result of the ownership change.

The preamble to the proposed regulations stated that the limitation increase rule was not included in the proposed regulations because of the additional complexity and because the rule is "inconsistent with the approach taken in the proposed regulations, which generally allows change year losses to offset change year income and gains without regard to the section 382 limitation." However, it appears the elimination of this rule from the closing-of-the-books election will cause loss corporations to be treated differently, depending on whether their tax year closes as a result of the ownership change.

The proposed regulations are to be effective for ownership changes occurring after the final regulations are published. Assuming the limitation increase rule is omitted from the final regulations, if a transaction would result in an ownership change during a tax year and the loss corporation is expecting larger losses subsequent to the change date, consideration should be given to structuring the transaction to cause the loss corporation's tax year to close.