Maximizing built-in loss benefits under Sec. 382.

Sec. 382 limits the availability of a corporate net operating loss (NOL) following an ownership change. A corporation undergoing an ownership change an use preexisting NOLs for any postchange year only to the extent of the corporation's value multiplied by the long-term federal tax-exempt rate, until the prechange losses are either used up or expire. This amount may be increased by the net unrealized built-in gain (which meets a certain de minimis threshold requirement) existing on the ownership change date that is recognized during the subsequent five-year period.

An ownership change can occur at the end of the tax year or at any time during the year. If the change date falls on the last day of the year, no income or loss allocation for the current year is necessary. If, however, the ownership change occurs during the year, that year's income or loss must be allocated. A loss allocated to the period after the change date is not subject to limitation, while any loss allocated to the period ending on the change date is subject to limitation under Sec. 382, since it is considered part of the "prechange" NOL.

Unless a letter ruling is obtained from the IRS to permit a corporation to close its books as of the change date so as to determine the loss suffered before that date, the taxable income must be prorated on a daily basis. The proration of income or loss is computed without regard to any recognized built-in gains (if the corporation has a net unrealized built-in gain) or built-in recognized losses (if the corporation has a net unrealized built-in loss).

Example 1: N Co., a calendar-year corporation, undergoes a change of ownership culminating on Apr. 1, 1992. N has neither a net unrealized built-in gain nor a net unrealized built-in loss. N suffers a loss of $800 during the 1992 calendar year. Since the ownership change took place on the ninety-second day of a 366-day year (1992 is a leap year), 92/366 of the loss, or $201, will be allocated to the prechange period. This amount will be added to the existing NOL carryforwards and will be subject to the Sec. 382 limitation. On the other hand, 274 days remain after the change date; therefore, 274/366 of the loss, or $599, will be attributable to the postchange period and will be eligible for carry-forward without application of the Sec. 382 limitation.

If the corporation has a net unrealized built-in loss (which meets certain de minimis threshold requirements), the daily proration can produces a windfall for taxpayers who properly time the recognition of built-in losses or deduction items. But before this concept can be appreciated, it is essential to know what a built-in loss or deduction item is, and how it affects the Sec. 382 limitation.

A built-in loss is the amount by which the adjusted basis of an asset exceeds its fair market value on the change date. Similarly, a built-in deduction item is any amount that is allowed as a deduction after the change date, but which is attributable to periods before the change date. Although no exhaustive list exists, the "atrisk" limitations under Sec. 465, charitable contribution carryovers under Sec. 170(d) and deductions relating to transactions with related parties under Sec. 267 are considered built-in deductions. If a built-in loss or deduction item is recognized within a certain time period (generally five years), the loss is subject to the Sec. 382 limitation. In many instances the benefit of this loss will be lost since many loss corporations have more prechange NOLs than could ever be used under the Sec. 382 limitations.

Example 2: N Co., from Example 1, has an NOL carryforward to the 1992 tax year in the amount of $15,000. In addition, at the time of the ownership change, N was valued at $10,000 and the prevailing long-term tax-exempt rate was 7%. N had a net unrealized built-in loss as of the ownership change date that meets the threshold requirement. On Apr. 15, 1992, the company disposed of assets that triggered recognition of $350 of built-in losses. As a result N's tax loss for the year was $1,150 ($350 + $800 from Example 1).

N's annual Sec. 382 limitation is $700 ($10,000 X 0.07). Therefore, at most $10,500 (the $700 Sec. 382 limitation x 15 years) of the $15,000 NOL carryforward can be used in subsequent years. In fact, the built-in loss ($350) and the 1992 loss of $201 allocated to the prechange period (from above) are considered part of the prechange NOL. The NOL carryforward subject to limitation becomes $15,551 ($15,000 + $350 + $201) rather than just ($15,000. Since the Sec. 382 limitation remains $700, it is apparent that the $350 built-in loss deduction resulted in no tax benefit.

Example 2 illustrates that the recognition of a built-in loss or deduction item in a subsequent period may not result in a tax benefit. This result, however unfortunate, is in keeping with the intent of Sec. 382, which is, in part, to limit losses originating prior to the ownership date, whether or not already recognized at that date.

This unfavorable treatment can, however, be circumvented by careful timing of the recognition of items that would be considered built-in losses or deduction items on the ownership change date. The window of opportunity falls between the first day of the year in which the ownership change occurs and the date of the ownership change. In Example 2, the built-in loss was recognized after the ownership change date and clearly resulted in no tax benefit. Likewise, if the "would be" built-in loss was recognized prior to the first day of the ownership change year it would become a component of the NOL carryforward to the change year and, as a result, would be subject to the Sec. 382 limitation. If, however, the item is recognized during the window period, the loss, at least in part, is preserved for future carryforward. (This is because the income or loss for the year of change is allocated by proration on a daily basis.)

Example 3: Assume the same facts as in Example 2, except that N disposes of the assets on Mar. 15, 1992 rather than Apr. 15, 1992. The resulting loss is not a "built-in loss" under Sec. 382(h)(3) because it was not built in "immediately before" the ownership change. The loss was recognized 16 days before the change date (i.e., it did not exist on the change date). Yet it is not considered part of the prechange NOL carried forward to 1992 ($15,000) because it was recognized subsequent to the close of the prior year.

N's loss subject to the daily proration rules is $1,150 ($800 + $350). Again, the $350 is not excluded from the daily proration since it is not a built-in loss by definition. Therefore, the loss allocated to the prechange period is 92/366 of the loss, or $289. This loss is subject to the Sec. 382 limitation as it becomes part of the prechange NOL. The loss allocated tot he postchange period is 274/366 of the loss, or $861. This amount is not subject to limitation and can be carried forward 15 years.

By disposing of the "would be" built-in loss assets during the window period, N preserved an additional $262 ($861 - $599) of loss carryforward. This amount represents the "would be" built-in loss recognized during the window period multiplied by the percentage of the number of days allocated to the postchange period using the daily proration rule to the total days in that tax year ($350 X 274/366). Note that this benefit would not have been achieved had N "closed its books" on the date of ownership change, since the deduction would have fallen into the prechange period.

This is jsut one example of the inequities that result from the daily proration method which taxpayers can use to their advantage. As a practical matter, while many built-in loss/deduction transactions can be controlled as to the timing (e.g., sale of assets), others are more difficult (e.g., charitable contribution carryovers). Therefore, practitioners need to be aware of the various built-in components and advise their clients accordingly.

Practitioners should also keep in mind that the inequities resulting from the use of the daily proration method can produce unfavorable results. One such example is the recognition of a "would be" built-in gain (if a corporation has a net unrealized built-in gain that meets the threshold requirement) prior to the ownership change date (i.e., during the window period). A portion of the built-in gain, which would otherwise give rise to an increase in the Sec. 382 limitation if recognized subsequent to the change date (and generally within five years), would instead offset part of the prechange loss, resulting in no tax benefit. Needless to say, practitioners need to monitor both built-in gains and losses during the window period and devise an appropriate plan of action in order to maximize loss carryforwards.

From Thomas D. Klein, CPA, San Francisco, Cal.