Proposed section 382 regulations.

On March 19, 1993, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under section 382 relating to the rules for allocating net operating losses or taxable income and net capital gain or loss for the taxable year during which a loss corporation undergoes an ownership change that does not trigger an automatic closing of the year. The letter was prepared under the aegis of TEI's Federal Tax Committee, whose

chair is David F. Nitschke of Amerada Hess Corporation. Contributing materially to the preparation of TEI's comments was John P. Orr, Jr. of Finlay Fine Jewelry.

On November 18, 1992, the Internal Revenue Service issued proposed regulations under section 382 of the Internal Revenue Code, concerning the rules for allocating net operating losses or taxable income and net capital gain or loss for the taxable year during which a loss corporation undergoes an ownership change that does not trigger a closing of the tax year. The proposed regulations (CO-49-88) were published in the Federal Register on November 19, 1992 (57 Fed. Reg. 54535), and in the Internal Revenue Bulletin (1992-50 I.R. B. 30).(1) A public hearing on the proposed rules originally scheduled for February 25, 1993, was canceled. Tax Executives Institute is pleased to submit the following comments on the proposed regulations.

Overview

Following an "ownership change" that satisfies certain threshold requirements, section 382 generally limits the amount of taxable income that may be offset by operating losses arising prior to such ownership changes (so-called pre-change losses). Under section 383, similar rules apply with respect to certain tax credits that arise before the ownership change. The purpose of both statutes is to limit the amount of prechange tax attributes that may be used following the change.

With respect to a taxable year of a corporation that straddles an ownership change date, section 382(b)(3) provides a general rule that requires a ratable daily allocation of the income or loss for the year to the pre-and post-change portions of the year. That section also states that the IRS may issue regulations affording a loss corporation the option to allocate year-of-change income or loss by some method other than the generally applicable ratable daily allocation method. The legislative history states that the regulations may provide an option for corporations to determine change-year income or loss as if they had closed their books as of the change date.(2)

In Notice 87-79, 1987-2 C.B. 387, the IRS announced its intention to issue regulations prescribing the manner of making a closing-of-the-books election. The Notice stated that, until the issuance of final regulations, taxpayers would be permitted to employ a closing-of-the-books allocation method provided they obtained a private letter ruling prescribing the terms and conditions for the use of such a method.

In accord with the congressional directive, Prop. Reg. Section 1.382-6 provides alternative rules for allocating net operating loss or taxable income and net capital loss or gain between the periods ending with and after the ownership change date. The preamble to the proposed regulations also announced that private letter rulings issued under Notice 87-79 would apply the allocation principles set forth in the proposed regulations. Thus, the principles of the proposed regulations apply immediately as if they had been issued as Temporary Regulations. Furthermore, there is a retroactive effect with respect to pending requests for rulings.

Limitation Increase Rule

For the taxable year of an ownership change, the proposed regulations generally permit pre-change and post-change items to be offset against one another without regard to the section 382 limitation. In light of this general approach, the IRS has not included the so-called "limitation increase" rule in the proposed regulations because doing so would "add considerable complexity to the regulations" and would be "inconsistent with the approach taken in the proposed regulations." Preamble, 1992-50 I.R.B. at 32.

In the private letter rulings issued under Notice 87-79, the IRS generally limited the amount of pre-change income allocable to the pre-change date period under the closing-of-the-books method to the total amount of taxable income earned during the period encompassing the ownership change. The limitation or "cap" rule effectively limits the amount of losses absorbed by change-year taxable income without regard to whether the income or loss accrues prior to the change date. The operative rules of Prop. Reg. Section 1.382-6(c) effectively import the cap rule employed in the IRS's private letter ruling practice.

A second aspect of the ruling practice relating to a section 382 limitation increase in a subsequent year was, however, not carried over to the proposed regulations. The letter rulings sensibly permitted a section 382 "limitation increase" in the subsequent taxable year in recognition of the secondary limit the cap rule imposed on the absorption of pre-change losses. The limitation increase was generally equal to the amount by which the income earned during the pre-change period exceeded the taxable income earned during the entire year of change.

Presumably, the limitation increase rule was included in the letter rulings by the IRS in recognition of the basic policy set forth in section 382. Income earned prior to the change date is subject to offset without limitation under section 382. Similarly, losses incurred subsequent to the change date are not subject to limitation. As stated in the legislative history of the statue:

In general, the section 382 limitation with respect to an ownership change that occurs during a taxable year does not apply to the utilization of losses against the portion of the loss corporation's taxable income, if any, allocable to the period before the change. For this purpose, except as provided in regulations, taxable income (not including built-in gains or losses) realized during the change year is allocated ratably to each day in the year. The regulations may provide that income realized before the change date from discrete sales of assets would be excluded from the ratable allocation and could be offset without limit by pre-change losses. Moreover, these regulations may provide a loss corporation with an option to determine the taxable income allocable to the period before the change by closing its books on the change date and thus forgoing the ratable allocation.(3)

Clearly, the ratable allocation rule prescribed in section 382(b)(3) for an ownership change that does not trigger an automatic closing of the year is a rule of administrative convenience. Congress evinced this intent by stating that, under regulations, the taxpayer may choose to forgo the administratively simple ratable allocation method in favor of a more precise allocation method.

By retaining the "cap" rule but failing to include a limitation increase rule, the proposed regulations depart drastically and, in TEI's view, unfairly from the approach permitted under the IRS's letter ruling practice. More important, TEI believes that the section 382 limitation was not intended to reduce the amount of taxable income earned or otherwise affect the tax attributes in existence prior to an ownership change date. The proposed regulations would thus engraft a further loss limitation on section 382 that appears unsupported by the statue and legislative history.

Taxpayers most likely to make a closing-of-the-books election are those that are profitable through the change date and incur losses subsequent to that date. The elimination of the limitation increase rule generally limits the benefit of making a closing-of-the-books election for these very taxpayers. The adverse effect of the proposed regulations is illustrated by the following example:

Taxpayer A has a $900 net operating loss carryover, taxable income of $200 in the year of change, and a section 382 limitation of $350 per year. The income earned during the year of change consists of a $500 profit earned prior to the change date and a $300 net loss subsequent to the change date. Under Notice 87-79, a taxpayer that obtained permission to make a closing-of-the-books election would be limited to an operating loss deduction of $200 for the year of change. The taxpayer would be entitled, however, to increase the following year's section 382 limitation by the $300 excess of its pre-change taxable income ($500) over the entire year's taxable income ($200).

With the limitation increase rule, a taxpayer is assured that all earnings through the date of change are taken into account in determing its tax attributes at the date of change. Under the proposed regulations, however, there is no similar limitation increase. Taxpayers most likely to benefit from a deemed closing of the books would be precluded from enjoying the benefit accruing from a more precise allocation of income between the pre- and post-change periods. In TEI's view, the proposed regulations are inconsistent with the objective expressed in the legislative history to section 382 that a closing-of-the-books option be permitted.

TEI recommends that the regulations be revised to provide a closing-of-the-books election that properly reflects a corporation's tax attributes at the date of the ownership change. This recommendation can be effected by adopting a limitation increase rule similar to that employed in the IRS's letter ruling process under Notice 87-79. Recognizing the desire for simplicity expressed in the preamble, we nevertheless believe that the routine issuance of private letter rulings under the Notice demonstrates that corporations are fully able to manage the additional complexity engendered by the more precise allocation method. The elective nature of the provision suggests that taxpayers should be permitted to determine the benefit and costs associated with making the election. The IRS should not entirely foreclose the benefit in the name of simplicity.

Conclusion

Tax Executives Institute is pleased to have the opportunity to present its views on the subject of the proposed regulations relating to allocations of taxable income to the periods ending with and after the date of an ownership change subject to section 382. These comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is David F. Nitschke. If you have any questions concerning these comments, please call either Mr. Nitschke of Amerada Hess Corporation at [phone] or Jeffery P. Rasmussen of the Institute's professional tax staff at [phone].

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. Section." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

(2) See H.R. Rep. No. 99-841, (Conference Report to the Tax Reform Act of 1986), 99th Cong., 2d Sess. II-186 (1986).

(3) Id.