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Closing of the books election pursuant to regs. sec. 1.382-6.

A loss corporation that undergoes a change in ownership may find the amount of taxable income that may be offset by its net operating losses (NOLs) is subject to limitation under Sec. 382. Unless the change date occurs exactly on the date of the corporation's year-end, the corporation will have to allocate its income or loss during the change year between the "prechange" and "postchange" periods. This allocation can have tremendous significance in determining the NOL subject to the limitations of Sec. 382.

Sec. 382(b)(3)(A) provides the general rule that taxable income or loss must be allocated ratably to each day in the year of the ownership change. The IRS announced in Notice 87-79 its intention to issue regulations that would allow a taxpayer to make a closing of the books election with respect to taxable income or loss in the change year. However, the Service mandated that the ratable allocation method must be used until regulations were issued, unless a letter ruling had been requested.

Several letter rulings were issued, stipulating that a taxpayer could use a closing of the books method. However, as a condition, the IRS mandated that the amount of income or loss that could be allocated to the prechange period could not exceed the amount of taxable income or loss for the entire year. The significance of this limitation can be seen in Example 1, below.

Example 1: Loss corporation L, a calendar-year taxpayer, has an ownership change on July 1, 19X5. L has an NOL carryforward of $1,500,000 to 19X5.
Prechange income $1,000,000
Postchange loss (750,000)
Entire year $ 250,000

The $250,000 is allocated entirely to the prechange period. The allocation to the postchange period is $0. The NOL subject to the Sec. 382 limitation is $1,250,000.

As a result of the Service's position, L would only be able to offset $250,000 of taxable income against the NOL, leaving a $1,250,000 carryforward subject to the Sec. 382 limitation. The IRS alleviated this negative result in regulations proposed in 1992, by allowing for an increase to the Sec. 382 limitation to the extent that postchange losses were offset against prechange income. L would increase its Sec. 382 limitation by $750,000.

Final regulations issued on June 22, 1994 (which minimally modified the proposed regulations) are effective for ownership changes occurring on or after that date. Significantly, however, the limitation increase rule did not make it into the final regulations.

The regulations maintain the general rule of ratable allocation but allow for a closing of the books election made on a timely filed return. The election is made as part of the information statement required by Temp. Regs. Sec. 1.382-2T, and is irrevocable. The election does not terminate the loss corporation's tax year as of the change date.

In the year of the ownership change, the taxable income or loss is determined, for purposes of allocating income to the pre- and postchange periods, without regard to capital gains or losses. Thus, capital items are tracked separately from ordinary income or loss. The regulations allow for offset of similar items in the pre-and postchange periods without respect to the Sec. 382 limitation. However, recognized built-in gains or losses must be allocated entirely to the postchange period. Also, any income or gain recognized during the postchange period on the disposition of assets transferred to the loss corporation for purposes of ameliorating the Sec. 382 limitation is allocated entirely to the postchange period.

The regulations mandate adjustments after the initial allocation to each period. First, any modified capital gain net income (MCGNI) allocated to each period is offset by any recognized built-in capital losses and any capital loss carry-overs, subject to the Sec. 382 limitation. MCGNI is defined in Regs. Sec. 1.382-6(g)(4) as the excess of capital gains over capital losses for the change year, excluding any capital loss carryover from a preceding year. Finally, any NOL allocated to each period is reduced by any remaining MCGNI in the same period, and then by the MCGNI remaining in the other period.

Examples 2 and 3 demonstrate the differing results that may be obtained if a loss corporation elects a closing of the books rather than a daily ratable allocation. In Example 2, above, the loss corporation will obtain a better result by making the closing of the books election. This is a result of the Sec. 382 limitation, which serves to reduce the amount of postchange period taxable income that may be offset by the prechange loss.

Example 2: Closing of the Books Election
L Corp.:
NOL carryforward from 12/31/94 $1,000,000
Change date July 1, 1995
Annual Sec. 382 limitation 200,000
Prechange income 1,000,000
Postchange loss (500,000)
Taxable income--change year $ 500,000
 Ratable Closing of
 allocation the books
Prechange $ 250,000 $ 500,000
Postchange 250,000 0
Taxable income before NOL 500,000 500,000
NOL (350,000)(*) (500,000)
Taxable income after NOL 150,000 0
NOL carryforward to 1996
 (subject to Sec. 382 limitation) $ 650,000 $ 500,000

(*)$250,000 prechange + $200,000/2 annual Sec. 382 limitation.

Example 3: Daily Ratable Allocation Election
L Corp.:
NOL carryforward from 12/31/94 $1,000,000
Change date July 1, 1995
Sec. 382 limitation 200,000
Preschange loss (400,000)
Postchange income 200,000
Taxable income--change year $ (200,000)
 Ratable Closing of
 allocation the books
Prechange $ (100,000) $ (200,000)(*)
Postchange (100,000) 0
Taxable income before NOL (200,000) (200,000)
NOL carryforward to 1996
 (subject to Sec. 382 limitation) 1,100,000 1,200,000
Postchange NOL $ 100,000 $ 0

(*)$400,00 prechange loss limited to the total loss for the year.

In Example 3, on page 81, while the taxpayer ends up with the same amount of NOL carryforward, the ratable allocation method yields $100,000 as a postchange loss, which is not limited by Sec. 382.

Obviously, the regulations do not contemplate situations in which corporations are unable to generate the information necessary to accurately close the books as of a given change date. Assuming this information exists, a loss corporation must factor in the amount of the Sec. 382 limitation in relation to the tax attributes being carried forward, as well as the amount of any postchange losses that can be used in the future without limitation.

From Adam Yalowich, CPA, Fort Lauderdale, Fla.
COPYRIGHT 1995 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Yalowich, Adam
Publication:The Tax Adviser
Date:Feb 1, 1995
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