IRS Issues Guidance On Identifying Built-In Items Through Safe Harbors.

Notice 2003-65

I. Purpose

[1] The Internal Revenue Service (IRS) is studying the circumstances under which items of income, gain, deduction, and loss that a loss corporation recognizes after an ownership change should be treated as recognized built-in gain (RBIG) and recognized built-in loss (RBIL) under section 382(h) of the Internal Revenue Code. This notice provides guidance regarding the identification of built-in items and requests comments on this subject. As described below under the heading Reliance on Notice, taxpayers may rely upon this guidance until the IRS and Treasury Department issue temporary or final regulations under section 382(h). This notice discusses two alternative approaches for the identification of built-in items for purposes of section 382(h): the 1374 approach and the 338 approach.

II. Background

[2] Section 382 provides that, after an ownership change, the amount of a loss corporation's taxable income for any post-change year that may be offset by pre-change losses shall not exceed the section 382 limitation for that year. The section 382 limitation generally equals the fair market value of the old loss corporation multiplied by the long-term tax-exempt rate. A loss corporation is any corporation that has a net operating loss, a net operating loss carryforward, or a net unrealized built-in loss for the taxable year in which the ownership change occurs. An ownership change is a greater than 50-percentage-point increase in ownership by 5-percent shareholders during the testing period, which is generally three years. Congress intended the section 382 limitation to apply when shareholders that did not bear the economic burden of the losses acquire a controlling interest in the loss corporation. See H.R. Rep. No. 99-426, 1986-3 C.B. (Vol. 2) 256; S. Rep. No. 99-313, 1986-3 C.B. (Vol. 3) 232.

[3] Section 382(h) provides rules for the treatment of built- in gain or loss recognized with respect to assets owned by the loss corporation at the time of its ownership change. Section 382(h), as described below, reflects that, as a general matter, losses that offset built-in gain should not be subject to the section 382 limitation merely because the gain is recognized after an ownership change because if the gain had been recognized before the ownership change, it would have been offset without limitation by the loss corporation's net operating losses. Similarly, built-in loss should not escape the section 382 limitation merely because it is recognized after an ownership change because if the loss had been recognized before the ownership change, it would have been subject to the section 382 limitation.

[4] The question of whether RBIG increases the section 382 limitation or whether RBIL is subject to the section 382 limitation begins with a determination of whether the loss corporation has a net unrealized built-in gain (NUBIG) or a net unrealized built-in loss (NUBIL). Pursuant to section 382(h)(3), a loss corporation's NUBIG equals the excess, if any, of the aggregate fair market value of its assets immediately before an ownership change over the assets' aggregate adjusted basis at that time, adjusted by the amount of certain items of income or deduction described in section 382(h)(6)(C) (described below). In addition, a loss corporation's NUBIL equals the excess, if any, of the aggregate adjusted basis of its assets immediately before an ownership change over the assets' aggregate fair market value at that time, adjusted by the amount of certain items of income or deduction described in section 382(h)(6)(C). Under section 382(h)(3)(B), if a loss corporation's NUBIG or NUBIL does not exceed a threshold amount (the lesser of $10,000,000 or 15% of the fair market value of its assets immediately before the ownership change), the loss corporation's NUBIG or NUBIL is zero. Thus, a loss corporation cannot have both a NUBIG and a NUBIL, but it can have neither.

[5] If a loss corporation has a NUBIG, pursuant to section 382(h)(1)(A), any RBIG for any taxable year within the 5-year recognition period following the ownership change increases the section 382 limitation for that year. Similarly, if a loss corporation has a NUBIL, pursuant to section 382(h)(1)(B), any RBIL for any taxable year within the 5-year recognition period following the ownership change is treated as a pre-change loss subject to the section 382 limitation. Thus, only a loss corporation with a NUBIG can increase the section 382 limitation by RBIG, and only a loss corporation with a NUBIL can have RBIL that is treated as a pre- change loss.

[6] In the case of dispositions of assets during the recognition period, section 382(h)(2) places the burden on the loss corporation to establish that any gain recognized is RBIG, and, conversely, that any loss recognized is not RBIL. Section 382(h)(2)(A) defines RBIG as any gain recognized during the 5-year recognition period on the disposition of any asset to the extent the new loss corporation establishes that (i) it held the asset on the change date and (ii) such gain does not exceed the asset's built-in gain on the change date. Furthermore, section 382(h)(2)(B) defines RBIL as any loss recognized during the 5-year recognition period on the disposition of any asset except to the extent the new loss corporation establishes that (i) it did not hold the asset on the change date or (ii) such loss exceeds the asset's built-in loss on the change date.

[7] Section 382(h)(6) and the second sentence of section 382(h)(2)(B) provide rules treating certain items of income or deduction as RBIG or RBIL. Specifically, section 382(h)(6)(A) provides that any item of income "properly taken into account during the recognition period" is treated as RBIG if the item is "attributable to periods before the change date." Section 382(h)(6)(B) provides that any item of deduction "allowable as a deduction during the recognition period" is treated as RBIL if the item is "attributable to periods before the change date." In addition, the second sentence of section 382(h)(2)(B) provides that allowable depreciation, amortization, or depletion deductions are treated as RBIL except to the extent the loss corporation establishes that the amount of the deduction is not attributable to the asset's built-in loss on the change date. Finally, section 382(h)(6)(C) provides that NUBIG or NUBIL shall be properly adjusted for items of income and deduction that would be treated as RBIG or RBIL under section 382(h)(6) if they were properly taken into account or allowable as a deduction during the recognition period.

[8] The IRS has issued two notices concerning guidance under section 382(h). In Notice 87-79, 1987-1 C.B. 388, the IRS announced that it anticipated that regulations under section 382 would permit income from a discharge of indebtedness that is integrally related to a transaction resulting in an ownership change to be allocated to the pre-change period. In Notice 90-27, 1990-1 C.B. 336, the IRS announced that it would promulgate regulations providing that, if a taxpayer that sells a built-in gain asset either prior to or during the recognition period reports the gain using the installment method under section 453, the provisions of section 382(h) will continue to apply to RBIG from the installment sale after the recognition period (including any gain recognized from the disposition of the installment obligation).

III. The 1374 Approach

[9] The 1374 approach generally incorporates the rules of section 1374(d) and §§ 1.1374-3, 1.1374-4, and 1.1374-7 of the Income Tax Regulations in calculating NUBIG and NUBIL and identifying RBIG and RBIL. The following sections describe the application of those rules in the context of section 382(h) and describe those areas in which the 1374 approach departs from those rules.

A. Calculation of NUBIG and NUBIL

[10] Under the 1374 approach, NUBIG or NUBIL is the net amount of gain or loss that would be recognized in a hypothetical sale of the assets of the loss corporation immediately before the ownership change. Specifically, NUBIG or NUBIL is calculated by determining the amount that would be the amount realized if immediately before the ownership change the loss corporation had sold all of its assets, including goodwill, at fair market value to a third party that assumed all of its liabilities, decreased by the sum of any deductible liabilities of the loss corporation that would be included in the amount realized on the hypothetical sale and the loss corporation's aggregate adjusted basis in all of its assets, increased or decreased by the corporation's section 481 adjustments that would be taken into account on a hypothetical sale, and increased by any RBIL that would not be allowed as a deduction under section 382, 383, or 384 on the hypothetical sale. See § 1.1374-3(a) (regarding the calculation of NUBIG). The amount by which this result exceeds $0 is the loss corporation's NUBIG; the amount by which $0 exceeds this result is the loss corporation's NUBIL.

[11] For all of the examples in this notice, unless otherwise noted, LossCo is a loss corporation (as defined in section 382(k)) that is a calendar year basis taxpayer that uses the accrual method of accounting and that has an ownership change on the last day of a taxable year.

1. Gain and Loss from Sales or Exchanges of Assets

[12] Under the 1374 approach, the amount of gain or loss recognized during the recognition period on the sale or exchange of an asset is RBIG or RBIL, respectively, subject to the limitations described in section 382(h)(2)(A) or (B). The sum of the RBIG or RBIL (including deductions that are treated as RBIL as described below) attributable to an asset cannot exceed the unrealized built-in gain or loss in that asset on the change date.

[13] With respect to gain from sales reported under the section 453 installment method, the 1374 approach follows the section 1374 regulations and Notice 90-27, which treat built-in gain recognized from installment sales that occur before or during the recognition period as RBIG, even if recognized after the recognition period. See § 1.1374-4(h); see also Notice 90-27, 1990-1 C.B. 336.

[14] In addition, as set forth in Notice 90-27, if a corporation transfers a built-in gain asset to an affiliated corporation, the gain is deferred under the consolidated return regulations, and, before the close of the recognition period, the affiliated corporation sells the built-in gain asset in a sale reportable under the installment method, such deferred gain is RBIG when such gain is taken into account by the selling or distributing member, and will cause an increase in the section 382 limitation for the taxable year of payment, even if the gain is taken into account after the recognition period. See Notice 90-27, 1990-1 C.B. 336, 338.

2. Items of Income and Deduction

a. In General

[15] In cases other than sales and exchanges, the 1374 approach generally relies on the accrual method of accounting to identify income or deduction items as RBIG or RBIL, respectively. Under this approach, items of income or deduction properly included in income or allowed as a deduction during the recognition period are considered "attributable to periods before the change date" under sections 382(h)(6)(A) and (B) and, thus, are treated as RBIG or RBIL, respectively, if an accrual method taxpayer would have included the item in income or been allowed a deduction for the item before the change date. However, for purposes of determining whether an item is RBIL, section 461(h)(2)(C) and § 1.461-4(g) (concerning certain liabilities for which payment is economic performance) do not apply. See §§ 1.1374-4(b)(1) and (2).

[17] The 1374 approach departs from the tax accrual rule and the regulations under section 1374 in its treatment of amounts allowable as depreciation, amortization, or depletion (collectively, "amortization") deductions during the recognition period. In accordance with the second sentence of section 382(h)(2)(B), except to the extent the loss corporation establishes that the amount is not attributable to the excess of an asset's adjusted basis over its fair market value on the change date, these amounts are treated as RBIL, regardless of whether they accrued for tax purposes before the change date. A loss corporation may use any reasonable method to establish that the amortization deduction amount is not attributable to an asset's built-in loss on the change date. One acceptable method is to compare the amount of the amortization deduction actually allowed to the amount of such deduction that would have been allowed had the loss corporation purchased the asset for its fair market value on the change date. The amount by which the amount of the actual amortization deduction does not exceed the amount of the hypothetical amortization deduction is not RBIL.

IV. The 338 Approach

[20] The 338 approach identifies items of RBIG and RBIL generally by comparing the loss corporation's actual items of income, gain, deduction, and loss with those that would have resulted if a section 338 election had been made with respect to a hypothetical purchase of all of the outstanding stock of the loss corporation on the change date (the "hypothetical purchase"). As a result, unlike under the 1374 approach, under the 338 approach, built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period, and deductions for liabilities, in particular contingent liabilities, that exist on the change date may be treated as RBIL.

A. Calculation of NUBIG and NUBIL

[21] Under the 338 approach, NUBIG or NUBIL is calculated in the same manner as it is under the 1374 approach. Accordingly, unlike the case in which a section 338 election is actually made, contingent consideration (including a contingent liability) is taken into account in the initial calculation of NUBIG or NUBIL, and no further adjustments are made to reflect subsequent changes in deemed consideration.

[22] The 338 approach identifies RBIG or RBIL by comparing the loss corporation's actual items of income, gain, deduction, and loss with the items of income, gain, deduction, and loss that would result if a section 338 election had been made for the hypothetical purchase. For purposes of identifying those items that would have resulted had a section 338 election been made with respect to the hypothetical purchase, after the hypothetical purchase, the loss corporation is treated as using those accounting methods that the loss corporation actually uses. The following sections describe the application of the 338 approach to certain items of the loss corporation.

1. Gain and Loss from Sales or Exchanges of Assets

[23] The 338 approach identifies RBIG or RBIL from sales and exchanges of assets by comparing the loss corporation's actual item of gain or loss with the gain or loss that would result if a section 338 election had been made for the hypothetical purchase. With respect to gain from sales reported under the section 453 installment method, the 338 approach follows Notice 90-27, which, as described above, treats built-in gain recognized from installment sales that occur before or during the recognition period as RBIG, even if recognized after the recognition period. In addition, the 338 approach follows Notice 90-27 in cases in which a corporation transfers a built-in gain asset to an affiliated corporation, the gain is deferred under the consolidated return regulations, and, before the close of the recognition period, the affiliated corporation sells the built-in gain asset in a sale reportable under the installment method. In such cases, the deferred gain is RBIG when it is taken into account by the selling or distributing member, even if the gain is taken into account after the recognition period. See Notice 90-27, 1990-1 C.B. 336.

2. Wasting or Consumption of Built-in Gain Assets

[24] As described above, for loss corporations with a NUBIG, the 338 approach treats certain built-in gain assets of the loss corporation as generating RBIG even if such assets are not disposed of during the recognition period. The 338 approach assumes that, for any taxable year, an asset that had a built-in gain on the change date generates income equal to the cost recovery deduction that would have been allowed for such asset under the applicable Code section if an election under section 338 had been made with respect to the hypothetical purchase. Therefore, with respect to an asset that had a built-in gain on the change date, the 338 approach treats as RBIG an amount equal to the excess of the cost recovery deduction that would have been allowable with respect to such asset had an election under section 338 been made for the hypothetical purchase over the loss corporation's actual allowable cost recovery deduction. The cost recovery deduction that would have been allowed to the loss corporation had an election under section 338 been made with respect to the hypothetical purchase will be based on the asset's fair market value on the change date and a cost recovery period that begins on the change date. The excess amount is RBIG, regardless of the loss corporation's gross income in any particular taxable year during the recognition period.

[26] The 338 approach treats a deduction for the payment of a liability that is contingent on the change date as RBIL to the extent of the estimated liability on the change date.

[27] Under the 338 approach, COD income that is included in gross income under section 61(a)(12) and that is attributable to any pre-change debt of the loss corporation is RBIG in an amount not exceeding the excess, if any, of the adjusted issue price of the discharged debt over the fair market value of the debt on the change date. The 338 approach treats a reduction of tax basis under sections 108(b)(5) and 1017(a) that occurs during the recognition period as having occurred immediately before the ownership change for purposes of section 382(h)(2) to the extent of the excess, if any, of the adjusted issue price of the debt over the fair market value of the debt on the change date. However, the reduction of tax basis does not affect the loss corporation's NUBIG or NUBIL under section 382(h)(3). As with the 1374 approach, taxpayers that otherwise follow the 338 approach may apply the rules described in Notice 87-79, rather than the rules included in the 338 approach to COD income for ownership changes that occur before September 12, 2003, but may not rely on the rules of Notice 87-79 for ownership changes that occur on or after September 12, 2003.

[28] The 338 approach incorporates the special rules in § 1.1374-4(i) concerning partnership items and § 1.1374-4(d) concerning section 481 adjustments, to the extent those items are not already taken into account in the basic methodology of the 338 approach of comparing actual items of the loss corporation to those that would have resulted had a section 338 election been made with respect to the hypothetical purchase.

V. Reliance on Notice

[29] Taxpayers may rely on the approaches set forth in this notice for purposes of applying section 382(h) to an ownership change that occurred prior to the issuance of this notice or on or after the issuance of this notice and prior to the effective date of temporary or final regulations under section 382(h). The IRS will not assert an alternative interpretation of section 382(h) against a taxpayer that consistently applies either the 1374 approach or the 338 approach described in this notice. Taxpayers may use either the 1374 approach or the 338 approach, but not elements of both, for each ownership change with respect to a loss corporation or a loss subgroup as defined in § 1.1502-91(d). Although the approaches described in this notice serve as safe harbors, they are not the exclusive methods by which a taxpayer may identify built-in items for purposes of section 382(h). Other methods taxpayers use to identify built-in items for purposes of section 382(h) will be examined on a case-by- case basis.

VI. Effect on Other Documents

Notice 87-79, 1987-1 C.B. 388, is modified.

VII. Request for Comments

[30] The IRS intends to publish, in the near future, proposed regulations providing a single set of rules for identifying built-in items for purposes of section 382(h). The IRS requests comments regarding whether one of the two approaches described in this notice should be adopted and to what extent, if any, the approaches should be combined or modified to produce a set of rules that is both reflective of statutory intent and administrable. The IRS also invites comments regarding other issues under section 382(h) that should be addressed in regulations. Finally, the IRS requests comments regarding the extent to which regulations promulgated under section 384 identifying built-in items should differ from regulations promulgated under section 382(h) identifying built-in items. Comments should refer to Notice 2003-65, and should be submitted to:

Internal Revenue Service

[32] DRAFTING INFORMATION: The principal author of this notice is Marie Byrne of the Office of Associate Chief Counsel (Corporate). For further information regarding this notice, contact Ms. Byrne at (202) 622-7750 (not a toll-free number).