IRS CUTS OFF INSTALLMENT SALE GAMES UNDER SECTIONS 382, 384, AND 1374.

Notice 90-27

1. INSTALLMENT SALES AND SECTION 384

The purpose underlying section 384 of the Internal Revenue Code is to prevent trafficking in tax benefits in connection with certain acquisitive reorganizations or stock acquisitions, by preventing a party to a business combination from using its losses to offset the unrealized gain inherent in the assets of another party to the transaction. H.R. Rep. No. 391, 100th Cong., 1st Sess. 1093 (1987). Section 384(a) provides that, if a corporation acquires directly (or through one or more other corporations) control of another corporation, or if the assets of a corporation are acquired by another corporation in a reorganization under sections 368(a)(1)(A), (C), or (D), and either of such corporations is a "gain corporation," income for any recognition period taxable year, to the extent attributable to recognized built-in gains, shall not be offset by any preacquisition loss (other than a preacquisition loss of the gain corporation). Section 384(f)(1) provides that the Secretary shall issue such regulations as may be necessary to ensure that the purposes of section 384 may not be circumvented through the use of any provision of law or regulations.

Under section 384(c)(3) of the Code, a "preacquisition loss" includes any net operating loss carryforward to the taxable year in which the acquisition date occurs, any net operating loss for that year to the extent such loss is allocable to the period in that year on or before the acquisition date, and any recognized built-in loss. Under section 384(c)(4), a "gain corporation" is any corporation with a net unrealized built-in gain. In general, a corporation has a net unrealized built-in gain if the fair market value of its assets, immediately before the acquisition date, exceeds their aggregate adjusted bases. If, however, the amount of the net unrealized built- in gain of any corporation is not greater than the lesser of (i) 15 percent of the fair market value of its assets immediately before the acquisition date, or (ii) $10,000,000, the net unrealized built-in gain shall be zero. Sections 384(c)(8) and 382(h)(3)(B)(i).

Under section 384(c)(1)(A) of the Code, a "recognized built-in gain" is any gain recognized during the recognition period on the disposition of any asset, except to the extent the gain corporation (or, in a case described in section 384(a)(1)(B), the acquiring corporation) establishes that (i) such asset was not held by the gain corporation on the acquisition date, or (ii) the gain exceeds the excess, if any, of the fair market value of the asset on the acquisition date over its adjusted basis on that date. Section 384(c)(1)(C) limits the amount of the recognized built-in gain for any recognition period taxable year to the net unrealized built-in gain, reduced by the amount of any recognized built-in gain for prior years ending in the recognition period which (but for the application of section 384) would have been offset by preacquisition losses. The term "recognition period" means the five-year period beginning on the acquisition date, and the term "recognition period taxable year" means any taxable year any portion of which is in the recognition period.

The purpose underlying the installment method of reporting income under section 453 of the Code is to alleviate the potential liquidity problems that might arise for taxpayers if they were required to recognize all of the income realized from the disposition of an asset when all or a portion of the sale price remains to be paid after the taxable year of the disposition. S. Rep. No. 1000, 96th Cong., 2d Sess. 7 (1980), 1980-2 C.B. 494, 497. Under section 453, an allocable share of the gross profit on an "installment sale," as defined in section 453(b), is recognized and taken into income in any year in which an installment payment is received by the seller. Under section 453(d), a taxpayer may elect out of reporting a sale on the installment method. An installment sale of an asset by a gain corporation that defers any portion of the payments with respect to the sale beyond the recognition period, would (but for the application of this Notice) result in avoiding the characterization of such gain as recognized built-in gain.

The Service has determined that the purposes underlying section 384 of the Code would not be carried out if a gain corporation could dispose of its assets either prior to or during the recognition period in a transaction in which installments are payable after expiration of the period, and thereby avoid the characterization of gain from the sale as recognized built-in gain by reporting the sale under the section 453 installment method. In order to carry out the purposes of section 384, the Service will issue regulations under section 384(f)(1) to provide that, if a taxpayer sells a built-in gain asset either prior to or during the recognition period in an installment sale and recognizes the income from the sale pursuant to the installment method, the provisions of section 384 will continue to apply to gain recognized from the installment sale after the recognition period (including any gain recognized from the disposition of the installment obligation). In such a situation, the regulations will treat the recognition period as if, solely with respect to such recognized gain, the recognition period were extended through the date of the last installment payment (or the date of the disposition of the installment obligation). All of the requirements for the application of the section 384 limitation on the use of preacquisition losses will be taken into account during the extended recognition period.

The regulations to be issued pursuant to this section 1 of this Notice will also apply if a corporation transfers a built-in gain asset to an affiliated corporation, the gain is deferred under the consolidated return regulations (see sections 1.1502-13 and 1.1502-14 of the Income Tax 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 general, any such deferred recognized gain will constitute "recognized built- in gain" when such gain is taken into account by the selling or distributing member and will be subject to section 384, whether or not the installment payment is made after the recognition period. See section 1.1502-13T(m)(1).

2. INSTALLMENT SALES AND SECTION 382

The amount of taxable income of a loss corporation for any taxable year following an ownership change that can be offset by pre- change losses (e.g., net operating loss carryforwards, certain net operating losses for the taxable year including the change date, and certain built-in losses) may not exceed the section 382 limitation for that year. Under section 382(b) of the Code, the section 382 limitation generally is an amount equal to the value of the old loss corporation multiplied by the long-term tax-exempt rate. Section 382(h)(1)(A) provides that, if a loss corporation has a net unrealized built-in gain, the section 382 limitation for any recognition period taxable year is increased by the recognized built- in gain for that year. Section 382(m) provides that regulations shall be issued as may be necessary or appropriate to carry out the purposes of section 382.

The increase in the section 382 limitation for any recognized built-in gain in a recognition period taxable year is limited to the amount of the net unrealized built-in gain, reduced by the amount of any recognized built-in gain for prior years ending in the recognition period. The net unrealized built-in gain of a loss corporation for purposes of section 382 of the Code is determined in the same manner as net unrealized built-in gain is determined with respect to a gain corporation for purposes of section 384 (as described in section 1 of this Notice). In contrast to the statutory presumptions in favor of finding that built-in gain results from any disposition of appreciated property by the gain corporation under section 384, section 382(h)(2)(A) provides that a "recognized built- in gain" is any gain recognized during the recognition period on the disposition of an asset only to the extent it is established that (i) the asset was held by the loss corporation immediately before the change date, and (ii) the gain so recognized does not exceed the excess of the fair market value of the asset on the change date over its adjusted basis on such date. The term "recognition period" means the five-year period beginning on the change date, and the term "recognition period taxable year" means any taxable year any portion of which is in the recognition period.

The Service has determined that regulations similar to those to be issued with respect to installment sales under section 384 of the Code (as described in section 1 of this Notice) also will be issued under section 382(m). The regulations will provide that, if a taxpayer sells a built-in gain asset either prior to or during the recognition period in an installment sale and gain is reported under the section 453 installment method, the provisions of section 382(h) will continue to apply to gain recognized from the installment sale after the recognition period (including any gain recognized from the disposition of the installment obligation). As a result, the recognized gain will cause an increase in the section 382 limitation for the taxable year of payment, provided that such an increase otherwise would be permitted under section 382(h) if, solely with respect to such recognized gain, the recognition period were extended through the date of the last installment payment (or the date of the disposition of the installment obligation).

The regulations to be issued pursuant to section 2 of this Notice will also apply if a corporation transfers a built-in gain asset to an affiliated corporation, the gain is deferred under the consolidated return regulations (see sections 1.1502-13 and 1.1502-14 of the 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 general, any such deferred recognized gain will constitute "recognized built-in gain" 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, provided that such an increase otherwise would be permitted under section 382(h) if the recognition period were extended through the date of the last installment payment (or the date of the disposition of the installment obligation). See section 1.1502-13T(m)(1).

3. INSTALLMENT SALES AND SECTION 1374

Section 1374 of the Code, as amended by subtitle D of title VI of the Tax Reform Act of 1986 (the "Act"), imposes a corporate-level tax with respect to certain gain recognized by an S corporation. Generally, the tax is imposed for any taxable year beginning in the recognition period of an S corporation in which the corporation has a net recognized built-in gain. Under section 1374(d)(2)(A), the term "net recognized built-in gain" means the lesser of (i) the amount that would be the taxable income of the corporation if only recognized built-in gains and recognized built-in losses were taken into account, or (ii) the corporation's taxable income (determined as provided in section 1375(b)(1)(B)). If, for any taxable year, the lesser amount is the corporation's taxable income determined under section 1375(b)(1)(B), the amount by which the excess of recognized built-in gain over recognized built-in loss exceeds taxable income is treated as recognized built-in gain in the succeeding taxable year. Section 1374(d)(2)(B). The amount of the net recognized built-in gain taken into account under section 1374 for any taxable year is limited to the excess, if any, of the net unrealized built-in gain over the net recognized built-in gain for prior taxable years beginning in the recognition period.

Generally, net unrealized built-in gain for purposes of section 1374 of the Code is determined in the same manner as that in which built-in gain is determined with respect to a gain corporation under section 384 (as described in section 1 of this Notice). See section 1374(d)(1). However, there is no rule in section 1374 providing that the net unrealized built-in gain is zero if the net unrealized built- in gain of the corporation does not exceed the lesser of 15 percent of the fair market value of its assets or $10,000,000. The term "recognition period" means the ten-year period beginning on the first day of the first taxable year for which the corporation was an S corporation.

Section 1374(e) of the Code provides that regulations shall be issued as may be necessary to carry out the purposes of section 1374. In addition, section 337(d), in part, provides that regulations shall be issued as may be necessary or appropriate to carry out the purposes of the amendments under the Act made to section 1374, including regulations to ensure that such purposes not be circumvented through the use of any provision of law or regulation. The Service has determined that the purposes underlying the repeal of the General Utilities doctrine and the related amendments to section 1374 would fail to be carried out in certain cases if an S corporation disposes of an asset either prior to or during the recognition period in an installment sale reported under the installment method.

Accordingly, the Service will issue regulations governing the treatment of installment sales under section 1374 of the Code, including regulations providing that, in certain cases, section 1374 will continue to apply to income recognized under the installment method during a taxable year ending after the expiration of the recognition period. Under the regulations, if a taxpayer sells an asset either prior to or during the recognition period and recognizes income (either during or after the recognition period) from the sale under the installment method, the income will, when recognized, be taxed under section 1374 to the extent it would have been so taxed in prior taxable years if the selling corporation had made the election under section 453(d) not to report the income under the installment method. For purposes of determining the extent to which the income would have been subject to tax if the section 453(d) election had not been made, the taxable income limitation of section 1374(d)(2)(A)(ii) and the built-in gain carryover rule of section 1374(d)(2)(B) will be taken into account.

EXAMPLE 1. In year 1 of the recognition period under section 1374, a corporation realizes a gain of $100,000 on the sale of an asset with built-in gain. The corporation is to receive full payment for the asset in year 11. Because the corporation does not make an election under section 453(d), all $100,000 of the gain from the sale is reported under the installment method in year 11. If the corporation had made an election under section 453(d) with respect to the sale, the gain would have been recognized in year 1 and, taking into account the corporation's income and gains from other sources, application of the taxable income limitation of section 1374(d)(2)(A)(ii) and the built-in gain carryover rule of section 1374(d)(2)(B) would have resulted in $40,000 of the gain being subject to tax during the recognition period under section 1374. Therefore, the regulations will subject $40,000 of the gain recognized in year 11 to tax under section 1374.

EXAMPLE 2. In year 1 of the recognition period under section 1374, a corporation realizes a gain of $100,000 on the sale of an asset with built-in gain. The corporation is to receive full payment for the asset in year 6. Because the corporation does not make an election under section 453(d), all $100,000 of the gain from the sale is reported under the installment method in year 6. If the corporation had made an election under section 453(d) with respect to the sale, the gain would have been recognized in year 1 and, taking into account the corporation's income and gains from other sources, application of the taxable income limitation of section 1374(d)(2)(A)(ii) and the built-in gain carryover rule of section 1374(d)(2)(B) would have resulted in all of the gain being subjected to tax under section 1374 in years 1 through 5. Therefore, notwithstanding that the taxable income limitation of section 1374(d)(2)(A)(ii) might otherwise limit the taxation of the gain recognized in year 6, the regulations will provide that the entire $100,000 of gain will be subject to tax under section 1374 when it is recognized in year 6.

These regulations shall not apply for purposes of the application of section 1374 of the Code as in effect prior to amendment by the Act.

The Service will also issue regulations to provide rules similar to those described in this Notice for regulated investment companies and real estate investment trusts that elect to be subject to rules similar to the rules of section 1374 of the Code. See Notice 88-19, 1988-1 C.B. 486.

4. EFFECTIVE DATE

The regulations to be issued pursuant to this Notice under the authority of sections 384(f)(1), 382(m), 1374(e), and 337(d) of the Code will be effective for installment sales occurring on or after March 26, 1990. For purposes of these effective dates, if the installment sale was pursuant to a binding written contract entered into and in continuous effect until the sale, the date the contract became binding is treated as the date of the sale.

5. DRAFTING INFORMATION

The principal authors of this Notice are Steve Cleary and Mark S. Jennings of the Office of Assistant Chief Counsel (Corporate). For further information regarding the portions of this Notice concerning sections 382 and 384 contact Mr. Cleary at (202) 566-2456 (not a toll-free call) and regarding the portion of this Notice concerning section 1374 contact Mr. Jennings at (202) 566-2455 (not a toll-free call).