Calculating the Section 382 Annual Limitation: A More Relevant Task for Consolidated Groups
by Mary Fung, manager, KPMG's Washington National Tax PracticeMergers & Acquisitions Group
A corporation that has a net operating loss for a tax year can either carry the NOL back to offset income in the prior two years and obtain a refund of taxes paid in those years, or the corporation can carry the NOL forward to offset taxable income in the next 20 years. (The two-year carryback and 20-year carryforward periods are applicable to NOLs generated in tax years beginning after August 5, 1997.) Thus, a corporation's NOL carryover is generally a favorable tax attribute. In fact, if a member of a consolidated group purchases the stock of a corporation that has a NOL carryover, the price paid for the stock may reflect the consolidated group's hope of using the NOL carryover to offset future income. Subject to certain limitations, the consolidated group can use the NOL carryover to offset future taxable income of the group. Among those limitations are the limitations imposed by section 382 and the separate return limitation year (SRLY) rules of the consolidated return regulations. Because of the "Overlap Rule" discussed below, many corporate tax departments may be more concerned with the section 382 limitation than the limitation imposed by the SRLY rules. Thus, this article focuses on the computation of the section 382 limitation.
Overview of Section 382 and SRLY Rules
The SRLY rules apply if a corporation with losses, including NOL carryovers, capital loss carryovers, and certain built-in losses, becomes a member of a consolidated group. For example, the SRLY rules generally limit the amount of the consolidated group's taxable income that may be offset by NOL carryovers that the acquired corporation brings with it into the consolidated group (separate return limitation year losses). In general, the SRLY rules limit the consolidated group's use of separate return limitation year losses to the amount of income generated by the acquired corporation after it becomes a member of the group (the SRLY limitation).
In general, if a corporation is acquired by a consolidated group, the acquired corporation's pre-ownership change (or separate return year) losses are subject to the lesser of (i.e., the more restrictive) the section 382 annual limitation and the SRLY limitation. The SRLY limitation has often been the more restrictive limitation, because the acquired corporation did not generate income and the SRLY limitation was therefore zero. But, for tax years with an unextended due date after June 25, 1999, the "Overlap Rule" generally makes the SRLY limitation inapplicable to NOLs, capital losses, and built-in losses of corporations joining a consolidated group within six months of (i.e., either before or after) a section 382 ownership change. See Treas. Reg. Sections 1.1502-21(g), -22(g) and -15(g). In these situations, the Overlap Rule makes the computation of the section 382 annual limitation an essential task for many corporate tax departments.
The section 382 provisions are among the most complex rules contained in the Code, providing detailed and thorny rules to calculate the section 382 annual limitation. This article is intended to provide taxpayers with a general guideline for computing basic section 382 limitations. Nevertheless, some intricacies of applying the mechanical section 382 rules are highlighted. The discussion is in a question and answer format. Unless otherwise indicated, assume that LossCo is a corporation with NOL carryovers that has had a section 382 ownership change and that LossCo is not a member of a consolidated group or controlled group prior to the section 382 ownership change.
1. What is the amount of the section 382 annual limitation?
The section 382 annual limitation for a given year may be increased for various items, including any unused portion of prior years' section 382 annual limitations. As discussed in Question 7, the limitation may also be increased by "recognized built-in gains."
LossCo must satisfy a two-year continuity of business requirement (COBE requirement), or LossCo's section 382 annual limitation may be reduced to zero retroactively to the ownership change date. Section 382(c). The COBE requirement is met if LossCo either continues a significant line of its historical business or continues to use a significant portion of its historical business assets for the two-year period. Even if the COBE requirement is not satisfied, LossCo may still use its pre-ownership change losses to the extent of the amount of recognized built-in gain for the year. See Question 7.
2. What is the "value" of LossCo for purposes of computing the section 382 annual limitation?
Several special rules prevent taxpayers from increasing the section 382 annual limitation by "inappropriately" increasing the value of LossCo. In particular, the value of LossCo must be adjusted for certain capital contributions (the "anti-stuffing rule"), redemptions and other corporate contractions, and substantial nonbusiness assets. See Questions 3 - 5, respectively. In addition, there may be a controlled group adjustment. See Question 6.
2a. Can a control premium be included in computing the value of LossCo?
2b. How about the value of "in the money" options?
3. What is the "anti-stuffing rule?"
3a. In applying the "anti-stuffing" rule, what constitutes a capital contribution?
3b. Is there a rebuttal for the two-year presumption?
It is important to properly document the use of capital contributions. If LossCo uses the proceeds from a capital contribution made within the two-year period to meet daily operating expenses or for another legitimate business purpose, and that purpose is documented, the capital contribution should be counted in computing the section 382 annual limitation.
4. What is the "substantial nonbusiness assets" adjustment?
|Immediately after the ownership change, LossCo will have total nonbusiness assets of $300 ($200 cash and $100 marketable securities on hand immediately before ownership change). Because the value of 60 percent of LossCo's only class of stock is $60, the equity value of LossCo at the time of, and also immediately before, the ownership change should be $100. Because the value of the nonbusiness assets ($300) exceeds one-third of the value of total gross assets ($600 x 33.33 percent = $200), LossCo has "substantial nonbusiness assets." Accordingly, LossCo must reduce its equity value by $50 in the following manner:|
5. How does a "corporate contraction" affect the section 382 annual limitation?
If a redemption or other corporate contraction occurs in connection with an ownership change, the loss corporation's value must be determined after taking the redemption or corporate contraction into account. Section 382(e)(2). The term "corporate contraction" refers to bootstrap acquisitions and similar transactions. See S. Rep. No. 445, 100th Cong., 2d Sess. 415 (1987).
The adjustment for a corporate contraction is illustrated by the following example: Individual A, the sole shareholder of LossCo stock (FMV = $100) sells 51 percent of his interest to an unrelated person, B, for $51 triggering an ownership change with respect to LossCo. As part of the transaction, LossCo redeems the remaining shares held by A for $49, resulting in B being the sole shareholder in LossCo. LossCo's value, for purpose of determining the section 382 annual limitation, is adjusted to $51 ($100 - $49 attributable to the redemption that occurred in connection with the ownership change). Because the section 382 value of LossCo is lower, so is LossCo's section 382 annual limitation.
6. How does the "controlled group" adjustment work?
Nevertheless, all or a portion of the value reduction can be restored to the owning member if an election is filed to reattribute the stock value to the owning member. If such an election is made, the value of the stock of the owned member must be reduced by the value ceded to the owning member.
If the ownership change occurred in tax years beginning before January 1, 1997, no formal election was required. The controlled group and the owning member were only required to use a method that did not result in double counting. For tax years beginning after January 1, 1997, an election must be filed with the owning member's tax return in the year of the section 382 ownership change.
To illustrate, assume LossCo owns 75 percent of the stock of Sub at the time of LossCo's section 382 ownership change. LossCo must adjust the value of its own stock to eliminate the value of the Sub stock, unless Sub elects to give that value back to LossCo. If the election is made, the value of Sub's stock is reduced for purposes of computing Sub's section 382 annual limitation.
7. What constitutes a "recognized built-in gain" that increases the section 382 annual limitation?
The increase to the section 382 annual limitation in aggregate for the recognition of built-in gains within the five-year period cannot exceed the amount of the NUBIG at the time of the ownership change. LossCo must prove that the recognition of a built-in gain during the five-year period is attributable to appreciation in its assets that occurred prior to the ownership change. To illustrate, assume that LossCo has two assets at the time of the ownership change. Asset 1 has a built-in gain of $100fair market value of $100 and tax basis of zero. Asset 2 has a built-in loss of $5fair market value of $10 and a tax basis of $15. LossCo has a NUBIG of $95 ($100 built-in gain less $5 built-in loss) that is substantial. Assume that LossCo sells Asset 1 one year after the ownership change for $110, resulting in $110 of gain to LossCo. Of the $110, the recognized built-in gain that can increase LossCo's section 382 annual limitation is limited to $95 (LossCo's NUBIG). If LossCo's NUBIG was more than $100 (say $150 because LossCo had other built-in gain assets), the recognized built-in gain that can increase LossCo's section 382 annual limitation is $100 (the built-in gain in Asset 1 at the time of the ownership change). The $10 of post-ownership change appreciation is not built-in gain for section 382 purposes.
Section 382 also has special provisions if a corporation has a "substantial" net unrealized built-in loss (NUBIL) rather than a NUBIG. If a corporation has a NUBIL, section 382 provides that certain built-in losses recognized during the five-year period are subject to limitation in the same manner as pre-ownership change NOL carryovers.
8. What happens if LossCo experiences successive section 382 ownership changes?