Although section 382 generally was left unchanged by the Tax Reform Act,1 issues have arisen regarding its application to a new provision that modifies the first-year treatment of certain deductions related to qualified property under the rules. Specifically, questions have arisen about how the new 100-percent expensing rules impact the calculation of built-in gains and losses under section 382. The IRS is beginning to address these issues in guidance and to consider questions related to the new section 163(j) interest limitation rules and their potential application under section 382 when there is an excess interest carryforward after an “ownership change” as defined in section 382(g).
In general, section 382 limits a loss corporation’s ability to use its tax net operating losses (and other tax attributes) following an “ownership change.” An ownership change is triggered if one or more “5-percent shareholders” of the loss corporation increase their ownership in the aggregate by more than 50 percentage points during a testing period. Once an ownership change has occurred, the amount of net operating losses that the corporation may use to offset taxable income in any year is limited to the “section 382 limitation” resulting from the ownership change. The section 382 limitation is a formulaic calculation that is basically equal to the product of the value of the loss corporation (subject to certain adjustments) and the long-term tax-exempt rate.
Built-In Gains and Losses
In addition to the section 382 limitation, taxpayers that are in a Net Unrealized Built-In Gain (NUBIG) may be allowed to increase their section 382 limitation for the first 60 months after the change date by applying the relevant rules outlined in Notice 2003-65. As a general rule, to determine if a taxpayer is in a NUBIG or in a Net Unrealized Built-In Loss (NUBIL) position as of the change date, the loss corporation must compare the fair market value of all of its assets to the tax basis of such assets, and, if the fair market value of the assets exceeds the tax basis by a statutory amount (generally the lesser of 15 percent of the total asset value or $10 million), the loss corporation is said to be in a NUBIG position. If the tax basis exceeds the fair market value of the assets on such date by the statutory amount, the loss corporation is in a NUBIL position. A loss corporation with a NUBIG may increase its ownership limitation to account for any recognized built-in gains (RBIG) that occur within the 60-month period following the ownership change. Under Notice 2003-65, RBIGs can arise for assets that are not disposed of during the 60-month period. Specifically, RBIGs can be the difference between the loss corporation’s actual allowable cost-recovery deduction with respect to an asset on the balance sheet at the time of the ownership change and its hypothetical cost-recovery deduction that would have arisen had there been a step-up in the tax basis to its fair market value as if a section 338 election had been made to treat the ownership change as a deemed purchase of the assets at their fair market value. The issue that arose as part of the Tax Reform Act is whether the new 100-percent expensing provision under section 168(k) for property acquired between September 27, 2017 and January 1, 2027 would increase RBIG in the first year following an ownership change because the deemed cost-recovery method would be to expense the “stepped-up” tax basis instead of depreciating the “stepped-up” tax basis under traditional depreciation methods.
On May 8, the IRS issued Notice 2018-30, modifying the NUBIG approaches in Notice 2003-65 by providing that hypothetical cost-recovery deduction approaches will be determined without regard to the 100-percent expensing rules under section 168(k). This approach has an effective date of May 8, 2018. The IRS claimed that allowing an immediate expensing for purposes of calculating NUBIG and RBIG would have been a “collateral consequence” to the expensing provision and cited the legislative history under section 168(k) as the primary reason for disallowing this beneficial treatment. According to the IRS, however, Congress implemented section 168(k) to encourage capital investment by reducing the cost of capital and simplifying record-keeping requirements. This view by the IRS as expressed in Notice 2018-30 has been seen by some tax commentators as inconsistent with the legislative history’s statement of the reason for the provision to simplify record-keeping requirements and will, thus, require loss corporations to compute RBIGs under a cost-recovery system that is different than the 100-percent expensing that taxpayers will use for non-section 382 purposes. As a result, certain loss corporations undergoing an ownership change under section 382 will be left with additional record-keeping requirements under Notice 2018-30.
Notice 2018-30 makes it clear that taxpayers following the section 338 approach for computing RBIG under Notice 2003-65 should use the hypothetical cost-recovery deductions that would have been allowable without regard to section 168(k). It does not specifically state that taxpayers need to determine the hypothetical recovery under the modified accelerated cost-recovery system. This raises the question of whether taxpayers are allowed to use an alternative method, such as straight line. Also, because the effective date of Notice 2018-30 is May 8, 2018, a question is raised with respect to a loss corporation that underwent an ownership change under section 382 between September 27, 2017 and May 8, 2018 and if such a loss corporation can utilize the expensing approach in section 168(k) in computing its hypothetical cost recovery.
Section 163(j) and Section 382
The Tax Reform Act modified section 163(j) by limiting a taxpayer’s annual deduction of business interest expense so that it “shall not exceed the sum of (A) the business interest income of such taxpayer for such taxable year, (B) 30 percent of the adjusted taxable income of such taxpayer for such taxable year, plus (C) the floor plan financing interest of such taxpayer for such taxable year.”2 Any amounts not allowed as a deduction in the year incurred shall be treated as “interest paid or incurred in the succeeding taxable year” under section 163(j)(2). The Tax Reform Act also added section 382(d)(3), which states that “the term ‘pre-change loss’ shall include any carryover of disallowed interest described in Section 163(j)(2) under rules similar to the rules of paragraph Section 382(d)(1).”3 Section 382(d)(3) provides that a loss corporation that undergoes an ownership change during the tax year should treat the portion of the annual loss arising from section 163(j)(2) as a pre-change loss. This addition to section 382 has created several unsolved issues.
Because the interest deduction that is carried forward is a deductible item in calculating operating income or loss, in a year in which a taxpayer has both net operating loss (NOL) carryforwards and a carryover of disallowed interest described in section 163(j)(2), the ordering of the use of either the disallowed interest carryover or a typical NOL carryforward is currently uncertain. Treasury Regulations section 1.383-1(d)(2) provides an ordering sequence for other attributes, such as pre-change capital losses, Recognized Built-In Losses and other tax credits. Absent guidance, it is difficult to determine where the excess interest deductions would be taken into account in this sequence if there is an ownership change. Secondly, section 382(d)(3) refers to “rules similar to the rules of” section 382(d)(1), which provides for ratable allocation in the absence of a closing of the books election for the allocation of losses in the year of an ownership change. However, no other information is provided as to how that rule will work for an interest deduction that arises at the end of a tax year. Specifically, the statute refers to section 163(j)(2) in defining the interest expense that is subject to section 382, which is only the carryforward portion of the excess interest. Thus, does section 382 apply to excess interest when there is a midyear ownership change because at the midyear point, the “excess interest” has not yet created a “carryforward”?
As the IRS described in Notice 2018-30, there can be “collateral consequences” to certain provisions of the changes enacted in the Tax Reform Act. Although section 382 was largely left intact, the interaction that section 382 has with other tax code provisions can have an impact on its application when the other provisions are changed. In the next year, the IRS and Treasury will likely issue guidance to help fill in these gaps. In the absence of this guidance, taxpayers undergoing ownership changes should consider preparing a detailed methodology memorandum to support their tax positions with respect to these types of transition and interpretation issues.
1 An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, PL 115-97 (Tax Reform Act). See Section 12001(a), modifying Section 55(a). Unless otherwise stated, all references to “section” are to the Internal Revenue Code.
2 Section 163(j) applies to all businesses regardless of form, with exceptions for taxpayers with average annual gross receipts of less than $25 million for the prior three-year period. There are no exceptions for financial services businesses, and the limitation applies regardless of the tax status of the payee or the payee’s relationship to the taxpayer. In determining the amount of the limitation, adjusted taxable income is taxable income computed without regard to (a) any item of interest, gain, deduction or loss that is not properly allocable to a trade or business; (b) any business interest or business interest income; (c) the amount of any net operating loss deduction; (d) the new 20 percent deduction for certain pass-through income; and (e) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion.
3 Section 382(d)(1) defines the term “pre-change loss.”
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.