RSM Resources

Background
In an effort to limit loss trafficking, congress enacted IRC§ 382, which operates to limit the utilization of corporate net operatinglosses following an ownership change.  Anownership change is defined generally as a greater than 50% change in theownership of stock among certain 5% shareholders over a 3-year period.  IRC § 382(g).  

In the event of an ownership change, utilization of the losscorporation’s NOLs and certain built in losses are limited under IRC § 382(b) tothe value of the loss corporation multiplied by the Adjusted Federal Long Term TaxExempt Rate. 

A loss corporation holding appreciated assets in excess oftheir tax basis is generally a Net Unrealized Built in Gain (NUBIG) corporation,in which case the annual IRC § 382 limitation is further increased forRecognized Built in Gains (RBIG) during the 5-year period beginning on the dateof the ownership change.  IRC §382(h)(1)(A).  However, if the losscorporation is a Net Unrealized Built in Loss (NUBIL) corporation, RecognizedBuilt in Losses (RBIL) during the 5-year recognition period are subject to theIRC § 382 limitation as if they were recognized prior to the ownership change.  IRC § 382(h)(1)(B).

In the event of a bargain sale, the Target corporation isgenerally a Net Unrealized Built in Loss (NUBIL) corporation, in which case,utilization of post ownership change deductions and losses may be limited byIRC § 382 (whether the Target corporation was a C corporation or Scorporation). 

Guidance

Bargain sales
Notice 2003-65 represents significant guidance in theapplication of IRC § 382 to NUBIL corporations. The notice defines two safe harbor methods for calculating thelimitation on post ownership change losses and deductions: (1) the IRC § 1374and (2) the IRC § 338 methods. 

Depending on the size of the bargain element, the approachchosen by the taxpayer could create significant differences in the ability toutilize deduction and losses.  In theevent of a bargain sale (NUBIL corporations) the IRC § 1374 approach isgenerally the more tax advantageous approach as unlike the IRC § 338 approach,it generally requires recognition of real losses in order to cause a limitationon the utilization of losses.

Leveraged buy-outs
Frequently acquisitions are structured as LBOs whereborrowing at the Target level finances a portion of the acquisition.  The structure of the acquisition and thesources for funding the acquisition can significantly affect the determinationof value for purposes of IRC § 382.  TheLBO structure has a detrimental affect to the ability to utilize Target NOLs.

For example, assume P acquires T for $200 through a directpurchase of T stock for $50 and a leveraged distribution from T of $150.  For purposes of IRC § 382, the value of T isonly $50 as the value of T must be reduced by the amount of the distribution.  Therefore, assuming a 5% long term tax exemptrate, the annual IRC § 382 is $2.5 versus $10 annually.  In addition, a borrowing at the P levelrather than the T level to finance the acquisition may have the same result.

Summary
Taxpayers should carefully analyze the implications of IRC §382 with respect to acquisitions and financings.  The methodology adopted, structure utilized,and location of borrowings may significantly affect the future utilization ofNOLs as well as post acquisition losses. Furthermore, a taxpayer cannot assume that IRC § 382 will not apply toan S corporation target.

This bulletin discusses certain general principles of taxlaw.  This bulletin does not address all the specific requirements orexceptions that may apply, and it does not apply these general tax principlesto any particular transaction or situation.  Accordingly, you should notrely upon the information in this bulletin for the purpose of implementing orreporting any particular transaction, and this bulletin may not be relied uponto provide any relief from any penalties under the Internal Revenue Code or anystate, local, or foreign tax law.  Consult your tax advisor regarding theapplication of these general tax principles to your specific situation.