United States

IRS closes perceived loop-hole in NOL guidance due to TCJA expensing

Full expensing eliminated from Notice 2003-65 RBIG calculation

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Full expensing on both newly constructed as well as pre-existing tangible property pursuant to section 168(k) is a significant benefit to many taxpayers. However, as is often the case with new tax legislation, application of the law can lead to curious results. In this case, the IRS and Treasury felt the impact of full expensing to the section 382 recognized built-in gain provisions of Notice 2003-65 was unintended. As a result, Notice 2018-30 modifies Notice 2003-65 requiring determination of recognized built-in gain (RBIG) or loss (RBIL) without regard to section 168(k) for ownership changes occurring after May 8, 2018. Note that ownership changes occurring prior to May 8, 2018 would generally be able to rely upon unmodified Notice 2003-65.

Section 382 Limitation

If an ownership change occurs, the amount of the loss corporation's pre-change losses, credits and in some cases future deductions that may offset taxable income for a post-change tax year cannot exceed the section 382 limitation for such year. The annual section 382 limitation equals the value of the stock of the loss corporation immediately before the ownership change multiplied by long-term tax-exempt rate with appropriate adjustments as necessary under the applicable code and regulations.

In addition to the general annual limitation defined within section 382(b)(1), the annual limitation may be increased if the loss corporation is a net unrealized built-in gain (NUBIG) corporation.1 However, if the loss corporation is a net unrecognized built-in loss (NUBIL) corporation, certain post-change losses and deductions may become subject to the annual limitation.2

A loss corporation has a NUBIG if the excess of the fair market value of its assets immediately before an ownership change over those assets’ aggregate adjusted basis exceeds a threshold amount of the lesser of $10 million or 15 percent of the fair market value of the corporation’s assets on the change date.3 Conversely, a loss corporation has a NUBIL if the excess of the aggregate adjusted basis of its assets over such assets’ fair market value exceeds the threshold.

If the loss corporation has a NUBIG, the annual limitation is increased by the built-in gain recognized in the tax year to the extent that the recognition of the built-in gain occurs within the recognition period and does not exceed the NUBIG reduced by prior recognition of built-in gains.4If the loss corporation has a NUBIL, “the recognized built-in loss for any recognition period taxable year shall be subject to limitation under section 382 in the same manner as if such loss were a pre-change loss,” limited to the loss corporation’s NUBIL reduced by prior recognition of built-in losses.5

Notice 2003-65

In Notice 2003-65, the IRS provided that a loss corporation may use one of two approaches to calculate built-in gains or losses, one based on section 338 and one based on section 1374.6 These methods are considered safe harbors and are not the exclusive means of identifying built-in items for the purpose of section 382(h).

For a loss corporation with a NUBIG, the section 338 approach treats certain built-in gain assets of the loss corporation as generating recognized built-in gain (RBIG) even if such assets are not disposed of during the recognition period. The section 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 a hypothetical asset acquisition. Therefore, with respect to an asset that had a built-in gain on the change date, the section 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 is 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.

Notice 2018-30

It is here in the application of the cost recovery approach that the changes made to section 168(k) provided the ‘unintended’ consequence. The changes made to section 168(k) removed the original use requirement from the definition of qualified property, thereby extending 100 percent bonus depreciation to acquired property placed in service by the taxpayer that may have been used by the prior owner. Thus, when calculating the cost recovery deduction that would have been allowed to the loss corporation had an election under section 338 been made, section 168(k) seemingly provided for immediate expensing of qualified property. In turn, the loss company would be treated as recognizing RBIG in an amount equal to the fair market value of its qualified property over its current year actual depreciation.

Notice 2018-30 states that the IRS and Treasury believed that the intent of section 168(k) was to incentivize investment in property and not to approximate the recovery of income related to an asset, and as such they modified Notice 2003-65 to eliminate the immediate expensing and accelerated RBIG resulting from section 168(k) for ownership changes occurring after May 8, 2018. Notice 2018-30 likewise modified the section 1374 approach to address similar concerns.

Summary

It is debatable whether the IRS and Treasury are correct in their assessment of the legislative intent of the statute. If the intent of the statute was to incentivize investment in pre-existing property acquired directly by the taxpayer, it would seem reasonable to argue that intent would also include an indirect acquisition of property through the acquisition of the owner of such property. In acquiring the stock of a loss company without a section 338 election, there is no basis step-up and no immediate expensing; however, the NOLs of the company are an attribute providing for future reductions in taxable income similar to depreciation. So is it unreasonable to assume that the intent of the immediate expensing provisions would equally apply to indirect acquisitions of pre-existing property? It is likely a moot point as Notice 2003-65 provides the only safe harbor for calculating RBIG and RBIL, so taxpayers wishing to avail themselves of the benefits of either the section 338 or section 1374 approach need to follow the notice as modified by Notice 2018-30.

1. section 382(h)(1)(A)

2. section 382(h)(1)(B)

3. section 382(h)(3)(B)

4. section 382(h)(1)(A)

5. section 382(h)(1)(B)(i) and (ii)

6. 2003-2 C.B. 47

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