In Notice 2018-30 the IRS has modified certain safe harbor calculations for recognized built in gain (RBIG) and recognized built in loss (RBIL) as it relates to limitations under IRC §382. The IRS has revised guidance found in Notice 2003-65 to modify the safe harbor rules found in the IRC §§338 and 1374 approaches described in that ruling.
IRC §382 serves to limit the ability to “buy losses” in an existing corporation, limiting the corporation’s ability to claim pre-ownership change losses against post-change taxable income. That ability is limited by the §382(b) limitation for each taxable year.
The corporation may have assets worth less than their book value at the time of the ownership change. The notice describes the treatment of such losses as follows:
Section 382(h) provides rules for the treatment of built-in gain or loss with respect to assets owned by the loss corporation at the time of its ownership change. Under that provision, if, at the time of an ownership change, a loss corporation has a net unrealized built-in gain (NUBIG), any RBIG for a taxable year within the 5-year recognition period following the ownership change increases the section 382 limitation for that year, but not above the amount of the NUBIG. Similarly, if a loss corporation has a net unrealized built-in loss (NUBIL), any RBIL for a taxable year within the 5-year recognition period is a pre-change loss subject to the section 382 limitation, but not above the amount of the NUBIL.
The IRS provided in Notice 2003-65 two safe harbor methods that could be used by a taxpayer to recognize that built in gain and/or built in loss over the years in question. Generally, the rule looks to provide a deemed recognized gain in a year equal to the additional depreciation that could have been claimed if that built-in gain was actually part of the basis of the asset. It also provides a similar calculation to take into the excess depreciation that is being claimed on assets with a fair value that is less than their basis at the time of the ownership change.
As the new Notice states:
Under the 338 approach, items of RBIG and RBIL are identified—
…generally by comparing the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if a section 338 election had been made with respect to a hypothetical purchase of all of the outstanding stock of the loss corporation on the change date…
Notice 2003-65, 2003-2 C.B. at 749. As described in Section IV of Notice 2003-65, under the 338 approach, certain assets generate RBIG or RBIL even if not disposed of during the recognition period. Specifically, the 338 approach treats as RBIG or RBIL (as the case may be) the difference between the loss corporation’s actual allowable cost recovery deduction with respect to an asset and the hypothetical cost recovery deduction that would have been allowable with respect to the asset had an election under section 338 been made for a purchase of the loss corporation’s stock.
The Recognized Built-In Gain for a year under the 338 approach is, per the Notice, determined as follows:
The 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 the hypothetical purchase. Therefore, with respect to an asset that had a built-in gain on the change date, the 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.
A similar approach is used to compute the recognized built-in loss, determining the “excess” depreciation being claimed by the entity.
All was well until the Tax Cuts and Jobs Act, which expanded IRC §168(k)’s bonus depreciation, now set at 100%, to apply to used property—which would include property that would be part of a §338 election. Thus, the calculations specified under the above methods would end up generating very different numbers than occurred prior to TCJA.
The IRS has decided to change the method to eliminate the use of bonus depreciation in these hypothetical calculations. As the IRS notes:
…[T]he Treasury Department and the IRS have determined that the hypothetical cost recovery deduction using the additional first year depreciation allowed under section 168(k) does not provide a reasonable estimate of the income or expense produced by a built-in gain or loss asset during the recognition period. Thus, the use of this additional first year depreciation would invalidate the assumption that underlies the section 338 approach, as set forth above.
The IRS notes that the problem also spills over to a portion of the alternative safe harbor §1374 approach described in the 2003 notice.
The 1374 approach generally incorporates the rules of section 1374(d) of the Code and §§ 1.1374-3, 1.1374-4, and 1.1374-7 of the Income Tax Regulations in identifying RBIG and RBIL. The 1374 approach relies on the accrual method of accounting in determining whether certain items of income or deduction are RBIG or RBIL respectively. However, in accordance with section 382(h)(2)(B), the 1374 approach treats any allowable deduction for depreciation, amortization, or depletion (collectively, “amortization”) of a built-in loss asset as RBIL, except to the extent the loss corporation establishes that the amount is not attributable to the excess of an asset’s adjusted basis over its fair market value on the change date, regardless of whether the amount accrued for tax purposes before the change date. In determining the amount of amortization deduction that is not attributable to an asset’s built-in loss on the change date, Notice 2003-65 provides:
One acceptable method is to compare the amount of the amortization deduction actually allowed to the amount of such deduction that would have been allowed had the loss corporation purchased the asset for its fair market value on the change date. The amount by which the amount of the actual amortization deduction does not exceed the amount of the hypothetical amortization deduction is not RBIL.
Notice 2003-65, 2003-2 C.B. at 749. This method is essentially the same as the 338 approach for determining RBIL.
Thus, the IRS again rules that the bonus depreciation provisions of IRC §168(k) are not to be used for this approach either.
The notice is effective for ownership changes occurring after May 8, 2018.