In September 2019, the Internal Revenue Service (IRS) and the Treasury Department issued proposed Section 382 regulations that, when finalized, would significantly reduce the value of net operating losses (NOLs) following Section 382 ownership changes, including those that occur in connection with mergers and acquisitions. (1)
In particular, the proposed regulations would eliminate the Section 338 approach described in Notice 2003-65 for adjusting a Section 382 limitation following an ownership change and would mandate the Section 1374 approach. (2) In addition, the proposed regulations would make changes to the Section 1374 approach that would result in a lower Section 382 limitation for many loss corporations. As discussed in more detail below, although these regulations are currently in proposed form, they can materially impact the terms and valuation approaches taken in current M&A transactions.
The Unbearable Uncertainty of Net Unrealized Built-in Gains and Losses
In general, following an ownership change, a loss corporation's NOLs are subject to a base Section 382 limit equal to the value of the loss corporation on the date of the ownership change multiplied by the long-term tax-exempt rate. (3) Currently, the long-term tax-exempt rate is less than two percent. (4) Assuming a long-term tax-exempt rate of two percent, upon an ownership change, a loss corporation with a value of $100 million would have a base Section 382 limitation of $2 million per year. If the loss corporation had hundreds of millions of dollars in NOLs at the time of the ownership change, it could literally take centuries to use all of the NOLs. And that calculation assumes that they were not pre-TCJA NOLs that would, for the most part, be certain to expire before being used. (5)
Under Section 382(h), the base Section 382 limitation can be adjusted upward for built-in gains or downward for built-in losses. If a loss corporation has a net unrealized built-in gain (NUBIG) on the ownership change date, the Section 382 limitation for any of the first five taxable years following the ownership change is increased by the amount of the realized built-in gain (RBIG) for the taxable year. (6) Conversely, if a loss corporation has a net unrealized built-in loss (NUBIL) on the ownership change date, the Section 382 limitation is decreased for any of the first five years following the ownership change by the amount of the recognized built-in loss (RBIL) for the taxable year. (7) The cumulative RBIG adjustment is limited to the amount of the NUBIG on the ownership change date, and the cumulative RBIL adjustment is limited to the amount of the NUBIL on the ownership change date. (8) If a loss corporation's NUBIG or NUBIL is not greater than the lesser of 1) fifteen percent of the fair market value of the loss corporation's assets immediately before the ownership change or 2) $10,000,000, then the loss...