Closing of the books election pursuant to regs. sec. 1.382-6.

• Author: Yalowich, Adam

A loss corporation that undergoes a change in ownership may find the amount of taxable income that may be offset by its net operating losses (NOLs) is subject to limitation under Sec. 382. Unless the change date occurs exactly on the date of the corporation's year-end, the corporation will have to allocate its income or loss during the change year between the "prechange" and "postchange" periods. This allocation can have tremendous significance in determining the NOL subject to the limitations of Sec. 382.

Sec. 382(b)(3)(A) provides the general rule that taxable income or loss must be allocated ratably to each day in the year of the ownership change. The IRS announced in Notice 87-79 its intention to issue regulations that would allow a taxpayer to make a closing of the books election with respect to taxable income or loss in the change year. However, the Service mandated that the ratable allocation method must be used until regulations were issued, unless a letter ruling had been requested.

Several letter rulings were issued, stipulating that a taxpayer could use a closing of the books method. However, as a condition, the IRS mandated that the amount of income or loss that could be allocated to the prechange period could not exceed the amount of taxable income or loss for the entire year. The significance of this limitation can be seen in Example 1, below.

Example 1: Loss corporation L, a calendar-year taxpayer, has an ownership change on July 1, 19X5. L has an NOL carryforward of $1,500,000 to 19X5.

Prechange income $1,000,000 Postchange loss (750,000) Entire year $ 250,000

The $250,000 is allocated entirely to the prechange period. The allocation to the postchange period is $0. The NOL subject to the Sec. 382 limitation is $1,250,000.

As a result of the Service's position, L would only be able to offset $250,000 of taxable income against the NOL, leaving a $1,250,000 carryforward subject to the Sec. 382 limitation. The IRS alleviated this negative result in regulations proposed in 1992, by allowing for an increase to the Sec. 382 limitation to the extent that postchange losses were offset against prechange income. L would increase its Sec. 382 limitation by $750,000.

Final regulations issued on June 22, 1994 (which minimally modified the proposed regulations) are effective for ownership changes occurring on or after that date. Significantly, however, the limitation increase rule did not make it into the final regulations.

The regulations...