Issues and pitfalls in Sec. 384 - limits on NOL use.

• Author: Lehrer, John
• Position: Net operating losses

The Code includes numerous provisions that limit a taxpayer's ability to use net operating losses (NOLs) (e.g., Sees. 269,382 and 384 (as well as the consolidated return separate return limitation year rules)), each of which was enacted to prevent a perceived abuse. For example, Sec. 269 disallows tax benefits from certain transactions when tax avoidance is the principal purpose; Sec. 382 prevents taxpayers from trafficking in loss corporations.

Sec. 384 generally applies to transactions that combine a loss corporation with a gain corporation that has built-in gain (BIG) assets. Originally enacted in 1987, it restricts a taxpayer's ability to offset certain recognized BIGs (RBIGs) of the gain corporation with a loss corporation's pre-acquisition NOLs. Its effect may be significant and should not be overlooked.

Sec. 384 Mechanics

Several requirements must be met for Sec. 384 to apply. First, under Sec. 384(a)(1), one corporation must acquire either (1) "control" of another corporation or (2) the assets in an A, a C or a D reorganization. Sec. 384(c) (5) states that the Sec. 1504(a)(2) definition of control applies (i.e., 80% of vote and value). Next, at least one of the corporations must be a "gain corporation" (i.e., it must have a net unrealized BIG (NUBIG)). Sec. 384(c)(8) provides that, for these purposes, NUBIG generally has the same meaning as in Sec. 382(h). Finally, one of the corporations must have pre-acquisition NOLs.

Generally, under Sec. 384(a), the gain corporation's income during any "recognition period taxable year" (RPTY) cannot be offset by pre-acquisition NOLs (other than those of the gain corporation) to the extent such income is attributable to RBIG. Cross-referencing the Sec. 382(h)(7)(B) definition, an RPTY is any tax year that includes a portion of the 60-month period following the acquisition date (the recognition period).

Exceptions and Limits

There are exceptions to and limits on applying Sec. 384. For instance, under Sec. 384(c)(1)(C), the RBIG in any given RPTY cannot exceed the initial NUBIG, reduced by the RBIG from prior RPTYs. Thus, the potential loss limit is capped by the NUBIG at acquisition. Additionally, Sec. 384 does not prevent a gain corporation from using its own preacquisition NOLs to offset RBIGs arising during the recognition period. Similarly, Sec. 384 does not limit use of post-acquisition NOLs, nor apply to gains attributed to post-acquisition appreciation or recognized after the recognition...