Temp. regs. explain sec. 382 and built-in loss rules.

• Author: Stewart, Dave N.

Temporary regulations were issued in 1996 (1996 TRs) effectively withdrawing 1991 proposed regulations (1991 PRs) on the use of NOLs by consolidated groups.(1) The 1996 TRs are substantially similar to the 1991 PRs and are generally effective for tax years (or testing dates) beginning after 1996. The areas most affected are (1) the SRLY rules, (2) the consolidated Sec. 382 rules and (3) the consolidated BIL rules.(2) A previous article(3) examined the SRLY rules and many of the planning opportunities available after the 1996 TRs. This article will analyze the consolidated Sec. 382 rules and the consolidated BIL rules. (Table 1 on page 441 defines the acronyms used in this article.)

Table 1: Acronymns Used in This Article

BIG = built-in gain BIL = built-in loss CNOL = consolidated net operating loss CNOLCO = consolidated net operating loss carryover CRY = consolidated return year CTI = consolidated taxable income FMV = fair market value NOL = net operating loss NOLCO = net operating loss carryover NUBIG = net unrealized built-in gain NUBIL = net unrealized built-in loss PCM = parent change method SM = supplemental method SNOL = separate net operating loss SRLY = separate return limitation year SRY = separate return year

Sec. 362 Overview

Overhauled in 1986, Sec. 382 embraces a "neutrality" principle that imposes an annual limit on the use of NOLs and other tax attributes following an ownership change of a loss corporation. Under this principle, the loss corporation's new owners should not be able to use more of its tax benefits than could its former owners; thus, under Sec. 382(b)(1), the losses and other benefits deemed available to the seller of the stock (and hence, available for use by the purchaser) are represented by the income that would be generated if the assets were sold for cash and the proceeds invested in long-term tax-exempt bonds.

According to Sec. 382(g), an ownership change occurs when one or more 5% shareholders of a loss corporation (defined by Sec. 382(k)(1) as a corporation entitled to use a NOL for the tax year in which the ownership change occurs) experience a change in ownership in the corporation's stock of more than 50% over the least amount they owned at any time during the testing period. The "testing period" normally begins, under Sec. 382(i)(1), three years before the date of the ownership change. In addition, Sec. 382(g)(4)(d) provides special rules for 50%-or-more shareholders who treat their loss corporation stock as becoming worthless during a tax year. If more than one ownership change occurs, a separate Sec. 382 limit must be computed for each.

Congress imposed additional restrictions under Sec. 382(1) in determining the loss corporation's value when computing the Sec. 382 limit. Generally, the value of the loss corporation's stock must be reduced by (1) capital contributions made during the two-year period ending on the ownership change date (Sec. 382(1)(1)(B)), (2) capital contributions made before the two-year period for the principal purpose of avoiding or increasing the Sec. 382 limit (Sec. 382(1)(1)(a)), (3) redemptions or other corporate contractions occurring in connection with the ownership change (Sec. 382(e)(2)) and (4) the net value of the nonbusiness assets on the change date, it at least one-third of the value of the corporation's total assets consists of nonbusiness assets immediately after the ownership change (Sec. 382(1)(4)). The Sec. 382 limit is reduced to zero under Sec. 382(c)(1) if the loss corporation fails to satisfy a continuity-of-business test for two years after the ownership change date.

In addition to the above restrictions, under Sec. 382(h)(3), if a loss corporation has a NUBIL on the change date that exceeds the lesser of $10 million or 15% of the FMV of the loss corporation's assets, the Sec. 382 limit applies to any BIL recognized by the loss corporation within five years after the change date as if it were a pre-change date NOL. Conversely, the Sec. 382 limit is increased by (1) any BIG recognized by the loss corporation within five years after the change date, if the loss corporation has a NUBIG on the change date that exceeds the $10 million/15% test and (2) any recognized deemed sale gain resulting from a Sec. 338(g) election made in connection with the ownership change.

While the foregoing is merely a brief summary of a very complex issue, it is intended to assist in the following discussion of the application of Sec. 382 to consolidated groups.

Example 1: On June 1, 1995, P corporation purchased 40% of the outstanding stock of S corporation. On Dec. 31, 1996, when S had an FMV of $1,000 and a $300 NOL, P purchased an additional 42% of S stock. The long-term tax-exempt rate for 1996 was 7%. Because a more-than-500/o change (40% + 42% -- 0%) in ownership took place in the three-year period ending Dec. 31, 1996, Sec. 382 applies to limit the amount of the $300 NOL that S can use in any given year to $70 ($1,000 FMV X 0.07). The $1,000 FMV must be reduced for any capital contributions made in anticipation of the Sec. 382 ownership change, including any contributions made within the past two years. Further, if S fails to continue its historic business in 1997 and 1998, its FMV will be deemed to be zero on Dec. 31, 1996, reducing the Sec. 382 limit to zero and rendering the NOL useless.

Consolidated Sec. 383 Rules

Historically, the consolidated return regulations (Regs. Sec. 1.1502) have generally applied a separate-entity theory in determining an affiliated group's taxable income, but employed a single-entity theory in examining the group as a whole. When the new Sec. 382 rules were enacted in 1986, no regulatory guidance was provided as to their application on a consolidated basis. As a practical matter, Sec. 382 could be applied on a separate-company basis, on a single-entity basis or on some hybrid basis (e.g., using an equity method). The 1991 PRs provided guidance on these issues, but confusion resulted from the failure to finalize those rules. The 1996 TRs effectively incorporate the 1991 PRs, effective for tax years (and testing dates) after 1996.

Both the 1991 PRs and the 1996 TRs offer a dual approach in their application of Sec. 382 to an affiliated group. Under each set of regulations, a loss group (or subgroup) is treated as a single entity (the parent change method (PCM)). As discussed below, to avert potential abuses of the PCM by having shareholders sell interests in subsidiaries, an equity approach (the supplemental method (SM)) also applies.

PCM

Whether a consolidated group has undergone an ownership change is determined using a single-entity approach; the group members are treated as divisions of a single taxpayer, with the common parent acting as the sole agent for each. Temp. Regs. Sec. 1.1502-92T(b) (1) (i) provides that, under the PCM, a loss group has an ownership change only if the common parent has undergone an ownership change under Sec. 382(g) and Temp. Regs. Sec. 1.382-2T. Thus, whether a loss group has an ownership change is not affected by transfers of ownership interests by group subsidiaries.

Example 2: P corporation files consolidated returns with its wholly owned subsidiary, L corporation, which has a NOL. In January 1997, 40% of P's stock is sold to an unrelated party; in July 1997, 20% of L's stock is sold to an unrelated party. Under the PCM, the sale of L's stock is ignored; because P's ownership changed by only 40%, there has been no Sec. 382 ownership change.

SM

Temp. Regs. Sec. 1.1502-92T(c)(2) applies the SM if a 5%-or-more shareholder of the common parent increases its percentage ownership in both the parent and a subsidiary within a three-year period; in such event, the group must use the PCM to determine whether an ownership change has occurred. However, any subsidiary stock received by a 5%-or-more shareholder is treated as common parent stock equal in value to the subsidiary stock received.

Example 3: A, an individual, owns 100% of P...