January 24, 2022

Volume XII, Number 24


January 21, 2022

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Proposed Regulations Alter the Scope of the Section 382 Loss Limitation Rules for Recognized Built-in Gains and Losses

Proposed Section 382(h) regulations released this week (the Proposed Regulations) potentially would increase the scope of a corporation’s income – namely, cancellation of debt income (COD Income) - recognized after an “ownership change” that is subject to limitation under Section 382 of the Internal Revenue Code. The Proposed Regulations also address certain other implications of the Tax Jobs and Cuts Act (TCJA), namely, disallowed interest expense deductions under new Section 163(j) and immediate expensing under Section 168(k), in these cases in a manner that potentially would limit the scope of the Section 382 Limitation on a case by case basis. 


Corporations long have had to contend with Section 382 and the complex set of regulations and guidance issued thereunder that are intended to prevent taxpayers from trafficking in losses.  Prior to the codification of Section 382, one corporation could acquire all of the outstanding stock of a corporation (often referred to as a loss corporation) with net operating losses (NOLs) and freely use those losses against its own income (or allow the loss corporation to freely use its pre-acquisition losses against post-acquisition income).  Section 382 primarily limits this practice by placing an annual limitation on a loss corporation’s ability to use NOLs arising before an ownership change.

In general, an ownership change occurs if the percentage of stock of the loss corporation held by its 5% shareholders (as specially defined for this purpose) increases more than 50 points within a specified testing period (generally, three years) over their lowest percentage of ownership during such period.  Note that as defined, an ownership change can occur in many situations outside of a 100% stock purchase by an unrelated buyer, including where existing 5% shareholders increase their ownership over the testing period, or where a creditor (such as in a restructuring) or other third party becomes a 5% shareholder during a testing period, and, together with other 5% shareholders increasing their ownership in the same period, cross over the 50 point mark.  

Once an ownership change has occurred, in general, the pre-change NOLs of the loss corporation only can be used against post-change income in an amount equal to the product of (A) the fair market value of the corporation at the time of the ownership change and (B) a statutorily prescribed rate (the long term tax exempt rate) (the Section 382 Limitation).  Pursuant to Section 382(h), if the corporation has a “net unrealized built-in loss” (or NUBIL) at the time of the ownership change, any recognized built-in loss for the five year period following the ownership change (the recognition period) also is subject to the Section 382 Limitation.  Conversely, if the corporation has a “net unrealized built-in gain” (or NUBIG), Section 382(h) provides that the Section 382 Limitation is increased by the amount of any “recognized built-in gain” (or RBIG), which is gain recognized in the same five-year period – in other words, generally pre-change NOLs freely may offset RBIG as if there were no Section 382 Limitation (as such gain is attributable to the pre-change period).  NUBIG or NUBIL is measured by the difference between the fair market value of the corporation’s assets immediately before the ownership change and the aggregate adjusted tax bases of such assets (as if the corporation sold all of its assets at fair market value at the time of the change).  

Notice 2003-65

For years, taxpayers had limited guidance on the items of gain and loss that properly are treated as items of built-in gain or loss, and primarily relied on guidance issued by the Internal Revenue Service (IRS) in Notice 2003-65 to determine whether a pre-change loss fully was available to offset post-change items of income.  Primarily, Notice 2003-65 provides two safe harbor methods for computing NUBIG and NUBIL – the “Section 1374 method” (borrowed from the rules regarding the built-in gain of a C corporation that becomes a subchapter S corporation) and the “Section 338 method” (borrowed from the election to treat a sale/purchase of stock of a corporation as an asset sale/purchase for tax purposes).  The Section 1374 method generally is an accrual method that identifies items of built-in gain/income and built-in loss at the time of the ownership change.  The Section 338 method, arguably more confusingly, compares the actual items of income/gain and loss recognized during the recognition period with those that would have been recognized if the corporation had in fact made a Section 338 election.

Taxpayers long have relied on Notice 2003-65 to be able to use pre-change NOLs to fully offset post-change COD Income (arising in the recognition period), which generally is taxable unless the taxpayer borrower is a debtor in a Title 11 bankruptcy case or is insolvent (to the extent of the insolvency); if the COD Income is excluded from taxable income, the taxpayer is required to reduce certain tax attributes, including tax basis in its assets (but does not pay tax on the COD Income).  Under both the Section 1374 and the Section 338 methods, taxable COD Income is RBIG, meaning that pre-change NOLs generally can offset such income unlimited by Section 382.  (The Section 338 method specifically limits the amount of COD Income that can be NUBIG to an amount not exceeding the excess of the adjusted issue price of the debt over the fair market value of the debt at the change date.  The Section 1374 method is silent on this point.) 

Proposed Regulations: Changes From Notice 2003-65

Apparently in response to taxpayer concerns over the years (as well as recent tax reform in the TCJA), the Proposed Regulations would eliminate the Section 338 method and make the Section 1374 method mandatory for the computation of built-in gains and losses – which overall further may limit the amount of pre-change NOLs that a taxpayer can use to offset post-change income.  Notably, the Proposed Regulations contain modifications to the treatment of COD Income that would limit the ability of taxpayers to include such income as RBIG eligible for offset against unlimited pre-change NOLs; if such income is not RBIG, it does not increase the Section 382 Limitation, which is the means by which it otherwise effectively would escape the limitation.

Notice 2003-65 did not specifically distinguish between taxable and excluded COD Income, which, as noted in the Preamble, “results in the overstatement of RBIG (or understatement of RBIL) in contravention of Section 382(h)(6)(C).”  Accordingly, the Proposed Regulations generally do not permit COD Income to be included in the calculation of NUBIG or NUBIL, but with some exception.  Namely, COD Income (including excluded COD Income, limited as described below) recognized with respect to recourse debt during the 12 month period following the change date is eligible for inclusion as RBIG, subject to certain further exceptions.  For one, with respect to taxpayers in bankruptcy with excluded COD Income, the maximum RBIG is the amount of debt discharged.  Second, the maximum RBIG for taxpayers recognizing COD Income during the first 12 months of the recognition period is the excess of liabilities over asset value immediately before the change date.  COD Income with respect to nonrecourse debt (recognized within the same 12 month period) also is treated as built-in gain, but only to the extent that the nonrecourse debt was undersecured immediately before the ownership change.  

The Preamble explains the complexity, and possibility for distortion, of including excluded COD Income (and corresponding attribute reduction) in the RBIG and NUBIL calculation, thus leading Treasury and the IRS to determine that excluded COD Income generally should not generate RBIG.  However, excluded COD Income for the 12 month period following the change date can be included as RBIG as described above to the extent that it is offset by a reduction in the tax basis of assets acquired after the ownership change.  The rationale for this rule is that such assets cannot themselves result in RBIG or be included in NUBIG or NUBIL (because they were not held prior to the ownership change), and thus no distortion is possible.

The net effect of the Proposed Regulations is to sharply curtail the use of pre-change NOLs against COD Income arising after an ownership change.  While taxpayers can rely on Notice 2003-65 until the Proposed Regulations are finalized, taxpayers should be aware that even a corporation with a NUBIG potentially will have to contend with a Section 382 limitation for most COD Income arising after an ownership change (instead of, in many cases, comfortably applying pre-change NOLs against such income within the five-year recognition period without limitation under Section 382).  While the one year period is helpful, the recourse and undersecured debt limitations render COD Income arising in many workouts from being ineligible for inclusion in RBIG – thus, the Section 382 Limitation would apply to pre-change NOLs that could be used against such income.

Section 163(j) & Section 168(k)

The Proposed Regulations also attempt to address issues arising from new Section 163(j), which limits the deductibility of interest, generally to 30% of taxable income (see HERE).  This new limit, passed in the TCJA, results in disallowed interest expense that, according to the Preamble, also would result in an “unwarranted increase” in NUBIL (or decrease in NUBIG) if treated as recognized built-in loss/RBIL.  Thus, the Proposed Regulations provide that such disallowed interest expense is not treated as RBIL if such amounts were allowable as a deduction during the recognition period. (Comments are requested regarding corporations that are partners in partnerships with disallowed interest expense.)

Finally, the Proposed Regulations would abandon the approach in Notice 2003-65 regarding cost recovery deductions.  Under that approach, the taxpayer compares (1) actual depreciation deductions on a given asset to (2) depreciation deductions that would be allowable (ignoring new 168(k) immediate expensing) if the asset were purchased at the change date by an unrelated party for fair market value.  Recognizing that depreciation deductions under Section 168 tend to be larger closer to the start of an asset’s life, and how this is more so following new Section 168(k) immediate expensing (see HERE), the Preamble notes that the approach in the Notice could lead to “absurd results” by creating RBIL even when the fair market value of a corporation’s assets is equal to their tax bases (and there thus is no NUBIL).  Under the Proposed Regulations, the hypothetical cost recovery deduction instead is computed by applying the same depreciation schedule actually used by the corporation to the fair market value of the asset.  This is expected to result in less RBIL, particularly for taxpayers with an asset the basis of which exceeds its fair market value.

Note that in both cases (with respect to new Sections 163(j) and (k)(8), avoiding RBIL is taxpayer-favorable, as it would allow the post-change deductions to escape inclusion in the Section 382 Limitation.  

The Treasury Department has requested comments with respect to most aspects of the Proposed Regulations, and we expect a fair amount of activity in that regard, especially given the significant modifications to the treatment of post-change COD Income.  In particular, we expect comments requesting broader safe harbors for treating COD Income as RBIG, and possibly comments asking for more specific guidance on the nature of debt as recourse or nonrecourse beyond general tax principles (which many otherwise have found to be lacking in other contexts).

© 2022 Bracewell LLPNational Law Review, Volume IX, Number 270

About this Author

Michele J. Alexander, Bracewell, Capital Markets Lawyer, Securities Offerings Attorney

Michele helps clients navigate complex tax issues while ensuring they meet their business goals. In her years of practice, Michele has counseled on an array of transactions, including mergers and acquisitions, capital markets and securities offerings, financings, joint ventures, and restructurings.

In recent years, Michele’s practice has evolved to include a strong focus on private equity and hedge funds and similar investment vehicles. Additionally, she is experienced in real estate investment trusts and the opportunities and challenges of...


Catherine (PRON. “Catrina”) Engell advises clients in tax matters related to corporate transactions, including mergers and acquisitions.  Previously she represented clients in federal, state, and local tax disputes before the Internal Revenue Service (IRS), the Tax Division of the US Department of Justice and state and local taxing authorities.