Unrealized Built-in Gains and Losses Under Section 382 and the Tax Accounting Rules

Originally published in The Tax Adviser, November 2010  [http://www.aicpa.org/Publications/TaxAdviser/2010/November/Pages/clinic_nov10-story-10.aspx]

Many practitioners already know that section 382 generally limits the use of a corporation’s net operating losses (NOLs) in cases where there is an increase in ownership of more than 50 percentage points by one or more 5% shareholders during a three-year testing period.

Many practitioners also know that section 382 addresses cases in which corporations have either net unrealized built-in gains (NUBIGs) or net unrealized built-in losses (NUBILs) as of the ownership change date. In such cases, under section 382(h) generally,

1. For corporations with NUBIGs, a year’s section 382 limitation is increased by recognized built-in gains for that year during the five-year recognition period following the change or
2. For corporations with NUBILs, recognized built-in losses for a year during the five-year recognition period following the change are treated as if they were pre-change NOLs.

Section 382(h)(3)(A) defines the terms NUBIG and NUBIL as the amounts by which the fair market value (FMV) of the corporation’s assets immediately before an ownership change is more or less, respectively, than the aggregate adjusted basis of such assets at such time.

Interestingly, what practitioners and taxpayers sometimes do not consider is section 382(h)(6)(C)’s requirement that NUBIGs and NUBILs must generally be further adjusted for items of accrued income and accrued deductions attributable to the pre-change period (to the extent not already recognized as of the change date).

This provision can yield unexpected results (sometimes good, sometimes bad). As shown in Example 1, it can mean that a corporation that at first appears to have a NUBIL might actually have a NUBIG. Alternatively (as shown in Example 2 below), given a seemingly minor factual difference, it can mean a corporation that at first appears not to have a NUBIL might not be able to avoid having one.

Example 1: All amounts are determined as of the change date (December 31, year 1). Legal settlement accrual is reasonably ascertainable in amount but is not agreed to or paid until January 5, year 2 (i.e., neither the all-events test of section 461(h)(4) nor economic performance per section 461(h)(1) is met as of the change date).

The corporation has a net unrealized built-in gain of $1.7 million, computed as follows (see exhibit below):

• Intangible: The FMV exceeds the basis by $2 million.
• Land: The basis exceeds the FMV by $300,000.
• Accrued legal settlement (related to a tort): This $3 million amount is excluded from the calculation because it did not represent a proper accrual (aside from required economic performance) as of the change date. Therefore, it is not treated as being attributable to the pre-change period and is not a component of any NUBIG or NUBIL.

Example 2: All amounts are determined as of the change date (December 31, year 1). Legal settlement accrual is reasonably ascertainable in amount and is agreed to but is not paid until January 5, year 2 (i.e., the all-events test is met as of the change date, with economic performance occurring after the change date). Pre-change NOLs are $500,000. The section 382 limitation is $1 million.

The corporation has a net unrealized built-in loss of $1.3 million, computed as follows (see exhibit below):

• Intangible: The FMV exceeds the basis by $2 million.
• Land: The basis exceeds the FMV by $300,000.
• Accrued legal settlement (related to a tort): This $3 million amount is included in the calculation because the deduction was a proper accrual at the change date under the all-events test but was deferred until paid under section 461(h)(2)(C). Therefore, it is treated as being attributable to the pre-change period and is a component of any NUBIG or NUBIL.

This means that the deduction (to the extent of the NUBIL of $1.3 million) is lumped together with the corporation’s pre-change NOLs and (in this case) is subject to the section 382 limitation as a realized built-in loss.

Exhibit

	Tax Basis	Fair Market Value	Difference
Assets
Intangible	0	2,000,000	2,000,000
Land	2,000,000	1,700,000	(300,000)
Liabilities
Accrued legal settlement (tort)			(3,000,000)

Using the numbers above, there would be a post-change deemed NOL of $1.8 million (pre-change losses of $500,000 plus $1.3 million of realized built-in losses), which could only offset income in the subsequent year (December 31, year 2) of up to the $1 million section 382 limitation, with the remainder ($800,000) of the disallowed realized built-in losses being carried forward under the rules applicable to NOLs.

While these two examples are admittedly simple (and focus only on accrued deductions), they do make one thing clear—corporate tax practitioners must pay close attention not only to the unrealized gains and losses inherent in a corporation’s assets when facing a section 382 limitation, but also to those less-obvious items of accrued income and expense. In fact, the author was approached about a year ago by another practitioner on a matter fairly similar to Example 1 above, where the numbers were many times higher than those given here. As a result, what initially looked like a large NUBIL instead turned out to be a substantial NUBIG, much to the relief of all involved.

Bottom line: Don't forget to consider the tax accounting method rules (for accrued income or expense items) when dealing with section 382.