September 24, 2019

M&A Tax: IRS Proposes to Limit Use of NOLs for Built-In Gains

Section 382 of the Internal Revenue Code significantly limits a buyer’s ability to use a target’s pre-acquisition net operating losses to offset future income. However, if a target has appreciated assets, Section 338 of the Code allows a buyer to use those NOLs more quickly to the extent that it opts to recognize the target’s “built-in” gains on those assets within five years after the ownership change.

On the off chance that the first paragraph persuaded at least a few of you that I know what I’m talking about here, I’m going to quit while I’m ahead and just point you in the direction of this recent Jones Day memo, which says that proposed IRS regulations would reverse this favorable treatment under Section 338:

Very generally, if a corporation experiences a more than 50% change in ownership over a rolling three-year period, section 382 of the Internal Revenue Code imposes an annual limit on the corporation’s ability to offset future income with existing NOLs. This limit is tied to equity value and interest rates and therefore may be extremely low, particularly for a distressed company whose NOLs are often among its most valuable assets. Significantly, to the extent a corporation recognizes “built-in” gain within five years after an ownership change (realized gain), the corporation increases its annual limit up to its overall net unrealized gain on the ownership change date.

IRS Notice 2003-65 helpfully permits a corporation to determine realized gain by comparing (i) the deemed depreciation/amortization that would result from a hypothetical sale of the corporation’s assets to (ii) the corporation’s actual (and often lower) depreciation/amortization. The difference between the above amounts represents realized gain even though no assets are sold.

The proposed regulations would significantly change the determination of overall net unrealized gain and realized gain. They would eliminate taxpayers’ ability to increase realized gain without actual dispositions of assets. The required calculations would significantly limit consideration of many liabilities in measuring asset value, reducing the amount (or existence) of overall net unrealized gain, a particularly meaningful change for distressed companies. Finally, the proposed regulations would make various technical (and generally taxpayer unfavorable) changes, including as to the treatment of contingent liabilities and debt cancellation income for these purposes.

The memo points out that start-up companies that experience a change in ownership as a result of a venture capital investment would be disproportionately impacted by the rule proposal.

John Jenkins