IRC 384: Buying a Winner yet Still Losing Out
You may be familiar with Internal Revenue Code Section 382 of the tax code, which limits an acquiring corporation’s ability to use certain preexisting tax attributes once the target corporation experiences an “ownership change.” The triggering of Section 382 can raise some rather complex issues, and may even serve as a potential roadblock to profitable, tax-paying corporations who are eager to reduce their tax burden by attempting to purchase the tax attributes of “loss corporations.”
by William G. Ruffner, CPA, and Michael J. Tighe, CPA Dec 20, 2019, 13:22 PM
You may be familiar with Internal Revenue Code (IRC) Section 382 of the tax code, which limits an acquiring corporation’s ability to use certain preexisting tax attributes once the target corporation experiences an “ownership change.” The triggering of Section 382 can raise some rather complex issues, and may even serve as a potential roadblock to profitable, tax-paying corporations who are eager to reduce their tax burden by attempting to purchase the tax attributes of “loss corporations.” Loss corporations are attractive to the acquirer because they possess highly coveted net operating losses and perhaps a variety of tax-credit carryforwards. Since Section 382 solely pertains to the acquisition of loss corporations, does that mean that those who acquire gain corporations can get away from the long arm of the tax law? The answer, of course, is no. There is a code section that packs just as big of a punch as Section 382 but gets significantly less attention: IRC Section 384.
Section 384 was enacted in 1987 (one year after the significant revision of Section 382) as part of the Revenue Act of 1987, and then was substantially revised one year later in the Technical and Miscellaneous Revenue Act (TAMRA) of 1988. The general purpose of Section 384 is to prohibit loss corporations from being able to immediately use their preexisting losses by sheltering built-in gains after acquiring a target corporation possessing built-in gains. Without the presence of taxable income generated on the disposition of those built-in gain assets, the pre-existing losses might otherwise expire unused. The rules are written so that Section 384 applies when one of the two (or both) corporations is a “gain corporation” and the other has preacquisition attributes such as net operating losses. Section 384(c)(4) broadly defines a gain corporation as any corporation with a net unrealized built-in gain (NUBIG), which is any amount where the fair market value of the corporation’s assets is more than the aggregate adjusted basis at the time of acquisition.
The following is an example of how Section 384 works when a target corporation that owns an asset with a NUBIG is acquired by a loss corporation:
Asset Corp. owns real estate property with an adjusted basis of $100, which has a fair market value of $500 in year one. In year two, the shares of Asset Corp. are purchased by Acquiring Co., which is a loss corporation due to the fact that it has preexisting tax attributes of net operating losses and a capital loss carryforward. As a result of the acquisition, Asset Corp. was included within Acquiring Co.’s consolidated federal income tax return. In this example, the real estate property is held as a capital asset in the hands of Asset Corp. and is subsequently sold to an unrelated third party in year three. The difference of $400 ($500 fair market value less basis of $100) is considered a NUBIG, and once sold would generate a recognized taxable gain, capital in nature, in year three. Since Acquiring Co. has expiring capital loss carryforwards, the ability to produce capital gains is critical to them as those losses are not deductible without the presence of offsetting capital gains under IRC Section 1211(a). In this example, Section 384 would disallow the use of the capital loss carryforward because the real estate was sold within five years after the acquisition of Asset Corp., which is how long Section 384 applies postacquisition.
It is easy to understand why a corporation with soon-to-expire tax attributes would be inclined to find creative ways to produce taxable income or trigger taxable gains to recognize a cash tax benefit from those losses. Without the existence of Section 384, corporations could simply shop for gains in the open market by purchasing other corporations with the right mix of attributes.
There is no question that Section 384 casts a big net, as it can apply to both stock and asset acquisitions (under IRC Section 368 A, C, or D reorganizations). There are, however, exceptions that serve to keep it at bay. As mentioned earlier, there is a postacquisition five-year window for which it applies. Therefore, if an entity acquires the stock of a gain corporation but does not trigger the gain recognition of the appreciated property in the first five years after acquisition, then Section 384 will not come into play. There is also a common control exception under Section 384(b)(1), which states that the impact of Section 384 does not apply if both parties were a part of a “controlled group” at all times during the five-year period ending on the acquisition date. Lastly, Section 384(a) specifically allows built-in gains to be offset by preacquisition losses as long as they are directly from the same gain corporation. This reflects the fact that the spirit of the law was designed to prevent losses from one corporation from the offsetting gains of another corporation.
On the surface, it may seem as though the IRS is trying to deter corporate ac-quisitions of any kind, but the reality is that it wants to ensure that there is a valid business purpose for the acquisition other than simply avoiding paying tax. Absent Section 384, a deferred tax liability could essentially be converted into a permanent avoidance of tax for a taxpayer. In today’s ever-so-complex tax environment, it is important to be aware of the technical issues and traps that are lurking when two corporations enter into an otherwise typical transaction involving a change of ownership.
William G. Ruffner, CPA, is director of taxation in Global Tax Management Inc.’s Pittsburgh office and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at bruffner@gtmtax.com.
Michael J. Tighe, CPA, is senior tax manager in Global Tax Management’s Radnor office. He can be reached at mtighe@gtmtax.com.
