algiers austin dallas fort worth houston macaÉ monterrey paris rio de janeiro vitÓria tax issues...

ALGIERS AUSTIN DALLAS FORT WORTH HOUSTON

MACAÉ MONTERREY PARIS RIO DE JANEIRO VITÓRIA

Tax Issues for Loss CorporationsOctober 19, 2004

Tax Issues for Loss CorporationsOctober 19, 2004

Presented Presented by

R. David WheatR. David Wheat

1700 Pacific Avenue, Suite 3300Dallas, Texas 75201

[email protected]

1700 Pacific Avenue, Suite 3300Dallas, Texas 75201

[email protected]

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OverviewOverview

Section 382Section 382

SRLY RulesSRLY Rules

Insolvent LiquidationsInsolvent Liquidations

Loss Disallowance RulesLoss Disallowance Rules

American Jobs Creation Act of 2004American Jobs Creation Act of 2004

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Section 382Section 382

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Section 382Section 382General RulesGeneral Rules

Section 382 of the Code limits the ability of a Section 382 of the Code limits the ability of a corporation to use its net operating losses corporation to use its net operating losses following an “ownership change.”following an “ownership change.”

Section 383 of the Code extends the limitation Section 383 of the Code extends the limitation to a corporation’s other tax attributes, such as to a corporation’s other tax attributes, such as tax credits and net capital loss carryovers.tax credits and net capital loss carryovers.

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Section 382Section 382Base CaseBase Case

P$100$100

L StockL Stock

L

$50 NOL$50 NOL

Facts: P buys 100% of L Stock from L’s shareholders for $100.Facts: P buys 100% of L Stock from L’s shareholders for $100.

Conclusion:Conclusion: The P - L group’s use of L’s $50 NOL is limited by Section 382.The P - L group’s use of L’s $50 NOL is limited by Section 382.

Shareholders

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Section 382Section 382Definition of “Ownership Change”Definition of “Ownership Change”

An “ownership change” occurs if the An “ownership change” occurs if the percentage of stock of the loss corporation percentage of stock of the loss corporation owned by one or more “5 percent shareholders” owned by one or more “5 percent shareholders” has increased by more than 50 percentage has increased by more than 50 percentage points over the lowest percentage of stock of points over the lowest percentage of stock of the corporation owned by such shareholders at the corporation owned by such shareholders at any time during the testing period (generally 3 any time during the testing period (generally 3 years or since the last ownership change, if years or since the last ownership change, if shorter).shorter).

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In applying the test, the methodology is:In applying the test, the methodology is:

Identify each 5 percent shareholder whose stock Identify each 5 percent shareholder whose stock ownership has increased compared with such ownership has increased compared with such shareholder’s lowest stock ownership percentage shareholder’s lowest stock ownership percentage during the testing period.during the testing period.

Add up the increases of each such 5 percent Add up the increases of each such 5 percent shareholder and see whether the sum amounts to shareholder and see whether the sum amounts to more than 50 percent.more than 50 percent.

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Section 382Section 382Ownership Change Ownership Change –– Example Example

A

2020

L

Facts:Facts: C buys 40 shares from B. D buys 20 shares from A.C buys 40 shares from B. D buys 20 shares from A.

Conclusion: C’s ownership has increased from 25% to 65% (40%) and D’s Conclusion: C’s ownership has increased from 25% to 65% (40%) and D’s ownership has increased from 15% to 35% (20%). The total increase ownership has increased from 15% to 35% (20%). The total increase by 5% shareholders is greater than 50% (60%) and, therefore, an by 5% shareholders is greater than 50% (60%) and, therefore, an ownership change has occurred.ownership change has occurred.

B C D

4040 2525 1515

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A “5 percent shareholder” is generally an individual or A “5 percent shareholder” is generally an individual or “public group” that, directly or indirectly through “public group” that, directly or indirectly through intermediate entities, owns 5 percent or more of the stock of intermediate entities, owns 5 percent or more of the stock of the corporation being tested for an ownership change.the corporation being tested for an ownership change.

A “public group” is a group of individuals, entities or other A “public group” is a group of individuals, entities or other persons each of whom owns less than 5 percent of the persons each of whom owns less than 5 percent of the corporation. There can be (and there often are) more than corporation. There can be (and there often are) more than one public group.one public group.

Special rules:Special rules: ““Plain vanilla” preferred stock is ignored (generally, non-voting, non-Plain vanilla” preferred stock is ignored (generally, non-voting, non-

convertible stock with a fixed coupon).convertible stock with a fixed coupon).

Options and warrants may be treated as stock in certain situations.Options and warrants may be treated as stock in certain situations.

All stock percentage calculations are based on value, not vote.All stock percentage calculations are based on value, not vote.

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Section 382Section 382Stock Ownership Percentage Based on ValueStock Ownership Percentage Based on Value

A stockholder’s stock ownership is measured by the A stockholder’s stock ownership is measured by the percentage of the fair market value of the stock owned by the percentage of the fair market value of the stock owned by the shareholder compared to the fair market value of the shareholder compared to the fair market value of the outstanding stock of the company.outstanding stock of the company.

Each share with the same terms is treated as having the same Each share with the same terms is treated as having the same value (i.e., no control premium or blockage discount).value (i.e., no control premium or blockage discount).

Any change in the proportionate ownership that is Any change in the proportionate ownership that is attributable solely to fluctuations in the relative fair market attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into values of different classes of stock shall not be taken into account. Thus, increases or decreases in the value of the account. Thus, increases or decreases in the value of the company generally should not cause an ownership change, company generally should not cause an ownership change, but the rule is not entirely clear.but the rule is not entirely clear.

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Section 382Section 382Fluctuation in Value Fluctuation in Value –– Example Example

L is a loss corporation with common and preferred stock L is a loss corporation with common and preferred stock outstanding. At the time L incurs its losses, the preferred outstanding. At the time L incurs its losses, the preferred stock is worth $100 (its face amount) and the common stock is worth $100 (its face amount) and the common stock is worth $900. Thus, the common shareholders own stock is worth $900. Thus, the common shareholders own 90% of the corporation by value. Two years later, the value 90% of the corporation by value. Two years later, the value of L drops dramatically to $150. The preferred stock of L drops dramatically to $150. The preferred stock continues to be worth $100, but the common stock continues to be worth $100, but the common stock declines in value to $50. Thus, based on value, the declines in value to $50. Thus, based on value, the preferred stockholder has increased its ownership in L preferred stockholder has increased its ownership in L from 10% to 66%.from 10% to 66%.

Has an ownership change ocurred? Probably not, because Has an ownership change ocurred? Probably not, because the change is due solely to fluctuations in value.the change is due solely to fluctuations in value.

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Section 382Section 382Certain Options and Warrants Deemed ExercisedCertain Options and Warrants Deemed Exercised

An option is treated as exercised for ownership change An option is treated as exercised for ownership change purposes only if the option is issued or transferred “with a purposes only if the option is issued or transferred “with a principal purpose of avoiding or ameliorating an ownership principal purpose of avoiding or ameliorating an ownership change” and it satisfies one of the following three tests:change” and it satisfies one of the following three tests: Ownership TestOwnership Test.. Was the option issued to avoid or ameliorate the Was the option issued to avoid or ameliorate the

impact of an ownership change by providing the holder of the impact of an ownership change by providing the holder of the option, prior to its exercise, with a substantial portion of the option, prior to its exercise, with a substantial portion of the attributes of ownership of the underlying stock?attributes of ownership of the underlying stock?

Control TestControl Test.. Did the holder and any related persons directly or Did the holder and any related persons directly or indirectly own more than the 50% of the company counting the indirectly own more than the 50% of the company counting the options as exercised?options as exercised?

Income TestIncome Test.. Does the issuance of an option facilitate the creation Does the issuance of an option facilitate the creation of income (including accelerating income or deferring deductions) of income (including accelerating income or deferring deductions) or value (including unrealized built-in gains) prior to the exercise or or value (including unrealized built-in gains) prior to the exercise or transfer of the option?transfer of the option?

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Section 382Section 382Option Option –– Example Example

POptionOption

L

Facts:Facts: P buys 49% of L with an option to buy the remaining 51%. P’s 49% P buys 49% of L with an option to buy the remaining 51%. P’s 49% stock (by value) has 60% of vote.stock (by value) has 60% of vote.

A

51%51%49%49%

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Section 382Section 382Certain Options and Warrants Deemed Exercised Certain Options and Warrants Deemed Exercised (cont’d.)(cont’d.)

Employee stock options generally are not deemed Employee stock options generally are not deemed exercised.exercised.

No warrants or options that have a nominal No warrants or options that have a nominal exercise price (e.g., one penny) are generally exercise price (e.g., one penny) are generally deemed exercised.deemed exercised.

Preferred stock generally is not deemed converted Preferred stock generally is not deemed converted into common.into common.

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Section 382Section 382Calculation of LimitationCalculation of Limitation

If there has been an ownership change, the amount If there has been an ownership change, the amount of taxable income of the loss corporation in any of taxable income of the loss corporation in any post-change year that can be offset by pre-change post-change year that can be offset by pre-change losses may not exceed the “Section 382 limitation.”losses may not exceed the “Section 382 limitation.”

The Section 382 limitation for any post-change year The Section 382 limitation for any post-change year is, in general, an amount equal to:is, in general, an amount equal to:

The value of the loss corporation determined as of the The value of the loss corporation determined as of the time immediately before the ownership change, time immediately before the ownership change, multiplied bymultiplied by

The long-term tax exempt rate published by the IRS.The long-term tax exempt rate published by the IRS.

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Section 382Section 382Allocation of Income for Change YearAllocation of Income for Change Year

The Section 382 limitation does not apply to income incurred in The Section 382 limitation does not apply to income incurred in the change year if it is allocated to the days of the year up to the change year if it is allocated to the days of the year up to and including the change date (the pre-change period). This and including the change date (the pre-change period). This rule requires an allocation of change year income where a rule requires an allocation of change year income where a corporation's taxable year does not end on the same date as the corporation's taxable year does not end on the same date as the ownership change date.ownership change date.

There are two ways to allocate income: a daily ratable There are two ways to allocate income: a daily ratable allocation method and the closing-of-the-books method. The allocation method and the closing-of-the-books method. The taxpayer must elect to apply the closing-of-the-books method. taxpayer must elect to apply the closing-of-the-books method. Treas. Reg. § 1.382-6; Notice 87-79.Treas. Reg. § 1.382-6; Notice 87-79.

Importantly, the IRS has ruled that discharge of indebtedness Importantly, the IRS has ruled that discharge of indebtedness income generated by an ownership change may all be allocated income generated by an ownership change may all be allocated to the pre-change period by applying the closing-of-the-books to the pre-change period by applying the closing-of-the-books method. See, method. See, e.g.e.g., PLR 9427033 (April 13, 1994)., PLR 9427033 (April 13, 1994).

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Section 382Section 382Continuity of Business EnterpriseContinuity of Business Enterprise

Continuity of business requirement – If the Continuity of business requirement – If the corporation does not continue the business corporation does not continue the business enterprise that it conducted prior to the enterprise that it conducted prior to the ownership change at all times during the 2 year ownership change at all times during the 2 year period beginning on the change date, the period beginning on the change date, the Section 382 limitation is zero.Section 382 limitation is zero.

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Section 382Section 382Recognized Built-in Gains and LossesRecognized Built-in Gains and Losses

Special rules apply to “built-in” gains and losses recognized Special rules apply to “built-in” gains and losses recognized within 5 taxable years of the ownership change. In general:within 5 taxable years of the ownership change. In general:

The Section 382 limitation is increased for any recognized built-The Section 382 limitation is increased for any recognized built-in gains (“RBIGs”) in the year those gains are recognized.in gains (“RBIGs”) in the year those gains are recognized.

Deductions for recognized built-in losses (“RBILs”) are subject Deductions for recognized built-in losses (“RBILs”) are subject to the Section 382 limitation along with pre-change losses.to the Section 382 limitation along with pre-change losses.

Important: foregoing rules only apply if the loss corporation Important: foregoing rules only apply if the loss corporation has a has a netnet unrealized built-in gain (“NUBIG”) or a unrealized built-in gain (“NUBIG”) or a netnet unrealized built-in loss (“NUBIL”) which exceeds de minimis unrealized built-in loss (“NUBIL”) which exceeds de minimis amount (lesser of $10 million or 15% of FMV of assets).amount (lesser of $10 million or 15% of FMV of assets).

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Section 382Section 382NUBIL ExampleNUBIL Example

P acquires 100% of stock of L from unrelated P acquires 100% of stock of L from unrelated shareholders.shareholders.

L has two assets:L has two assets: Asset A (FMV $100/Basis $0) and Asset A (FMV $100/Basis $0) and Asset B (FMV $0/Basis $100). L also has a $100 Asset B (FMV $0/Basis $100). L also has a $100 NOL.NOL.

One year after P acquires L, L sells Asset B for a One year after P acquires L, L sells Asset B for a $100 loss.$100 loss.

L did not have a NUBIL and, therefore, Section 382 L did not have a NUBIL and, therefore, Section 382 does not limit L’s use of the $100 loss.does not limit L’s use of the $100 loss.

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Section 382Section 382Built-In Income and DeductionBuilt-In Income and Deduction

As noted above, RBIGs increase the Section 382 limitation As noted above, RBIGs increase the Section 382 limitation and RBILs are subject to the Section 382 limitation.and RBILs are subject to the Section 382 limitation.

Section 382(h)(6)(A) provides that any item of income Section 382(h)(6)(A) provides that any item of income “properly taken into account during the recognition “properly taken into account during the recognition period” is treated as RBIG if the item is “attributable to period” is treated as RBIG if the item is “attributable to periods before the change date.” A similar rule is provided periods before the change date.” A similar rule is provided for built-in deductions.for built-in deductions.

The theory is that items economically accruing before the The theory is that items economically accruing before the change date should be subject to Section 382 in the same change date should be subject to Section 382 in the same manner as if they had actually been recognized before the manner as if they had actually been recognized before the change date. Example – COD income triggered after the change date. Example – COD income triggered after the change date.change date.

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Section 382Section 382Built-In Income and DeductionBuilt-In Income and Deduction

Notice 2003-65 allows taxpayers two Notice 2003-65 allows taxpayers two approaches for applying Section 382(h)(6) to approaches for applying Section 382(h)(6) to built-in items:built-in items:

Section 1374 ApproachSection 1374 Approach


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OverviewOverview –– Under the 1374 approach, NUBIG or Under the 1374 approach, NUBIG or NUBIL is the amount of gain or loss that would be NUBIL is the amount of gain or loss that would be recognized in a hypothetical sale of the assets of the recognized in a hypothetical sale of the assets of the loss corporation immediately before the ownership loss corporation immediately before the ownership change.change.

Gains and Losses from Sale or Exchange of AssetsGains and Losses from Sale or Exchange of Assets – – The amount of gain or loss recognized during the The amount of gain or loss recognized during the recognition period on the sale or exchange of an recognition period on the sale or exchange of an asset is RBIG or RBIL. The sum of the RBIG or RBIL asset is RBIG or RBIL. The sum of the RBIG or RBIL attributable to an asset cannot exceed the unrealized attributable to an asset cannot exceed the unrealized built-in gain or loss in that asset on the change date.built-in gain or loss in that asset on the change date.

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Section 1374 Approach Section 1374 Approach (cont’d.)(cont’d.)

Items of Income and DeductionItems of Income and Deduction – In cases other than sales – In cases other than sales and exchanges, the 1374 approach generally relies on the and exchanges, the 1374 approach generally relies on the accrual method of accounting to identify income or accrual method of accounting to identify income or deduction items as RBIG or RBIL, respectively. Items of deduction items as RBIG or RBIL, respectively. Items of income or deduction during the recognition period are income or deduction during the recognition period are treated as RBIG or RBIL, respectively, if an accrual method treated as RBIG or RBIL, respectively, if an accrual method taxpayer would have included the item in income or been taxpayer would have included the item in income or been allowed a deduction for the item before the change date.allowed a deduction for the item before the change date.

ExampleExample:: Immediately before an ownership change, LossCo, Immediately before an ownership change, LossCo, which uses the cash method of accounting, has a $50 which uses the cash method of accounting, has a $50 account receivable with a fair market value of $40 and a basis account receivable with a fair market value of $40 and a basis of zero. In Year 2 of the recognition period, LossCo sells the of zero. In Year 2 of the recognition period, LossCo sells the account receivable for $40 before collecting any part of it. account receivable for $40 before collecting any part of it. LossCo has $40 of RBIG in Year 2.LossCo has $40 of RBIG in Year 2.

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Section 1374 Approach Section 1374 Approach (cont’d.)(cont’d.)

Income Generated by Built-In Gain AssetsIncome Generated by Built-In Gain Assets – In general, the 1374 – In general, the 1374 approach does not treat income from a built-in gain asset during approach does not treat income from a built-in gain asset during the recognition period as RBIG because such income did not the recognition period as RBIG because such income did not accrue before the change date.accrue before the change date.

ExampleExample:: LossCo has a NUBIG of $300,000 that is attributable to several LossCo has a NUBIG of $300,000 that is attributable to several non-amortizable assets with an aggregate fair market value of $650,000 and non-amortizable assets with an aggregate fair market value of $650,000 and an aggregate adjusted basis of $500,000, and a patent with a fair market value an aggregate adjusted basis of $500,000, and a patent with a fair market value of $170,000 and an adjusted basis of $20,000. This patent is an “amortizable of $170,000 and an adjusted basis of $20,000. This patent is an “amortizable Section 197 intangible” as defined in Section 197(c). In Year 1 of the Section 197 intangible” as defined in Section 197(c). In Year 1 of the recognition period, LossCo has gross income of $75,000, $20,000 of which is recognition period, LossCo has gross income of $75,000, $20,000 of which is attributable to royalties collected in connection with the license of the patent. attributable to royalties collected in connection with the license of the patent. No part of the $20,000 attributable to the royalties is RBIG in Year 1 because No part of the $20,000 attributable to the royalties is RBIG in Year 1 because the income would not have been properly taken into account before the the income would not have been properly taken into account before the change date by an accrual method taxpayer. Accordingly, LossCo’s Section change date by an accrual method taxpayer. Accordingly, LossCo’s Section 382 limitation for Year 1 is not increased by any part of that amount.382 limitation for Year 1 is not increased by any part of that amount.

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OverviewOverview – The 338 approach identifies items of RBIG and RBIL generally by – The 338 approach identifies items of RBIG and RBIL generally by comparing the loss corporation’s actual items of income, gain, deduction, comparing the loss corporation’s actual items of income, gain, deduction, and loss with those that would have resulted if a Section 338 election had and loss with those that would have resulted if a Section 338 election had been made with respect to a hypothetical purchase of all the outstanding been made with respect to a hypothetical purchase of all the outstanding stock of the loss corporation on the change date (the “hypothetical stock of the loss corporation on the change date (the “hypothetical purchase”). As a result, unlike under the 1374 approach, under the 338 purchase”). As a result, unlike under the 1374 approach, under the 338 approach, built-in gain assets may be treated as generating RBIG even if approach, built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period, and they are not disposed of at a gain during the recognition period, and deductions for liabilities, in particular contingent liabilities, that exist on the deductions for liabilities, in particular contingent liabilities, that exist on the change date may be treated as RBIL.change date may be treated as RBIL.

Calculation of NUBIG and NUBILCalculation of NUBIG and NUBIL – Under the 338 approach, NUBIG or – Under the 338 approach, NUBIG or NUBILs are calculated in the same manner as under the 1374 approach.NUBILs are calculated in the same manner as under the 1374 approach.

Calculation of RBIG and RBILCalculation of RBIG and RBIL – The 338 approach identifies RBIG or RBIL by – The 338 approach identifies RBIG or RBIL by comparing the loss corporation’s actual items of income, gain, deduction, comparing the loss corporation’s actual items of income, gain, deduction, and loss with the items of income, gain, deduction and loss that would and loss with the items of income, gain, deduction and loss that would result if a Section 338 election had been made for the hypothetical purchase.result if a Section 338 election had been made for the hypothetical purchase.

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Section 338 Approach – Wasting or Section 338 Approach – Wasting or Consumption of Built-In Gain AssetsConsumption of Built-In Gain Assets

Wasting AssetsWasting Assets –– As described above, for loss corporations with As described above, for loss corporations with a NUBIG, a 338 approach treats certain built-in gain assets of the a NUBIG, a 338 approach treats certain built-in gain assets of the loss corporation as generating RBIG even if such assets are not loss corporation as generating RBIG even if such assets are not disposed of during the recognition period. The 338 approach disposed of during the recognition period. The 338 approach assumes that, for any taxable year, an asset that had built-in assumes that, for any taxable year, an asset that had built-in gain on the change date generates income equal to the cost gain on the change date generates income equal to the cost recovery deduction that would have been allowed for such asset recovery deduction that would have been allowed for such asset under the applicable Code section if an election under Section under the applicable Code section if an election under Section 338 had been made with respect to the hypothetical purchase. 338 had been made with respect to the hypothetical purchase. Therefore, with respect to an asset that had a built-in gain on the Therefore, with respect to an asset that had a built-in gain on the change date, the 338 approach treats as RBIG an amount equal change date, the 338 approach treats as RBIG an amount equal to the excess of the cost recovery deduction that would have to the excess of the cost recovery deduction that would have been allowable with respect to such asset had an election under been allowable with respect to such asset had an election under Section 338 been made for the hypothetical purchase over the Section 338 been made for the hypothetical purchase over the loss corporation’s actual allowable cost recovery deduction.loss corporation’s actual allowable cost recovery deduction.

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Section 338 Approach – Wasting or Section 338 Approach – Wasting or Consumption of Built-In Gain Assets Consumption of Built-In Gain Assets

Example:Example:

LossCo has a NUBIG of $300,000 that is attributable to various non-LossCo has a NUBIG of $300,000 that is attributable to various non-amortizable assets with an aggregate fair market value of $710,000 amortizable assets with an aggregate fair market value of $710,000 and an aggregate adjusted basis of $500,000, and a patent with a fair and an aggregate adjusted basis of $500,000, and a patent with a fair market value of $120,000 and an adjusted basis of $30,000. The market value of $120,000 and an adjusted basis of $30,000. The patent is an “amortizable Section 197 intangible” as defined in patent is an “amortizable Section 197 intangible” as defined in Section 197(c) for which ten years of tax depreciation remain. In Section 197(c) for which ten years of tax depreciation remain. In Year 1 of the recognition period, LossCo has gross income of Year 1 of the recognition period, LossCo has gross income of $75,000. In Year 1, $5,000 is RBIG attributable to the patent (the $75,000. In Year 1, $5,000 is RBIG attributable to the patent (the excess of the $8,000 amortization deduction that would have been excess of the $8,000 amortization deduction that would have been allowed had a Section 338 election been made with respect to a allowed had a Section 338 election been made with respect to a hypothetical purchase of all of the stock of LossCo ($120,000 fair hypothetical purchase of all of the stock of LossCo ($120,000 fair market value divided by 15, the amortization period) over $3,000 (the market value divided by 15, the amortization period) over $3,000 (the actual allowable amortization deduction). This $5,000 of RBIG actual allowable amortization deduction). This $5,000 of RBIG increases LossCo’s Section 382 limitation for Year 1. increases LossCo’s Section 382 limitation for Year 1.

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Section 382Section 382Bankruptcy RulesBankruptcy Rules

Two special rules exist for ownership changes Two special rules exist for ownership changes occurring in a bankruptcy case:occurring in a bankruptcy case:

Section 382(l)(5)Section 382(l)(5) – Provides a one-time “free pass” – Provides a one-time “free pass” from the Section 382 rules for ownership changes from the Section 382 rules for ownership changes in a limited class of bankruptcy cases.in a limited class of bankruptcy cases.

Section 382(l)(6)Section 382(l)(6) – Provides for a higher Section – Provides for a higher Section 382 limitation than would otherwise apply in cases 382 limitation than would otherwise apply in cases not falling under Section 382(l)(5).not falling under Section 382(l)(5).

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Under Section 382(l)(5), no Section 382 limitation will Under Section 382(l)(5), no Section 382 limitation will apply if:apply if: The corporation is, immediately before the ownership The corporation is, immediately before the ownership

change, under the jurisdiction of a court in a title 11 or change, under the jurisdiction of a court in a title 11 or similar case;similar case;

The transaction resulting in the ownership change is The transaction resulting in the ownership change is ordered by the court or pursuant to a plan approved by the ordered by the court or pursuant to a plan approved by the court; andcourt; and

The shareholders and “old and cold” creditors of the The shareholders and “old and cold” creditors of the corporation as of the time immediately before the corporation as of the time immediately before the ownership change own at least 50 percent of the ownership change own at least 50 percent of the corporation’s stock following the ownership change.corporation’s stock following the ownership change.

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Old and cold creditors include:Old and cold creditors include:

Creditors who held their debt for at least 18 months prior to the Creditors who held their debt for at least 18 months prior to the filing of the title 11 case (bonds owned by “vultures” may not filing of the title 11 case (bonds owned by “vultures” may not qualify); andqualify); and

Creditors who have continuously held debt of the corporation Creditors who have continuously held debt of the corporation that arose in the ordinary course of the corporation’s business.that arose in the ordinary course of the corporation’s business.

E.g.E.g., trade debt, liabilities arising from employment , trade debt, liabilities arising from employment relationships, tort claims, etc.relationships, tort claims, etc.

A claim that arises upon the rejection of a burdensome A claim that arises upon the rejection of a burdensome contract or lease also qualifies as ordinary course contract or lease also qualifies as ordinary course indebtedness.indebtedness.

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Drawbacks of the Section 382(l)(5) exception:Drawbacks of the Section 382(l)(5) exception:

The Section 382 limitation will be zero if there is The Section 382 limitation will be zero if there is another ownership change within 2 years.another ownership change within 2 years.

Pre-change NOLs are reduced by the amount of Pre-change NOLs are reduced by the amount of any interest paid or accrued by the corporation any interest paid or accrued by the corporation during the three years prior to the date of the during the three years prior to the date of the ownership change on debt that was converted into ownership change on debt that was converted into equity.equity.

Because of the drawbacks, a corporation may Because of the drawbacks, a corporation may elect not to have Section 382(l)(5) apply.elect not to have Section 382(l)(5) apply.

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Section 382(l)(6) provides that if Section 382(l)(5) does Section 382(l)(6) provides that if Section 382(l)(5) does not apply, the value of the corporation for purposes of not apply, the value of the corporation for purposes of determining the Section 382 limitation shall reflect the determining the Section 382 limitation shall reflect the increase in value resulting from any surrender or increase in value resulting from any surrender or cancellation of creditors’ claims in the transaction.cancellation of creditors’ claims in the transaction.

Under this provision, the Section 382 limitation will be Under this provision, the Section 382 limitation will be based on the lesser of:based on the lesser of:

The value of the stock of the corporation immediately after The value of the stock of the corporation immediately after the ownership change; orthe ownership change; or

The value of the corporation’s assets immediately before the The value of the corporation’s assets immediately before the ownership change.ownership change.

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Section 382(l)(6) Example:Section 382(l)(6) Example:

L has assets with a fair market value of $250 million and debt of L has assets with a fair market value of $250 million and debt of $300 million. Y does an in-bankruptcy restructuring in which its $300 million. Y does an in-bankruptcy restructuring in which its creditors exchange the $300 million of debt for $200 million in creditors exchange the $300 million of debt for $200 million in new debt plus all of the common stock in Y. The existing equity new debt plus all of the common stock in Y. The existing equity holders receive nothing.holders receive nothing.

Without Section 382(l)(6), and assuming Section 382(1)(5) does Without Section 382(l)(6), and assuming Section 382(1)(5) does not apply, the Section 382 limitation would be zero because the not apply, the Section 382 limitation would be zero because the company’s stock had no value immediately before the ownership company’s stock had no value immediately before the ownership change.change.

With Section 382(l)(6), the Section 382 limitation is $50 million With Section 382(l)(6), the Section 382 limitation is $50 million (i.e., the value of Y’s stock immediately following the ownership (i.e., the value of Y’s stock immediately following the ownership change) multiplied by the tax-exempt rate.change) multiplied by the tax-exempt rate.

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Section 382Section 382Application to Consolidated GroupsApplication to Consolidated Groups

Overview: Single Entity TheoryOverview: Single Entity Theory

Determine the following on a group basis (v. entity Determine the following on a group basis (v. entity by entity):by entity):

Ownership ChangeOwnership Change

Amount of Section 382 LimitationAmount of Section 382 Limitation

NUBIG/NUBILNUBIG/NUBIL

COBECOBE

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Section 382Section 382Consolidated Ownership ChangeConsolidated Ownership Change

Parent Change MethodParent Change Method.. The general rule is that if the The general rule is that if the common parent of the loss group experiences an ownership common parent of the loss group experiences an ownership change, all of the loss group’s pre-change consolidated change, all of the loss group’s pre-change consolidated Section 382 attributes become subject to the consolidated Section 382 attributes become subject to the consolidated Section 382 limitation. Although an individual subsidiary may Section 382 limitation. Although an individual subsidiary may not experience an ownership change on a separate company not experience an ownership change on a separate company basis, its share of the consolidated NOL will be subject to the basis, its share of the consolidated NOL will be subject to the Section 382 limitation.Section 382 limitation.

Supplemental MethodSupplemental Method.. The supplemental method is an anti- The supplemental method is an anti-abuse rule. The supplemental method aggregates increases abuse rule. The supplemental method aggregates increases in percentage ownership by a 5% shareholder of the common in percentage ownership by a 5% shareholder of the common parent in both the subsidiary and the common parent during parent in both the subsidiary and the common parent during a three-year period or such increases are pursuant to a “plan a three-year period or such increases are pursuant to a “plan or arrangement.”or arrangement.”

36

Section 382Section 382Consolidated Ownership Change - ExampleConsolidated Ownership Change - Example

Facts:Facts: Individual A owns all the stock of L, which files a consolidated return with its Individual A owns all the stock of L, which files a consolidated return with its 80% owned subsidiary, L1. Individual B owns the other 20% of L1. During 80% owned subsidiary, L1. Individual B owns the other 20% of L1. During 2003, the L group incurred a 100 consolidated NOL, attributable entirely to 2003, the L group incurred a 100 consolidated NOL, attributable entirely to L1. On August 1, 2004, A sold 60% of its L stock to C, an unrelated L1. On August 1, 2004, A sold 60% of its L stock to C, an unrelated individual.individual.

Conclusion: The stock sale causes an ownership change with respect to the L-L1 Conclusion: The stock sale causes an ownership change with respect to the L-L1 group. Note that L1 did not experience an ownership change on a separate group. Note that L1 did not experience an ownership change on a separate company basis (i.e., L1 has experienced only a 48% ownership shift).company basis (i.e., L1 has experienced only a 48% ownership shift).

L

20%20%

A C

L1

B

$$

60%60%

80%80%

37

Section 382Section 382Consolidated NUBIG/NUBIL Determination Consolidated NUBIG/NUBIL Determination –– Example Example

Facts:Facts: L has Asset A (FMV $100 / Basis $0). L1 has Asset B (FMV $0 / Basis $100) L has Asset A (FMV $100 / Basis $0). L1 has Asset B (FMV $0 / Basis $100) and a $100 NOL.and a $100 NOL.

Conclusion: On a separate company basis, L has a NUBIG and L-1 has a NUBIL. Conclusion: On a separate company basis, L has a NUBIG and L-1 has a NUBIL. But L-L1 group has no NUBIL or NUBIG.But L-L1 group has no NUBIL or NUBIG.

L

A

L1

38

Section 382Section 382Sale of a Member of a Consolidated GroupSale of a Member of a Consolidated Group

Apportionment of Section 382 limitation to Departing MemberApportionment of Section 382 limitation to Departing Member. . Generally, when a subsidiary ceases to be a member of a loss group Generally, when a subsidiary ceases to be a member of a loss group after such group has had an ownership change, the issue arises of after such group has had an ownership change, the issue arises of how the Section 382 limitation should be allocated between the how the Section 382 limitation should be allocated between the remaining group members and the departing member. The general remaining group members and the departing member. The general rule provides that the Section 382 limitation of the departing member rule provides that the Section 382 limitation of the departing member becomes zero unless the common parent of a loss group elects to becomes zero unless the common parent of a loss group elects to apportion all or a part of the consolidated Section 382 limitation to the apportion all or a part of the consolidated Section 382 limitation to the departing member.departing member.

Apportionment of NUBIG to Departing MemberApportionment of NUBIG to Departing Member.. As with As with apportionment of the Section 382 limitation, the NUBIG allocable to a apportionment of the Section 382 limitation, the NUBIG allocable to a departing member would be zero unless the common parent elects to departing member would be zero unless the common parent elects to apportion all or a part of the NUBIG to the departing member. apportion all or a part of the NUBIG to the departing member.

39

Section 382Section 382Apportionment of Section 382 Limitation and NUBIG Apportionment of Section 382 Limitation and NUBIG –– Example Example

Facts:Facts: P group has a $200 per year Section 382 limitation and a $100 NUBIG P group has a $200 per year Section 382 limitation and a $100 NUBIG from a prior ownership change. L1 and L2 each have $100 of NOL from a prior ownership change. L1 and L2 each have $100 of NOL subject to the Section 382 limitation. A buys L2 for $50.subject to the Section 382 limitation. A buys L2 for $50.

L1

P

L2

A$50$50

L2 StockL2 Stock

40

SRLY RulesSRLY Rules

41

SRLY RulesSRLY RulesOverviewOverview

General RuleGeneral Rule.. When a loss corporation joins a When a loss corporation joins a consolidated group, the SRLY regulations allow the consolidated group, the SRLY regulations allow the group to utilize the loss corporation’s NOLs only against group to utilize the loss corporation’s NOLs only against the loss corporation’s share of consolidated net income. the loss corporation’s share of consolidated net income. Treas. Reg. § 1.1502-21(c). Treas. Reg. § 1.1502-21(c).

Built-in LossesBuilt-in Losses.. Like Section 382, the SRLY rules apply Like Section 382, the SRLY rules apply to built-in losses as well as NOLs.to built-in losses as well as NOLs.

Creeping AcquisitionsCreeping Acquisitions.. The SRLY rules apply to a new The SRLY rules apply to a new member of an affiliated group without regard to the member of an affiliated group without regard to the degree of ownership change that occurs when the new degree of ownership change that occurs when the new member joins the group.member joins the group.

42

SRLY RulesSRLY RulesCreeping Acquisition – ExampleCreeping Acquisition – Example

Facts: P has owned 75% of L for several years. Facts: P has owned 75% of L for several years. During that period, L has incurred significant During that period, L has incurred significant NOLs. Now P acquires another 5% of L’s NOLs. Now P acquires another 5% of L’s subsidiary stock and includes L in its subsidiary stock and includes L in its consolidated group.consolidated group.

Conclusion: L’s NOLs are subject to the SRLY Conclusion: L’s NOLs are subject to the SRLY limitation.limitation.

43

SRLY RulesSRLY RulesNon-Applicability in Section 382 OverlapNon-Applicability in Section 382 Overlap

General RuleGeneral Rule. . When a corporation becomes a When a corporation becomes a member of a consolidated group (a “SRLY event”) member of a consolidated group (a “SRLY event”) within six months of the change date of an ownership within six months of the change date of an ownership change that gives rise to a Section 382 limitation with change that gives rise to a Section 382 limitation with respect to NOL carryover (a “Section 382 event”), the respect to NOL carryover (a “Section 382 event”), the SRLY rules will not apply to such corporation’s NOL SRLY rules will not apply to such corporation’s NOL carryover.carryover.

Coextensive SubgroupsCoextensive Subgroups.. The overlap rule only The overlap rule only applies if the SRLY loss subgroup is coextensive with applies if the SRLY loss subgroup is coextensive with (i.e., identical to) the Section 382 loss subgroup.(i.e., identical to) the Section 382 loss subgroup.

44

SRLY RulesSRLY RulesSection 382/SRLY Overlap – ExampleSection 382/SRLY Overlap – Example

Facts:Facts: P buys 80% of L stock from A, an unrelated individual. L has both a P buys 80% of L stock from A, an unrelated individual. L has both a SRLY event and a Section 382 event. L-L1 group constitutes both a SRLY event and a Section 382 event. L-L1 group constitutes both a 382 subgroup and a SRLY subgroup.382 subgroup and a SRLY subgroup.

L

A

L1

$$

80%80%P

45

SRLY RulesSRLY RulesLoss Subgroup Election Under Treas. Reg. § 1.1502-91(d)(4)Loss Subgroup Election Under Treas. Reg. § 1.1502-91(d)(4)

L, L1 and L2 are all members of the same SRLY subgroup but they do not L, L1 and L2 are all members of the same SRLY subgroup but they do not comprise a Section 382 subgroup. Absent the -91(d)(4) election, the SRLY comprise a Section 382 subgroup. Absent the -91(d)(4) election, the SRLY restrictions would apply to the losses of L, L1 and L2.restrictions would apply to the losses of L, L1 and L2.

L L1

P T$$

L + L1 stockL + L1 stock

L2

46

SRLY RulesSRLY RulesPlanning OpportunitiesPlanning Opportunities

MergerMerger.. Merge SRLY member with a profitable Merge SRLY member with a profitable member.member.

Conversion to LLCConversion to LLC.. Convert SRLY member into Convert SRLY member into a single-member LLC which is disregarded so a single-member LLC which is disregarded so that parent’s income will count when computing that parent’s income will count when computing SRLY limitation.SRLY limitation.

StuffingStuffing.. Parent contributes income generating Parent contributes income generating assets to SRLY member.assets to SRLY member.

47

SRLY RulesSRLY RulesStuffing - Conduit TransactionsStuffing - Conduit Transactions

Facts:Facts: Shareholder P contributes Asset A with built-in gain to S. S promptly sells Asset A to Shareholder P contributes Asset A with built-in gain to S. S promptly sells Asset A to third party and shelters gain on Asset A with S’s SRLY NOLs.third party and shelters gain on Asset A with S’s SRLY NOLs.

Business Purpose:Business Purpose: Stewart v. Comm’rStewart v. Comm’r, T.C. Memo 1982-209, , T.C. Memo 1982-209, aff’daff’d., 714 F.2d 977 (9th Cir. 1983);., 714 F.2d 977 (9th Cir. 1983);Kluener v. Comm’rKluener v. Comm’r, T.C. Memo 1996-579, , T.C. Memo 1996-579, aff’daff’d., 154 F.3d 630 ., 154 F.3d 630

(6th Cir. 1998); (6th Cir. 1998); Hallowell v. Comm’rHallowell v. Comm’r, 56 T.C. 600 (1971); , 56 T.C. 600 (1971); W.& K. Holding W.& K. Holding Corp. v. Comm’rCorp. v. Comm’r, ,

38 B.T.A. 830 (1938).38 B.T.A. 830 (1938).

Substance Over Form:Substance Over Form: Comm’r v. Court HoldingsComm’r v. Court Holdings, 324 U.S. 331 (1943)., 324 U.S. 331 (1943).

Section 482:Section 482: National Securities Corp. v. Comm’rNational Securities Corp. v. Comm’r, 137 F.2d 600 (3d Cir. 1943); , 137 F.2d 600 (3d Cir. 1943); Ruddick v. United StatesRuddick v. United States, 643 F.2d 747 (Ct. Cl. 1981)., 643 F.2d 747 (Ct. Cl. 1981).

S 3P

Asset AAsset A

Asset AAsset A

$$

P

48

SRLY RulesSRLY RulesInvestment Basis AdjustmentsInvestment Basis Adjustments

The amount of a stock basis adjustment is the The amount of a stock basis adjustment is the net of S’s:net of S’s:

+ Contributions+ Contributions

- Distributions- Distributions

+ Taxable income+ Taxable income

- Taxable loss- Taxable loss

+ Tax-exempt income+ Tax-exempt income

- Noncapital, nondeductible expenses (including- Noncapital, nondeductible expenses (including expiring loss carryovers) expiring loss carryovers)

49

SRLY RulesSRLY RulesLoss Waiver ElectionLoss Waiver Election

P

T

T1

T2

X

T

T1

T2

T StockT Stock

$200$200

Asset AAsset AFMV:FMV: $200$200Basis:Basis: $10$10

$50 Basis$50 Basis

$60 Basis$60 Basis

$100 NOL$100 NOL

Analysis:Analysis: Without a loss waiver election, T2’s $100 expiring NOL reduces T1’s stock Without a loss waiver election, T2’s $100 expiring NOL reduces T1’s stock basis, creating a $40 ELA in T1’s T2 stock. This basis adjustment tiers up to T, basis, creating a $40 ELA in T1’s T2 stock. This basis adjustment tiers up to T, creating a $50 ELA in T’s T1 stock. See Treas. Reg. creating a $50 ELA in T’s T1 stock. See Treas. Reg. § 1.1502-32(b)(4).§ 1.1502-32(b)(4).

50

Insolvent LiquidationsInsolvent Liquidations

51

Insolvent Subsidiary – LiquidationInsolvent Subsidiary – Liquidation

Typically, when P liquidates an 80% or greater Typically, when P liquidates an 80% or greater owned subsidiary, the transaction qualifies for owned subsidiary, the transaction qualifies for nonrecognition treatment under Section 332.nonrecognition treatment under Section 332.

Where S is insolvent, however, there is no Where S is insolvent, however, there is no distribution with respect to its common stock, distribution with respect to its common stock, and, therefore, Section 332 is inapplicable. Treas. and, therefore, Section 332 is inapplicable. Treas. Reg. § 1.332-2(b); Reg. § 1.332-2(b); Spaulding Bakeries, Inc. v. Spaulding Bakeries, Inc. v. Comm’rComm’r, 27 T.C. 684 (1957), , 27 T.C. 684 (1957), aff’d,aff’d, 252 F2d 693 252 F2d 693 (2nd Cir. 1958).(2nd Cir. 1958).

52

Tax Consequences of Insolvent Tax Consequences of Insolvent LiquidationLiquidation

S recognizes gain or loss on the transfer of its property in S recognizes gain or loss on the transfer of its property in satisfaction of its liabilities. I.R.C. § 1001.satisfaction of its liabilities. I.R.C. § 1001.

S recognizes cancellation of indebtedness income on the S recognizes cancellation of indebtedness income on the discharge of any remaining indebtedness. I.R.C. § 61(a)(12).discharge of any remaining indebtedness. I.R.C. § 61(a)(12).

S’s tax attributes do not carry over to the shareholder (i.e., S’s tax attributes do not carry over to the shareholder (i.e., attributes vanish).attributes vanish).

The creditor takes a fair market value basis in the assets The creditor takes a fair market value basis in the assets received in satisfaction of any indebtedness and a loss with received in satisfaction of any indebtedness and a loss with respect to the indebtedness. I.R.C. §§ 165(g), 166.respect to the indebtedness. I.R.C. §§ 165(g), 166.

The shareholders take a loss on the subsidiary’s stock (after The shareholders take a loss on the subsidiary’s stock (after adjustment for any income or loss if the subsidiary is a adjustment for any income or loss if the subsidiary is a member of an affiliated group filing a consolidated return). member of an affiliated group filing a consolidated return). I.R.C. § 165(g).I.R.C. § 165(g).

53

Liquidating an Insolvent Subsidiary – Example 1Liquidating an Insolvent Subsidiary – Example 1

P

S

100%100%

Facts:Facts: Year 1 – P capitalized S with $50 of equity and $150 of debt.Year 1 – P capitalized S with $50 of equity and $150 of debt.Year 2 – S incurred operating losses of $180.Year 2 – S incurred operating losses of $180.End of Year 2 – S becomes insolvent and adopts a plan ofEnd of Year 2 – S becomes insolvent and adopts a plan of liquidation, distributing its only assets ($20) to P in satisfactionliquidation, distributing its only assets ($20) to P in satisfaction of its outstanding debt to P.of its outstanding debt to P.

$50 Equity$50 Equity

$150 Debt$150 Debt

$20 Assets$20 Assets

$180 NOL$180 NOL

54

Liquidating an Insolvent Subsidiary – Example 2Liquidating an Insolvent Subsidiary – Example 2

P

S

100%100%

Facts:Facts: Same as Example 1, except that at the end of Year 2 P contributes the Same as Example 1, except that at the end of Year 2 P contributes the $150 debt to capital immediately before liquidating S such that S is $150 debt to capital immediately before liquidating S such that S is solvent at the time of the liquidation.solvent at the time of the liquidation.

Conclusion: IRS would assert that the liquidation does not qualify under Conclusion: IRS would assert that the liquidation does not qualify under Section 332 per Rev. Rul. 68-602.Section 332 per Rev. Rul. 68-602.

$50 Equity$50 Equity

$150 Debt$150 Debt

$20 Assets$20 Assets

$180 NOL$180 NOL

55

Check the Box Stock Worthlessness Check the Box Stock Worthlessness Rev. Rul. 2003-125Rev. Rul. 2003-125

P(U.S.)

Facts: The fair market value of S-1’s assets (including goodwill and going concern value) Facts: The fair market value of S-1’s assets (including goodwill and going concern value) exceeded the sum of its liabilities. The fair market value of S-2’s assets (including exceeded the sum of its liabilities. The fair market value of S-2’s assets (including goodwill and going concern value) did not exceed the sum of its liabilities.goodwill and going concern value) did not exceed the sum of its liabilities. P checked P checked the box on S-1 and S-2 to cause them to be treated for U.S. tax purposes as liquidating. the box on S-1 and S-2 to cause them to be treated for U.S. tax purposes as liquidating. S-1 and S-2 continue to be treated as corporations under the foreign country laws and S-1 and S-2 continue to be treated as corporations under the foreign country laws and continue to operate as they had before the election.continue to operate as they had before the election.

Analysis:Analysis: In considering whether P was entitled to a loss under Section 165(g) with In considering whether P was entitled to a loss under Section 165(g) with respect the stock of S-1 and S-2, the IRS concluded that the deemed liquidation respect the stock of S-1 and S-2, the IRS concluded that the deemed liquidation occasioned by the change in classification election was an identifiable event permitting occasioned by the change in classification election was an identifiable event permitting the loss under Section 165(g). P was allowed a worthless stock deduction for S-2, but the loss under Section 165(g). P was allowed a worthless stock deduction for S-2, but not S-1.not S-1.

S-1(Foreign)

S-2(Foreign)

56

Tax-Free Reorganizations of Tax-Free Reorganizations of Insolvent CorporationsInsolvent Corporations

The IRS is currently studying whether a merger of an The IRS is currently studying whether a merger of an insolvent target corporation into another corporation insolvent target corporation into another corporation may qualify as a tax-free reorganization under Section may qualify as a tax-free reorganization under Section 368. 368.

Existing law is unclear, although at least one case Existing law is unclear, although at least one case indicates that an insolvent target corporation may indicates that an insolvent target corporation may engage in a tax-free reorganization. engage in a tax-free reorganization. Norman Scott, Norman Scott, Inc. v. Comm’rInc. v. Comm’r, 48 T.C. 598 (1967)., 48 T.C. 598 (1967).

57

Insolvent ReorganizationsInsolvent ReorganizationsTax Consequences if Section 368 Does Not ApplyTax Consequences if Section 368 Does Not Apply

Gain or loss is recognized by the target corporation on Gain or loss is recognized by the target corporation on the transfer of its assets.the transfer of its assets.

Transferor corporation recognizes cancellation of Transferor corporation recognizes cancellation of indebtedness income on the full or partial satisfaction of indebtedness income on the full or partial satisfaction of its indebtedness for an amount less than the “adjusted its indebtedness for an amount less than the “adjusted issue price” of the outstanding indebtedness.issue price” of the outstanding indebtedness.

Transferee corporation takes a fair market value basis in Transferee corporation takes a fair market value basis in the assets acquired from the transferor. I.R.C. § 1012.the assets acquired from the transferor. I.R.C. § 1012.

Tax attributes of transferor vanish.Tax attributes of transferor vanish.

Transferor, shareholders and security holders recognize Transferor, shareholders and security holders recognize gain or loss equal to the amount realized less the tax gain or loss equal to the amount realized less the tax basis in the stock or securities surrendered.basis in the stock or securities surrendered.

58

Loss Disallowance RulesLoss Disallowance Rules

59

Loss Disallowance RulesLoss Disallowance RulesSon of Mirror ExampleSon of Mirror Example

P B

T

Asset AAsset A

T StockT Stock

$250$250

Asset BAsset B

Asset BAsset B

Basis = $100Basis = $100FMV = $250FMV = $250

Basis = $150Basis = $150FMV = $250FMV = $250

Facts:Facts: P purchases T stock for $500. Later, T distributes Asset B to P and then P P purchases T stock for $500. Later, T distributes Asset B to P and then P sells T stock to B for $250.sells T stock to B for $250.

Analysis:Analysis: T recognizes $100 of gain on the distribution of Asset B, which T recognizes $100 of gain on the distribution of Asset B, which increases P’s stock basis in T. The dividend of Asset B reduces P’s stock increases P’s stock basis in T. The dividend of Asset B reduces P’s stock basis in basis in T by $250, causing a net negative adjustment of $150. Thus, P’s basis in T by $250, causing a net negative adjustment of $150. Thus, P’s basis in T stock is $350 and P has a $100 loss on the sale of the T stock to B. T stock is $350 and P has a $100 loss on the sale of the T stock to B. P, therefore, has no net gain on the transaction but obtained P, therefore, has no net gain on the transaction but obtained a stepped-up basis in Asset B.a stepped-up basis in Asset B.

60

Computation of Allowed LossComputation of Allowed LossUnder Former Treas. Reg. § 1.1502-20Under Former Treas. Reg. § 1.1502-20

P’s capital loss is deductible to the extent it P’s capital loss is deductible to the extent it exceeds:exceeds:

Extraordinary GainExtraordinary Gain

Positive Investment AdjustmentsPositive Investment Adjustments

Duplicated LossDuplicated Loss

61

Rite AidRite Aid Decision Decision

Fed. Circuit held LDR and duplicated loss factor Fed. Circuit held LDR and duplicated loss factor invalid – Taxpayer’s loss is deductible despite LDR.invalid – Taxpayer’s loss is deductible despite LDR.

Reasoning: “In the absence of a problem created Reasoning: “In the absence of a problem created from the filing of consolidated returns, the secretary from the filing of consolidated returns, the secretary is without authority to change the application of is without authority to change the application of other tax code provisions to a group of affiliated other tax code provisions to a group of affiliated corporations filing consolidated returns.”corporations filing consolidated returns.”

Thus, LDR could not override Section 165, which Thus, LDR could not override Section 165, which allowed the taxpayer to deduct the loss.allowed the taxpayer to deduct the loss.

62

Summary of Current LDRSummary of Current LDRTreas. Reg. § 1.337(d)-2TTreas. Reg. § 1.337(d)-2T

General Rule:General Rule: Loss recognized by a Loss recognized by a consolidated group member with respect to the consolidated group member with respect to the disposition of consolidated sub stock is disposition of consolidated sub stock is disallowed.disallowed.

Exception:Exception: Loss is allowed if not attributable to Loss is allowed if not attributable to built-in gain recognized on the disposition of an built-in gain recognized on the disposition of an asset that is reflected in the basis of the stock asset that is reflected in the basis of the stock of the disposed subsidiary when it was created of the disposed subsidiary when it was created or acquired.or acquired.

63

LDR – Base Case (Son of Mirror)LDR – Base Case (Son of Mirror)

T Shareholders P

T

STEP 1STEP 1$100$100

T StockT Stock

X

STEP 2STEP 2Asset AAsset A

$100$100

Asset AAsset AFMV:FMV: $100$100Basis:Basis: $ 0$ 0

Facts:Facts: P purchases 100% of stock of T for $100. T has one asset, Asset A, with a P purchases 100% of stock of T for $100. T has one asset, Asset A, with a $100 built-in gain. P causes T to sell Asset A to X. T’s $100 gain increases $100 built-in gain. P causes T to sell Asset A to X. T’s $100 gain increases P’s basis in T to $200.P’s basis in T to $200.

Analysis:Analysis: If P sells the T stock to a third party for $100, P’s $100 capital loss will be If P sells the T stock to a third party for $100, P’s $100 capital loss will be disallowed. Treas. Reg. disallowed. Treas. Reg. § 1.337(d)-2T.§ 1.337(d)-2T.

Y

STEP 3STEP 3

$100$100

T StockT Stock

64

LDR – No Loss CaseLDR – No Loss Case

T Shareholders P

T


T StockT Stock

X


$100$100 Asset AAsset AFMV:FMV: $100$100Basis:Basis: $ 0$ 0

Facts:Facts: Same facts as the previous example (Base Case), except that T invests the $100 Same facts as the previous example (Base Case), except that T invests the $100 sales proceeds in Asset B that appreciates to $200. P sells the T stock for $200 sales proceeds in Asset B that appreciates to $200. P sells the T stock for $200 and recognizes no loss.and recognizes no loss.

Analysis:Analysis: Since P has not recognized a loss, Treas. Reg. § 1.337(d)-2T does not apply even Since P has not recognized a loss, Treas. Reg. § 1.337(d)-2T does not apply even though P increased its basis in T stock by $100 (step 2) that was already reflected though P increased its basis in T stock by $100 (step 2) that was already reflected in P’s basis when T’s stock was acquired.in P’s basis when T’s stock was acquired.

Y

T StockT Stock

$200$200

STEP 3STEP 3

65

LDR – Offsetting Built-in Gains LDR – Offsetting Built-in Gains and Lossesand Losses

T Shareholders P

T

STEP 1STEP 1$100 $100

T StockT Stock

X

STEP 2STEP 2Assets A & BAssets A & B

$100$100


Asset BAsset BFMV:FMV: $ 0$ 0Basis:Basis: $100$100

Facts:Facts: P purchases 100% of the stock of T for $100. T has two assets, Asset A, with P purchases 100% of the stock of T for $100. T has two assets, Asset A, with $100 built-in gain and Asset B with $100 built-in loss. P causes T to sell Assets $100 built-in gain and Asset B with $100 built-in loss. P causes T to sell Assets A and B to X. P has no net increase in its stock basis in T and thus, P’s T stock A and B to X. P has no net increase in its stock basis in T and thus, P’s T stock basis remains $100. T invests the $100 unwisely and the value of its assets basis remains $100. T invests the $100 unwisely and the value of its assets declines to zero.declines to zero.

Analysis:Analysis: If P sells the T stock to a third party for $0, P’s $100 capital loss will be allowed. If P sells the T stock to a third party for $0, P’s $100 capital loss will be allowed. Treas. Reg. § 1.337(d)-2T(c)(4), Example.Treas. Reg. § 1.337(d)-2T(c)(4), Example.

Y

STEP 3STEP 3

$0$0

T StockT Stock

66

Difficulties in the Application of Difficulties in the Application of Treas. Reg. § 1.337(d)-2TTreas. Reg. § 1.337(d)-2T

Difficulty in determining whether P’s basis increase in Difficulty in determining whether P’s basis increase in T was attributable to built-in gain in an asset of T. T was attributable to built-in gain in an asset of T. This is particularly true where there are multiple This is particularly true where there are multiple subsidiaries and many adjustments to P’s stock basis subsidiaries and many adjustments to P’s stock basis in T.in T.

Determining the built-in gain in T’s assets on the date Determining the built-in gain in T’s assets on the date P acquires the T stock is often difficult due to the P acquires the T stock is often difficult due to the passage of time. Also, T may have its own passage of time. Also, T may have its own subsidiaries acquired at earlier dates.subsidiaries acquired at earlier dates.

The regulation applies only to built-in gain and not The regulation applies only to built-in gain and not built-in income.built-in income.

67

LDR – Built-in IncomeLDR – Built-in Income

T Shareholders P

T


T StockT Stock

X

STEP 2STEP 2Natural GasNatural Gas

$100$100


Facts:Facts: When P acquires T, T’s only asset is an oil and gas property worth $100. T When P acquires T, T’s only asset is an oil and gas property worth $100. T produces the oil and gas property and receives $100 from the sale of natural produces the oil and gas property and receives $100 from the sale of natural gas. The $100 of income increases P’s basis in the T stock to $200. P then gas. The $100 of income increases P’s basis in the T stock to $200. P then sells the T stock for $100 and claims a $100 capital loss.sells the T stock for $100 and claims a $100 capital loss.

Analysis:Analysis: Since T did not “dispose” of an asset with built-in gain that had been Since T did not “dispose” of an asset with built-in gain that had been reflected in P’s stock basis in T, Treas. Reg. § 1.337(d)-2T does not apply.reflected in P’s stock basis in T, Treas. Reg. § 1.337(d)-2T does not apply.

Y

STEP 3STEP 3T StockT Stock

$100$100

68

Notice 2004-58Notice 2004-58

The IRS will accept various methods under –2T(c), The IRS will accept various methods under –2T(c), including “tracing,” “basis disconformity,” and other including “tracing,” “basis disconformity,” and other methods.methods. No consistency required between different dispositions.No consistency required between different dispositions.

What are “other” acceptable methods?What are “other” acceptable methods?

Basis disconformity adopts a single entity approach.Basis disconformity adopts a single entity approach. S’s asset gain is not treated as already reflected in S stock S’s asset gain is not treated as already reflected in S stock

basis if S’s inside asset basis at least equals S’s outside basis if S’s inside asset basis at least equals S’s outside stock basis (i.e., basis conformity).stock basis (i.e., basis conformity).

S’s asset gain is treated as reflected in S stock basis to the S’s asset gain is treated as reflected in S stock basis to the extent of any excess of S’s outside stock basis over S’s extent of any excess of S’s outside stock basis over S’s inside asset basis (i.e., basis disconformity). inside asset basis (i.e., basis disconformity).

69

Basis DisconformityBasis DisconformityCalculationCalculation

Loss on subsidiary stock is disallowed to the extent of the Loss on subsidiary stock is disallowed to the extent of the leastleast of three factors:of three factors: Gain amountGain amount.. The sum of all The sum of all gainsgains, net of directly related expenses, , net of directly related expenses,

from asset dispositions.from asset dispositions.

Not necessary to the theory, but required by the language of –Not necessary to the theory, but required by the language of –2T(c). 2T(c).

No netting of asset gains with asset losses.No netting of asset gains with asset losses.

Disconformity amountDisconformity amount.. Any excess of stock basis over “net asset Any excess of stock basis over “net asset basis.” Net asset basis equals any excess of (a) the asset basis basis.” Net asset basis equals any excess of (a) the asset basis (other than subsidiary stock), loss carryforwards available under –(other than subsidiary stock), loss carryforwards available under –21(b) in SRYs, and deferred deductions, over (b) tax liabilities.21(b) in SRYs, and deferred deductions, over (b) tax liabilities.

Positive investment adjustment amount (“PIA”).Positive investment adjustment amount (“PIA”). Any excess of the Any excess of the sum of the positive – 32 adjustments over the sum of the negative – sum of the positive – 32 adjustments over the sum of the negative – 32 adjustments, excluding adjustments for distributions.32 adjustments, excluding adjustments for distributions.

Nets operating profits and losses, as well as asset gains and Nets operating profits and losses, as well as asset gains and losses.losses.

70

Tracing v. Basis DisconformityTracing v. Basis Disconformity

In some cases, tracing disallows losses that In some cases, tracing disallows losses that basis disconformity would allowbasis disconformity would allow

In others, basis disconformity disallows losses In others, basis disconformity disallows losses that tracing would allow.that tracing would allow.

71

LDR – Offsetting Built-in Gains LDR – Offsetting Built-in Gains and Lossesand Losses

T Shareholders P

T

STEP 1STEP 1$100 $100

T StockT Stock

X


$100$100


Asset BAsset BFMV:FMV: $ 0$ 0Basis:Basis: $100$100

Facts:Facts: P purchases 100% of the stock of T for $100. T has two assets, Asset A, with P purchases 100% of the stock of T for $100. T has two assets, Asset A, with $100 built-in gain and Asset B with $100 built-in loss. P causes T to sell Assets $100 built-in gain and Asset B with $100 built-in loss. P causes T to sell Assets A to X. P has $100 increase in its stock basis in T and thus, P’s T stock basis is A to X. P has $100 increase in its stock basis in T and thus, P’s T stock basis is $200. $200.

Analysis:Analysis: If P sells the T stock to a third party for $100, P’s $100 capital loss will be If P sells the T stock to a third party for $100, P’s $100 capital loss will be disallowed under the tracing rules but not under basis conformity. There is disallowed under the tracing rules but not under basis conformity. There is basis conformity because P’s stock basis in T is $200 and T’s inside basis is basis conformity because P’s stock basis in T is $200 and T’s inside basis is $200.$200.

Y

STEP 3STEP 3

$0$0

T StockT Stock

72

Tracing v. Basis DisconformityTracing v. Basis Disconformity

Requires knowledge of how P Requires knowledge of how P (or its predecessor) valued (or its predecessor) valued each T asseteach T asset

Requires asset valuationsRequires asset valuations

Might take into account FMV Might take into account FMV fluctuationsfluctuations

Does not require knowledge of Does not require knowledge of how P (or its predecessor) valued how P (or its predecessor) valued each T asseteach T asset

Does not require asset valuationsDoes not require asset valuations

Does not take into account FMV Does not take into account FMV fluctuationsfluctuations

Basis Disconformity method is significantly more administrable.Basis Disconformity method is significantly more administrable.

TRACINGTRACING BASIS DISCONFORMITYBASIS DISCONFORMITY

73

Overview of Overview of Treas. Reg. § 1.1502-35TTreas. Reg. § 1.1502-35T

The goal is to prevent a consolidated group from recognizing The goal is to prevent a consolidated group from recognizing more than one tax loss on a particular economic loss. more than one tax loss on a particular economic loss. Charles Charles Ilfeld Co. v. Comm’rIlfeld Co. v. Comm’r, 292 U.S. 62 (1934)., 292 U.S. 62 (1934).

The -35T rule applies only if P sells less than all of its T stock The -35T rule applies only if P sells less than all of its T stock within a single taxable year. Conversely, the rule does not within a single taxable year. Conversely, the rule does not apply if P sells all of its T stock in a single taxable year. Treas. apply if P sells all of its T stock in a single taxable year. Treas. Reg. §1.1502-35T(b)(3).Reg. §1.1502-35T(b)(3).

The -35T regulation contains two main rules: a loss The -35T regulation contains two main rules: a loss disallowance rule and a basis spreading rule.disallowance rule and a basis spreading rule.

The -35T rules address two main scenarios: where T is The -35T rules address two main scenarios: where T is deconsolidated immediately after P’s sale of T stock and where deconsolidated immediately after P’s sale of T stock and where T remains consolidated immediately after the sale of T stock.T remains consolidated immediately after the sale of T stock.

74

-35T – Basic Deconsolidation Case -35T – Basic Deconsolidation Case (Assets First)(Assets First)

P

T

N

STEP 3STEP 3Asset YAsset Y

$100$100

Facts:Facts: P contributes $100 cash to T for Share A. At a later date, P contributes Asset Y to T for Share B. Asset P contributes $100 cash to T for Share A. At a later date, P contributes Asset Y to T for Share B. Asset Y has a basis of $200 and a fair market value of $100 and, therefore, has a $100 built-in loss. T later Y has a basis of $200 and a fair market value of $100 and, therefore, has a $100 built-in loss. T later sells Asset Y for $100 and recognizes a $100 Section 1231 loss. The loss reduces P’s basis in both sells Asset Y for $100 and recognizes a $100 Section 1231 loss. The loss reduces P’s basis in both Share A and Share B by $50 each. P then sells Share B to N for $100 and recognizes a $50 capital Share A and Share B by $50 each. P then sells Share B to N for $100 and recognizes a $50 capital loss. Thus, the P-T group has realized $50 of the $100 built-in loss twice.loss. Thus, the P-T group has realized $50 of the $100 built-in loss twice.

Analysis: The -35T regulation would prevent P from recognizing the $50 loss via the basis spreading rule. Analysis: The -35T regulation would prevent P from recognizing the $50 loss via the basis spreading rule. Immediately before P’s deconsolidating sale of the T stock, P’s aggregate $200 basis in all of its Immediately before P’s deconsolidating sale of the T stock, P’s aggregate $200 basis in all of its T stock would be spread equally among all of the shares. Thus, P’s basis in its B share would T stock would be spread equally among all of the shares. Thus, P’s basis in its B share would be reduced from $150 to $100, resulting in no loss on P’s sale of such share to N. be reduced from $150 to $100, resulting in no loss on P’s sale of such share to N.

X

STEP 4STEP 4Share BShare B

$100$100

STEP 1STEP 1$100 Cash for $100 Cash for

Share AShare ASTEP 2STEP 2

Asset Y with $100 Asset Y with $100 BIL for Share BBIL for Share B

75

Basis Reallocation RuleBasis Reallocation Rule

This rule applies when:This rule applies when:

T is deconsolidated from P, andT is deconsolidated from P, and

Immediately before the deconsolidation, any of the P stock in T is Immediately before the deconsolidation, any of the P stock in T is worth less than its tax basis.worth less than its tax basis.

If this rule applies, then the basis of all the T stock is If this rule applies, then the basis of all the T stock is reallocated in a manner so as to equalize to the extent reallocated in a manner so as to equalize to the extent possible the ratio of value to basis of each share. If P possible the ratio of value to basis of each share. If P owns any preferred stock of T with a built-in gain, the owns any preferred stock of T with a built-in gain, the reallocable basis is first reallocated to such preferred reallocable basis is first reallocated to such preferred stock in a manner so as to increase the basis to the value stock in a manner so as to increase the basis to the value to the extent possible. The remainder of the reallocable to the extent possible. The remainder of the reallocable basis is then allocated to the common stock in a manner basis is then allocated to the common stock in a manner so that, to the extent possible, the ratio of basis to the so that, to the extent possible, the ratio of basis to the value of each share is the same.value of each share is the same.

76

-35T Loss Disallowance Rule-35T Loss Disallowance Rule

This loss disallowance rule applies when:This loss disallowance rule applies when:

P transfers any stock of T,P transfers any stock of T,

Such T stock is worth less than its tax basis, Such T stock is worth less than its tax basis,

Immediately after the transfer, T remains a member of the P group. Immediately after the transfer, T remains a member of the P group.

In that case, the regulation requires the following:In that case, the regulation requires the following:

The basis of all of the T stock held by members of the P group immediately before the The basis of all of the T stock held by members of the P group immediately before the transfer is aggregated.transfer is aggregated.

The aggregate basis is allocated to any preferred stock up to the value of such stock. Any The aggregate basis is allocated to any preferred stock up to the value of such stock. Any remaining basis is allocated proportionately to the common stock.remaining basis is allocated proportionately to the common stock.

Any loss remaining in the stock after the foregoing reallocation of basis is suspended to Any loss remaining in the stock after the foregoing reallocation of basis is suspended to the extent of the “duplicated loss” allocated to such stock. The total duplicated loss the extent of the “duplicated loss” allocated to such stock. The total duplicated loss generally equals the net inside asset basis of the subsidiary less the value of the generally equals the net inside asset basis of the subsidiary less the value of the subsidiary stock.subsidiary stock.

The foregoing suspended loss is permanently reduced to the extent that T recognizes any The foregoing suspended loss is permanently reduced to the extent that T recognizes any loss or deduction after the stock sale while it remains a member of the P group, unless either loss or deduction after the stock sale while it remains a member of the P group, unless either (i) P establishes that T’s loss or deduction was not reflected in the computation of duplicated (i) P establishes that T’s loss or deduction was not reflected in the computation of duplicated loss on P’s stock sale date, or (ii) T’s loss reduces the basis of T shares then held by P.loss on P’s stock sale date, or (ii) T’s loss reduces the basis of T shares then held by P.

P’s remaining suspended loss is allowed in the taxable year that T leaves the P group.P’s remaining suspended loss is allowed in the taxable year that T leaves the P group.

77

-35T - Basic Consolidation Case-35T - Basic Consolidation Case(Assets First)(Assets First)

Facts:Facts: In Step 1, P contributes $40 of cash to T in exchange for four shares of T common stock. In Step 1, P contributes $40 of cash to T in exchange for four shares of T common stock. In Step 2, P contributes Asset A with a $50 built-in loss (tax basis of $60 and value of In Step 2, P contributes Asset A with a $50 built-in loss (tax basis of $60 and value of $10) in exchange for one new share of common stock. T sells Asset A to M for $10 and $10) in exchange for one new share of common stock. T sells Asset A to M for $10 and recognizes a $50 Section 1231 loss. Later, P sells the one new share to N for $10 and recognizes a $50 Section 1231 loss. Later, P sells the one new share to N for $10 and recognizes a $40 loss. Thus, $40 of the $50 built-in loss in Asset A is duplicated within recognizes a $40 loss. Thus, $40 of the $50 built-in loss in Asset A is duplicated within the P-T consolidated group.the P-T consolidated group.

Analysis:Analysis: Prior to the stock sale, the basis reallocation rule will eliminate the built-in loss in the Prior to the stock sale, the basis reallocation rule will eliminate the built-in loss in the one new share. Thus, P will recognize no loss when it sells the new share for $10. The one new share. Thus, P will recognize no loss when it sells the new share for $10. The basis reallocation rule will allocate P’s aggregate $50 basis in the shares evenly among basis reallocation rule will allocate P’s aggregate $50 basis in the shares evenly among the five shares ($10 to each share).the five shares ($10 to each share).

P

T

N


$10$10M

STEP 4STEP 41 new share1 new share

$10$10

STEP 1STEP 1$40 for $40 for 4 shares4 shares

STEP 2STEP 2Asset A for 1 new share Asset A for 1 new share ($60 basis / $10 value)($60 basis / $10 value)

78

-35T - Basic Consolidation Case-35T - Basic Consolidation Case(Stock First)(Stock First)

Facts:Facts: The facts are the same as the previous example, except that P sells the new The facts are the same as the previous example, except that P sells the new share for $10 before T sells Asset A to M. After the stock sale, T remains a share for $10 before T sells Asset A to M. After the stock sale, T remains a member of the P group. P would have a $50 loss on the sale of the new stock member of the P group. P would have a $50 loss on the sale of the new stock and a $50 loss on the sale of Asset M. and a $50 loss on the sale of Asset M.

Analysis:Analysis: First, P’s basis in the new share will be decreased under the basis reallocation First, P’s basis in the new share will be decreased under the basis reallocation rule. In particular, P’s aggregate basis of $100 will be allocated pro rata among rule. In particular, P’s aggregate basis of $100 will be allocated pro rata among each of the five shares ($20 per share). Further, P’s $10 loss on the sale of the each of the five shares ($20 per share). Further, P’s $10 loss on the sale of the one new share to N will be suspended. T’s loss on the sale of Asset A to M will one new share to N will be suspended. T’s loss on the sale of Asset A to M will eliminate the suspended loss.eliminate the suspended loss.

P

T

N


$10$10M

STEP 3STEP 31 new share1 new share

$10$10

STEP 1STEP 1$40 for $40 for 4 shares4 shares

STEP 2STEP 2Asset A for 1 new share Asset A for 1 new share ($60 basis / $10 value)($60 basis / $10 value)

79

American Jobs Creation American Jobs Creation Act of 2004Act of 2004

80

American Jobs Creation Act of 2004American Jobs Creation Act of 2004Importation of Built-in LossesImportation of Built-in Losses

The Act adds new Section 362(e)(1) that applies to a The Act adds new Section 362(e)(1) that applies to a transaction described in Sections 351 or 368(a)(1) where transaction described in Sections 351 or 368(a)(1) where there is “an importation of a net built-in loss.” Such there is “an importation of a net built-in loss.” Such “importation” occurs where:“importation” occurs where:

The transferor of property is not subject to U.S. income tax on The transferor of property is not subject to U.S. income tax on gain or loss at the time of the transfer, but the transferee is; andgain or loss at the time of the transfer, but the transferee is; and

The aggregate adjusted basis of the property transferred The aggregate adjusted basis of the property transferred exceeds its fair market value immediately after the transaction.exceeds its fair market value immediately after the transaction.

In such a case, Section 362(e)(1) provides that the basis of In such a case, Section 362(e)(1) provides that the basis of each property transferred is “stepped down” to its fair each property transferred is “stepped down” to its fair market value immediately after the transaction. market value immediately after the transaction.

81

American Jobs Creation Act of 2004American Jobs Creation Act of 2004Importation of Built-in Losses Importation of Built-in Losses –– Example Example

Facts: F, a foreign corporation, transfers an Facts: F, a foreign corporation, transfers an asset with a basis of $200 and a value of $50 to asset with a basis of $200 and a value of $50 to its wholly-owned domestic subsidiary, S, in a its wholly-owned domestic subsidiary, S, in a Section 351 transaction.Section 351 transaction.

Conclusion: S’s basis in the asset is stepped Conclusion: S’s basis in the asset is stepped down to $50.down to $50.

82

American Jobs Creation Act of 2004American Jobs Creation Act of 2004Elimination of Loss Duplication in Section 351 Transactions Elimination of Loss Duplication in Section 351 Transactions

GenerallyGenerally

New Section 362(e)(2) applies when:New Section 362(e)(2) applies when:

there is no “importation” of the net built-in loss (and thus, Section 362(e)(1) there is no “importation” of the net built-in loss (and thus, Section 362(e)(1) does not apply), anddoes not apply), and

the aggregate adjusted basis of the transferred property exceeds its fair market the aggregate adjusted basis of the transferred property exceeds its fair market value.value.

In such a case, new Section 362(e)(2) generally limits the transferee’s In such a case, new Section 362(e)(2) generally limits the transferee’s aggregate adjusted basis of the property transferred to the fair market aggregate adjusted basis of the property transferred to the fair market value of such property.value of such property.

The aggregate reduction in basis is allocated among the assets The aggregate reduction in basis is allocated among the assets transferred in proportion to their respective built-in losses.transferred in proportion to their respective built-in losses.

Alternatively, the transferor and the transferee can jointly elect to Alternatively, the transferor and the transferee can jointly elect to reduce the transferor’s basis of the stock received in the transaction reduce the transferor’s basis of the stock received in the transaction to its fair market value.to its fair market value.

83

American Jobs Creation Act of 2004American Jobs Creation Act of 2004Elimination of Loss Duplication in Section 351 Transactions Generally Elimination of Loss Duplication in Section 351 Transactions Generally ––

ExampleExample

Facts: P transfers two assets to S in a Section 351 Facts: P transfers two assets to S in a Section 351 transaction. Asset A has a fair market value of zero transaction. Asset A has a fair market value of zero and a basis of $100 and Asset B has a fair market and a basis of $100 and Asset B has a fair market value of $100 and a basis of zero.value of $100 and a basis of zero.

Conclusion: Section 362(e)(2) does not apply Conclusion: Section 362(e)(2) does not apply because the assets transferred do not have a net because the assets transferred do not have a net built-in loss.built-in loss.

84

American Jobs Creation Act of 2004American Jobs Creation Act of 2004 Elimination of Loss Duplication in Section 351 Transactions Generally Elimination of Loss Duplication in Section 351 Transactions Generally ––

ExampleExample

Facts: P transfers two assets to S in a Section Facts: P transfers two assets to S in a Section 351 transaction. Asset A has a fair market value 351 transaction. Asset A has a fair market value of $100 and a basis of zero and Asset B has a fair of $100 and a basis of zero and Asset B has a fair market value of zero and a basis of $150. Thus, market value of zero and a basis of $150. Thus, the assets transferred have a net built-in loss of the assets transferred have a net built-in loss of $50.$50.

Conclusion: Section 362(e)(2) applies. The basis Conclusion: Section 362(e)(2) applies. The basis of Asset B is reduced to $100.of Asset B is reduced to $100.

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