Originally published July, 2003. To read this article in full, please go to the bottom of this page

1. INTRODUCTION

A. Section 10226 of the Revenue Act of 1987, P.L. 100-203 ("OBRA"), added section 384 to the Code. The general purpose of section 384, as originally enacted, was to prohibit loss corporations from using their losses to shelter built-in gains of an acquired target corporation if such gains were recognized within the five-year period after the target's acquisition. See H.R. Rep. No. 391, 100th Cong., 1st Sess. 1093-94 (1987).

1. The original version of section 384 generally applied where a loss corporation became affiliated with a gain corporation as a result of the acquisition of gain corporation stock. In addition, the original version of section 384 generally applied to certain tax-free asset acquisitions by loss corporations (where built-in gain in the acquired assets was preserved).

2. An exception was provided where the loss corporation and the gain corporation were under common control.
B. However, the original version of section 384 was so seriously flawed that Congress substantially revised section 384 in the Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647 ("TAMRA").

1. Revised section 384 now applies to: (1) stock acquisitions in which control of the target is acquired, and (2) certain tax-free asset acquisitions, regardless of whether the loss corporation acquired the gain corporation (or its assets) or vice-versa.

2. The general thrust of revised section 384 is that, following such an acquisition, built-in losses (i.e., preacquisition losses) of one corporation cannot offset built-in gains of another corporation which are recognized within five years of the acquisition.

3. TAMRA offers taxpayers an election to have the old version of section 384, rather than the revised version, apply to transactions for which the acquisition date is before March 31, 1988. See TAMRA, § 2004(m)(5). For procedures to make this election, see Announcement 89-40, 1989-12 I.R.B. 95.

4. Accordingly, the old statute remains relevant for purposes of this election. For this reason, discussions of the old statute are retained in this outline.
C. Section 384 does not displace any of the current provisions limiting loss carryovers. Thus, for example, sections 172, 269, 382, and the consolidated return regulations (the SRLY and reverse acquisition rules) continue to apply. However, the interaction among section 384 and these other provisions is uncertain at this time.

1. Apparently, the limitations of section 384 are to apply independently of, and in addition to, section 382. See Staff, Joint Committee on Taxation, Description of the Technical Corrections Act of 1988, at 421 (1988) ("Gen. Expl."). See also H.R. Rep. No. 795, 100th Cong., 2d Sess. 412 (1988) ("House Report"); S. Rep. No. 445, 100th Cong., 2d Sess. 436 (1988). Thus, for example, it is possible that both section 382 and 384 will apply as the result of a single transaction (e.g., gain corporation acquires loss corporation). Dual application of these sections creates enormous complexity.

2. Section 384 overlaps to some extent with section 269(a), except that section 269(a) may apply where the loss corporation acquires only 50 percent control of the profitable corporation.

a. In contrast to section 269, however, section 384 is not dependent on the subjective intent of the acquiring corporation.

b. Also, losses may be disallowed if section 269 applies, whereas section 384 only prevents preacquisition losses from offsetting another corporation's recognized built-in gains.

3. As originally drafted, section 384 essentially was the converse of section 269(b) (profitable corporation makes a qualified stock purchase of a loss target without electing section 338 and liquidates target). However, revised section 384 now overlaps to some extent with section 269(b) except that no liquidation is needed to trigger this section.

4. Section 384 also overlaps with the SRLY rules where a gain corporation acquires the stock of a loss corporation (unless the acquisition is a reverse acquisition, in which case section 384 generally would apply but not the SRLY rules).

a. However, the SRLY rules extend to the gain corporation's operating income, whereas section 384 applies only to recognized built-in gains.

b. In addition, prior to the introduction of subgroup principles to the SRLY rules, the SRLY rules may have been more restrictive than the section 384 rules if the gain corporation acquires (not in a reverse acquisition) a consolidated group having both gain and loss members. Prior to 1997 (or 1991 if a retroactive election is made), the SRLY rules applied separately to each member of the acquired group. However, as discussed below, section 384 generally treats the acquired group as one corporation. This result has been mitigated by the SRLY subgroup rules. See Treas. Reg. §§ 1.1502-15(c) and –21(c) (finalized in T.D. 8823, 1999-29 I.R.B. 34).

D. The alternative minimum tax ("AMT") must also be considered. A corporation's built-in gains and losses (including net operating loss carryovers) are likely to differ for regular and minimum tax purposes. Presumably, section 384 will be applied separately for AMT purposes. See Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 438 and 470 (1987) ("Blue Book"); Ltr. 9804013 (stating that section 384 will apply in the computation of alternative minimum taxable income in the same manner as it applies in the computation of taxable income). Cf. section 382(l)(7).

II. ACQUISITIONS SUBJECT TO SECTION 384

A. The Revised Statute

1. Stock Acquisitions

a. With respect to stock acquisitions, revised section 384(a) provides that:

(1) if a corporation "acquires directly (or through 1 or more corporations 'control' of another corporation,"

(2) and either corporation is a "gain corporation,"

(3) then income for "any recognition period taxable year" (to the extent attributable to "recognized built-in gains") may not be offset by any preacquisition loss (other than a "preacquisition loss" of the gain corporation). Section 384(a)(1)(A).

b. Thus, the first requirement is that one corporation must acquire "control" of another corporation.

(1) The term "control" means ownership of stock in a corporation which meets the requirements of section 1504(a)(2) (80 percent vote and value). Section 384(c)(5).

i. Presumably, this standard incorporates section 1504(a)(4) so that "vanilla" preferred stock is ignored.

ii. It is unclear what effect the regulations under section 1504(a)(5) will have in a section 384 context. Cf. Notice 87-63, 1987-2 C.B. 375 (indicating section 1504(a)(5) regulations will apply, in general, prospectively for section 332 and 338 purposes).

(2) Control may be acquired in a taxable or tax-free manner. Also, there is no time limit as to the acquisition of control -- a creeping 20-year acquisition would become subject to section 384 once control was acquired.

(3) Since this term is different from "control" as used in the section 351 context, a section 351 exchange can fall outside revised section 384(a)(1)(A). But see section 384(f)(2).

(4) Further, it is unclear how a corporation may acquire control through "1 or more corporations" under Section 384(a)(1)(A) as neither Section 384 nor Section 1504(a)(2) expressly provide constructive ownership rules. However, the Service has advised that the stock of two acquiring corporations may only be aggregated for the purpose of determining control of an acquired corporation under Section 384(a)(1)(A) if one of the corporations controls the other by means of direct stock ownership determined under the Section 1504(a)(2) control test (80 percent vote and value). FSA 200125007.

(5) In contrast, old section 384 applied where the gain corporation became a "member of an affiliated group."

c. The second requirement is that at least one corporation must be a "gain corporation."

(1) Section 384(c)(4) defines a gain corporation as any corporation with a net unrealized built-in gain.

i. Note that under this definition, a corporation may be a gain corporation, yet still possess loss carryovers

ii. An example of such a case is a real estate concern that owns appreciated real property but has losses resulting from depreciation and interest deductions.

(2) The revised statute clearly would apply where a gain corporation acquires control of a loss corporation and vice versa; whereas the old statute seemed applicable only where a loss corporation acquires a gain corporation.

d. In addition, except as may be provided in regulations, section 384(c)(6) also provides that all corporations which are members of the same affiliated group (as defined in section 1504) immediately before the acquisition generally will be treated as one corporation.

(1) To the extent provided in regulations, section 1504 will be applied without regard to the limitations in section 1504(b).

i. That is, once implementing regulations are issued, foreign corporations, certain insurance companies, etc. may be included as members of the gain corporation's affiliated group. But see H.R. Rep. No. 1104, 100th Cong., 2d Sess. 19 (1988).

ii. This rule apparently will apply on both sides of the transaction to aggregate members of the acquiring group and the acquired group.

(2) Thus, under the revised statute, where the loss corporation acquires the common parent of an affiliated group, all members of the acquired group generally would be treated as one corporation. Preacquisition losses attributable to one acquired member of the group apparently may be offset by recognized built-in gains of another member of such acquired group.

i. This change tends to correct the SRLY effect under the language of old section 384.

ii. Under old section 384, preacquisition losses of former members of the gain corporation's affiliated group who were also acquired by the loss corporation were technically limited under old section 384(a)(1).

e. Revised section 384(a) expressly allows built-in gains to be offset by preacquisition losses of the gain corporation. This reflects the fact that the statute is designed to prevent losses from one corporation from offsetting gains of another corporation.

f. The other terms contained in revised section 384(a) will be defined in Part III., below.

2. Asset Acquisitions

a. With respect to asset acquisitions, revised section 384(a) provides that:

(1) if the assets of a corporation are acquired by another corporation in an (A), (C) or (D) reorganization,

(2) and either corporation is a gain corporation,

(3) then income for any recognition period taxable year (to the extent attributable to recognized built-in gains) may not be offset by any preacquisition loss (other than a preacquisition loss of the gain corporation).

b. The principles outlined in Part II.A.1.c. through e., above, with respect to stock acquisitions, apply here with respect to asset acquisitions.

c. In contrast to the old statute, a section 332 liquidation is not treated as an asset acquisition within the realm of section 384. According to the TCA 88 General Explanation, the reference to section 332 liquidations was deleted because the successor rule of revised section 384(c)(7) renders the liquidation rule unnecessary. See discussion below at Part III.D.

d. Section 384(a)(1)(B) does not apply, on its face, to F or G reorganizations. It is unclear whether section 384 would apply to a transaction that is both a G or an F, and an A, C or D reorganization as well.

B. The Old Statute

1. Stock Acquisitions

a. Old section 384(a)(1) provided that:

(1) if a corporation (the "gain corporation") became a member of an affiliated group,

(2). and the gain corporation had a net unrealized built-in gain,

(3) then the income of the gain corporation for any recognition period taxable year (to the extent attributable to recognized built-in gains) could not be off-set by any preacquisition loss of any other member of such group.

b. Old section 384(a)(1) essentially covered stock acquisitions -- whether taxable or tax-free. This provision conceivably was broad enough to encompass section 351 transfers (e.g., where "Newco" was formed by a consolidated group member and appreciated property was transferred to it).

c. Importantly, the language of old section 384(a)(1) would prevent recognized built-in gains from being offset by any other member of the acquiring corporation's affiliated group, including those members that were formerly included in the target gain corporation's affiliated group.

d. As will be discussed below in Part III.C.2. (the old definition of "acquisition date"), it was not clear precisely when a corporation became a "member of an affiliated group."

(1) Construed broadly, this language would cover the situation where a "stand alone" gain corporation acquired a loss corporation and the two corporations filed consolidated returns thereafter. In such a case, the gain corporation literally would have "become a member of an affiliated group."

(2) It was unclear from the original statute whether this was an intended result. As discussed above, revised section 384 makes clear that the statute would apply where a gain corporation acquires a loss corporation.

2. Asset Acquisitions

a. Old section 384(a)(2) provided that:

-- if the assets of the gain corporation were acquired by another corporation (1) in a section 332 liquidation, or (2) in a reorganization described in section 368(a)(1)(A), (C) or (D),

-- and the gain corporation had a net unrealized built-in gain,

-- then the income of the acquiring corporation for any recognition period taxable year (to the extent attributable to recognized built-in gains of the gain corporation) could not be offset by any preacquisition loss of any corporation other than the gain corporation.

b. The effect of old section 384(a)(2) was to prevent recognized built-in gains attributable to the gain corporation from being offset by preacquisition losses of any other member of the acquiring group, including those members that formerly were included in the target gain corporation's group.
III. DEFINITIONS

A. Recognized Built-in Gain

1. Under section 384(c)(1), the term "recognized built-in gain" means any gain recognized during the "recognition period" on the disposition of any asset, except to the extent that the taxpayer establishes that:

-- such asset was not held by the gain corporation on the "acquisition date," or

-- such gain exceeds the excess (if any) of: (1) the fair market value of such asset on the acquisition date, over (2) - 11 -the adjusted basis of such asset on the acquisition date.

In other words, any gain recognized during the recognition period is presumed to be limited under section 384, unless the loss corporation can prove otherwise (presumably on the basis of a preponderance of the evidence).

2. Recognized built-in gains for any recognition period may not exceed the net unrealized built-in gain reduced by the recognized built-in gains for prior years (ending in the recognition period) which would have been offset by preacquisition losses but for section 384. See section 384(c)(1)(C).

3. Presumably, gain will be treated as being recognized under the corporation's usual method of accounting.

a. Thus, if inventory is reported on the LIFO method, built in gain would not be recognized until the pre-acquisition LIFO layers are invaded. Cf. Announcement 86- 128, 1986-51 I.R.B. 22 (applying a similar rule for section 1374 purposes).

b. Query whether a corporation could successfully adopt the LIFO method after the acquisition date. Cf. S. Rep. No. 445, 100th Cong., 2d Sess. 66 (1988) (indicating that regulations under section 337(d) will prevent such maneuvers for section 1374 purposes).

4. The term "recognized built-in gain" also includes accrued income items. Section 384(c)(1)(B).

a. Accrued income items would include accounts receivable held by a cash basis corporation (a dying breed following section 448 enactment). Also, accrued income would include deferred gain inherent in installment obligations arising from pre-acquisition date transactions, and contract income earned but not reported under the completed contract method of accounting. Accrued income could also include section 481 adjustments from pre-acquisition date periods.

b. Although no offsetting provision for accrued deductions is expressly provided, section 382(h)(6)(B) (which treats accrued deductions as recognized built-in losses) apparently is incorporated into section 384 as part of the computation of net unrealized built-in gain and recognized built-in losses. See section 384(c)(8).

(1) Thus, to the extent that section 382(h)(6)(B) treats accrued deductions as recognized built-in losses (with an adjustment to net unrealized built-in gain under section 382(h)(6)(C)), it appears that accrued deductions would operate to reduce the amount of net unrealized built-in gain.

(2) This in turn limits the amount of recognized built-in gains that can be subject to section 384. See section 384(c)(1)(C).

(3) A better approach would be to provide a direct offset in section 384 for accrued deductions.

c. Operating and investment income (such as business income, rents and dividends) that accrues after the acquisition generally would not be captured by section 384.

5. The section 384 legislative history provides that built-in gains are to include "phantom" gains derived from depreciation deductions, as well as any income recognized after an acquisition in which the fair market value of the property acquired is less than the present value of taxes that would be due on the income associated with the property (e.g., where a burnt-out leasing subsidiary with built-in income is transferred to a loss corporation). See House Report at 1094. The purpose or scope of this passage is not entirely clear.

6. The section 384 definition for built-in gain more closely follows the definition under section 382 for built-in loss. Compare section 384(c)(1) with section 382(h)(2)(B). Built-in losses under section 382 and built-in gains under section 384 are presumed to be limited under the respective provisions, unless the corporation can prove that such items are not limited.

7. Installment Sales

a. If the gain corporation sells assets for an installment note payable after the close of the recognition period, such gain would not appear to be recognized built-in gain under section 384(c)(1) since no gain was recognized in the recognition period.

b. However, the Service intends to issue regulations providing that if a taxpayer sells a built-in gain asset prior to or during the recognition period in an installment sale, the provision of section 382(h) will continue to apply to gain recognized from the installment sale after the recognition period. Notice 90-27, 1990- 1 C.B. 336.

c. The Service concluded that permitting installment sale treatment to avoid characterization as built-in gain did not carry out the purposes of section 384.

d. This does not appear to be the correct result as a policy matter; the corporation has "complied" with section 384 by not offsetting such gains with preacquisition losses within five years.

e. Note: Installment method reporting has been eliminated for accrual basis taxpayers for sales or other dispositions occurring on or after December 17, 1999. Section 453(a)(2).

B. Preacquisition Loss

1. Under section 384(c)(3)(A), the term "preacquisition loss" means: (1) any net operating loss carryforward to the taxable year in which the acquisition date occurs; and (2) any net operating loss for the taxable year in which the acquisition date occurs, to the extent such loss is allocable to the period in the year on or before the acquisition date.

2. Also, if a corporation has a "net unrealized built-in loss," the term "preacquisition loss" includes any recognized built-in losses. Section 384(c)(3)(B).

3. This definition closely parallels the section 382(d)(1) definition of "pre-change losses." That is, losses incurred prior to the acquisition date, in general, are preacquisition losses. It is unclear whether section 384 regulations will contain provisions similar to those described in Notice 87-79, 1987 C.B. 387 (permitting a closing of books for allocating income and losses under section 382 if a private ruling is obtained). See LTR 200238017 (allowing a parent corporation and each member of its affiliated group to allocate net operating losses for purposes of section 384(c)(3)(A)(ii) by treating their books as if they closed on the date of the merger of two subsidiaries of the affiliated group); LTR 9027008 (allowing a corporate group to allocate net operating losses for purposes of section 384(c)(3)(A)(ii) by treating their books as closed as of the acquisition date).

C. Acquisition Date

1. Revised Statute

a. The term "acquisition date" is defined as the date on which the acquisition of control occurs. See section 384(c)(2)(A). Query: what is the effect on the section 384 acquisition date if a 30-day election under Treas. Reg. § 1.1502-76(b)(5) is made?

b. In the context of an asset acquisition, the "acquisition date" is defined as the date of the transfer in the reorganization. Section 384(c)(2)(B).

2. Old Statute

a. With respect to stock acquisitions, old section 384(c)(2) defined the term "acquisition date" as the date on which the gain corporation became a "member of the affiliated group." It was unclear precisely what this phrase meant.

(1) First, this phrase could have meant the date when 80 percent of the vote and value of the gain corporation was acquired by the loss corporation or members of the loss corporation's group. Cf. section 338(d)(3) (definition of a qualified stock purchase).

(2) However, the phrase may also mean the first day when the gain corporation is included in the loss corporation's consolidated tax return. Under the consolidated return regulations, the gain corporation generally is included in such return on the day after the acquisition of 80 percent vote and value. See Treas. Reg. § 1.1502- 76(b)(3).

b. With respect to asset acquisitions, old section 384(c)(2) included a reference to section 332 liquidations in defining the acquisition date (consistent with old section 384(a)(2) that included section 332 liquidations as a section 384 trigger.

D. Corporation -- Predecessor and Successors

1. Section 384(c)(7) states that any reference to a corporation includes a reference to any predecessor and successor corporations.

2. This provision apparently is intended to ensure that the section 384 limitation applies to any successor corporation to the same extent that it applied to its predecessor. See Gen. Expl. at 421.

a. For example, assume that loss corporation (L) acquires control of gain corporation (G). The two corporations subsequently file a consolidated return.

(1) Under the stock acquisition rule, income attributable to G's recognized built-in gains may not be offset by L's preacquisition losses during the subsequent five-year recognition period.

(2) If G is liquidated into L under section 332 within five years after the acquisition, income attributable to G's recognized built-in gains may not be offset by L's preacquisition losses during the remainder of the five-year period. Gen. Expl. at 421.

(3) The TCA 88 General Explanation states that because of this successor rule, the reference to section 332 liquidations in the asset acquisition rules of section 384(a) was deleted. Gen. Expl. at 421.

b. As another example, assume the same facts as above except that, three years after G was acquired by L, G merges into an unrelated gain corporation (X), with X surviving. Assume that X thereafter files a consolidated return with L.

(1) Under the successor rule, during the two remaining years of the recognition period with respect to G, L is precluded from using its preacquisition losses -- those attributable to periods before it acquired control of G -- against income of X attributable to built-in gains inherited from G that would have been subject to such limitation prior to the merger.

(2) In addition, the general asset acquisition rule would prevent X's built-in gains that accrued prior to the merger with G but that are recognized during the 5-year recognition period following that merger from being offset by losses of L accruing before that merger. Id.

c. Further, suppose G were subsequently merged into a loss group member that was affiliated with G prior to the acquisition (e.g., where G has a subsidiary, GL-1, and G is merged into GL-1).

(1) The merger apparently would be ignored since revised section 384(c)(6) treats G and GL-1 as the same corporation.

(2) Apparently, under section 384(c)(7), L and GL-1 would be subject to section 384 to the same extent as before the merger.

3. One unfortunate by-product of the successor rule is that corporations will be forced to trace assets and the related built-in gain and losses through their various corporate incarnations.

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