october 2, 2008

IRS LIBERALIZES USE OF TAX LOSSES OF BANKS ATTRIBUTABLE TO BAD DEBTS AFTER AN OWNERSHIP CHANGE

The IRS has issued guidance, in Notice 2008-83, indicating that any deduction properly allowed after an ownership change to a bank with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) will not be treated as a built-in loss or a deduction that is attributable to periods before the ownership change date, for purposes of section 382(h) of the Internal Revenue Code.

Banks may rely on this notice unless and until the IRS issues additional guidance. The effect of this notice is that such tax deductions will not be subject to a limitation that might otherwise apply to prevent the use of the deductions to offset post-ownership change taxable income.

An ownership change occurs as to a corporate taxpayer when there is an increase of more than 50 percent in the percentage of stock owned1 by 5 percent shareholders2 over the lowest percentage of stock held by such shareholders during the testing period (the lesser of the three-year period ending on the testing date or the period since the last ownership change). If there is an ownership change, a limit applies to how much of the pre-change net operating losses and other tax attributes can be used each year to offset post-change taxable income. This limit is generally based on the value of the bank immediately before the ownership change multiplied by the long-term tax-exempt rate in effect at the time of the change in ownership.

The general net operating loss limitation is adjusted if the bank has a significant net unrealized built-in gain or a significant net unrealized built-in loss (or NUBIL), based on comparing the fair market value of the bank’s assets to the aggregate adjusted tax basis of such assets as of the ownership change date. NUBIL is significant if the amount exceeds the lesser of $10 million or 15 percent of the fair market value of the assets on the date of the ownership change.

If there is such a NUBIL:

  • any built-in loss which is recognized during the five-year period beginning on the ownership change date is treated as if it were a
    pre-change loss, subject to limitation; and
  • any built-in gain recognized during such five-year period does not increase the limitation.

With respect to deduction items recognized during the five-year period, the focus is on whether the amount is “attributable to” periods before the ownership change date but is allowable as a deduction after such date. The bank has the burden of proving whether a deduction is attributable to the pre-change period.

In general, under the so-called “1374 approach” of IRS Notice 2003-65, items of deduction properly allowed as a deduction during the recognition period are considered “attributable to periods before the change date” only if an accrual method taxpayer would have been allowed a deduction for the item before the change date but for the failure of economic performance or the application of another statutory or regulatory limitation on the deduction. With respect to bad debt, however, the timing of the deduction is based on a determination of degree of worthlessness, and the 1374 approach generally treats bad debt deductions as recognized built-in losses if the deductions are claimed within the first 12 months of the recognition period and relate to a debt owed to the loss corporation as of the beginning of the recognition period. Under Notice 2008-83, a bank would not need to treat a bad debt loss claimed within the first 12 months of the recognition period as a recognized built-in loss, even if the debt was owed to the bank on the ownership change date.

1 Determined based on value.
2 With certain of the less than 5 percent owners generally grouped together as one
5 percent shareholder.