Built in loss

What Is Built in Loss?

A built-in loss, in the context of corporate taxation and accounting, refers to the amount by which the fair market value of an asset or a group of assets is less than its adjusted tax basis at a specific point in time, typically at the time of a corporate ownership change. This concept is particularly relevant in corporate taxation and accounting, especially when a corporation with a history of losses undergoes a change in ownership. The Internal Revenue Service (IRS) and other tax authorities employ rules to prevent the exploitation of such losses for tax avoidance purposes following an acquisition or restructuring.

Built-in losses often relate to assets that have declined in fair market value below their book value or tax basis. This valuation gap means that if the asset were sold at its current market value, a loss would be realized. The recognition of a built-in loss can have significant implications for a company's financial reporting and future tax liabilities, particularly concerning its ability to utilize net operating losses (NOLs) or other tax attributes.

History and Origin

The concept of built-in loss, particularly in the context of corporate ownership changes, gained prominence with the enactment of tax legislation designed to limit the trafficking of tax attributes, such as net operating losses. A key piece of this legislation in the United States is Section 382 of the Internal Revenue Code. This section was introduced to prevent corporations with substantial NOLs from being acquired solely for the purpose of utilizing those losses to offset future taxable income of the acquiring entity or its assets.

Prior to such regulations, companies with significant accumulated losses could be attractive acquisition targets, not necessarily for their operational synergy, but for the value of their tax loss carryforwards. This could lead to a situation where a profitable company acquires a "loss corporation" and uses the acquired losses to reduce its own tax burden, undermining the principle of economic substance.

To address this, Section 382 imposes an annual limitation on the amount of pre-change losses that a loss corporation can use following an "ownership change." As part of this, the rules also address "built-in" gains and losses. If a corporation has a "net unrealized built-in loss" (NUBIL) at the time of an ownership change, any recognized built-in losses (RBILs) within a specified period (typically five years) after the ownership change are subject to the same Section 382 limitation.

The IRS has issued extensive guidance on Section 382(h), including Notice 2003-65, which provided methods for identifying built-in items for purposes of recognized built-in gains and losses.⁷ This regulatory framework helps ensure that tax benefits from pre-change losses, including built-in losses, are appropriately limited to reflect the economic reality of the business rather than being used for tax arbitrage.

Key Takeaways

• A built-in loss represents the excess of an asset's tax basis over its current fair market value.
• It is particularly relevant in the context of corporate ownership changes and mergers and acquisitions.
• Tax regulations, such as IRS Section 382, limit the utilization of built-in losses after an ownership change to prevent tax avoidance.
• The determination of a built-in loss position involves assessing the net unrealized built-in loss (NUBIL) of a corporation's assets and liabilities.
• Recognized built-in losses (RBILs) are subject to limitations if they occur within a specific recognition period following an ownership change.

Formula and Calculation

The presence of a built-in loss is determined by comparing the aggregate adjusted tax basis of a company's assets with their total fair market value. For an individual asset, a built-in loss exists if its adjusted tax basis exceeds its fair market value. For a corporation, the concept of a "net unrealized built-in loss" (NUBIL) is critical under Section 382.

The Net Unrealized Built-in Loss (NUBIL) is calculated as:

$\text{NUBIL} = \sum (\text{Adjusted Tax Basis of Assets}) - \sum (\text{Fair Market Value of Assets}) + \text{Certain Built-in Deductions}$

where:

• Adjusted Tax Basis of Assets: The original cost of the assets, adjusted for depreciation, capital improvements, and other tax adjustments.
• Fair Market Value of Assets: The price at which assets would change hands between a willing buyer and a willing seller in an arm's-length transaction.
• Certain Built-in Deductions: Includes items like accounts payable or other liabilities that have not yet been deducted for tax purposes but economically accrued prior to the ownership change.

If the aggregate adjusted tax basis of a corporation's assets, less certain liabilities, exceeds the aggregate fair market value of those assets, the corporation is considered to have a NUBIL. This calculation is usually performed on the "change date" when a significant ownership change occurs.

Interpreting the Built in Loss

Interpreting a built-in loss requires understanding its implications for a company's financial health and its ability to manage future tax obligations. For a corporation, a substantial net unrealized built-in loss (NUBIL) indicates that its assets, if liquidated at their current market values, would result in a significant pre-tax loss compared to their tax cost.

From an investor's perspective, a large built-in loss could signal past operational challenges, poor investment decisions, or adverse market conditions that have eroded asset values. However, for an acquiring company, it can also present a complex scenario involving potential future tax benefits, albeit subject to strict limitations.

The presence of a NUBIL often triggers the application of Section 382 rules, which limit the use of pre-change losses, including recognized built-in losses (RBILs), to offset post-change income. Therefore, while a built-in loss might represent a real economic decline, its tax usability is heavily regulated. For companies with a NUBIL, the objective is typically to manage and potentially accelerate the recognition of these losses in a tax-efficient manner, within the confines of IRS rules, or to mitigate the impact of the limitations on their future tax liabilities. Conversely, the acquiring entity must carefully evaluate how these limitations will affect its own future profitability and cash flow.

Hypothetical Example

Consider "Alpha Corp," a manufacturing company that, due to shifts in technology and consumer preferences, holds specialized machinery that has significantly depreciated in market value but still has a high tax basis.

• Adjusted Tax Basis of Machinery: $5,000,000
• Fair Market Value of Machinery: $2,000,000

In this scenario, the individual piece of machinery has a built-in loss of $3,000,000 ($5,000,000 - $2,000,000).

Now, imagine "Beta Corp" acquires 60% of Alpha Corp's stock, triggering an "ownership change" under Section 382. On the change date, a comprehensive valuation of all Alpha Corp's assets and liabilities is performed. If the aggregate adjusted tax basis of Alpha Corp's assets (including the machinery) exceeds their total fair market value by more than the statutory threshold (e.g., 15% of the fair market value of assets or $10 million), Alpha Corp would be deemed to have a Net Unrealized Built-in Loss (NUBIL).

For instance, if Alpha Corp's total assets have an adjusted tax basis of $50,000,000 and a fair market value of $40,000,000, it would have a NUBIL of $10,000,000. Under Section 382, any actual losses recognized from the sale of these assets (like the machinery) within the subsequent five years would be considered "recognized built-in losses" (RBILs) and would be subject to the Section 382 limitation, restricting how much of this loss can be used annually to offset Beta Corp's or the combined entity's future taxable income.

Practical Applications

Built-in loss provisions have several practical applications, primarily in the areas of corporate finance, taxation, and mergers and acquisitions. They are critical considerations for:

• Corporate Restructuring: When companies undergo significant reorganizations, spin-offs, or liquidations, the identification and management of built-in losses are crucial for tax planning. Proper accounting for these losses can influence the tax efficiency of the restructuring.
• Mergers and Acquisitions (M&A): For acquiring companies, understanding the target's built-in loss position is vital during due diligence. A substantial net unrealized built-in loss (NUBIL) in the target company can significantly impact the valuation and structure of the deal, as the usability of these losses post-acquisition is limited by tax rules. The Securities and Exchange Commission (SEC) also enhances disclosure requirements for significant business acquisitions, which often involve complex asset valuations.⁶
• Tax Planning and Compliance: Companies with potential built-in losses must meticulously track the adjusted tax basis and fair market value of their assets. This is essential for accurate financial reporting and for determining compliance with tax limitations on capital loss utilization, particularly those related to Section 382. The IRS provides guidance, such as Notice 2003-65, to help taxpayers understand how to identify built-in gains and losses.⁵
• Financial Statement Analysis: Investors and analysts scrutinize financial statements, including the balance sheet, to identify the extent of potential built-in losses, as these can impact a company's future earnings and tax obligations. This can inform decisions about investing in companies that have undergone significant ownership changes or asset value declines. Discussions around corporate tax rates also highlight the broader environment in which built-in loss rules operate.⁴
• Bankruptcy and Insolvency: In situations of financial distress, companies may have substantial built-in losses. The tax treatment of these losses, particularly in the context of debt restructuring or bankruptcy proceedings, is complex and governed by specific tax laws that can affect a company's recovery prospects and the interests of creditors. The Federal Reserve Bank of San Francisco has discussed how tax reform impacts net operating losses, which are often affected by built-in loss rules.³

Limitations and Criticisms

While built-in loss rules are designed to prevent tax avoidance, they come with several limitations and criticisms:

• Complexity: The rules surrounding built-in losses, particularly those under Section 382 of the Internal Revenue Code, are highly complex. This complexity can lead to significant compliance burdens and potential misinterpretations, requiring extensive tax and legal expertise. The IRS itself issues notices and regulations, like Notice 2003-65, to provide guidance on the identification of built-in items, underscoring the intricate nature of these provisions.¹, ²
• Impact on M&A Activity: The limitations on built-in losses can deter economically sound mergers and acquisitions involving loss corporations. An acquiring company might be less willing to purchase a business with significant built-in losses if the ability to utilize those losses for tax purposes is severely restricted, potentially hindering industry consolidation and restructuring that could otherwise be beneficial.
• Valuation Challenges: Accurately determining the fair market value of all assets and liabilities on a specific "change date" can be challenging, especially for intangible assets or unique property. Discrepancies in valuation can lead to disputes with tax authorities and alter the calculation of a net unrealized built-in loss.
• Economic vs. Tax Recognition: There can be a disconnect between the economic reality of a loss and its recognition for tax purposes. A business might genuinely have assets that have declined in value, representing a true economic loss or impairment, but the tax rules might limit the immediate or full utilization of that loss if it's considered "built-in" and subject to limitation. This can impact a company's deferred tax asset calculations.
• Unintended Consequences: Critics argue that overly restrictive rules can sometimes lead to unintended economic consequences, such as discouraging investment in struggling companies or creating a preference for asset sales over stock sales, even when stock sales might be more efficient from a business perspective.

Built in Loss vs. Tax-Loss Harvesting

"Built-in loss" and "Tax-loss harvesting" both relate to recognizing losses for tax purposes but differ significantly in their context, application, and scope.

While both concepts involve the strategic management of losses to impact tax outcomes, a built-in loss is a pre-existing state of an asset or entity, often subject to strict limitations upon a change of control, whereas tax-loss harvesting is an active investment strategy employed by individuals or funds to optimize their current tax situation by realizing losses from declining investments.

FAQs

Q: What is the primary purpose of identifying a built-in loss?
A: The primary purpose is to identify unrealized losses in a company's asset base, especially before a significant corporate event like an ownership change. This identification is crucial for applying tax regulations, such as Section 382 of the Internal Revenue Code, which limit the use of these losses to prevent tax avoidance.

Q: How does a built-in loss affect a company's net operating losses (NOLs)?
A: If a company has a net unrealized built-in loss (NUBIL) at the time of an ownership change, any recognized built-in losses (RBILs) during the subsequent five-year "recognition period" are treated as pre-change losses. This means their utilization is subject to the Section 382 limitation, which restricts the amount of pre-change net operating loss that can be offset against post-change taxable income annually.

Q: Is a built-in loss only relevant for corporate entities?
A: While the term "built-in loss" is most formally and critically applied in the context of corporate taxation, particularly under Section 382 for corporations, the underlying concept of an asset having a tax basis higher than its fair market value can apply to any taxpayer holding an asset. However, the specific regulatory implications and limitations discussed, especially regarding ownership changes, are primarily pertinent to corporate finance and taxation.

Q: Does a built-in loss always lead to a tax deduction?
A: Not necessarily. A built-in loss represents a potential future tax deduction. The loss must first be "recognized" (e.g., by selling the asset) to become a "recognized built-in loss." Even then, if it arises within the five-year recognition period following an ownership change, its deductibility may be limited by tax rules like Section 382.