Tax Rules May Limit Loss Deductions of Acquired Institutions By: Joseph M. Press, CPA Date: 8/27/09 Looking back on merger and acquisition transactions prior to late 2008, little time was spent contemplating the various tax rules that would limit the deductibility of the realized built-in loss of an acquired "loss corporation" (defined below).  However, given current economic conditions, potential acquirers would be well advised to be aware of the loss limitation rules of Code Section 382.  Congress implemented Section 382 to curb the buying of companies with net operating loss carryovers (or other built-in losses) in order to use them to offset the income of the profitable purchaser.  In fact, it was the relaxing of this law (albeit temporarily) that prompted the much publicized acquisition by Wells Fargo of Wachovia Bank. In general, if a loss corporation has net unrealized built-in losses (such as an allowance for loan losses), and such losses are recognized within the five-year period beginning with the date an ownership change takes place, the loss is subject to the annual Section 382 limitation.  This annual limitation is equal to the fair value of the loss corporation immediately before the ownership change multiplied by the long-term tax-exempt rate (as published monthly by the IRS).  For example, if a loss corporation is worth $10 million at purchase date and the long-term tax-exempt rate in effect that month was 4.82%, then the use of the loss corporation’s losses would be limited to $482,000 per year.  If a loss deduction exceeds the limitation and is thus denied in a given year, the loss is carried forward to subsequent years under rules similar to the net operating loss carry forward rules, but is still subject to the annual limitation in the later year. In determining the potential impact of these rules, the following terms are important to understand: Loss Corporation - a corporation that has a net operating loss carry forward, a net operating loss arising from the year up until the change in ownership occurs, or has net unrealized built-in losses (e.g. ALLL). Net Unrealized Built-in Losses - the excess of the aggregate adjusted tax bases of the assets of the corporation over the fair market value of the assets immediately before the ownership change. Threshold Requirement - If the net unrealized built-in loss is not greater than the lesser of: 15% of the fair market value of assets of the target (without regard to cash, cash items or any marketable security which has a value which does not substantially differ from its adjusted basis) or $10 million, then the net unrealized built-in loss is deemed to be zero. Although we have tried to simplify the rules in order to get the concept across without too much of the technical jargon, it is important to note that the rules under Section 382 are very complex and fact sensitive.  If you are considering acquiring an institution that might be a loss corporation, be sure to discuss the potential impact with your tax advisor as it could be significant.