When one company acquires a target company with lots of red ink on its balance sheet, the acquirer is limited in the use of that bad debt to offset its taxable income after the merger. That, at least, has been a long-held assumption.

In a private letter ruling (LTR 201105031) released on February 4, however, the Internal Revenue Service has drilled a hole in that assumption. Under certain circumstances, no ceiling will be imposed on the amount of taxable income that those bad debt deductions can properly offset.

To be sure, issues involving the use of bad debt to minimize tax payments most concern financial institutions, since they’re by far the biggest holders of debt, both good and bad. But nonfinancial institutions have bad debt, too. While their bad debt tends to be much smaller, the ruling could affect any company with loans that go bad.

The acquirer in the case at hand, a bank holding company, intended to buy another bank holding company in a deal in which the target would merge into the acquirer, according to the letter ruling. The target, which had one class of publicly traded common stock and one class of preferred stock that was issued to the federal government under the Troubled Asset Relief Program, wholly owned a bank we’ll call DebtBank.

Following the merger, the common and preferred stock of the target would be converted, respectively, into common and preferred stock of the acquirer. The deal would result in DebtBank becoming a wholly owned subsidiary of the acquirer.

When a corporation with net losses undergoes an “ownership change” within the meaning of the tax code’s Section 382(g), limits can be imposed on the amount of taxable income that may be offset by the company’s prechange losses. That curb, known as the “Section 382 limitation,” is calculated by multiplying the fair-market value of the loss corporation’s stock immediately before the ownership change by the long-term tax-exempt rate.

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The conditions of merger under consideration by the IRS would indeed bring about such an ownership change of DebtBank. Under Section 382(g) of the Internal Revenue Code, such a change occurs when the percentage of the stock of a “loss corporation” (in this case, DebtBank) owned by one or more 5% shareholders has increased by more than 50 percentage points over a three-year period.

On the date of the merger, DebtBank “is expected to be a loss corporation” under the tax code’s definition, in that it would be both a net operating loss (NOL) carryover and a “net unrealized built-in loss” (NUBIL). The latter occurs when, as in DebtBank’s case, the adjusted basis of the subsidiary’s debt portfolio exceeds its fair-market value on the change date.

After the merger, DebtBank may use one or more bad debt deductions because it had charged off debts it held before the merger. Such bad debt deductions are anticipated to be used during and after the first year of the five-year “recognition period” (the five-year period beginning on the date of the ownership change).

Further, DebtBank intended to identify which of its deductions taken into account during the five-year recognition period will be “recognized built-in losses” (RBILs). The term means any loss recognized during the recognition period on the sale of any asset, with two exceptions: (1) the new loss corporation can establish that the asset wasn’t held by the old loss corporation immediately before the change date, or (2) if the loss exceeds the excess of the adjusted basis of the asset over the fair-market value of such asset on that date.

In its current ruling, the IRS held that any bad debt deduction arising from a debt owed to DebtBank at the beginning of the recognition period will not be an RBIL “if the deduction is properly taken into account after the first 12 months of the recognition period.” By removing the RBIL status from such deductions, the service removed the limits imposed on the amount of taxable income that those bad debt deductions can properly offset.

More broadly, avoiding RBIL status for such bad debt deductions is important. Because such deductions aren’t classified as RBILs, they can be employed to offset unlimited amounts of taxable income earned in taxable years ending after the date of the ownership change.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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