Exterminator Corporation was a small, closely held business that provided pest control services to commercial businesses. Generally, Exterminator's clients purchased three- or six-month contracts, with full payment due when the contracts were signed. These payments were treated as liabilities and converted into income only when services were rendered. This is the customary industry standard and is accepted by the IRS as proper reporting.
A few years ago, a large national corporation, Terminator, Inc., moved into Exterminator's territory and undercut its prices. This substantially hurt its business, and Exterminator accumulated a $300,000 NOL. Realizing that the only way to survive was to merge with Terminator, the Exterminator shareholders exchanged 100% of their stock for a 5% interest in Terminator, in a transaction qualifying as a "Type C" reorganization. At the time of the reorganization, Exterminator held assets valued at $600,000, services liabilities of $100,000, other liabilities of $50,000, and an adjusted basis in its assets of $150,000.
After the reorganization, Terminator provided services to Exterminator customers and converted the liabilities into income. Terminator treated the income as recognized built in gains when computing the yearly § 382 limitation.
Upon audit, the IRS disallowed this treatment. The IRS did not question the timing of the income recognition, but it did inquire whether these prepaid pre-change amounts constituted built-in gains under § 382.
Prepare a memo for Terminator's tax file explaining whether the IRS is correct in disallowing the built-in gains treatment?