It can take years of R&D investment for technology companies to create a successful product. During this time, they accumulate tax net operating losses (NOLs) and credits—but when the time comes to use those credits, some tech companies discover they can’t. What became of those hard-earned credits and NOLs? The Internal Revenue Code’s Section 382 limitation is often to blame.
Whether you’ve never heard of Section 382 or know just enough to associate it with the terms ownership change or 5 percent shareholder, the complex rules of this code section make it difficult to know even how or why additional work—such as a Section 382 study, which examines the availability of credits and NOLs—may be required. If you’ve been told your company should have a Section 382 study performed, you may have thought:
- “I know our company didn’t have an ownership change.”
- “We know an ownership change occurred, so why do we need to do a study?”
- “We have so many NOLs we don’t need to do a study.”
Due to the complexities of Section 382, the truth is these very common responses many times aren’t enough. If you’re accumulating NOLs and credits, you need to consider Section 382.
Why Perform a Section 382 Study?
There are several reasons a company may be asked to do a Section 382 study. The most common reasons include:
- For your financial statements, to support the amount of deferred tax assets from NOLs or credits
- For your tax returns, to support the amount of NOLs or credits being used to offset taxable income
- For a transaction, to value the NOLs or credits and support that value during due diligence
Ownership Change Triggers
Section 382 generally limits the use of NOLs and credits following an ownership change, which occurs when one or more 5 percent shareholders increase their ownership, in aggregate, by more than 50 percentage points over the lowest percentage of stock owned by such shareholders at any time during the “testing period” (generally three years).
There’s a lot of nuance involved in calculating whether an ownership change has occurred, which can snag companies that don’t realize they’ve had an ownership change. Some of the most common pitfalls concern the following:
Section 382 measures shareholders’ ownership percentage based on value. Companies need to understand the value of each class of stock—not just the number of shares—on any given testing date to track the ownership percentages (and potential increases) of respective shareholders.
The term 5 percent shareholder can include multiple groups of shareholders that individually own less than 5 percent. The aggregation and segregation rules that determine how these groups are created can result in large issuances that trigger an ownership change even if most of the issuance is to shareholders with less than a 5 percent interest.
Large R&D investments in technology often require several rounds of financing. Section 382 generally measures an ownership change by looking at cumulative increases over a three-year period, which means an ownership change can be triggered by rounds of financing that occur during a three-year period.
NOL and Credit Limitations
When an ownership change occurs, Section 382 limits the use of NOLs and credits in subsequent periods. The annual limitation is based on the value of the corporation’s stock prior to the ownership change multiplied by the applicable federal long-term tax-exempt interest rate.
In a very basic example (with many assumptions), say an ownership change occurred in April 2016, when the applicable long-term tax-exempt rate was 2.53 percent. If the company’s equity value immediately prior to the ownership change was $10 million, this would result in an annual limitation of $253,000. Even if the company’s equity value after the transaction increases to $15 million, the $253,000 limitation applies.
Here are a few of the most common pitfalls technology companies encounter related to the limitation calculation:
- Since the limitation is based on the value of the stock immediately before the ownership change, the company needs to make sure to exclude the value of any shares issued on the ownership change date.
- When multiple ownership changes occur, the lower limitation applies. This means that even if you have a known ownership change, you may still need to do a historical Section 382 study to make sure no previous ownership changes further limit your NOLs or credits.
- Potential adjustments to the corporate value may be required for items such as redemptions, substantial nonbusiness assets (when the fair market value of nonbusiness assets, such as cash and marketable securities, is at least one-third of the value of total assets), and certain capital contributions.
- Many companies completely ignore the calculation of net unrealized builtin gain (NUBIG) or loss (NUBIL), which is calculated by comparing the value of the company’s assets to its tax basis in those assets. If the company has a NUBIG, any recognized built-in gains could substantially raise the limitation for the five years after the ownership change, allowing the company to utilize more NOLs or credits. On the other hand, if the company has a NUBIL, recognized built-in losses for those five years are treated similarly to the prechange NOLs and limited by the annual Section 382 limitation.
We're Here to Help
While Section 382 can be a frustratingly complex set of rules, it’s an important one to stay on top of. You don’t want your company to plan on using NOLs or credits only to find they aren’t available in a year you need to use them.
You also want to make sure your company isn’t caught off-guard by Section 382 when a transaction comes up. All too often, it’s only when companies are in the negotiation phase that sellers look into the actual value of their NOLs and credits—usually when a buyer tries to value those NOLs or credits at $0. Neither buyer nor seller wants a Section 382 study to be the last thing holding up a transaction.
To learn more about the Section 382 limitation or whether and how you can use your NOLs and credits, contact your Moss Adams professional.