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What Businesses Need to Know About Section 382 and Other Changes to Net Operating Loss Rules

10.01.19

Gladys TamThis article originally appeared on October 1, 2019 in the San Francisco Business Times and Silicon Valley Business Journal

It often surprises people that Amazon, arguably the most valuable public company in the world, likely paid no federal taxes last year. Some of that is the result of activities that fall under favorable tax incentives, such as those designed to encourage research and development.

But at least one of the strategies Amazon is pursuing to reduce its tax liability is available to any company that has failed to make a profit at some point.

For decades, the Internal Revenue Code has offered corporations “carryback” and “carryforward” opportunities for net operating losses (defined as years when tax-deductible expenses exceed taxable revenue). The carryback allows businesses that have experienced a net operating loss, or NOL, to apply those losses to past (profitable) years — meaning they can subtract the NOL from that year’s taxable income and receive a refund. Similarly, the carryforward allows companies to apply those losses to future, profitable tax years.

The reasoning behind these rules is that taxpayers in the U.S. are taxed on their income, so not giving companies a break when they lose money would amount to an unfair tax burden. Sounds simple enough, right? Unfortunately, like many provisions of the Internal Revenue Code, the rules surrounding NOLs are complex. And changes resulting from the Tax Cuts and Jobs Act (TCJA) of 2017, while warranted, have only served to add to the confusion.

The first thing to note is that there’s a limit on how far back and how far forward businesses can carry NOLs. In general, prior to the TCJA, a business’s NOL could be carried back two years and carried forward 20 years to offset taxable income. However, under the TCJA, NOLs generated beginning after Dec. 31, 2017 are subject to different requirements:

  • The two-year carryback is repealed
  • The NOLs will have an indefinite carryover
  • The NOL carryover can only offset 80% of taxable income

These revisions to the tax code complicate things for businesses attempting to make use of NOL tax deductions. Because NOLs that arose in tax years beginning on or before Dec. 31, 2017 will not be subject to the 80% taxable income limit, taxpayers will have to distinguish between the two types of NOLs when computing the NOL deduction on their tax returns. Basically, NOLs generated before 2018 have a 20-year carryforward but can be used to offset 100% of taxable income, while NOLs generated after 2017 have indefinite carryforward but can only offset 80% of taxable income.

Companies may find that these pre-2018 “super NOLs” are more valuable to offset future tax liability. However, these NOLs may also be subject to limitations, and a company cannot safely assume they will be fully available for 2018 and future years.

Also affecting the use of NOL tax deductions is Section 382, which puts further limitations on the use of NOLs and other tax attributes when a corporation undergoes an ownership change. An ownership change per Section 382 occurs when there is a change in ownership of a loss corporation that results in a more than 50% increase in the value of stock owned by 5% or more shareholders over a three-year testing period.

The impetus for introducing Section 382 was that a corporation’s NOL can, counterintuitively, actually be quite valuable on the market. Some companies have indeed gone so far as to purchase other companies specifically for their NOLs. This is called NOL “trafficking” — with the implication of illegal commerce intended.

Together, these changes to NOL rules will be particularly relevant in industries like life sciences, where companies commonly incur NOLs during the R&D phase. Common transactions that would trigger a Section 382 ownership change include issuance of stock to raise capital, issuance of certain convertible debt instruments, and mergers and acquisitions.

Once an ownership change is determined, the Section 382 limitation must be calculated to accurately determine the amount of NOLs that are available to offset future taxable income. This includes calculation of the value of the old loss corporation, removal of liquid assets for anti-stuffing provisions, and computation of any net realized built-in gain or loss.

The rules and calculations behind Section 382 are complex. To learn more about Section 382 limitations and whether your business’s NOLs and credits may be subject to the limitations, contact BPM today.