Many high-tech start-up businesses incur significant expenditures before they begin generating sales and become profitable. The time required to develop a successful product is often counted in years. As a result, a company may accumulate large net operating losses and tax credit carryovers. In general, when a company becomes profitable, these can be used to offset up to 80% of the company’s annual taxable income. In some circumstances, however, the tax law creates additional limitations. One such limitation is imposed by Section 382 of the Tax Code.
When is Section 382 applicable?
Congress enacted Section 382 to prevent a corporation with a large taxable income from purchasing a company with net operating losses (NOL) carryforwards and using those “acquired” NOLs to offset income. Provisions of this section apply when there is a change in the ownership of a C corporation with accumulated NOL carryforwards. A company may issue additional shares of its stock to new shareholders, existing shareholders may sell their shares to new shareholders, or the company may repurchase some of its own stock. All these transactions can trigger applicability of Sec. 382.
How is the limitation calculated?
The first step in determining whether NOLs are going to be limited is to establish if and when a 50% change in ownership occurred. A taxpayer is required to calculate whether a change of ownership occurred every time the ownership of a 5%-or-more shareholder increases. If a cumulative change in the ownership of 5%-or-more shareholders is more than 50% within a period of three years, the amount of NOL carryforwards that can be used in the future is limited.
There are many variables involved in calculating whether a change in ownership occurred. The ownership is measured based on value of different classes or stock, or other equity instruments, not their number. For private companies it often means that a business valuation needs to be performed. There may be multiple changes in ownership within a testing period. There are also complex rules that need to be followed, when determining who meets the definition of the 5%-or-more shareholder.
Once it is concluded the change in ownership is more than 50%, the annual limitation is calculated as follows:
Value of the Corporation x Federal Long-Term Tax-Exempt Interest Rate
Value of the Corporation: Fair market value of the corporation’s stock immediately before ownership change.
Long-Term Tax-Exempt Interest Rate: The highest of the adjusted federal long-term rates in effect for any month in the three months prior to the ownership change.
Here is an example:
Loss Corporation, Inc. had $1 million of NOL carryforwards on 7/1/17, the date when more than 50% ownership change occurred. The value of the corporation on 6/30/17 was $3 million. The highest federal long-term tax-exempt interest rate in the three-month period prior to 7/31/17 was 10%. The limitation amount is calculated as follows:
$3,000,000 x 10%=$300,000
If Loss Corporation has a taxable income for the period of 7/1/18-12/31/18 of $700,000, it can reduce it by $300,000 of NOL carryforwards. The remaining $700,000 is going to be carried forward and can be used to reduce taxable income by $300,000 in 2018 and 2019 and $100,000 in 2020.
Why is it important to pay attention to Section 382?
Understanding whether NOLs are available to offset future income is important for any business. Even if a company is not expected to be profitable for some time, the Section 382 limitation may be important if a sale transaction is being negotiated. Potential buyers are going to value the NOLs and ask questions. There are disclosures that are required on a corporation’s annual income tax return as well.
How can we help?
Our firm has performed Section 382 calculations for many clients, and we can help guide you through complexities of this tax code. If you would like to learn more about this topic, please contact our office.
By Renata Dabrowska, CPA and Megan Dake, CPA