Congress created Internal Revenue Code (IRC) Section 382 to make it less attractive for buyers to acquire corporations solely for their loss attributes. The code section limits the ability of a post-acquisition business to offset future gains with acquired net operating loss (NOL) carryforwards based on a formula that multiplies the value of the old loss corporation by a rate published by the IRS.
The application of Section 382 NOL carryforward limitations can be relatively straightforward when there’s a planned merger or acquisition where the parties agree to a transfer of greater than 50% of all stock. But the rules also create a type of “incremental” ownership change for transactions involving shareholders that own 5% or more of the business. The IRC deems that an ownership change has occurred if, immediately after any owner shift involving a 5% shareholder, the percentage of the stock owned by one or more 5% shareholders has increased by more than 50% over the lowest percentage of stock held by those shareholders during a three-year testing period. This type of ownership change can occur in some cases without a corporation ever becoming aware of it. The issuance of additional stock, as well as new classes of stock, can result in existing shareholders crossing the 5% threshold even though they don’t own more than 5% of any one class of stock. Crossing these thresholds can cause significant tax challenges that executives can’t address when they don’t realize the limitations have been triggered.
How a creeping ownership change can limit net operating loss carryforwards
It’s hard to imagine that a corporation could have an ownership change and not be aware of it, but it’s important to remember the incremental ownership change in Section 382 noted above includes certain significant changes in stock ownership by any 5% shareholder. Ownership interests at this level might be relatively easy to track in SEC filings of public corporations.
For privately held corporations, the issue is more complex since ownership interests may be held by a variety of individuals and entities. Shares may be held by another corporation or a partnership, and Section 382 rules require that ownership be traced through those entities to track indirect holdings in the company and determine the “ultimate” owner for purposes of determining a 5% shareholder. Thus, the amount of stock held by any one ultimate owner may be more difficult to track. Even those businesses that maintain ownership records can be surprised to learn that Section 382 definitions for ownership and attribution can differ from accounting principles. For example, capital tables maintained by corporations typically reference direct ownership or custodianship only and don’t identify the ultimate indirect owners.
Common practices that can lead to unexpected ownership changes include:
- The issuance of additional stock and new classes of stock. Startup businesses may operate at a loss for years and periodically issue new stock to maintain financial resources until they can turn a profit. Existing shareholders that may start out below the 5% level may cross that threshold as they acquire some of these new shares. Owners of multiple classes of stock may also unknowingly cross the 5% level, depending on the relative value of the stock classes.
- Ownership of a U.S. corporation by a foreign parent. Businesses face challenges in the United States when their ownership structures include foreign corporations that may be subject to different disclosure rules about ownership. In such cases, the company may need to spend additional time to determine the ultimate 5% shareholder. This information could be difficult to obtain, particularly if the company didn’t track ownership effectively through loss years and attempts to reconstruct the data once it starts to make a profit. Relying on “best available information” without further diligence could subject companies to additional questions and risks during IRS examinations.
- Ownership of a corporation by multiple types of multilevel entities. A privately held corporation could have an ownership group that includes individuals, partnerships, and corporations, and the entity owners could easily have ownership structures that include additional multitiered entities (e.g., private equity groups). Even a business that maintains a capital table of its owners is unlikely to have details of the partners and shareholders who are the ultimate owners of its stock. When the corporation turns a profit and attempts to claim NOL carryforwards, it may be subject to an IRS examination that requires disclosure of the ultimate owners revealing 5% owners by attribution who were previously unknown.
Section 382 rules also contain a variety of wrinkles, and the details of those are beyond the scope of this article. But it’s still helpful to be aware that these topics may arise in a discussion with your advisors, including:
- Public group ownership. This concept aggregates all owners who hold less than 5% interests into one group of 5% shareholders known as the “public group.” This adds complexity to tracking ownership interests, as members of this group who acquire additional stock must be transferred to the individual 5% holder list, and vice versa for those whose holdings fall below 5%.
- Cash issuance and small issuance exceptions. When a corporation issues new stock solely for cash, fsuch as in a public offering, the “cash issuance” exception may apply to attribute a portion of the issued stock to existing public groups. In addition, a “small issuance” exception may prevent issuances during a year that combine to no more than 10% of the corporation’s value at the beginning of the year from being attributable to 5% shareholders. These may save some corporations from inadvertent triggering of Section 382 limitations. They also provide opportunities for those that carefully track their ownership, helping them plan ahead and possibly avoid crossing Section 382’s thresholds.
- Multiple ownership changes. Given the fact that companies can trigger Section 382 limitations without knowing it, it’s plausible that they can do so multiple times over the years. Every time an ownership change occurs, Section 382 limitations apply to all prior attributes, including some that may have been subject to an earlier limitation due to a previous ownership change. The fluid nature of corporate ownership makes it even more critical that companies effectively monitor ownership transactions and identify ownership changes in a timely manner.
What does Section 382 actually limit?
With all the ways that businesses can find themselves subject to Section 382, it’s important to understand exactly what the statute limits are. Whether it’s the result of an “equity structure shift” like a merger or reorganization, or an “ownership change” involving a 5% shareholder, the rules state that the taxable income of a “new loss corporation” (the term for the post-event business) for any post-change year can’t be reduced by pre-change losses in excess of the section 382 limitation. That limitation is the value of the old loss corporation multiplied by the long-term, tax-exempt rate published by the IRS.
This limitation may be further increased or reduced due to the existence of assets whose fair market value is higher or lower than the corporation’s tax basis in those assets at the time of the ownership change. These net unrealized built-in gains (NUBIGs) or losses (NUBILs) need to be factored into the limitation at the time of an ownership change. While many taxpayers have relied on guidance from the IRS in Notice 2003-65 (as modified by Notice 2018-30) to determine how NUBIGs and NUBILs may impact limitations, the IRS has signaled that it may be releasing regulations in this area. If and when regulations are issued, the long-standing guidance under the notices could be subject to change.
Pre-change losses that are subject to the Section 382 limitations include:
- Built-in ordinary and capital losses that are recognized (RBILs) (e.g., assets with NUBILs at the time of the ownership change that are later sold at a loss) within a five-year period starting from the change date, to the extent that the old loss corporation had a NUBIL at the change date.
- Pre-change capital loss carryovers.
- The NOL carryover of the old loss corporation to the year ending with the ownership change (or in which the ownership change occurs).
- The portion of an NOL incurred by the old loss corporation during the year the ownership change occurs is allocable to the pre-change period. In the absence of an election by the corporation, the NOL for the year would simply be allocated proportionately based on the date of the event. Corporations do have the option of allocating based on actual income and loss at the date of the transaction, if a front-loading of expenses or gains before the event is beneficial.
- Carryforwards of previously disallowed business interest deductions under Section 163(j).
- Pre-change tax credit carryovers. Even though technically, the carryforwards for tax credits earned (but not used) by the old loss corporation are governed by Section 383, the rules effectively intertwine the two sections to create a unified limit that applies to both. The new loss corporation taps the credit carryforwards once it has exhausted the loss carryforwards that had been subject to the limitation.
Steps corporations can take to avoid surprise Section 382 limitations
In many cases, privately held corporations that trigger Section 382 limitations on their net operating loss carryforwards and other attributes fail to realize that an ownership change has occurred until they are preparing their reporting. Once a corporation becomes profitable and starts to apply the carryforwards to reduce taxable income, at that point, the IRS often sees the use of the prior year attributes and asks for documentation of ownership, revealing that a change occurred in a previous year where the limitations apply.
Corporations looking to avoid this surprise imposition of the limitations can engage a tax professional to perform an Section 382 ownership study to monitor the owner group for any changes. These studies look for particularities like accumulation of multiple classes of stock and attribution of holdings in multitiered businesses that might not normally come to the attention of the business. Such a study should also become a regular part of the M&A due diligence process, as an acquiring company needs to know upfront if a target is potentially subject to any previously uncovered Section 382 limitations. These errors can be particularly costly because, even though the unnoticed ownership change may have occurred outside the statute of limitations, the impact routinely is felt on the more recent tax return under examination where such losses are utilized.
It’s true Section 382 ownership studies will add to the cost of tax compliance, often during a period when a corporation is operating at a loss. However, the cost of failing to detect ownership changes can be much more significant, especially if discovered by an acquirer during due diligence or by the IRS during an examination when such losses are utilized.
