This article was updated on September 21, 2023.
It can take years of R&D investments 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 technology companies discover they can’t. The Internal Revenue Code (IRC) Section 382 limitation is often to blame.
Whether you’ve never heard of IRC Section 382 or know just enough to associate it with the terms ownership change or 5% shareholder, the complex rules of this code section make it difficult to know how or why additional work may be required. This includes an IRC Section 382 study, which examines the availability of credits and NOLs.
The bottom line is, if your company is accumulating NOLs and credits, you need to consider IRC Section 382—whether or not your company has undergone a clear ownership change.
This article addresses the following questions and topics:
What Is an IRC Section 382 Limitation?
When an ownership change, as defined in IRC Section 382, occurs, it results in an IRC Section 382 limitation that applies to all NOLs and credits generated prior to the ownership change date that can be used to offset taxable income incurred after the ownership change date.
The annual limitation is based on the corporation’s stock value prior to the ownership change, multiplied by the applicable federal long-term, tax-exempt interest rate. This amount may be decreased by items, such as redemptions or other corporate contractions, such as debt pushed down, that occurred in conjunction with the ownership change. It can also be increased by recognized built-in gains for a five-year period after the ownership change.
What Is an IRC Section 382 Study?
An IRC Section 382 study usually includes two components:
- Detailed analysis of all issuances, transfers, repurchases, or other movements in the company’s stock to determine when or if ownership changes have occurred
- Calculation of IRC Section 382 limitations and any impact of net-unrealized, built-in gains, or losses for any ownership changes that occurred
Why Perform an IRC Section 382 Study?
There are several reasons a company may consider performing an IRC Section 382 study. The most common reasons include:
- Financial statements disclosures. A study could support the amount of deferred tax assets from NOLs or credits being disclosed on audited financial statements.
- Tax returns. A study may be needed to support the amount of NOLs or credits being used to offset taxable income.
- Transactions. A study can help the company obtain additional value from a sale of its stock by determining the potential value of the NOLs or credits to a buyer and support that value during due diligence.
Understanding an Ownership Change Under IRC Section 382
IRC Section 382 generally limits the use of NOLs and credits following an ownership change. This occurs when one or more 5% shareholders increase their ownership, in aggregate, by more than 50% over the lowest percentage of stock owned by these shareholders at any time during the testing period, generally three years.
There’s a lot of complexities involved in calculating whether an ownership change has occurred, which can create problems for companies that don’t realize they’ve had an ownership change.
Some of the most common pitfalls concern the following:
- IRC Section 382 measures shareholders’ ownership percentage based on value. Companies need to understand the relative 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% shareholder can include multiple groups of shareholders that individually own less than 5%. 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% interest.
- Large R&D investments in technology often require several rounds of financing. IRC Section 382 generally measures an ownership change by looking at cumulative increases over a three-year period. This means an ownership change can be triggered by rounds of financing that occur during a three-year period. It also means a company could have several historical ownership changes. If a company has more than one ownership change, the lowest limitation will apply.
If you’re considering selling your company, see 4 Ways to Prepare for Due Diligence and Help Your Company Secure a Better Deal. You can also read more ways to prepare for mergers and acquisitions (M&A) activity here.
NOL and Credit Limitations
When an ownership change occurs, IRC Section 382 limits the use of NOLs and credits in subsequent periods.
Here are a few of the most common pitfalls technology companies encounter related to the limitation calculation:
- Exclude shares issued on the ownership-change date. 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.
- Complete a historical IRC Section 382 study. 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 complete a historical IRC Section 382 study to make sure no previous ownership changes further limit your NOLs or credits.
- Adjust your corporate value. Potential adjustments to the corporate value may be required—see the section on how IRC Section 382 limitations are calculated below.
What Is Net Unrealized Built-In Gain (NUBIG) and Net Unrealized Built-In Loss (NUBIL)?
Many companies ignore the calculation of net unrealized built-in gain (NUBIG) or net unrealized built-in loss (NUBIL), which are calculated by comparing the value of the company’s assets to its tax basis in those assets.
If your company has a NUBIG, any recognized built-in gains (RBIG) could substantially raise the limitation for five years after the ownership change, allowing you to utilize more NOLs or credits.
On the other hand, if your company has a NUBIL, recognized built-in losses (RBIL) for those five years are treated similarly to the pre-change NOLs and are limited by the annual IRC Section 382 limitation.
How Are IRC Section 382 Limitations Calculated?
Generally, there are two components of the IRC Section 382 limitation that companies must calculate:
- Base limitation
- Increases to the base limitation for recognized built-in gains
The annual base limitation is based on the value of a corporation’s stock prior to the ownership change. This is multiplied by the applicable federal long-term, tax-exempt interest rate.
For example, say an ownership change occurred in June 2021 when the applicable long-term, tax-exempt rate was 1.64%. If the company’s equity value immediately prior to the ownership change was $15 million, this would result in an annual base limitation of $246,000.
Note that in calculating the base limitation, potential adjustments to the corporate value may be required for items such as:
- Redemptions and other corporate contractions, such as debt pushed down
- 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
- Certain capital contributions
Recognized Built-In Gains
At the date of an ownership change, a company is required to calculate the amount of NUBIG or NUBIL by comparing the value of its assets to its tax basis in those assets.
If a company has a NUBIG, it can increase the base limitation by the amount of RBIG for a five-year period after the ownership change date. RBIG could result from selling specific assets, but, more often with technology companies, it’s a result of applying the IRC Section 338 approach identified in IRS Notice 2003-65.
IRC Section 338 Approach
The IRC Section 338 approach compares a company’s actual income, gain, deduction, or loss items to hypothetical results that could have occurred if an IRC Section 338 election had been made. This approach factors in a hypothetical purchase of all assets on the ownership change date.
For example, if a company’s equity value is $15 million, with no liabilities and a tax basis in assets that’s zero, there would be $15 million of hypothetical intangibles. This would result in annual hypothetical amortization of $1 million, and this amount would increase the base limitation for the first five years. This would mean the total IRC Section 382 limitation for the first five years would be $1.25 million per year, then $246,000 per year annually after the five-year period.
If the IRC Section 382 limitation isn’t utilized in a year, it carries forward and accumulates the following year. So, in the example above, if NOLs weren’t used in the five-year period after the ownership change, there would be $6.48 million available in year six—$1.25 million times five, plus $246,000 for year six.
It’s important to note the IRS has proposed regulations to remove a company’s ability to apply the IRC Section 338 approach discussed above. These regulations aren’t final, and thus the IRC Section 338 approach can currently be applied, but once finalized, they’ll apply to any ownership change that occurs 30 days after the date of its publication.
IRC Section 174 Amortization Considerations
Technology companies are now required to capitalize and amortize research and experimental expenses over five—domestic expenses—or fifteen—foreign expenses—years for tax years beginning after December 31, 2021. These new rules also explicitly include software development costs to be treated as research and experimental expenses.
Prior to these new rules, the deduction of research and experimental and software development costs in the year incurred often resulted in technology companies being in a loss position rather than having taxable income. With the change to these rules, many technology companies that have built up large NOLs now find themselves generating taxable income for the first time because of capitalizing rather than deducting these costs. This has increased the importance of IRC Section 382—and the urgency of preparing an IRC Section 382 analysis—as these companies are looking to offset taxable income with historical NOLs.
We're Here to Help
While IRC Section 382 may seem frustrating and complex, it’s an important rule to keep in mind and 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 the year you need to use them.
You also want to make sure your company isn’t caught off-guard by IRC Section 382 when a transaction comes up. All too often, companies are in the negotiation phase of a sale when they investigate the actual value of their NOLs and credits—usually when a buyer tries to value those NOLs or credits. Neither buyer nor seller wants an IRC Section 382 study to hold up a transaction.
To learn more about the IRC Section 382 limitation, or how you can use your NOLs and credits, contact your Moss Adams professional.