Use NOLs and Credits When You Need To: Keep an Eye on IRC Section 382

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 tech companies discover they can’t. The Internal Revenue Code (IRC) 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% shareholder, the complex rules of this code section make it difficult to know how or why additional work may be required. This includes a 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 Section 382—whether or not your company has undergone an ownership change.

This article addresses the following questions and topics:

What Is a Section 382 Limitation?

When an ownership change, as defined in Section 382, occurs, it results in a 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 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 a Section 382 Study?

A 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 Section 382 limitations and any impact of net-unrealized, built-in gains or losses for any ownership changes that occurred

Why Perform a Section 382 Study?

There are several reasons a company could be asked to do a 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 Section 382

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 nuance 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:

  • 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. 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, 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 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 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 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 Section 382 limitation.

How Are Section 382 Limitations Calculated?

Generally, there are two components of the Section 382 limitation that companies must calculate:

  • Base limitation
  • Increases to the base limitation for recognized built-in gains

Base Limitation

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 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
  • 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 be a result from selling specific assets, but, more often with technology companies, it’s a result of applying the Section 338 approach identified in IRS Notice 2003-65.

IRC Section 338 Approach

The Section 338 approach compares a company’s actual income, gain, deduction, or loss items to hypothetical results that could have occurred if a Section 338 election had been made. This approach factors in a hypothetical purchase of all stock 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 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 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 Section 338 approach discussed above. These regulations aren’t final, and thus the 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.

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While 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 Section 382 when a transaction comes up. All too often, companies are in the negotiation phase of a sale when they look into the actual value of their NOLs and credits—usually when a buyer tries to value those NOLs or credits. Neither buyer nor seller wants a Section 382 study to hold up a transaction.

To learn more about the Section 382 limitation, or how you can use your NOLs and credits, contact your Moss Adams professional. For more information about NOL carryback opportunities, especially in the wake of COVID-19, watch our webcast.