How to Navigate Section 382 During an Economic Downturn

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With an economic downturn forecasted, corporations should explore how Internal Revenue Code (IRC) Section 382 could factor into their future tax planning strategy.

Section 382 controls how a corporation can use net operating losses (NOLs) and credits. In the 2008 recession, many corporations incurred NOLs that accumulated, and once these corporations turned profitable, the NOLs were often limited by Section 382.

What Is Section 382?

Section 382 limits the amount of NOLs or other attributes, such as credits, that can be used to offset taxable income following an ownership change greater than 50%. It was originally enacted with the Tax Reform Act of 1986, and was intended to prevent acquisitions of corporations with NOLs motivated by the tax benefits of using the NOLs in the future.

These rules, however, can be very complex, and an ownership change—and thus limitation—can be triggered by other types of equity shifts or an accumulation of shifts during a three-year period.

Why Do Companies Perform Section 382 Studies?

When a corporation has accumulated NOLs or credits, the application of Section 382 must be considered. A study is most commonly performed in the following situations:

  • The corporation is anticipating taxable income and needs to confirm that the NOLs and credits will be available to offset taxable income.
  • The corporation is considering an acquisition and they can prove the NOLs and credits will have value to a potential buyer.
  • The corporation needs to have audited financial statements and must know the amount of deferred tax asset to properly accrue and disclose. This applies even when the corporation has a full valuation allowance offsetting the deferred tax asset.

How Do NOLs Carry Forward?

IRC Section 172 allows for the carryforward of NOLs. To the extent NOLs were incurred in a taxable year beginning before January 1, 2018, they have a 20-year carryforward period.

For example, an NOL incurred in 2009 would be available to be carried forward until the year 2029. It then would expire if there hasn’t been taxable income to offset it or if there’s a Section 382 limitation low enough that the NOL wasn’t available during this time. NOLs incurred in a taxable year beginning after December 31, 2017, carry forward indefinitely.

How Does Section 382 Affect M&A?

Section 382 is often a consideration during tax due diligence. If NOLs or credits were utilized in prior years, the buyer will want to make sure those attributes were actually available for use under Section 382, so they aren’t taking on any historical exposure.

The buyer will want to know which NOLs or credits may carryforward and be available for use post-acquisition.

When a corporation is considering a future transaction and has NOLs or credits from prior years, they may be able to obtain additional purchase price value for these attributes.

To increase this value, it’s important to have a Section 382 study completed prior to entering into negotiations. If no Section 382 study has been completed, the buyer might assume the attributes have no value for future use, and no value will be attributed to the NOLs or credits.

Section 382 in the 2008 Recession

Section 382 can be a trap for the unwary, especially in a recession.

In the 2008 recession, corporations that were previously in a taxable income situation and were not used to incurring losses suddenly were accumulating NOLs.

This may be correlated with a cash shortage and coupled with the need to raise additional equity funding or restructure, which often can result in a Section 382 ownership change.

To make things worse, if this ownership change occurs when the equity value is low, which is common in a recession, it results in a low limitation that can substantially limit the usage of those NOLs going forward.

Then, when the corporation starts generating taxable income again and attempts to offset that taxable income with NOLs, they may no longer be available.

We’re Here to Help

Navigating Section 382 and how it relates to your M&A tax strategy during a potential economic downturn can be intimidating. Explore how your organization might plan on using NOLs or credits for your M&A tax strategy.

To learn more about NOL carryback and more, reach out to your Moss Adams professional.

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