Section 382 is designed to prevent “trafficking of net operating losses (NOLs),” where companies acquire loss corporations primarily to use their tax losses. Section 382 limitations are triggered when a loss corporation has an ownership change. Determination of an ownership change can be complex. Failing to detect an ownership change can result in a company overestimating the value and availability of its NOLs, disallowed interest carryforwards or tax credits (tax attributes). Thus, considering Section 382 is critical, especially for growth-stage technology companies that intend to utilize tax attributes.

Ownership changes

An ownership change does not require a sale of the entire company. For example, a series of financing rounds, redemptions, warrant exercises, or other ownership shifts may cumulatively trigger an ownership change if during a rolling three-year testing period the aggregate increase in stock ownership by one or more 5% shareholders exceeds 50 percentage points. These “creeping” changes are often more difficult to identify than a straightforward acquisition transaction and require a formal analysis to detect.

A simple review of the cap table is rarely sufficient. The rules require the company to identify 5% shareholders; test ownership shifts over time while applying intricate aggregation and segregation rules that group shareholders. Constructive ownership, related party attribution, multiple classes of stock, and ownership through derivative securities can all affect ownership determinations. Also, indirect ownership changes can be triggered by shifts in the ownership of entity shareholders.

A Section 382 analysis requires a deep examination of the company’s historical ownership records, financial statements, financing documents, stock valuations, and publicly available records for SEC registrants.

Impact of an ownership change

Once an ownership change is identified, the company must determine the amount of pre-change tax attributes that may be used post-change, referred to as the “annual limitation,” which generally equals the company's pre-change equity value multiplied by the long-term tax-exempt rate. Recognized built-in gains may increase the limitation, while recognized built-in losses may be treated as pre-change losses subject to it. Each ownership change creates a separate limitation; later changes may further restrict attributes already limited. For tech companies, these rules often intersect with R&D capitalization, tax credits, and other carryforwards that matter to both management and potential buyers.

Why perform an analysis?

Given the complex nature of Section 382, best practice is to engage a tax professional to perform the analysis. An analysis requires professional judgment, familiarity with tax law, and relevant experience. A proper analysis is documented in a tax memorandum that should withstand scrutiny during tax diligence, financial statement audit, and potentially IRS examination.

Many companies defer the performance of a Section 382 analysis when there is no immediate need. However, failing to perform the analysis or performing it incorrectly can create significant risks. If Section 382 is not addressed prior to a financing, acquisition, or audit, the company may overstate the value of its losses and credits, create an uncertain tax position, or lose credibility and negotiating leverage in diligence. Utilizing NOLs without considering Section 382 may lead to an IRS adjustment, additional tax liability and interest, and, depending on the facts, penalties. A well-documented study helps management understand what attributes remain usable, helps buyers assess value, and reduces risk of any unexpected shortfall of tax attributes when they are needed most.

Strategic planning around Section 382

Proactive planning can help mitigate the impact of Section 382 and preserve the value of tax attributes. Potential strategies include:

• Accelerating taxable income or transactions, where appropriate, to utilize NOLs or applicable credit carryforwards before an anticipated ownership change.
• Assessing potential Section 382 and related Section 383 limitations before undertaking an R&D credit analysis or other tax attribute review, so resources are focused on attributes expected to be usable.
• Avoiding significant stock issuances or ownership changes when company equity value is low.
• Evaluating Section 382 implications in conjunction with continuity of business enterprise considerations, particularly when significant changes to the company’s historic business operations are contemplated.

A proactive approach to Section 382 can help preserve valuable tax attributes, facilitate future transactions, and provide management with greater certainty regarding the company’s tax position. A well-documented Section 382 analysis can help preserve tax attribute value, support transaction readiness, and help reduce financial reporting risks.