September 28, 2023

Profit from Losses? How IRS’s Section 382 Can Make or Break Your Business Strategy

By Katy Daiell, Partner, Tax & Business Services & Diane Giordano, Partner, Tax & Business Services

Profit from Losses? How IRS’s Section 382 Can Make or Break Your Business Strategy Corporate Tax

It’s common for businesses to weather periods of tax losses and then carry those losses forward to future years to offset taxable income with these net operating losses (NOL). Depending on a corporation’s history and the losses which might be available, Internal Revenue Code’s Section 382 presents a labyrinth of provisions that could limit the utilization of these losses. For corporations intending to harness the potential of NOLs, the intricacies of this code section become critically important to understand, analyze, and navigate.

Corporations contemplating a significant event, such as an acquisition, sale, or capital raise in the near future, can especially be subject to limitations. A Section 382 study to ascertain the worth of NOLs and other tax attributes could prove instrumental, especially since their benefit might be curtailed post-transaction.

Let’s delve into the implications of Section 382’s loss limitations and stock ownership and its ripple effects on business strategy.

To begin, this code section only applies to a loss corporation classified as a “C” corporation. A corporation with a Section 382 ownership change faces an annual limitation on its ability to use NOL carryovers and certain other tax attributes, such as tax credits and capital loss carryovers, arising before the ownership change date. For purposes of Section 382, an ownership change occurs when the stock ownership percentage of “5-percent shareholders” has increased by more than 50 percentage points over such shareholders’ lowest ownership percentages within the testing period (generally, a three-year period).

A 5-percent shareholder is a person who directly or indirectly owns five percent or more of the total value of the outstanding stock of the loss corporation. The term “5-percent shareholder” can also refer to a group of shareholders that individually own less than 5 percent of the total value of the outstanding stock of the loss corporation (commonly referred to as a “public group”). If a 5-percent owner is an entity, indirect ownership, and related party rules must also be considered. The ownership of these ultimate 5-percent shareholders, including public groups, is considered when determining whether a greater than 50 percentage point change has occurred.

Should a corporation experience such a change of ownership, losses will be limited based on prescribed IRS rates issued monthly and determined by multiplying such rates by the fair market value of the entity. Additionally, depending on the corporation’s value and the value of its assets, should the NOL be limited due to an ownership change, the annual limitation may be increased to the extent a loss corporation has a net unrealized built-in gain (NUBIG), which is the amount by which the fair market value of the assets of a corporation, exceeds the adjusted basis of those assets immediately before the ownership change. This taxpayer-friendly provision is available for the first five years after an ownership change. The five-year recognition period begins on the change date.

Other Section 382 provisions further limit loss utilization to zero should more than one ownership change occur, which is why loss and ownership tracking is important.

Section 382 must be considered by corporations that plan to use NOLs to offset taxable income. The rules of Section 382 are complex, and a tax professional should be consulted to determine what amount of NOLs are available for use in a given tax year.

There are many nuances and complexities to Section 382 that are beyond the scope of this article. As business owners contemplate selling or issuing stock, we suggest seeking the help of your Marcum tax advisor.