Valuation considerations relating to NOL limits under CARES Act and TCJA
Section 382 of the Internal Revenue Code generally requires a corporation to limit the amount of its income in future years that can be offset by historic losses (i.e., net operating loss carryforwards and certain built-in losses), after a corporation has undergone an ownership change.
This article provides an overview of the Section 382 limitation and valuation considerations concerning the calculation of the Section 382 limitation. Additionally, it discusses the sweeping changes to the utilization of NOLs under Section 172 subsequent to the enactment of the Coronavirus Aid, Relief and Economic Security Act (CARES Act) in 2020, as well as the Tax Cuts and Jobs Act (TCJA) in 2017.
Section 382 basics
A loss corporation is a corporation that is entitled to use a tax attribute carryover (pre-change losses), such as an NOL, a net unrealized built-in loss (NUBIL), and after the TCJA, a carryover of disallowed business interest expense under Section 163(j) for tax years beginning after 2017. The following basic example shows the application of Sec. 382:
Alpha Corporation is a highly successful corporation wishing to acquire 100 percent of the stock of an unrelated company, Zeta Corporation.
- Zeta Corporation is a private company with valuable IP, which was funded with several rounds of preferred financing.
- Zeta Corporation has generated net operating losses during every tax year since its inception. Thus, it is a loss corporation.
- After the acquisition, Section 382 will limit the amount of Zeta NOLs available to offset the group’s future taxable income. Also, the Zeta NOLs may be subject to additional Section 382 limitations caused by earlier ownership changes incurred during the rounds of financing.
The two primary components of Section 382 are ownership change and limitation. An ownership change occurs if, immediately after an owner shift or an equity structure shift, there is a greater than 50 percent change in the value of the stock owned by 5 percent shareholders during the testing period (generally three years). An ownership change is triggered by the purchase and sale, redemption or new issuance of stock.
Stock may include any of the following:
- Common stock;
- Convertible preferred stock;
- Certain convertible debt instruments;
- Certain voting preferred stock; and
- Certain stock options or warrants.
Section 382 limitation
During each year after an ownership change, the new loss corporation may only deduct its pre-change losses against taxable income in an amount equal to the Section 382 limitation amount. The annual Section 382 limitation comprises the base limitation, which is driven by the value of the stock, plus or minus certain adjustments including:
1. Built-in gains, which is driven by the value of the assets;
2. Carryforwards of unused Sec. 382 limitations from previous years; and
3. Proration for short taxable years.
The Sec. 382 base limitation amount is approximated using the following equation:
Fair Market Value of Old Loss Corporation Stock x Federal Long-term Tax Exempt Rate = Section 382 Base Limitation
The fair market value is subject to potential adjustments described in the regulations, and the federal long-term tax-exempt rate is published monthly in the Internal Revenue Bulletin.
To utilize its pre-change losses, a company will strive to calculate the largest Section 382 limitation amount possible. As mentioned previously, the base limitation amount is driven by the value of the stock.
Determining the value of the stock involves a consideration of the following:
- All classes of loss company stock, including the pure preferred stock immediately prior to the change. Preferred stock with similar terms, rights and preferences should be valued equally.
- For publicly traded companies, the IRS has acknowledged that the stock value does not necessarily equal the trading value on an exchange, i.e., certain blocks of stock may have a higher value due to control rights.
- For privately held companies, different classes of stock may have different rights and vary in value.
A full discussion of recognized and net unrealized built-in gains and losses is beyond the scope of this article. However, two things are essential to note.
First, recognition of pre-change built-in gains will increase the Section 382 limitation for that tax year. For example, assume Company A has $500 of pre-change NOLs subject to an annual Section 382 base limitation of $50 due to an ownership change in year one. In year three, Company A has taxable income of $100 that includes $25 of recognized built-in gain. In this case, Company A can utilize $75 of its NOL’s to offset its year three taxable income, equal to the base limitation of $50 plus the recognized built-in gain of $25.
Second, if you have assets with a pre-change built-in loss, any realization of those losses (including a portion of any deductions for depreciation or amortization related to assets with pre-change NUBIL) during the five-year recognition period following the ownership change is subject to the Section 382 limitation. Because the Section 382 limitation is an annual cap on the total pre-change losses that may be deducted in each successive year, the amount of any built-in loss that is realized during the recognition period decreases the amount of other pre-change losses (e.g., NOLs or disallowed interest expense carryforwards) that may be utilized. Therefore, to the extent possible, it is best to limit the amount of those losses that are realized during the recognition period, which may include holding onto those assets for at least five years.
For Section 382 purposes, any change in proportionate ownership, which is attributable solely to fluctuations in relative FMVs of different classes of stock, will not be taken into account. Under Notice 2010-50, the IRS will not challenge the reasonable application of the following two methods as long as either is applied consistently:
1. Full value methodology, in which the determination of the percentage of stock owned by any person is made based on the relative fair market value of the stock owned by the person to the total fair market value of the outstanding stock of the corporation, or
2. Hold constant principal, in which the value of a share, relative to the value of all other stock of the corporation, is established on the date that a particular shareholder acquires the share.
Section 163(j) limitation
The TCJA established the new Section 163(j) which limits the taxpayer’s annual deduction of business interest expense generally to the sum of:
1. Business interest income, and
2. 30 percent of the taxpayer’s adjusted taxable income (ATI).
ATI generally equals taxable income, but excluding business interest income and deductions for depreciation, amortization, interest expense and NOLs. To the extent that business interest expense was greater than the Section 163(j) limitation, the excess business interest expense is disallowed in that year. Still, it may be treated as paid or accrued in the succeeding tax year or carried forward indefinitely.
The CARES Act modified these rules for 2019 and 2020. For all taxpayers except partnerships, the ATI percentage increased from 30 percent to 50 percent for tax years 2019 and 2020. Furthermore, all taxpayers may (but are not required to) use their ATI from 2019 to determine the Sec. 163(j) limitation in 2020, which should be beneficial for most taxpayers whose earnings in 2020 were less than 2019.
For partnerships, the percentage of ATI remained at 30 percent for 2019 but increased to 50 percent for 2020. Additionally, 50 percent of any excess business interest carried forward from 2019 may be deducted in 2020 without being subject to the Sec. 163(j) limitation.
Corporations without pre-change NOLs, who previously would not have been considered loss corporations for Section 382, will now find it necessary to review the impact of Section 382 on their disallowed business interest expense carryforward. Taxpayers subject to this limitation need to consider whether they have had an ownership change that could affect their ability to deduct the interest carryover in the future.
Changes to Section 172
Subsequent to the enactment of both the CARES Act and the TCJA, the carryforward and carryback periods have been modified as follows:
1. NOLs generated before 2018 may be carried back two years or carried forward 20 years,
2. NOLs generated in 2018–2020 may be carried back five years or carried forward indefinitely, and
3. NOLs generated after 2020 may not be carried back but may be carried forward indefinitely.
Furthermore, the TCJA imposed a limitation on NOLs generated in or after 2018, such that deductions for these NOLs in a given tax year are equal to the lesser of:
1. The aggregate of the NOL carryover to such year, plus the NOL carrybacks to such year, or
2. 80 percent of taxable income (determined without regard to the NOL deduction).
The CARES Act delayed the effective date of this 80 percent limitation. As a result, NOL deductions are not subject to the 80 percent taxable income limitation until 2021, regardless of the year that the loss was generated. Then, beginning in 2021, there will be no taxable income limitation on deductions for NOLs generated before 2018. Still, NOLs generated in or after 2018 will not be able to offset more than 80 percent of taxable income.
These changes to Section 172 will impact the valuations of NOL benefits for both tax and financial reporting purposes going forward.