As a result of the COVID-19 pandemic, many businesses are facing financial challenges including declining revenue and rising operating costs. In addition, the 2017 Tax Cuts and Jobs Act (“TCJA”) amended the tax treatment of Research and Development (“R&D”) expenditures under Internal Revenue Code Section 174. Effective for tax years beginning after December 31, 2021, taxpayers are required to capitalize and amortize Section 174 costs over five years for domestic expenses and 15 years for foreign expenses.
How does this impact corporate taxpayers? As a result of this provision, many corporate taxpayers could find themselves in taxable income positions due to the book-tax differences in the treatment of Section 174 expenses. As it is unclear when or if this unfavorable provision will be delayed or repealed by Congress, taxpayers will need to consider the impact on their interim period financial statements as well as cash flows for quarterly estimated tax payments.
To determine whether a corporation can utilize its net operating loss (NOL) carryovers and other tax attribute carryovers to offset taxable income and minimize tax liability, IRC Section 382 comes into play.
The Basics of Section 382:
- Section 382 (together with Section 383) limits the amount of tax attribute carryovers (NOLs, general business credits, business interest expense, etc.) that could be utilized if the loss corporation has undergone an ownership change;
- An ownership change occurs if the loss corporation has a cumulative owner shift of greater than 50% of stock owned by five percent shareholders (measured based on value), generally over a three-year rolling testing window;
- Once it is determined that an ownership change has occurred, an annual base limitation will be imposed on the loss corporation’s ability to utilize the pre-change attribute carryovers to the post-change period;
- The Section 382 annual base limitation is determined by multiplying the fair market value of the loss corporation immediately prior to ownership change by the applicable federal long-term tax-exempt interest rate;
- If the corporation has Net Unrealized Built-in Gain (NUBIG), the limitation can be increased by the amount of recognized built-in gains (RBIG) during the five-year recognition period following the ownership change;
- If the corporation has Net Unrealized Built-in Loss (NUBIL), the recognized built-in loss (RBIL) during the five-year recognition period is treated as pre-change losses and subject to the Section 382 limitation.
When Should You Consider Section 382?
In addition to determining the amount of tax attributes that could be used to offset taxable income and tax liabilities, there are other circumstances where a company could be required to perform a Section 382 study:
- Financial statement reporting – Determine if any of the tax attribute-related deferred tax assets (DTA) are more likely than not to be recognized prior to expiration for audited financial statement purposes.
- Mergers and acquisitions (M&As) – Determine potential value of the tax attributes to support additional value and due diligence in a stock purchase transaction.
Current NOL Carryback and Carryforward Rules Under the CARES Act
|NOLs generated prior to tax year 2018||2 years||20 years||No Limitation|
|NOLs generated between tax year 2018 and 2020||5 years||Indefinite||No Limitation|
|NOLs generated after tax year 2020||No carryback allowed||Indefinite||80% Limitation|
How BPM Can Help
The rules and calculations behind Section 382 are complex. It is important for taxpayers to be mindful of the potential impact that Section 382 has on their tax planning and tax strategies. Even if a company is not expected to be profitable soon, changes in tax laws can expedite the need for a Section 382 study. It can also play a significant role in an M&A transaction. To learn more about Section 382 limitations and whether your corporation’s tax attribute carryovers are subject to limitation, contact BPM.