Proactive Elections to Mitigate Sec. 382 Applicability

Editor: Greg A. Fairbanks, J.D., LL.M.

Corporations & Shareholders

Sec. 382, which limits the use of net operating loss (NOL) carryovers after an ownership change of a loss corporation, often comes as a rude surprise to corporations in the fields of technology, life sciences, pharmaceutical, and similar industries. Such companies typically have a life cycle involving initial rounds of equity financing from “angel” financial backers followed by later investors, as well as intensive research and development activities. The problem is that these companies often generate NOLs for many years but also trigger ownership changes with successive rounds of equity financing.

Thus, a company may end up with restricted NOL usage once the company becomes profitable without ever having had an ownership change in the classic, business understanding of the term. There has been no one person acquiring over 50% of the stock in either a one-step or multistep purchase. Instead, the ownership change(s) have occurred because the new investors are treated as new 5% shareholders, and the changes have been triggered due to an accumulation of this activity within the Sec. 382 testing period (typically a rolling, three-year period).

Often, companies in these industries will have an unfortunate combination of relatively low equity value (upon which the Sec. 382 limitation is based) and relatively high loss attributes (NOLs, research and development (R&D) tax credits, orphan drug credits, etc.). The companies have not been engaging in what ordinarily is thought of as “loss trafficking,” but are merely following what most would consider a typical tech company business life cycle of raising capital through a combination of debt and equity financings. What many companies in this position do not realize is that there are a couple of elections that may mitigate the effects of Sec. 382.

Sec. 174(b)

Example 1: T incorporates and commences business on Jan. 1, year 1. In year 1, T generates $15 million of federal NOLs. Of this total, $5 million comes from ordinary and necessary business deductions under Sec. 162(a). The remaining $10 million comes from Sec. 174 research and experimentation (R&E) expense deductions. T has an ownership change on Dec. 31, year 1, due to the issuance of Series B Preferred Stock (the angel round of Series A Preferred Stock occurred when T was formed). The company’s prechange value was only $1 million. Assuming a long-term tax-exempt rate of 3%, that yields a baseline Sec. 382 limitation of $30,000 per year. With a 20-year carryover period for the NOLs, only $600,000 of the $15 million total NOLs generated in year 1 will ever be usable. The remaining $14.4 million will expire—unused and unusable.

Sec. 174(b) provides an election that allows the taxpayer to amortize R&E costs over a period of 60 months (or more) instead of presently deducting them. The period of amortization begins when the taxpayer first realizes a benefit from the expenses. The taxpayer must make the election on a timely filed original return. The election can be made on a project-by-project basis, however, with differing total amortization periods for each project. This gives a well-informed taxpayer a great deal of flexibility.

In the above example, if a Sec. 174(b) election is made for all $10 million of R&E expenses, and profit on those expenses is not realized until after year 1, then all $10 million of Sec. 174(b) expenses are not realized until after the Dec. 31, year 1, ownership change date. All such expenses have been spared the stringent limitation from the ownership change. Instead of $14.4 million of NOL expiring due to the Sec. 382 limitation, only $4.4 million of NOL from the Sec. 162(a) pool is due to expire.

Sec. 59(e)

Example 2: Assume the same facts as Example 1, except T knows that the R&E undertaken in year 1 is in its infancy and likely will not generate profit for several years.

In this example, a Sec. 174(b) election may not be ideal. While the election spares the $10 million of R&E expense from being treated as a prechange NOL, the amortization period might not begin for a number of years. If the company thinks it may be generating profits from other research or other business lines, the realization of the expense deduction may be pushed much further down the road than expected.

Sec. 59(e) provides an alternative method to forgo a present deduction of expenses and, instead, amortize them over a specified period. Unlike Sec. 174(b), the election is not made on a project-by-project basis. The election also stipulates what the ratable period is, depending on the kind of expense. While these features are more restrictive, Sec. 59(e) applies to a larger class of expenses. Sec. 59(e) allows a taxpayer to elect a 10-year amortization period for Sec. 174(a) expenses; a 60-month period for Sec. 263(c) intangible drilling expenses; a three-year period for Sec. 173 circulation expenses; and a 10-year period for development expenditures or mining exploration expenditures under Secs. 616(a) and 617(a), respectively.

Under either alternative expense treatment (Sec. 174(b) or 59(e)), a well-informed taxpayer may be able to avoid adverse Sec. 382 consequences with some planning and forethought. The question may arise whether the expenses that are pushed to a period after an ownership change may be treated as “built-in items” of deduction under Sec. 382(h)(6)(B). If that treatment applies, then the built-in items of deduction may be treated as a recognized built-in loss (RBIL) and potentially subject to the Sec. 382 limitation. There would be no benefit except for the ratable part of any expenses that fall after the five-year recognition period after the ownership change. However, this treatment may not apply if the taxpayer makes the proper election under either Sec. 174(b) or 59(e). If the taxpayer has a net unrealized built-in gain (NUBIG), then the taxpayer cannot have an RBIL by definition.

Thus, having a NUBIG in the taxpayer’s assets immediately before the ownership change does not necessarily create adverse consequences. However, if there is a net unrealized built-in loss (NUBIL), then an RBIL is subject to the Sec. 382 limitation. It is only in the case of a NUBIL that the issue of treatment of deferred deductions under Sec. 174(b) or Sec. 59(e) appears to be potentially contentious.

However, in Notice 2003-65, the IRS provides two safe-harbor methodologies for determining RBIG/RBIL. If the Sec. 1374 safe harbor is elected (which applies the built-in-gain rules of S corporations), RBIL tends to be narrowly defined. The notice provides:

Under this approach, items of income or deduction properly included in income or allowed as a deduction during the recognition period are considered “attributable to periods before the change date” under sections 382(h)(6)(A) and (B) and, thus, are treated as RBIG or RBIL, respectively, if an accrual method taxpayer would have included the item in income or been allowed a deduction for the item before the change date.

It appears that in the instant case, the taxpayer is not allowed a deduction for the item before the change date because it has elected to be disallowed the deduction presently and, instead, to amortize it ratably. Thus, amounts for which a taxpayer makes a Sec. 174(b) or 59(e) election are not treated as RBIL under the above definition.

In sum, a proactive taxpayer may be able to mitigate Sec. 382 consequences by having a present understanding of what its future need for capital may be (and when ownership changes may be likely to occur), when the company is likely to become profitable and need those deductions to offset income, and the elections it must make on a timely filed, original return.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.