Exploring IRC Section 382: An Essential Consideration for Life Sciences Entities

A pivotal change emerged on January 1, 2022. Research and Experimentation (R&E) expenditures, once directly deductible, now must be capitalized for tax purposes. Companies must identify these expenses and amortize them over a five-year period domestically or fifteen years internationally. This move to capitalize R&E expenses introduces a scenario where life sciences entities, even those scarcely generating revenue, could face taxable income in theory. This is problematic, as the intricacies of Section 382 potentially hinder the strategic use of historic NOLs.

Section 382’s inception aimed to curb the misuse of NOLs, particularly through ownership changes. It restricts a Loss Corporation’s — a corporation with entitlement to NOL carryforwards or having a net operating loss during an ownership change year — ability to offset taxable income using these NOLs. An applicable ownership change, as defined in Section 382, occurs when there’s over a 50% increase in the ownership of one or more 5% shareholders, generally across a three-year testing period.

Ownership changes often arise from mergers and acquisitions (M&A) or multiple rounds of equity financing. Conducting a Section 382 study is crucial as it helps determine if an ownership change has occurred under Section 382 and assists in calculating any resulting limitations. Section 382 will also affect other tax attributes like interest expense, capital losses, and general business credits under Section 383. The complexities of these rules and calculations make it beneficial for companies to undertake such studies for effective tax planning.

Despite unprofitable financial statements, tax returns might tell a different story due to tax adjustments such as Section 174 R&E capitalization, necessitating the use of historic NOLs to balance taxable income. With frequent equity financing, many life sciences entities might face an earlier-than-expected need for a Section 382 study.

Author: Sudha Vishwanath, Principal | [email protected]

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For more information about the Sec. 382 limitation or if you need assistance with a Sec. 382 study, contact a member of Withum’s Life Sciences Services Team.