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IRS Issues Proposed Regs Affecting Utilization of NOLs Upon Sale of a Company

If your company is contemplating raising capital or planning an exit strategy, have you ever considered the value of the company’s net operating losses (NOLs)?

In the past, quite often companies were able to take advantage of IRS rules dating back to 2003 that increased the value of their NOLs in business deals. With the September 2019 issuance of proposed regulations (REG-125710-18), there is a change in the tax treatment for NOLs after an ownership change occurs that could significantly impact many companies.

An ownership change generally is defined as when the percentage of 5% shareholders increases by more than 50% within a 3-year period. When a change in ownership takes place, section 382 imposes an annual limit on the utilization of NOLs, credit carryforwards, carryforward of disallowed business interest under section 163(j), and other tax attributes of the company. It is important to note that these limitations can be triggered from capital raises by a company even without a “sale” of the company.

For more information or questions regarding the tax treatment of NOLs, please contact a member of the Tax Services Group.

Subsequent to an ownership change, the company may offset future taxable income with the carryover NOLs only up to the fair market value of the company at the time of the ownership change multiplied by the applicable IRS long-term tax-exempt rate (currently about 1.6%). Historically, companies also would be able to increase their annual limitation by the amount of certain built-in gains and losses. Built-in gains and losses are determined by measuring the fair market value of the assets of the company in relation to the basis of the assets immediately prior to the ownership change.

The proposed regulations would significantly change the treatment of built-in gains and losses under section 382(h). Under previous guidance from the IRS, companies had a choice between adopting two methods: the 338 Approach or the 1374 Approach.

  • The 338 Approach allowed companies to calculate built-in gains and losses as if there were a hypothetical sale of the company; this typically increases the annual limitation of NOLs a company could utilize upon an ownership change.
  • Under the 1374 Approach, no built-in gains or losses are calculated unless there is a physical disposition of the assets; this can lower the value of a company’s NOLs.

If these regulations are finalized, the option to choose the 338 Approach will be removed, and companies will be required to use a modified 1374 Approach. Originally, the regulations proposed in September 2019 would have been effective only for companies undergoing ownership changes after the date on which the regulations were finalized. However, after receiving practitioner and taxpayer input, the IRS in January 2020 withdrew a portion of the September 2019 proposed regulations, delayed the applicability of those proposed regulations, and provided transition relief for eligible taxpayers.

If you are a company that is considering an equity raise or sale of your business, then you should reach out to your Withum Tax Advisor for guidance on the effect these proposed regulations may have on your company’s NOLs and the ultimate value of your company.
Author: Bryan Nachwalter, CPA | bnachwalter@withum.com

Tax Services

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