Section 382 Common Traps and Pitfalls

The rules under Section 382 apply to NOLs, however Section 383 utilizes the same limitation to credits. Furthermore, Section 384 complements Sections 382 and 383 by limiting the use of pre-existing NOLs against recognized built-in gains of acquired corporations. Therefore this article uses 382 as a general term applicable to any attribute carryforward.

Internal Revenue Code (“IRC”) Section 382 was enacted to prevent loss trafficking. The premise of the provision was to promote tax neutrality when acquiring a corporation. To the extent a corporation undergoes an ownership change, the amount of taxable income that may offset by the corporation’s pre-change losses may be limited. An ownership change for Section 382 purposes occurs when the corporation’s “5-percent shareholders” increase their ownership interest by more than 50 percentage points over their lowest ownership interest during a rolling testing period that generally covers 3 years (less if there was an ownership change or since inception).

The testing period begins the tax year in which losses or credits carryforward to a post-change year. For example, a calendar year corporation that first generated losses in tax year 2024 would begin the testing period on January 1, 2024. Choosing an arbitrary start date for the analysis would lead to incorrect conclusions. Not starting the testing period on the appropriate date could result in incorrect percentage ownership shifts or be at risk of missing earlier ownership changes.

Often overlooked are looking through 5-percent entity shareholders and determining if there are any owner shifts at the higher-tier levels. Some corporations may be hesitant to inquire with their investors over confidentiality and other reasons but under the rules, a corporation has a duty to inquire under Reg. §1.382-2T(k)(3)(i). Owner shifts occurring at the entity-shareholder level must be tracked and measured, of which those owner shifts could possibly contribute to ownership percentage increases.

Whenever there are multiple ownership changes, any earlier ownership changes are still applicable. Pre-change losses and credits would be limited by both ownership changes, this can have drastic issues specifically when net unrealized built in gains (“NUBIG”) or losses (“NUBIL”) exist. A larger Section 382 limitation generated by a subsequent ownership change does not free up pre-change losses from earlier ownership changes.

After an ownership change date has been identified, many practitioners incorrectly include the value of the issuance that caused the ownership change overstating the annual Section 382 limitation. The Section 382 limitation is based on the value of the “old loss corporation”, which is the value of its stock immediately before the ownership change. Additionally for purposes of NUBIG/NUBIL, some companies ignore the rules under Section 382(h)(8) which requires the value of the assets to be pegged to the implied value of the equity adjusted for liabilities based on the amount actually paid in the transaction that triggered the ownership change. Lastly there is a value reduction for non-business assets, which are assets held for investment (i.e., cash and marketable stock and securities). The reduction to value applies when there are nonbusiness assets equaling 1/3rd or more of its total debt-adjusted assets.

In the context of mergers and acquisitions, where a Company acquires a corporation with tax attributes, the acquisition itself typically is an ownership change but any ownership changes that might have occurred pre-acquisition are still applicable. Any earlier ownership changes would limit those pre-change losses or credits.

Less than 5-percent shareholders are initially aggregated into groups called “public groups” and are treated as separate 5-percent shareholders. Transactions thereafter may require the creation of additional public groups and tracked separately until an ownership change. Often times these rules are ignored and less than 5-percent shareholders are grouped into one single public group. Furthermore, exceptions to the segregation rules should also be applied where appropriate. Exceptions to segregation include the small issuance exception and the cash issuance exception. Not applying these exceptions could increase percentage ownership interest.

Certain stock that is not entitled to vote and otherwise doesn’t participate in corporate growth and other factors is not treated as stock for 382 purposes. Analyses often overlook the features of preferred stock, which can significantly distort the identification of 5% shareholders and lead to inaccurate results. The terms of preferred stock should be carefully reviewed.

Certain capital transactions occurring within two years of an ownership change are presumed to be part of a plan for the principal purpose of avoiding the Section 382 limitation. The rules then exclude these amounts from the determination of the value of the loss corporation. Capital contributions made in the prior two-year period ending on the change date should be analyzed carefully to ensure the Section 382 limitation is not overstated.

Tax planning in conjunction with a Section 382 analysis is frequently an afterthought. Under Section 382 a taxpayer is permitted to elect a closing of the books to determine the income allocated to the pre- and post- change periods. When there is taxable income in the year of an ownership change, properly allocating it between pre-change and post-change periods is crucial, as full pre-change losses can be applied against pre-change income. Under the general rule, taxable income is allocated on a pro rata basis, with an equal portion assigned to each day of the year. Because the Section 382 limitation does not apply to the pre-change period, allocating taxable income to that period can be advantageous, as it allows full utilization of pre-change losses. This election must be made on a timely filed tax return, including extensions.

Certain states apportion 382 limitations and others do not. Additionally some states (e.g. California) apportion differently for the general 382 limit and the NUBIG/NUBIL. Some states do not conform at all to 382. Many studies disproportionately emphasize federal issues, often overlooking state-level analysis, which deserve equal attention and consideration.

The continuity of business enterprise (COBE) requirement under Section 382 can be easily missed if the right questions are not being asked. This rule requires the business enterprise of the loss corporation to continue for a 2-year period beginning on the change date or the Section 382 limitation may be reduced to zero. This is especially true in cases where a corporation acquires a loss corporation but does not continue its business operations, which can jeopardize the ability to utilize the losses of the acquired corporation.

Section 382 analysis is a highly technical undertaking that requires a deep understanding of complex tax rules and regulations. The rules and regulations are filled with nuanced provisions that can easily lead to unintended consequences if not carefully navigated. As discussed above, these complexities often give rise to traps and pitfalls, such as misidentifying ownership changes or misapplying built-in gain and loss rules, that can significantly affect a taxpayer’s position. In our work with clients on their Section 382 matters, we regularly encounter these high-vulnerability areas.

Author: Nathan Chu | [email protected]