Expanding Your Cap Table? Watch out for Tax Trap 382.
There is a significant amount of money spent on research and development (R&D) each year in the United States. In 2020 the total private sector spending was roughly $532 billion. While the money spent is clearly significant, sometimes it takes years before the investment in R&D produces a viable product. Despite the change in deductibility of R&D expenses (see our article “The Impact of the New R&D Capitalization Rules on December 15, 2022, Estimated Tax Payments”), many companies in the start-up phase accumulate significant net operating loss carryforwards, and they are also potentially able to generate tax research credits.
While these accumulated tax losses are available to shelter future taxable income, depending upon the year in which the net operating loss (NOL) was generated, the carryforward may only be able to shelter up to 80% of taxable income.
Due to the capital-intensive nature of many of the industries that are heavily involved in R&D, finding investors willing to provide cash to the company is critical. As with any investment, the investors want to ensure a healthy return on their investment. While there are many different ways to structure the investment, many times, the investors will take back an equity position in the company. Companies with accumulated NOLs who have or are considering issuing equity to new shareholders need to be aware of Internal Revenue Code (IRC) Section 382.
IRC Section 382 is a provision that imposes potentially severe limitations on a company’s ability to utilize its accumulated NOLs to offset future taxable income and accumulated tax credits to offset future tax. The limitations under IRC Section 382 are imposed when a company undergoes an “ownership change,” as defined in Section 382. In its simplest form, an ownership change for purposes of Section 382 occurs when one or more 5% shareholders increase their ownership, in aggregate, by more than 50% over a three-year period.
Assuming an ownership change triggers the limitation under IRC Section 382, the amount of NOL that will be available on an annual basis to offset future taxable income will be based on the value of the company prior to the ownership change occurring multiplied by a federally published interest rate factor. A similar limitation applies to any tax credits or other favorable tax attributes that a company has at the time of the ownership change.
The rules under IRC Section 382 are extremely complex. These are often overlooked by companies with accumulated NOLs who issue equity in exchange for cash to fund the business operations. If you are considering issuing equity and you have accumulated NOLs, please reach out to your WG tax advisor for assistance in determining whether these rules apply to you.