Proactive elections to mitigate sec. 382 applicability.

• Author: Fairbanks, Greg Alan

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 Twos 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...