Changes to R&D Deductibility Could Bring IRC Sec. 382 to the Forefront
December 01, 2022
Critical Change Impacting R&D
For the last few years, it seems as though there have been major changes to the tax code on an annual basis. Unfortunately, 2022 is no different. Beginning January 1, 2022, research and development (R&D) expenses are no longer allowed to be immediately expensed. Instead, these expenses are now required to be amortized over five years for domestic expenses and over 15 years for non-domestic expenses. Also detrimental to the company is the requirement of half-year convention on these capitalized expenses. This would result in only a 10% deduction of the total cost in the first year. Prior to 2022, these costs could be fully expensed in the year incurred. By deducting the expenses as they were incurred, many companies in the technology and life sciences world have been recognizing net operating losses (NOLs) for tax purposes throughout their existence. Starting in 2022, many of these companies may be in the unsettling position of having taxable income for the first time in their history. If that is not unsettling enough, these companies could also be operating under the false premise that they have sufficient NOLs to offset the resulting taxable income. That is where IRC Sec. 382 comes into play and could throw a wrench into tax planning.
IRC Sec. 382
IRC Sec. 382 imposes a limitation on the ability of a loss company that has undergone an ownership change to utilize their tax attribute carryovers to offset taxable income. An ownership change is defined as a greater than 50% cumulative change in ownership of the outstanding stock of the company over a rolling three-year period. While there are the obvious ownership change situations, such as a 100% acquisition, there are also less obvious ownership changes that can occur. These can take place through various equity raises spread out over time. This is prevalent in the technology and life science industries as many companies are funding the R&D and normal operations through stock issuances. Although each of these raises may not result in a greater than 50% change on their own, when analyzed through the lens of IRC Sec. 382, they could cumulatively result in an ownership change. Once there is a change in ownership, the historical NOL carryovers incurred up to the date of the ownership change become limited in their future availability.
The availability of NOLs will be dependent on two driving factors. The first is the value of the loss company immediately prior to the ownership change. The second is the adjusted long-term tax-exempt rate  the IRS publishes each month. These two factors are multiplied and the product is referred to as the annual limitation. The annual limitation represents the amount of limited NOLs that become available each subsequent year after the ownership change including a proration in the year of change. The greater the value or higher the interest rate, the greater the annual limitation which results in a greater amount of available NOL.
Back in 2003, the IRS gave a gift to taxpayers who had undergone an ownership change under IRC Sec. 382. It provided two methods to “supercharge” the annual limitation for the first five years after an ownership change if the company was in a net unrealized built-in gain (NUBIG) position immediately prior to the ownership change. In short, when the fair market value (FMV) of the company’s assets exceeds the tax basis of those assets, the company is in a NUBIG position. It would then be able to increase their annual limitation by the amount of recognized built-in gain (RBIG) for each of the subsequent five years. Under Notice 2003-65, the IRS provided taxpayers two methods to calculate the RBIG: the IRC Sec. 338 approach and the IRC Sec. 1374 approach. Under the IRC Sec. 338 approach, built-in gain assets could be treated as generating RBIG without actually being disposed. Please note that companies can also be in a net unrealized built-in loss (NUBIL) position which would have a detrimental impact in subsequent years. However, the IRC Sec. 1374 methodology would be preferable in that situation.
The IRS has recently indicated that the IRC Sec. 338 approach may be too beneficial to taxpayers and not in line with the intent of the statute. In response, the Treasury issued proposed regulations in 2019 that would eliminate this approach. However, the IRC Sec. 338 methodology can still be utilized until final regulations are issued. Accordingly, the timing presents an opportunity to accelerate any potential ownership change transactions to take advantage of the methodology before any modifications are made or it is possibly eliminated altogether.
With the everchanging tax landscape, it is now more important than ever to determine whether your planning strategies will enable you to maximize the utilization of historical tax attributes. This is especially true for companies that are not used to worrying about their tax bills. Therefore, it is imperative to have a current IRC Sec. 382 study in place so that you can properly manage the availability of your NOLs and other tax attributes while planning to mitigate any unexpected tax liabilities.