United States: Technology Companies Need to Manage Net Operating Losses (NOLs)

By Ms Taci Darnell

Research and development activity is at the core of technology companies. As these companies are spending millions on developing the next big thing, they often incur large losses. The expectation is that these losses will be available in the future when the companies have taxable income. These net operating losses (NOLs) are deferred tax assets, because their benefit will not be utilized until the future.

Generally, companies put a lot of effort into protecting and managing their assets. For example, insurance is purchased to replace damaged property and intangible assets are protected through patents. However, many technical companies do not focus attention on managing their net operating losses. Without proper management of their NOLs they may lose the full value of the NOLs. NOLs can be limited through the application of Internal Revenue Code (IRC) Section 382 or simply through the expiration of the NOLs.

Under IRC Section 382, if there is a more than 50% ownership change, based on value, of a company with losses, the utilization of the losses may be limited. The original purpose for this code section was to prevent companies from buying other companies and using their NOLs. However, a round of venture financing can also trigger a more than 50% ownership change and thus may be a significant tax issue for venture backed technology companies.

In order to prevent using gradual changes over a short period of time to side step an ownership change, the code generally treats all changes occurring in a three year period will be treated as one change.

If a company has had more than a50% ownership change, the actual limitation amount must be calculated as follows:

The limitation calculated above is imposed on the loss corporation’s accumulated NOLs at the time of the change of ownership. Therefore, the NOL that can be used to offset taxable income in any post-change year can not exceed the calculated limitation amount. However, if the entire 382 limitation cannot be used in a given year (e.g., not enough taxable income to absorb the NOL) the excess limitation is carried over and may be used in addition to the annual limitation in the following year.

Sometimes, the 382 limitation is too low to absorb NOLs before they expire. NOLs are eligible to be carried forward 20 years for Federal tax purposes and only 5 years for Massachusetts purposes.

Example: Company X has $20 million of NOLs. The company received its second round of financing which triggered a 50% or more ownership change. The value of the company immediately before the financing was $10 million. Therefore, the annual Section 382 limitation would be approximately $500,000 ($10 million x 5%). This would mean that if in the next year Company X had taxable income of $1 million, they would only have $500,000 available to offset the taxable income, even though they had a total of $20 million of NOLs carrying forward.

There are generally two strategies for avoiding having NOLs significantly limited. One is to avoid a change in ownership. However, no company is going to turn down financing just to avoid a potential ownership change. The other is to keep the losses to a minimum so that if a loss limitation is triggered the NOLs subject to the limitation would be very small.

Losses can be reduced by extending the time period in which the expense is taken on the tax return. Since the largest expense these companies have is their research and development costs how these expenses are treated can impact the size of a company’s NOLS. There are several tax accounting methods that can be used to manage NOLs.

Net operating losses, as with any asset, require managing and planning in order to maintain their full value. If a company waits until it has taxable income to evaluate their ability to utilize their NOLs, it may be too late.

Taci Darnell, JD, LLM, CFP is a tax manager at PricewaterhouseCoopers LLP in the technology industry group and specializes in emerging technology companies.