Financial Glossary
Section 382
Section 382 of the Internal Revenue Code limits the annual amount of net operating loss (NOL) carryforwards and certain tax credits a corporation can use to offset taxable income after an 'ownership change.' An ownership change occurs when one or more 5%-or-greater shareholders increase their aggregate ownership by more than 50 percentage points over a rolling three-year testing period. The annual limitation equals the fair market value of the corporation's stock immediately before the ownership change multiplied by the applicable long-term tax-exempt rate published by the IRS. NOLs in excess of the annual cap can still be carried forward into future years but are metered.
Problem & Application
A venture-backed startup has accumulated $10,000,000 in NOL carryforwards from early losses. A Series B round causes an ownership change under Section 382. The company's pre-round fair market value is $20,000,000 and the applicable IRS rate is 4%, producing an annual Section 382 limitation of $800,000. Rather than immediately using all $10M in NOLs against future taxable income, the company may only shield $800,000 per year -- meaning full utilization takes more than 12 years. If the company becomes profitable within three years at $5M/year taxable income, it still pays tax on $4.2M annually despite holding large NOL balances. For founders and acquirers, this is a critical pre-close due diligence item. Tax advisors conduct a Section 382 study to quantify usable NOLs and model the after-tax impact on deal economics.
In Short
Understanding Section 382 is crucial for tax efficiency, particularly for companies undergoing ownership transitions or seeking to preserve NOLs.