The so-called Tax Cuts and Jobs Act (TCJA), enacted in December 2017, made major changes in the tax treatment of both domestic and foreign corporations. The TCJA did not make any changes directly to Section 382, which provides limitations on the use of corporate net operating losses (NOLs) and other tax attributes. However, carryforwards of excess business interest were added to the list of tax attributes that potentially can be subject to Section 382. As a result, the TCJA dramatically expands the number of corporate taxpayers that will need to perform Section 382 calculations and understand the application of the rules. Previously, Section 382 generally only applied to unprofitable companies. Starting in 2018, Section 382 can apply to profitable companies with large interest deductions.
When Does 382 Apply?
Even disregarding the addition of excess business interest as a subject attribute, the rules are still ripe with pitfalls. And as planning continues around tax reform, ownership changes (or even multiple ownership changes) in corporations are bound to happen – making it vital to maintain an up-to-date and accurate understanding of the rules. Lee G. Zimet, a Senior Director at Alvarez and Marsal Taxand, LLC, recently published an extensive analysis of Section 382 and related provisions. A copy of the paper can be found here.
Section 382 was enacted to prevent corporations from trafficking in NOLs and sets forth limitations on the use of NOLs and other tax attributes when a corporation undergoes an “ownership change.” The definition of an ownership change is a change in stock ownership that results in a more than 50% increase in stock ownership (by value) by 5% shareholders (or shareholder groups) over a three-year period. An ownership change may occur through the sale or exchange of stock by a shareholder or through the issuance or redemption of stock by the company. An ownership change calculation can be very complicated and time consuming. Any corporation with an NOL or other tax attribute (no matter how small) is required by regulations to determine if an ownership change has occurred during a taxable year and report the conclusion on a Section 1.382-11(a) statement on the corporation’s tax return.
If an ownership change has occurred, a corporation is required to determine the NOL carryforward limitation under Section 382. This limitation represents the amount of losses and deductions that can be applied to offset taxable income after the ownership change. The limitation in a taxable year generally equals the value of the corporation’s stock (before the ownership change) times a rate published monthly by the IRS (2.32% for ownership changes occurring in July 2018). This limitation can be increased or decreased by other factors (including built-in gains) and can be carried forward to the extent unused in a taxable year. If successive ownership changes occur, some of the attributes can be subject to multiple limitations.
Application to Excess Business Interest
The TCJA added a new limitation on the deduction of business interest (effective starting in 2018), which applies to both corporations and individuals. If the business interest in any taxable year exceeds the limit, the excess can be carried forward indefinitely. The deduction of business interest that is carried forward to a later taxable year will be further limited by Section 382 if the taxpayer is a C corporation that undergoes an ownership change.
Pursuant to new Section 163(j), the deduction of business interest expense is generally limited to the sum of (i) 30% of adjusted taxable income, and (ii) the amount of any business interest income. The adjusted taxable income generally equals taxable income before (i) business interest income or expense, (ii) NOL deductions, and (iii) deductions for depreciation, amortization, and depletion. This is commonly referred to as EBITDA. After 2021, the adjustment for depreciation, amortization, and depletions will end. There are exemptions from Section 163(j) for small businesses, as well as for certain taxpayers in the real estate, farming, or utilities businesses.
The TCJA dramatically expands the number of corporate taxpayers that will need to perform Section 382 limitation calculations and understand the application of the rules. This is due to the inclusion of carryforwards of excess business interest as an attribute that is subject to the carryforward limitation under Section 382. The Section 382 rules remain dense and complex. Corporate tax attributes can often have significant financial impacts, and, therefore, should be planned around carefully. To navigate these rules regarding limitations on corporate tax attributes, please see A&M Taxand’s annual release of “Limitations on Corporate Tax Attributes: An Analysis of Section 382 and Related Provisions.”