Why Net Operating Losses are Valuable but Limited

The Story of Nolan, an NOL and a Very Bad Haircut

Welcome to David in Taxland—a series of tax articles written for business owners. Spoilers: this article only considers C-corporations. Hint: don’t be like Nolan. Future articles will bring happier subjects, shorter articles and, of course, Al Capone.

Businesses are usually created for profit, but many operate at a loss in the early years. In Taxland, a business is profitable when it has more revenue than deductions. If it has more deductions than revenue, it’s operating at a net loss—it has a Net Operating Loss, an NOL. We call a C-corporation with an NOL a loss corporation.

Let’s get right into our example: Pat and Sam, over a second pint of IPA, found themselves inspired to build an awesome app that connects craft beer aficionados to brew pubs. Six months later they formed a C-corp—Pat invested $60K and Sam $40K so they were 60%/40% owners. A little later they arranged $1 million in borrowing. During the first two years, the corporation spent about $1 million on salaries, contractors, interest, and other tax-deductible business costs, but earned zero revenue, no income of any kind. Revenues were zero while deductions were $1 million, so there is a $1 million NOL (net operating loss) from the first two years of business.

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NOLs are normal in the early years of businesses and can bring tax benefits because NOLs usually can be carried forward to offset future taxable profits. This can reduce income taxes when the business becomes profitable. Tax law allows NOL carryforwards to encourage Pat and Sam to start a business, raise money and spend it—it’s good for the economy.

If a loss corporation has a profitable year, it usually can use the NOL to offset some the profits—it reports less taxable income in the profitable year and, therefore, pays less income taxes. Unused NOL gets carried forward to benefit future years. With the current 21% C-corp income tax rate along with state income taxes that range from 0% to 12%, this can save a business some serious cash when it eventually turns a profit. Note: NOLs help with income tax and have no relationship to sales tax.

A C-corp with $1 million of NOL that earned $750K taxable profit in a future year would only pay income taxes on $150K that year—instead of paying taxes on $750K! It works like this:

 

$750K taxable income before NOL deduction

– 600K NOL deduction (80% of $750K)

$150K taxable income (in first profitable year)

X 27% federal (21%) plus state (assuming 6%) income tax rates

$40K Income taxes in C-corp’s first profitable year

– 202K Income taxes if there was no NOL carryforward ($750K X 27%)

$162K Income taxes saved by NOL carryforward

 

Every C-corp owner I know could probably come up with other uses for $162K shortly after their first big profits.

Back to Pat and Sam. After the second year, Pat wants out and Nolan wants in. Nolan thinks he can help the business succeed. Also, he is enticed by the NOL because he wants to pay as little taxes as possible. Nolan buys all of Pat’s shares so he is now a 60% owner. He believes the NOL will offset future profits. It won’t. Here’s why:

The IRS (in Section 382 of the tax code) generally limits NOL carryforward for corporations that have ownership changes greater than 50%. They do this because they don’t want the owners of corporations to sell NOLs. We call this a Section 382 NOL limitation—or, simply, a 382 limitation.

When Nolan bought Pat’s share of the business, a greater than 50% owner shift occurred—this is what triggered the 382 limitation. It’s an annual limitation that’s calculated by multiplying the market value of the business by a percentage, usually about 2%. If this business was valued at $2 million, the NOL would be limited to $40K (2% of $2mn) per year. In this first profitable year, with taxable income of $750K, instead of getting a $600K NOL deduction it would only get a $40K NOL deduction. If this appears extreme, that’s because it is. It looks like this:

 

Without 382 limitations

$750K taxable profits before NOL deduction – ($600K) NOL = $150K taxable income

$150K taxable income X (21% federal + 6% state tax) = $40K taxes

 

With 382 limitation

$750K taxable profits before NOL deduction – ($40K) NOL = $710K taxable income

$710K taxable income X (21% federal + 6% state tax) = $192K taxes

 

This corporation is paying $152K more taxes this year because of the 382 limitation. The NOL carryforward goes from $1 million to $960K…next year it’ll go down to $920K and so on. For many years this corporation will get a $40K NOL deduction instead of using the entire NOL in the first few profitable years.

In Taxland, we call a rule that reduces a tax benefit from a good amount to a bad amount, i.e. taking it off the top, a tax haircut – or simply a haircut. When it comes to a Section 382 limitation, it’s a very bad haircut.

 

What you need to know if you own a loss corporation:

1. The Section 382 NOL limitation rules are absurdly complicated; this article only covers the basic ideas. It’s so complicated there are tax pros that specialize in Section 382 studies so accountants (including indinero) recommend these studies are done by them.
2. If you already have had a substantial equity shift for your loss corporation and think you might be subject to an NOL limitation, it’s time to study, learn what you can, and ask your tax pro.
3. If you are considering a substantial ownership change/reorg for your loss corporation: study, learn what you can, and ask your attorney and tax pro beforehand so you can consider any Section 382 (or Section 383) limitation concerns in the deal.
4. There is also a Section 383 limitation that can limit other tax benefits such as tax credits. If your loss corporation is eligible for an R&D credit you may be able to take advantage of the payroll tax offset. This can save current year cash on payroll taxes.
5. NOLs created in 2018 and later are subject to an 80% of taxable income limitation. NOLs created before 2018 are not subject to the 80% limitation (the arithmetic when both exist is weird). NOLs arising prior to 2018 are subject to a two-year carryback limit and twenty-year carryforward limit. NOLs arising in 2018 and later have no carryback option and the carryforward no longer has a time limit. You can thank the 2018 Tax Act for these changes.
6. There are exceptions and oddities to much of this—just the basic ideas are presented. Study, learn what you can and ask your tax pro.

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Quick Note: This article is provided for informational purposes only, and is not legal, financial, accounting, or tax advice. You should consult appropriate professionals for advice on your specific situation. indinero assumes no liability for actions taken in reliance upon the information contained herein.