This article was originally published on June 02, 2017
Understanding a target’s net operating losses (NOLs) is an important part of due diligence, but simply being aware of the state implications is not enough. An analysis of the limitation on federal NOL’s without analysis of state attributes may result in misstatements of the value of deferred tax assets and state income tax exposure for the taxpayer.
Internal Revenue Code (IRC) section 382 limits a company’s ability to use NOLs after a corporation is deemed to have an ownership change. Similar to the federal NOL limitations, the majority of states also place limitations on the NOL usage that may be more or less stringent than the federal limitation. Many states do not conform to section 382 and instead rely on completely separate tests to determine if NOLs can be utilized after an ownership change. However, many businesses fail to analyze the impact of significant transactions on state NOLs. Businesses should consider which state NOLs are significant to the business and consider the potential loss or limitation of an NOL before mergers or acquisitions occur. Companies should strive to understand the state NOL profile before entering into acquisitions, reorganizations, or other material transactions, and consider opportunities to modify proposed deal structures to maximize the value of state NOLs.
If a federal section 382 study has been conducted, taxpayers often oversimplify the state NOL limitation by taking the federal NOL multiplied by the state apportionment rate and booking the resulting figure. That analysis is technically correct in some, but not all states. Businesses that take the “one size fits all” approach can result in adjustments on audit, even for tax years otherwise outside the statute of limitations because some states allow the modification of NOLs utilized in open years. For example, consider a taxpayer that takes the federal section 382 limitation multiplied by the state apportionment percentage for a 2005 acquisition and applies that method to all states. In 2015, upon audit, the state disallows the NOLs in the current years because the state does not conform to section 382. The NOLs are lost because the years where the company could have used the benefit are already closed under the statute.
Before using an approach that may have NOLs expiring and financial statement valuation misstatements there are some key questions that should be asked.
- Are the NOLs completely lost due to the change event?
- Is there a way to structure the deal which provides the best use of state NOLs?
- For states that do not conform to section 382, or may have additional rules on NOL utilization such as state-specific separate return limitation year considerations, are those properly taken into account?
- In states where section 382 does apply, does the limitation apply on a pre-or post-apportionment basis?
- If the state applies a post-apportionment methodology, does section 382 apply based on the year of ownership change, or is the company required to recalculate each year?
- If the business is acquiring a consolidated group of companies, while federal section 382 limits might be calculated at the group level, will any of the states require computations on a company-by-company basis?
- Are there any state differences in how section 382 is calculated based on state modifications?
While some states have defined how section 382 applies or have otherwise described NOL carryforward limitations by statute, in other states, companies must determine treatment based on case law. There is, however, a silver lining. Because of the disparity between federal and state treatment of NOLs, you may have increased or accelerated NOL utilization in some states that do not conform to section 382. It is important to be proactive when it comes to state NOLs and significant corporate transactions and to collaborate with RSM’s state and local tax professionals to properly document the positions to maximize opportunities and mitigate risks.