FAQs on NOLs in M&A Deal Structuring

Net Operating Losses (NOLs) are a critical tax consideration in mergers and acquisitions (M&A). They arise when a company's tax-deductible expenses exceed its taxable income, offering potential tax savings by offsetting future taxable income. However, the rules surrounding NOLs are complex and heavily influenced by tax laws, deal structures, and ownership changes. Here's what you need to know:

• What are NOLs? They allow companies to reduce future taxable income, up to 80% post-2017 (per the Tax Cuts and Jobs Act). NOLs can be carried forward indefinitely but are subject to limitations, especially after ownership changes.
• Why do NOLs matter in M&A? Buyers view NOLs as tax-saving assets, often influencing deal valuations and negotiations. Sellers may highlight NOLs to justify higher pricing.
• Key rules to know: Section 382 of the Internal Revenue Code limits annual NOL usage after significant ownership changes. The limit depends on the company’s equity value and IRS-published interest rates.
• Deal structure impacts: Stock purchases allow buyers to inherit NOLs but with restrictions. Asset purchases generally forfeit NOLs.
• Post-acquisition management: Accurate tracking, compliance with federal and state rules, and monitoring ownership changes are essential to preserve NOL benefits.

Navigating NOLs requires careful planning, thorough due diligence, and expert guidance to maximize tax savings while avoiding compliance pitfalls.

Tax Rules and Limits for NOLs in M&A

The Internal Revenue Code sets specific guidelines for how net operating losses (NOLs) are handled after a company is acquired. These rules determine whether NOLs survive the transaction and, if they do, how much can be used each year. Let’s break down how the deal structure, Section 382, and compliance requirements influence NOL preservation.

Stock vs. Asset Purchases: Impact on NOLs

The structure of an M&A deal plays a major role in determining what happens to NOLs. In a stock purchase, the buyer acquires all of the target company’s assets and liabilities - including off-balance sheet items - along with its NOLs. However, the use of these NOLs is subject to annual limits under Section 382. Since the target company remains a legal entity, its tax attributes, including NOLs, are retained.

In contrast, an asset purchase allows the buyer to pick specific assets and liabilities, leaving the target company intact as a separate entity. In this scenario, the target’s NOLs are typically rendered unusable by the buyer, as they are written down entirely. Similarly, a Section 338(h)(10) election, which treats a stock purchase as an asset purchase for tax purposes, usually results in the complete write-down of the target’s NOLs.

Choosing between these structures often involves weighing the potential preservation of NOLs against other strategic and financial considerations.

Section 382 Limits

Section 382 sets strict limits on how NOLs can be used following a change in ownership. These rules aim to prevent companies from acquiring others purely to benefit from their loss attributes.

An ownership change occurs when there is a 50% or greater shift in ownership among shareholders holding at least 5% of the company’s stock over a rolling three-year period. Calculating this requires not only tracking the number of shares but also assessing the relative value of each class of stock on the testing date.

The annual limit on NOL usage is calculated by multiplying the company’s equity value immediately before the ownership change by the long-term, tax-exempt interest rate published by the IRS. For example, in June 2021, with an applicable rate of 1.64% and an equity value of $15 million, the annual limit on NOL usage would be $246,000 ($15 million × 1.64%).

Fluctuations in interest rates can significantly impact these calculations. From July 2020 to March 2024, rates rose from 0.89% to 3.34%, altering the annual NOL limits for companies undergoing ownership changes during that time.

Companies with net unrealized built-in gains may benefit from increased annual limits over the five years following an ownership change. On the other hand, those with net unrealized built-in losses face stricter limits, slowing the pace at which historical NOLs can be utilized.

"Section 382 is often a consideration during tax due diligence. If NOLs or credits were utilized in prior years, the buyer will want to make sure those attributes were actually available for use under Section 382, so they aren't taking on any historical exposure."

• Jennifer Menendez, Managing Director, M&A Tax Services, Moss Adams

Another key rule is the continuity of business enterprise requirement, which mandates that the buyer must continue the target’s historical business or use a significant portion of its assets in an existing business for at least two years post-transaction. Failing to meet this condition results in a Section 382 limitation of zero for any post-change year. Additionally, companies with multiple ownership changes must apply the lowest applicable limitation, making it crucial to understand how successive transactions affect NOLs.

Compliance Requirements to Avoid NOL Losses

Preserving NOLs requires meticulous due diligence, accurate documentation, and ongoing monitoring. Both buyers and sellers need to verify the origination of NOLs, their expiration dates, and any prior restructurings that might have influenced their availability. Conducting Section 382 studies can confirm NOL availability, help prospective buyers assess their value, and ensure accurate deferred tax asset reporting in financial statements.

Post-acquisition monitoring is just as critical. Changes in shareholder composition or additional equity financing after the acquisition can trigger new Section 382 limitations. Consistently tracking ownership percentages and staying alert to events that might impose further restrictions are essential for maintaining NOL value.

Expert guidance is often necessary to navigate these complexities. Tax professionals can perform Section 382 ownership studies to monitor changes, assist in structuring transactions to minimize limitations, and ensure compliance with intricate regulations. Firms like Phoenix Strategy Group specialize in providing tailored advice to help buyers optimize NOL benefits in M&A transactions.

How to Maximize NOL Value in M&A

To get the most out of Net Operating Losses (NOLs) during mergers and acquisitions (M&A), focus on smart deal structuring, careful timing, and precise financial modeling. By working within the framework of tax rules and Section 382 limitations, you can unlock significant tax benefits.

Deal Structures That Maximize NOL Benefits

In M&A, structuring the deal properly is crucial to preserving and utilizing NOLs. Stock purchases are typically the most effective way to retain NOLs. Since NOLs belong to the entity itself, acquiring the target’s stock allows the buyer to inherit these losses. This makes stock purchases a preferred method for transferring NOL carryforwards.

Timing also plays a key role. Section 382 limitations are triggered when more than 50% of a company’s ownership changes hands within three years. To avoid steep limitations, buyers can stagger transactions to stay below this threshold.

Additionally, the valuation of the target company directly impacts how much NOL can be used annually. Section 382 calculates the annual NOL usage cap by multiplying the target’s equity value by the federal long-term tax-exempt rate. A higher valuation means a higher usage limit, so conducting thorough valuation work is critical.

By choosing the right structure and timing, you can set the stage for maximizing NOL benefits. Next, let’s look at how financial models can help quantify these advantages.

Building Financial Models for NOL Use

Financial models are essential tools for projecting the tax benefits of NOLs. Start by creating a tax loss carryforward schedule to track cumulative losses and their application over future years. This schedule should account for expiration dates and Section 382 limitations.

Key steps in modeling NOL usage include:

• Calculating Earnings Before Tax (EBT) for future years.
• Tracking the opening balance of NOL carryforwards, adding current losses, and applying them to taxable income.
• Factoring in the 80% limit on NOL deductions for tax years after 2020.

NOLs generated after 2017 can be carried forward indefinitely, but older NOLs may expire if not used in time. To maximize their value, prioritize using NOLs with earlier expiration dates. A well-built financial model integrates these details, ensuring no opportunities are missed.

Using Advisory Services for NOL Optimization

Navigating the complexities of NOL regulations often requires expert guidance. Professional advisory services can help structure deals, perform due diligence, and ensure compliance with tax laws.

Tax advisors can conduct Section 382 ownership studies to monitor changes in ownership percentages and structure transactions to minimize limitations. They also verify the origin and expiration of NOLs, as well as assess the impact of prior restructurings.

Financial advisors, on the other hand, can create detailed models that simulate various scenarios, helping buyers understand the potential tax savings from NOLs. These insights can shape negotiation strategies, influencing purchase prices and deal terms.

Firms like Phoenix Strategy Group specialize in M&A advisory services, including strategies for NOL optimization. Their expertise spans financial modeling, due diligence, and transaction structuring, helping buyers extract maximum value from NOLs while staying compliant with tax regulations.

Post-acquisition, it’s important to monitor ownership changes and financing activities, as these can trigger new Section 382 limitations. Advisory services can implement systems to track shareholder composition and flag any events that might impose additional restrictions.

Investing in professional advisory services often pays off by optimizing deal structures, avoiding compliance pitfalls, and ensuring the full utilization of NOLs. Given the complexity of NOL regulations and their impact on deal value, expert support is invaluable for navigating these challenges in M&A transactions.

NOLs in Deal Negotiations and Valuation

Continuing our discussion on maximizing the value of Net Operating Losses (NOLs), let's dive into how NOLs influence deal negotiations and valuations. These tax attributes don't just adjust numbers; they can reshape the entire negotiation landscape, impacting purchase prices and contract terms. Understanding their role is critical for both buyers and sellers aiming to navigate these discussions effectively.

How NOLs Affect Transaction Value

NOLs can make a target company more appealing, but their true value hinges on their usability and regulatory limits. When applicable, NOLs reduce tax liabilities, translating into cash savings. However, Section 382 of the Internal Revenue Code restricts the annual use of NOLs by multiplying the target's equity value by the federal tax-exempt rate. The higher the valuation, the greater the potential NOL cap, which can support a stronger deal price.

Sellers often highlight the tax savings tied to NOLs to justify higher asking prices, emphasizing their post-acquisition benefits. On the other hand, buyers may discount the value of NOLs to account for practical challenges, such as usage limitations, expiration risks, and the possibility of disallowed losses during review. Additionally, regulatory restrictions can delay the realization of NOL benefits, prompting buyers to consider longer payback periods.

The 2020 CARES Act introduced another layer to these negotiations by allowing NOLs from 2018, 2019, and 2020 to be carried back five years. This provision gave sellers more room to showcase potential tax benefits during deal discussions, adding flexibility to the conversation.

Comparing Deal Structures for NOL Preservation

The structure of a deal - whether it's a stock purchase or an asset purchase - plays a critical role in determining how NOLs are preserved and utilized. Here's a quick comparison:

Buyers often demand protective clauses in purchase agreements to safeguard against tax-related liabilities or invalid NOL claims. They may also request price adjustments or earn-out arrangements if any NOLs are later disallowed. On the flip side, sellers might negotiate compensation structures tied to actual tax savings realized post-closing, typically spread over two to three years.

Once the deal structure is determined, ensuring the validity of NOLs through thorough due diligence becomes a top priority.

Due Diligence for Verifying NOLs

Proper due diligence is essential to confirm the authenticity and value of NOLs before finalizing any deal. Buyers should request detailed schedules of NOLs and examine tax returns from the past three to five years, covering federal, state, and local filings. Key steps include:

• Identifying the tax years when losses occurred and noting expiration dates for time-sensitive NOLs.
• Evaluating past restructurings or ownership changes that might restrict or disallow portions of the NOLs under Section 382.
• Reviewing internal controls and tax strategies that could impact NOL usability.

This process involves not just document reviews but also interviews with finance teams and a detailed analysis of NOL balances and usage projections. Both parties must verify the validity of NOL claims to support negotiation outcomes and avoid surprises after the deal closes.

Professional advisors can be invaluable in this process. For instance, Phoenix Strategy Group provides comprehensive M&A due diligence support, helping buyers and sellers validate NOLs and ensure compliance with tax laws. Their expertise in financial modeling and transaction structuring can help quantify NOL value and assess potential risks.

Thorough investigation of NOL claims is non-negotiable. Missteps in validation can lead to significant financial repercussions. A well-prepared tax diligence report that identifies risks, quantifies exposures, and suggests mitigation strategies is essential for making informed decisions during negotiations.

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Legal and Post-Acquisition NOL Management

Closing an M&A deal that includes valuable net operating losses (NOLs) is just the beginning. Successfully managing these NOLs after the acquisition requires strict adherence to legal requirements, precise tracking, and thoughtful integration into financial plans. Below, we’ll dive into the key legal regulations, tracking methods, and strategies for incorporating NOLs into financial planning.

Regulations for NOL Usage

Once the acquisition is complete, the use of NOLs is subject to regulations under Sections 381 and 382 of the Internal Revenue Code. Section 381 allows NOL carryforwards to transfer during tax-free reorganizations. However, Section 382 imposes restrictions when there’s a change in control. Specifically, the annual usage of NOLs is capped at the value of the loss corporation multiplied by the adjusted federal long-term tax-exempt rate.

"These losses, accumulated by the acquired company, can significantly reduce future taxable income for both companies and individuals involved, as reflected in the financial statement, serving as a carryforward, carryover, and carryback benefit, freeing up resources for further expansion."
– Tax Extension

State-level rules add another layer of complexity. While about 22 states and the District of Columbia align with federal regulations on a rolling basis (as of early 2018), most states calculate NOL limits differently. For example, 36 states and the District of Columbia apply post-apportionment calculations, while only 11 states use pre-apportionment rules. This creates a challenging scenario where federal limitations are determined on a pre-apportionment basis, but state rules often require post-apportionment calculations.

Post-Acquisition NOL Tracking and Reporting

Accurate tracking is essential for leveraging NOLs effectively. Poor record-keeping or missing valuations can jeopardize NOL utilization, leading to penalties, audits, or lost deductions. To avoid these risks, companies must carefully monitor both federal and state NOLs and record deferred tax assets accurately. This is no small task - Fortune 1000 companies, for instance, report an estimated $200 billion in deferred income tax assets tied to NOL carryforwards.

To ensure compliance, firms should:

• Continuously monitor ownership changes to avoid triggering additional restrictions under Section 382.
• Conduct Section 382 studies with tax professionals to assess ownership shifts that might limit NOL usage.
• Use technology that automatically updates state NOL rules, reducing administrative headaches and ensuring compliance.
• Secure robust valuations of acquired companies at the time of purchase. These valuations are critical for determining NOL limitations under Section 382 and provide the foundation for calculating annual usage caps that can hold up under IRS scrutiny.

Adding NOL Management to Financial Planning

Incorporating NOL management into your financial planning is vital for unlocking their full value. This requires a structured approach that aligns with the broader goals of post-merger integration. A well-rounded NOL management strategy should include clearly defined roles, realistic timelines for utilization, and performance metrics to measure the tax benefits realized.

As business conditions change or ownership structures evolve, it’s important to revisit and adjust the strategy to ensure NOLs remain a valuable asset. Firms like Phoenix Strategy Group specialize in helping businesses navigate this process. Their M&A advisory services include post-acquisition NOL management, offering expertise in financial planning and analysis to integrate NOL strategies seamlessly into broader financial systems. Their fractional CFO services provide ongoing oversight, ensuring compliance and helping businesses stay focused on their core operations.

Successful NOL management requires collaboration across tax, finance, and operations teams. This teamwork ensures that tax planning aligns with operational needs and that business decisions account for NOL implications. Regular reporting and communication are key to maintaining visibility into NOL utilization and identifying opportunities for optimization. By treating NOLs as an integral part of your financial strategy - not just a one-time benefit - you can unlock meaningful tax savings and maintain the strategic flexibility needed to maximize the value of your acquisition.

Conclusion

Net Operating Losses (NOLs) represent a unique and intricate aspect of mergers and acquisitions. When handled effectively, they can turn a solid deal into a strategic advantage. These aren't just numbers on a balance sheet - they're tools that can help bridge valuation gaps, lower future tax obligations, and create meaningful value for both buyers and sellers.

Thorough due diligence is a non-negotiable first step. This process ensures that NOL details, such as expiration dates, regulatory constraints, and prior ownership changes, are fully understood. Skipping this step can lead to costly missteps, but careful preparation lays the groundwork for a well-structured deal.

The structure of the transaction plays a pivotal role. Stock purchases generally preserve NOL carryforwards more effectively than asset purchases, but Section 382 of the Internal Revenue Code imposes limits on how much of the NOL can be used after significant ownership changes. Navigating these restrictions requires experienced guidance to ensure compliance and maximize benefits.

The numbers back up the importance of professional expertise in M&A. According to research from the University of Alabama, nearly half (47%) of successful transactions involved an M&A advisor. Additionally, business owners reported a 6% to 25% boost in final sale prices when working with advisory firms. For middle-market sellers, 83% saw advisory estimates align closely with final results. These stats highlight the value of having expert support when structuring deals.

Successfully managing NOLs doesn’t end at acquisition. It requires ongoing monitoring of NOL details and ownership changes, as well as accurate valuations at the time of acquisition. These valuations are crucial for understanding Section 382 limitations and calculating annual usage caps.

For growth-focused companies navigating these challenges, experienced advisors can provide a critical edge. Phoenix Strategy Group specializes in M&A advisory services, helping businesses structure transactions that maximize the benefits of NOLs while staying compliant with intricate tax laws. Their fractional CFO services also ensure that NOL management integrates seamlessly into broader financial strategies, offering continued oversight post-acquisition.

Given the complexities of NOL regulations, expert guidance isn’t just helpful - it’s essential. With the right planning and deal structuring, these intricate tax attributes can become powerful tools for driving value and achieving long-term tax savings.

FAQs

How can companies comply with Section 382 rules when using NOLs in an M&A transaction?

To navigate Section 382 rules and make the most of net operating losses (NOLs) during an M&A transaction, companies should focus on the following:

• Determine the annual NOL usage limit: This limit is typically tied to the acquisition price and the long-term tax-exempt rate, so accurate calculations are crucial.
• Track ownership changes carefully: Significant shifts in ownership can trigger restrictions under Section 382, potentially limiting NOL utilization.
• Consult with seasoned tax professionals: The rules can be intricate, and expert advice can help ensure compliance while optimizing the use of NOLs.

By planning strategically and seeking expert input, businesses can maximize the benefits of NOLs without stepping outside IRS regulations.

How do stock and asset purchases affect the preservation and use of NOLs in M&A deals?

In mergers and acquisitions (M&A), stock purchases and asset purchases handle net operating losses (NOLs) in distinct ways. With a stock purchase, the target company’s NOLs usually carry over to the buyer, but they come with strings attached - namely, Section 382 limitations. These rules can cap how much of the NOLs the buyer can use after the ownership change, based on factors like the purchase price and the long-term tax-exempt rate.

On the other hand, asset purchases typically don’t allow the buyer to inherit the seller’s NOLs. Instead, the buyer often gains a step-up in the tax basis of the acquired assets. This step-up enables depreciation or amortization deductions, which can translate into immediate tax savings. Knowing these differences is key to structuring deals in a way that optimizes tax benefits and supports broader strategic objectives.

How does financial modeling help optimize the tax benefits of NOLs in M&A deals?

Financial modeling plays an important role in making the most of net operating losses (NOLs) during M&A transactions. By forecasting future taxable income and evaluating how NOL carryforwards can be used, it helps both buyers and sellers understand the potential tax savings and the value these assets bring to the table.

It also factors in restrictions like Section 382, which can limit the use of NOLs after a change in ownership. Careful modeling ensures that deal structures are crafted to protect these tax benefits, minimize liabilities, and boost the overall profitability of the transaction. This kind of strategic planning can have a major impact on the financial success of the deal.

Related posts

• Checklist: Tax Prep for M&A Transactions
• NOL Utilization in M&A: Asset vs. Stock Purchases
• Stock-for-Stock Mergers: Tax-Free or Not?
• 5 Ways to Avoid Double Taxation in M&A Deals