Technological Organizations' Restrictions Under Section 382 Regarding Research and Development Capitalization Demands
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Hey there,
I've been diving deep into the IRC Section 174 changes, highlighting the impact of the TCJA on research and experimental costs. The IRS finally gave us some clarity on how to calculate the capitalization, shedding light on the future implications for tech companies at every stage of their journey.
Over the past decade, I've worked with numerous growth-stage technology companies. These companies often struggle with net operating losses (NOLs) resulting from expenses such as developer hiring, technology investment, and product marketing. Pre-revenue tech companies, often raising eight-figure Series B and C fundraising rounds, are accustomed to large taxable losses and no federal income tax.
However, even with a history of losses and growing research and development (R&D) credit carryforwards, many growth-stage companies have been surprised by potential corporate income tax liabilities due to limitations resulting from the application of IRC Section 382.
What's IRC Section 382?
For those unfamiliar, this section of the tax code limits a corporation's ability to utilize its “prechange” NOLs and other carryforward attributes following an ownership change. While a 100% business sale is relatively easy to identify, ownership changes can be more subtle. They often happen over multiple transactions throughout a three-year testing period, resulting in potential “creeping” ownership changes.
Determining whether a change has occurred requires careful analysis, especially in a tech industry currently experiencing a resurgence in fundraising, thanks to record-breaking fundraising in the artificial intelligence (AI) space. Rapid fundraising rounds, combined with valuation changes due to the terms of successive preferred rounds, can result in a significant shift in ownership—potentially crossing the 50% threshold.
Calculating the Limitation
The calculation of the annual limitation under 382 involves a formula involving the implied valuation of the company and the IRS-published long-term tax-exempt rate at the time of the ownership change. This might seem straightforward, but factors such as multiple ownership changes and valuation shifts can complicate the calculation.
The Importance of Proper Documentation
Properly documenting these limitations can offer significant benefits, including:
1. Net Unrealized Built-In Gain
Companies may be eligible to utilize losses based on Net Unrealized Built-In Gain (NUBIG) at the time of the ownership change. Significant built-in gains can materially increase the total post-change limitation.
2. Due Diligence At Liquidity Events
Maintaining thorough 382 documentation helps ensure that NOLs existing at the time of acquisition can provide value to buyers. Failure to meet 382 documentation requirements may create uncertain tax positions, reducing the company's valuation during a liquidity event.
3. NOL and R&D Credit Limitations
The Tax Cuts and Jobs Act of 2017 limited NOLs created after December 31, 2017, to offset only 80% of taxable income in future periods. The longer a company has been in existence with rounds of equity funding, the more likely its NOLs are impacted by 382. Proactively identifying potential limitations can help companies plan to optimize their use of NOLs and R&D credits within the constraints imposed by 382 and TCJA.
In conclusion, IRC Section 382 is a complex provision that affects almost every growth-stage tech company. Being prepared for unexpected tax liabilities resulting from 382, as well as the R&D expense changes, is crucial. Collaborating with a tax advisor can help companies navigate these complexities and ensure compliance.
Remember, this information is not investment, tax, or financial advice. Always consult with a licensed professional for advice concerning your specific situation.
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- Shane Scutellaro, an expert in the field, has been discussing the impact of IRC Section 174 changes, particularly on tech companies, and highlighting the importance of proper capitalization and documentation for future implications in 2025.
- In his work with numerous tech companies, Scutellaro often encounters challenges related to tech expenses, such as developer hiring, technology investment, and product marketing, which can lead to significant net operating losses (NOLs).
- As a tax advisor, Scutellaro emphasizes the importance of understanding Section 382, especially for tech companies experiencing ownership changes, to ensure proper calculation of expenses and limitations, and to effectively utilize NOLs and R&D credits in future tax filings.
