The Tax Cuts and Jobs Act of 2017 provided significant changes to the net operating loss (“NOL”) system for corporate and individual taxpayers, including:
- NOL can no longer offset all of a taxpayer’s net income in a subsequent year. Instead, NOLs can only offset a maximum of 80% of net income. For corporations, this rule effectively produces a 4.2% minimum tax rate on current year income, regardless of the magnitude of its NOL carryforwards.
- NOLs can be carried forward indefinitely (instead of for only 20 years), but generally they can no longer be carried back to prior years.
These rules are generally effective for NOLs arising in taxable years after 2017; NOLs generated in prior years will be subject to the old rules. As such, businesses with historic NOLs will effectively have some phase-in time as they use up their historic NOLs.
Growth companies have few resources in abundance other than talent, enthusiasm, and NOLs. Unfortunately, these changes make the NOLs less valuable. Consider these situations:
- Reaching profitability. If a growth company became profitable after years of incurring losses, NOL carryforwards could shelter its net income from tax for several years. Now, at least 20% of its net income will always be taxable. For a company with boom and bust years of alternating profits and losses, the timing of income and expenses is suddenly important; and they may want to find a way to “smooth” earnings if possible. Needless to say, this is a substantial complication in tax planning.
- M&A targets. Growth companies going through an exit event may feel the sting in two scenarios.
- First, a company that was never profitable may nevertheless have significant capital gains from selling its appreciated assets, like IP or goodwill. It may face a tax liability notwithstanding a bounty of NOL carryforwards. Worse, the target may then liquidate or otherwise not earn a net profit again, rendering the unused NOLs permanently worthless.
- Regardless of deal structure, previously profitable M&A targets often generate net losses in the year of sale because of one-time, transaction-related deductions, such as sale bonuses, option cash-outs, etc. By carrying back the resulting NOL, the target or its shareholders could generate a nice windfall of extra cash in the form of a prior year tax refunds. Eliminating NOL carrybacks forecloses this strategy. Instead, owners of S corp and partnership targets will need to wait for future net income. Owners of C corp targets may try to negotiate a purchase price adjustment with the buyer. Although the NOLs may now be carried forward indefinitely, buyers will generally be ungenerous to such efforts. On top of the 80% limitation described above, annual use of the NOLs will still be generally limited by the Section 382 “ownership change” rules. Further, buyers traditionally chafe at the tax benefits sellers enjoy from paying transaction-related compensation and other expense, financed of course by the buyer’s cash.