Net Operating Losses: Using Tax Shields in M&A

What if there was a way to transform large past losses into a powerful tool for your future acquisition? Net Operating Losses (NOLs) can reduce or even eliminate tax obligations—potentially making your M&A deal more profitable and attractive. But how exactly does this tax shield work, and how can you ensure you’re capturing the full value?

In this article, you will learn how to:

• Understand what net operating losses (NOLs) are and why they’re a critical tax shield

• Evaluate the benefits and limitations of using NOLs in M&A transactions

• Structure deals to preserve and maximize NOL carry forwards

• Navigate legal and operational considerations to protect your NOL-based strategy

What Are Net Operating Losses (NOLs)?

Net operating losses (NOLs) occur when a company’s allowable tax deductions exceed its taxable income in a given tax year. Rather than letting these losses go to waste, the tax code generally permits businesses to apply them to future (and, in some cases, past) tax obligations. This provision, often referred to as an NOL carry forward or carry back, can significantly reduce or even eliminate future tax bills.

Quick Tip: If your small business has experienced inconsistent earnings—strong in some years and weaker in others—NOL carry forwards can help even out the tax burden over business cycles. Consult a tax professional to confirm carry forward rules based on current regulations.

Why Do NOLs Matter to Small Business Owners?

• Reduced Tax Liabilities: If you have un-utilized NOLs, you can offset future taxable profits, effectively lowering your tax exposure.

• Greater Deal Appeal: If you’re selling a business that holds substantial NOLs, buyers may be motivated to offer a premium, anticipating reduced tax costs.

• Opportunity to Capture Past Losses: Instead of viewing past years’ losses as sunk costs, you can leverage them as a strategic tax advantage in the right M&A deal.

Why NOLs Matter in M&A Deals

Bridging Valuation Gaps

When buying or selling a business, tax considerations can be just as vital as the purchase price. A seller might tout significant NOL carry forwards as an incentive, while a buyer sees reduced tax bills on the horizon. This dynamic can bridge a gap in perceived value:

• Buyers who see an opportunity to offset future earnings will likely factor that into the purchase negotiations.

• Sellers can point to verified NOLs to justify a higher valuation, especially if the buyer can utilize them at scale.

Quick Tip: Just as you’d verify financial statements, conduct thorough due diligence on any NOL claims. Confirm details like the expiration date of the losses, the regulatory framework, and any changes triggered by previous ownership transitions.

Deal Structuring

NOLs can influence the structure of your transaction—whether it’s an asset purchase or a stock purchase. Generally, stock purchases are more conducive to transferring NOL carry forwards because the losses belong to the entity itself. Asset purchases, on the other hand, often trigger a new tax basis in the assets, which may wipe out existing NOLs at the entity level.

Structuring Your Acquisition to Optimize NOLs

Asset vs. Stock Purchase

Picking the right acquisition structure is critical. Each approach has distinct implications for how—and whether—you can use or preserve NOLs.

Quick Tip: Asset transactions can offer benefits like a stepped-up basis for depreciable assets. However, if capturing an NOL tax shield is your main objective, stock or certain reorganization structures are usually the way to go.

Section 382 Limitations

Section 382 of the Internal Revenue Code places restrictions on the annual utilization of NOLs following a significant ownership change—often a key consideration when one company acquires another. These rules might limit how much of the target company’s NOL can be used each year based on:

• Equity Ownership Change: Typically, if a purchase transaction results in more than a 50% ownership change of the target over a three-year period, Section 382 limitations may apply.

• Long-Term Tax-Exempt Interest Rate: The limit on your NOL usage is often tied to a calculation that involves the federal long-term tax-exempt rate, updated monthly by the IRS.

• Company’s Available NOLs: The larger the target’s NOL base, the more crucial it is to factor in Section 382 constraints when modeling future savings.

Allocating Purchase Price

Just like an earn-out can hinge on performance metrics, deals that revolve around NOL utility can hinge on tax attributes. You’ll want to carefully negotiate:

• Price Allocation: In many M&A deals, the purchase price is allocated among tangible and intangible assets to optimize tax benefits. However, you must also consider the impact on existing NOLs.

• Advisory Support: A reputable M&A attorney and tax accountant can help structure the transaction to maintain NOL integrity. This approach often includes verifying that the NOL usage potential outweighs any deal complications or constraints.

Protecting Your NOLs and Avoiding Pitfalls

Conducting Thorough Due Diligence

Buyers and sellers alike should investigate any NOL claims:

• Verify the Origination: Confirm the tax years during which the net operating losses occurred.

• Check Expiration Dates: Some NOLs expire if not used within a specific timeframe, though recent tax law changes may have expanded carry forward possibilities indefinitely.

• Assess Past Restructurings: If the target business underwent major changes, you might find that some or all of the NOLs are already disallowed or restricted.

Safeguarding Against Ownership Change Issues

Even if you structure a deal with stock, the buyer may face an annual cap on how much NOL it can claim. Proper planning means identifying whether:

• You can mitigate Section 382 limitations by timing the ownership change.

• A phased transaction over time could help spread ownership changes to avoid hitting a sudden threshold, though this can be more complex legally and financially.

Quick Tip: The amount of detail you include in the purchase agreement matters. Just as you might specify earn-out performance metrics, consider adding protective covenants ensuring the seller discloses all relevant NOL details.

Potential Impact of External Factors

• Tax Law Changes: NOL rules can shift with new legislation, so build flexibility into your deal.

• Audits and Challenges: The IRS may scrutinize aggressive NOL usage, especially if there are rapid changes in corporate structure or lines of business.

• Revenue Generation Timeline: If the acquiring entity doesn’t generate sufficient taxable income in the near term, the NOL carry forwards may not offer immediate benefits.

Negotiating the Terms and Post-Deal Integration

Buyer’s Perspective

From the buyer’s vantage point, the presence of significant NOLs can lower effective acquisition costs over time—if used properly. Expect the buyer to:

• Request Detailed Schedules: They’ll likely ask for a full accounting of all NOLs, complete with documentation of how they were generated.

• Push for Protective Language: Buyers often want contractual assurances that the seller has no outstanding tax liabilities or misrepresentations that could invalidate the NOLs.

• Include Contingencies or Purchase Price Adjustments: A buyer might request a purchase price reduction or an earn-out mechanism if some portion of the NOLs is disallowed.

Seller’s Perspective

If you’re selling a small business with valuable NOL carry forwards, you’ll want to:

• Highlight NOL Value: Show prospective buyers the potential post-deal tax savings. This might bolster your asking price or justify a higher multiple.

• Conduct a Tax Audit: Proactively confirm your NOLs are valid and up to date so there are no surprises during buyer due diligence.

• Negotiate Clear Protections: If the buyer tries to attribute low or zero value to NOLs due to risk, consider a structure that compensates you more fairly when and if those NOLs are successfully utilized.

Post-Sale Transition and Compliance

After the sale closes, ensure you maintain accurate tax records and reporting. Depending on the complexity of your agreement:

• Continuation of Business Activities: The buyer may need to continue substantially the same business operations to avoid losing NOL benefits, a requirement in certain reorganizations.

• Document Retention: Keep all historical tax returns, supporting schedules, and relevant forms in case the IRS or state authorities request them.

Quick Tip: Just as you’d keep track of earn-out performance data, monitor the buyer’s compliance with any agreed-upon operational covenants to preserve the NOLs. A best practice is to set up periodic check-ins or require documentation on business activities.

Summary

1. Understand the Value of NOLs: Net operating losses can serve as a powerful tool to reduce post-deal tax liabilities. Make sure you know how they’re generated, their expiration date, and how they might be limited.

2. Factor NOLs into Deal Structure: Opt for an approach (often a stock purchase) that best facilitates the transfer of NOLs, but remain vigilant about Section 382 and other restrictions.

3. Conduct Thorough Due Diligence: Whether you’re a buyer or seller, verify all details about the NOL carry forwards, including the amounts, valid timelines, and any prior restrictions.

4. Negotiate Clear Terms: Align purchase price, representations, and warranties to reflect the NOL’s potential value. Consider contingencies if the NOL usage is uncertain.

5. Plan for Post-Sale Compliance: Even after the deal closes, preserving NOLs may require certain operational or structural decisions. Monitor these carefully to lock in the anticipated benefits.

Next Steps

NOLs can dramatically alter the financial landscape of an M&A deal, but these tax attributes are subject to a complex array of rules and limitations. If you’re weighing how best to integrate NOLs into your acquisition or sale.

Schedule a free confidential consultation to:

• Explore customized strategies for leveraging NOLs and maximizing your tax shield

• Learn the most effective ways to structure your transaction while preserving future tax benefits

• Receive expert guidance on compliance, Section 382 limitations, and other crucial NOL considerations

• Ensure that all bullet points are on their own line.

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