The CFO of the buyer pulled up the target’s tax returns during diligence, scrolled to the NOL carryforward line, and made an audible whistle. The target had $14 million of federal net operating losses carrying forward from the lean years between 2018 and 2022, when the business had burned cash on R&D before its 2023 turnaround. At the buyer’s effective combined federal-and-state tax rate of roughly twenty-five percent, those NOLs were nominally worth $3.5 million in deferred tax shielding — real money in a $42 million deal. The CFO walked into the modeling meeting that afternoon and announced that the buyer was prepared to bump the purchase price by $1.5 million on the strength of the tax asset.
I was in the meeting representing the seller. I asked, gently, whether the buyer had run the Section 382 limitation. There was a pause. The CFO had not. Two days later he came back with the actual number: the limitation would cap the buyer’s annual usage of the pre-acquisition NOLs at roughly $180,000 a year for the next twenty years. The buyer would never come close to using the $14 million of accumulated losses. The actual present value of the tax asset to the buyer, properly modeled, was somewhere between $400,000 and $600,000 — not the $3.5 million face value, and not the $1.5 million bump that had been floated at the modeling table. The bump came down to $300,000. The seller, who had been quietly delighted by the prospect of $1.5 million in incremental purchase price, ate the difference.
This pattern recurs in nearly every C-corporation stock deal where the target has meaningful NOLs. Both sides walk into the diligence room assuming the NOLs are worth their face value times the buyer’s tax rate. Section 382 quietly cuts that value by ninety percent or more. The seller does not get paid for the NOLs the buyer cannot use. The buyer does not get the tax shield the buyer thought it was buying. Both sides walk away from a tax asset that could have been preserved at higher value through a different deal structure — if either side’s tax counsel had been engaged at the term-sheet stage rather than at the closing balance-sheet review.
What Section 382 actually does
Internal Revenue Code Section 382 limits a corporation’s ability to use its pre-acquisition net operating losses after an “ownership change” — generally, a transaction in which more than fifty percentage points of the corporation’s stock changes hands among five-percent shareholders within a three-year period. A founder stock sale to a strategic or private-equity buyer almost always triggers the ownership change. The limitation that follows is the heart of the doctrine.
The annual limitation on NOL usage is computed by multiplying the value of the corporation’s equity immediately before the ownership change by the long-term tax-exempt rate published monthly by the Treasury. The long-term tax-exempt rate has been hovering in the three-to-four percent range for most of the post-2020 era, with some variability. For a corporation with $42 million of equity value, an annual NOL usage limitation in the range of $1.3 million to $1.7 million is typical. The corporation can use up to that limitation amount of pre-acquisition NOLs each year to offset post-acquisition taxable income; unused capacity carries forward, but the lifetime cap on usage is still bounded by the limitation times the remaining carryforward life.
For a target with NOLs that significantly exceed the limitation times the remaining carryforward years, the bulk of the NOL face value is simply unrecoverable post-acquisition. The $14 million of NOLs in the deal above, with a $180,000 annual limitation and twenty years of carryforward, produces a usage ceiling of roughly $3.6 million — twenty-six percent of the face value. The remaining seventy-four percent is, for practical purposes, gone.
The “built-in gains” overlay
Section 382 also contains a separate adjustment for “built-in gains” — appreciation in the target’s assets at the time of the ownership change. If the target’s assets have appreciated above their tax basis at the change date, the built-in gain (if recognized in the five years following the change) increases the annual limitation. This is the one piece of good news in the Section 382 architecture: a target whose primary value is in goodwill or amortizable intangibles with a high fair-market-value-to-basis spread can sometimes generate substantial additional NOL usage capacity through the post-acquisition amortization of those intangibles.
The built-in gains adjustment is technically called “Section 382(h),” and the calculation is non-trivial. The buyer’s tax counsel runs a valuation of the target’s assets as of the change date, identifies the gross built-in gain, and projects how much of that gain will be recognized in the five-year period following closing. The recognized built-in gain increases the Section 382 limitation dollar-for-dollar. For targets with goodwill recently acquired in pre-deal transactions, or with appreciated intangibles being amortized for tax purposes, the built-in gains adjustment can move the recoverable NOL amount from ten percent of face value to forty or fifty percent. The calculation is the kind of thing buyers’ tax counsel should be running in diligence and frequently is not, particularly in deals where the tax counsel is engaged late.
Where the deal structure can preserve more NOL value
The cleanest preservation move is to do an asset deal rather than a stock deal. In an asset deal, the target corporation retains its NOLs and the buyer’s new entity that holds the purchased assets does not inherit them. The selling corporation can then use the NOLs to offset the gain on the asset sale, which often produces an immediate dollar-for-dollar offset that captures most of the NOL face value at the seller level. The buyer does not get the NOLs, but the buyer was not going to get most of their face value anyway under Section 382, and the seller gets full value through the gain offset.
The trade-off is that asset deals carry the well-known tax disadvantages on the seller side — particularly the double-tax problem in a C-corp seller and the recapture income in many intangible-heavy targets. The asset-vs-stock decision in a target with significant NOLs is therefore a multi-variable optimization: the buyer’s preference for a stock deal (for the step-up and the operational continuity) trades against the seller’s ability to use the NOLs against the asset-sale gain. The right structure depends on the relative magnitudes, and the analysis should be running in parallel with the deal-structure conversation rather than getting tacked on at the end.
The intermediate option is a stock deal with a Section 338(h)(10) election (where available — typically S-corps and subsidiaries of consolidated groups) or a Section 336(e) election. These elections treat the stock sale as a deemed asset sale for federal tax purposes, which can produce a Section 382-style limitation that is more favorable than the straight stock-deal limitation. The mechanics are technical and the eligibility constraints are narrow, but for targets where the election is available, it sometimes recovers a meaningful portion of the NOL value that the straight stock-deal structure would destroy.
The diligence question both sides should be asking
The buyer’s diligence team should be running the Section 382 limitation calculation in the second or third week of diligence, before the purchase price is finalized. The inputs are the target’s equity value (which the buyer is presumably modeling anyway), the long-term tax-exempt rate (publicly available), the NOL carryforward amounts (in the target’s tax returns), and the built-in gains analysis (which requires a basic asset valuation). The output is the present value of the post-acquisition NOL usage, which is the number that should actually drive any purchase-price adjustment for the tax asset.
The seller’s diligence team should be running the same calculation and should not let the buyer’s CFO leave the modeling meeting with a purchase-price bump based on NOL face value rather than Section 382 limited value. The seller has every incentive to claim the higher number. The buyer’s CFO who later runs the actual limitation calculation and concludes that the bump was overpriced will either reduce the bump (best case from the seller’s perspective if the bump has not yet been committed) or seek to claw it back through some other mechanism in the deal documents (worst case). The seller is better off pricing the tax asset correctly the first time and capturing whatever genuine value the asset has, rather than pricing it incorrectly and losing the entire bump when the buyer figures out the math.
The seller’s tax counsel should also be looking at whether the seller corporation can use the NOLs against the gain on the sale before the ownership change occurs. The timing of the NOL utilization relative to the ownership change matters: NOLs used to offset the gain on the sale at the seller level are used at full value, while NOLs that survive into the post-acquisition period are subject to the limitation. For a seller with a meaningful gain on the sale and meaningful pre-existing NOLs, the structure that allows the seller to use the NOLs against the gain captures the full value of the asset in a way that no buyer-side preservation move can replicate.
What the merger agreement should say
The merger agreement provisions that interact with the Section 382 analysis are usually overlooked. First, the tax representations should include a representation that the target has not had any prior ownership changes that would have already limited NOL usage. A second ownership change layered on top of a first can produce a limitation that is even more punitive than a single-change limitation, and the buyer should know about any prior changes before pricing.
Second, the tax covenants should address pre-closing actions that could affect Section 382 — particularly any equity issuances or redemptions that could constitute a partial ownership change, and any restructurings that could affect the corporation’s equity value at the change date (which determines the limitation amount). Sellers sometimes do equity cleanups in the pre-closing period that inadvertently affect the Section 382 calculation, and the covenant should require the buyer’s tax counsel to sign off on any such actions.
Third, the closing-deliverables list should include a Section 382 study — typically prepared by the seller’s accountants or by an independent tax-services firm — that documents the NOL amounts, the equity value at the change date, the built-in gains analysis, and the resulting annual limitation. The study is the document the buyer’s post-closing tax team will rely on when filing the first post-closing tax return, and the seller has every incentive to make sure the study is solid. The interaction between deal structure and post-closing tax planning is one of the cleanest examples of how the M&A document and the tax planning document need to be drafted as a single integrated workstream rather than as parallel tracks.
The NOLs that show up in the target’s tax returns look, on a quick scan, like a tax asset the buyer is acquiring at no incremental cost. Section 382 takes most of that asset away. The deal that prices the tax asset correctly, structures the deal to preserve as much of it as possible, and documents the analysis in a study the buyer can defend on examination is the deal that captures the real value of the NOLs for whichever party is in the best position to use them. The deal that ignores Section 382 leaves money on the table for both sides. Sell-side and buy-side tax planning on this point is one of the highest-leverage uses of tax counsel in the deal, and it should happen at the term sheet, not at the closing balance sheet.
If you are negotiating a stock deal where the target has meaningful NOLs and you are trying to figure out what the tax asset is actually worth post-closing, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
— John
