Section 383 Limitations on Corporate Tax Attributes

Section 383 of the Internal Revenue Code is a tax law that limits a corporation’s use of specific tax attributes after a significant change in its ownership. These attributes, including certain tax credits and capital loss carryforwards, can reduce a company’s tax bill. The purpose of Section 383 is to discourage “tax attribute trafficking,” a practice where a profitable company acquires a struggling one merely to use its accumulated tax benefits to offset its own income.

This regulation is a direct companion to Section 382, which restricts Net Operating Losses (NOLs) after the same type of ownership change. If an ownership shift triggers Section 382, Section 383 simultaneously imposes limits on these other tax attributes, ensuring the policy against trading in corporate tax benefits is comprehensive.

The Ownership Change Prerequisite

Section 383 restrictions are triggered only when a corporation experiences an “ownership change.” An ownership change occurs when one or more “5-percent shareholders” increase their stock ownership by more than 50 percentage points over a “testing period.” This measurement is based on the fair market value of the corporation’s stock.

A “5-percent shareholder” is any individual or entity that owns 5% or more of the stock at any point during the testing period. To determine if an ownership change has happened, the corporation must identify these shareholders. All shareholders who own less than 5% are grouped together and treated as a single 5-percent shareholder, which simplifies tracking for public companies.

The “testing period” is the three-year period ending on a “testing date,” which is any day a 5-percent shareholder’s ownership changes, such as through a purchase, stock issuance, or redemption. On each testing date, the company compares the current ownership of each 5-percent shareholder to their lowest percentage at any time during the preceding three years.

For instance, if Investment Firm A buys 30% of a company’s stock on July 1, 2024, and Firm B buys another 25% on December 31, 2025, the cumulative increase is 55 percentage points. Since this shift exceeds the 50-point threshold within the three-year period, an ownership change has occurred.

Tax Attributes Subject to Limitation

When an ownership change triggers Section 383, the annual use of the following pre-change tax attributes becomes subject to limitation:

• Net Capital Loss Carryforwards: Under Section 1212, when a corporation’s capital losses exceed its capital gains, the net loss is carried forward to offset future capital gains. Section 383 limits the amount of these pre-change losses that can be used annually.
• General Business Credit Carryforwards: Governed by Section 39, this combines various credits designed to incentivize activities like R&D or hiring from targeted groups. If a company cannot use all its credits in one year, the unused portion is carried forward, and Section 383 restricts these pre-change carryforwards.
• Minimum Tax Credit Carryforwards: The corporate Alternative Minimum Tax (AMT) was repealed, but companies may still have unused credit carryforwards under Section 53 from prior years. Section 383 limits the annual use of these pre-existing credits after an ownership change.
• Foreign Tax Credit Carryforwards: To prevent double taxation, U.S. corporations can claim a credit for taxes paid to foreign governments on foreign income, as detailed in Section 904. If foreign taxes paid exceed the annual limit, the excess is carried forward, and Section 383 limits its use.

The Limitation Calculation Framework

The process for calculating the annual limit on tax attributes under Section 383 is tied directly to the framework established by Section 382. It is a multi-step process that begins with the Section 382 limitation.

Calculate the Base Section 382 Limitation

The starting point is the annual Section 382 limitation. This is determined by a formula: the fair market value of the old loss corporation’s stock immediately before the ownership change, multiplied by the long-term tax-exempt rate. The fair market value is a snapshot of the company’s equity value. The long-term tax-exempt rate is published monthly by the IRS, and a company must use the highest of the rates for the three-month period ending with the month of the ownership change.

Account for NOLs

Once the annual Section 382 limitation is established, it must first be applied to any pre-change NOLs that the corporation wishes to use in the post-change year. The tax code prioritizes the use of NOLs. For example, if a company has a $1 million Section 382 limitation for the year and uses $600,000 of its pre-change NOLs, that amount is subtracted from the limitation.

Determine the Remaining Limitation

The amount of the Section 382 limitation that is left over after absorbing any pre-change NOLs for the year becomes the pool available for the attributes covered by Section 383. In the previous example, after using $600,000 of the $1 million limitation for NOLs, a remaining limitation of $400,000 is available.

Convert to a Credit Limitation

The final step involves converting this remaining dollar-based limitation into a “Section 383 credit limitation.” This represents the amount of tax liability that can be offset by pre-change credits. The conversion is done by calculating the hypothetical income tax that would be due on the remaining limitation amount. Using the 21% corporate tax rate, a $400,000 remaining limitation would result in an $84,000 credit limitation ($400,000 x 21%).

Application and Ordering Rules

After calculating the available Section 382 limitation and the corresponding Section 383 credit limitation, a corporation must follow a strict sequence for applying these limits to its various pre-change tax attributes. Treasury Regulations provide ordering rules that dictate which attributes are used first, ensuring the limitation amounts are consumed in a predictable manner.

The process begins with the remaining Section 382 limitation after any recognized built-in gains have been accounted for. The first attribute to be applied against this amount is any pre-change net capital loss carryforward. For example, if a company has a remaining Section 382 limitation of $500,000 and capital gains of $100,000, it can use up to $100,000 of its pre-change capital losses, leaving $400,000 of the limitation.

Next, the focus shifts to the Section 383 credit limitation. The ordering rules for credits are also specific, with pre-change foreign tax credits being the first to be applied against the company’s tax liability.

Following the use of foreign tax credits, the company can then apply its pre-change general business credits. The use of these credits is constrained by the calculated Section 383 credit limitation.

The final attribute in the sequence is the pre-change minimum tax credit. Each application of a credit reduces the available credit limitation for the next item. For instance, if the initial credit limitation was $84,000 and the company used $30,000 in foreign tax credits, only $54,000 would remain available for general business credits and, subsequently, minimum tax credits.