Net operating losses (NOLs) are a tax concept that shows up frequently in investment banking — in valuation, in M&A deal structuring, and in financial modeling. Understanding how NOLs work and how they affect a company’s value is important for anyone preparing for investment banking interviews, particularly if you are interested in M&A advisory or restructuring. This guide covers the fundamentals of NOLs, the key tax rules that govern them (including Section 382 limitations), and how bankers think about NOLs in the context of transactions and valuation.
What Are Net Operating Losses (NOLs)?
A net operating loss occurs when a company’s tax-deductible expenses exceed its taxable revenue in a given year. In simple terms, the company loses money from a tax perspective. Rather than letting that loss “go to waste,” the US tax code allows companies to carry forward NOLs and use them to offset taxable income in future years. This means a company with accumulated NOLs can reduce or eliminate its tax bill in profitable years by applying those prior losses against current taxable income.
For example, if a company lost $50 million in 2023 and earns $30 million of taxable income in 2024, it can use $30 million of its NOL carryforward to offset the 2024 taxable income entirely, paying zero federal income tax. The remaining $20 million of NOLs would carry forward to future years.
Key Tax Rules Governing NOLs
The rules around NOLs have changed significantly over the years, so it is important to understand the current framework:
Post-2017 Tax Cuts and Jobs Act (TCJA) Rules
The TCJA, enacted in December 2017, made significant changes to NOL rules:
- No carryback (generally). For NOLs arising in tax years beginning after December 31, 2017, the general rule is that NOLs cannot be carried back to prior years. (There was a temporary exception under the CARES Act that allowed 5-year carrybacks for NOLs arising in 2018-2020, but that has expired.)
- Indefinite carryforward. Post-2017 NOLs can be carried forward indefinitely. Previously, NOLs could only be carried forward for 20 years.
- 80% limitation. Post-2017 NOLs can only offset up to 80% of taxable income in any given year. This means even a company with massive NOLs will still pay some tax. For example, if a company has $100 million of taxable income and $200 million of post-2017 NOLs, it can only use $80 million of NOLs, leaving $20 million subject to tax.
Pre-2018 NOLs
NOLs that arose before 2018 are governed by the prior rules: they can offset 100% of taxable income (no 80% limitation) but have a 20-year carryforward period. Many companies still have pre-2018 NOLs on their books that are subject to the older rules.
Section 382: The Critical M&A Limitation
Section 382 of the Internal Revenue Code is one of the most important tax provisions for investment bankers to understand because it directly affects how NOLs are treated in M&A transactions.
What Section 382 Does
Section 382 limits the annual amount of NOLs that a company can use after an “ownership change.” An ownership change occurs when the ownership of a company’s stock by certain shareholders (those owning 5% or more) increases by more than 50 percentage points over a rolling three-year period. Most M&A transactions trigger an ownership change because the buyer acquires more than 50% of the target’s stock.
After an ownership change, the annual limit on NOL usage is calculated as:
Section 382 Limitation = Fair Market Value of the Company (immediately before the change) x Long-Term Tax-Exempt Rate
The long-term tax-exempt rate is published monthly by the IRS and has historically been in the range of approximately 2-5% (though it fluctuates with interest rates). So if a company with $500 million of NOLs is acquired and has a fair market value of $200 million immediately before the ownership change, and the long-term tax-exempt rate is 4%, the annual Section 382 limitation would be $8 million per year. That means the acquirer can only use $8 million of the target’s NOLs per year, regardless of how much taxable income it generates.
Why Section 382 Exists
Section 382 exists to prevent “trafficking” in NOLs. Without it, a profitable company could simply acquire a money-losing company solely for its NOLs and immediately use them to shelter all of its own taxable income. Section 382 prevents this by limiting the rate at which acquired NOLs can be used, ensuring the tax benefit is spread out over time rather than being immediately captured by the acquirer.
Built-In Gains and Losses (NUBIG/NUBIL)
Section 382 also addresses “net unrealized built-in gains” (NUBIG) and “net unrealized built-in losses” (NUBIL). If the target has net unrealized built-in gains at the time of the ownership change, the Section 382 limitation may be increased during the five-year “recognition period.” If there are net unrealized built-in losses, the limitation may effectively be reduced. These concepts can get quite technical and are typically analyzed by tax advisors, but it is worth knowing they exist.
How NOLs Affect Valuation
NOLs have real value because they reduce future tax payments. In a DCF analysis, the value of NOLs shows up through lower projected tax expense (and therefore higher after-tax free cash flow) in the years when the NOLs are used.
Modeling NOLs in a DCF
There are two common approaches to valuing NOLs in a DCF:
Approach 1: Incorporate NOLs into the cash flow projections. Project the company’s taxable income in each year, apply the NOLs to reduce taxable income (subject to the 80% limitation for post-2017 NOLs and any Section 382 limitations), and calculate the actual tax expense. The resulting unlevered free cash flow will be higher in years where NOLs are being utilized. This approach captures the NOL benefit within the enterprise value calculated by the DCF.
Approach 2: Value NOLs separately. Calculate the DCF using a “normalized” tax rate (as if no NOLs existed), and then calculate the present value of the tax savings from NOLs as a separate item. Add this PV of tax savings to the enterprise value. Some practitioners prefer this approach because it clearly separates the operating value of the business from the tax asset value.
In either case, the key inputs are: the amount of available NOLs, the projected taxable income (which determines how quickly the NOLs are used), the applicable tax rate, any Section 382 limitations, and the discount rate used to present value the tax savings.
NOLs in Comparable Company Analysis
When using comparable company analysis, NOLs can distort P/E ratios because a company with large NOLs will have lower tax expense and higher net income than an otherwise identical company without NOLs. This is one reason why bankers prefer EV/EBITDA multiples — EBITDA is a pre-tax metric and is not affected by the company’s NOL position. However, when bridging from enterprise value to equity value, the value of NOLs may need to be considered as part of the equity value bridge.
How NOLs Affect M&A Transactions
NOLs play several important roles in M&A deal structuring and negotiation:
Deal Motivation
While tax savings alone rarely justify an acquisition, the presence of significant NOLs at a target company can make a deal more attractive to a profitable acquirer. The acquirer can potentially use the target’s NOLs (subject to Section 382) to shelter its own taxable income, creating real cash value. This is especially relevant in situations where a profitable company acquires a money-losing company in the same industry for strategic reasons — the NOLs are an additional source of value.
Deal Structure
The structure of the transaction affects how NOLs are treated. In a stock deal (where the buyer acquires the target’s equity), the target’s NOLs generally survive but become subject to Section 382 limitations. In an asset deal, the target’s NOLs typically do not transfer to the buyer — they stay with the selling entity. This makes stock deals more favorable from an NOL preservation perspective.
Tax-free reorganizations (like stock-for-stock mergers) can also preserve NOLs, though they are still subject to Section 382. The specific deal structure and the relative sizes of the buyer and target affect the analysis significantly, and tax advisors are heavily involved in optimizing the structure.
Purchase Price Allocation
In the purchase price allocation process, the value of NOLs is reflected in the deferred tax asset (DTA) on the target’s balance sheet. If the NOLs are expected to be fully realized, the DTA represents a real asset. If there is a valuation allowance against the DTA (because the company does not expect to generate enough taxable income to use the NOLs), the acquirer may need to assess whether the combination will generate enough income to release the valuation allowance — which would be an additional source of value from the deal.
NOLs on the Balance Sheet
NOLs are not directly visible on the balance sheet. Instead, their value is reflected through deferred tax assets (DTAs). A company with $100 million of NOLs and a 21% corporate tax rate would have a deferred tax asset of $21 million (representing the expected future tax savings). However, if the company is not confident it will generate enough taxable income to use the NOLs, it must record a valuation allowance that reduces the DTA. This is why you sometimes see companies with large NOLs showing a DTA that is partially or fully offset by a valuation allowance.
Understanding the interaction between NOLs, DTAs, and valuation allowances is important for building accurate three-statement models and for understanding the target’s tax position in a transaction.
NOLs in Restructuring
NOLs are particularly relevant in restructuring situations. Companies that file for bankruptcy often have significant NOLs from years of losses. There is a special provision — Section 382(l)(5) — that can exempt NOLs from the Section 382 limitation if the ownership change occurs in a Title 11 (bankruptcy) proceeding and certain conditions are met. Alternatively, Section 382(l)(6) provides a more favorable calculation of the limitation for companies emerging from bankruptcy. These provisions can significantly affect the value of the reorganized entity and the recoveries available to different creditor classes.
Common Interview Questions on NOLs
Here are NOL-related questions you may encounter in your interviews:
“What is a net operating loss and why does it matter?” An NOL arises when a company’s tax deductions exceed its taxable income. It matters because NOLs can be carried forward to offset future taxable income, reducing the company’s cash tax payments. This has real value in both standalone valuation and M&A contexts.
“What is Section 382?” Section 382 limits the annual amount of NOLs that can be used after an ownership change (more than 50% change in ownership over three years). The annual limit equals the company’s fair market value before the change multiplied by the long-term tax-exempt rate.
“How do you value NOLs?” You can either incorporate the NOL tax savings into your DCF cash flow projections (using a lower effective tax rate in years where NOLs are used) or value the NOLs separately by calculating the present value of the projected tax savings. Either way, you need to account for the 80% limitation (for post-2017 NOLs) and any Section 382 limitations.
“Do NOLs transfer in an asset deal?” Generally, no. In an asset deal, the NOLs stay with the selling entity. In a stock deal, the target’s NOLs transfer with the entity but become subject to Section 382 limitations.
“How do NOLs appear on the balance sheet?” NOLs are reflected as deferred tax assets, calculated as the NOL amount multiplied by the tax rate. A valuation allowance may offset part or all of the DTA if the company does not expect to fully utilize the NOLs.
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