by Robert Miller, CPA, Lattimore, Black, Morgan & Cain P.C. (“LBMC”); with input from Brian McCuller, JD, CPA, state and local Senior Manager
We are honored to present this guest blog post by Robert (Bob) Miller, CPA, a tax partner with LBMC. Over the course of his 18-year career, Bob has provided tax services to numerous public companies including over 20 Fortune 500 companies. He has also served many of the country’s premiere mega and middle market private equity firms and has significant experience in both buy-side and sell-side tax due diligence and structuring – assisting clients with hundreds of transactions including acquisitions, divestitures, internal restructurings, spin-offs and initial public offerings. Prior to joining LBMC, Bob was a transaction tax partner in Ernst & Young’s Transaction Advisory practice.
Failing to properly manage the tax issues surrounding the purchase or sale of a business may be the surest way to kill a deal. Here are four tips for mitigating these kinds of problems:
1. Structure the transaction in the most tax efficient manner.
Buyers of businesses want to reduce their tax burden during the period they own a company. If it is possible to structure the transaction in a manner that can provide the buyer with fair market value tax basis in the assets of the business, the business will have a tax shield as it depreciates or amortizes its assets.
For example, if a business has internally created goodwill and other intangible assets with a value of $10 million, the selling entity will have zero tax basis in those intangible assets. If the business is an S corporation, the buyer and seller may choose to make a joint tax election (a Section 338(h)(10) election) to treat the sale of stock as a deemed asset sale. If this were the case, the buyer should be able to amortize the goodwill and other intangible assets over 15 years straight line for tax purposes. Assuming a federal and state cash tax rate of 40%, this would generally reduce federal and state income tax by $266,667 during each of the 15 years post-closing or $4.0 million during the amortization period.
In a competitive auction of a business, buyers will generally pay extra purchase price for fair market basis in assets purchased. The same election may be made when a corporate buyer purchases a corporate subsidiary from a consolidated group.
There can be incremental tax costs to the seller when making a Section 338 election (i.e., incremental state tax, depreciation recapture, etc.). Typically, a seller will require a buyer to be contractually obligated to make the seller whole for any incremental tax incurred due to the election. Generally, the buyer will calculate a cost/benefit analysis when deciding whether to make the election.
If a purchaser acquires 100% of an entity classified as a partnership (i.e., a general partnership, a limited partnership, a limited liability company, etc.), the purchase is treated as a purchase of the partnership’s assets. If the purchaser of a partnership interest purchases less than 100%, so long as the partnership makes or has made a Section 754 election, the purchaser will generally be deemed to purchase an undivided interest in the partnership’s assets equal to the percentage purchased.
The long and short of it is there may be a way to structure a deal so that the buyer gets the benefit of additional future depreciation and amortization. Furthermore, if the buyer takes into account the step-up in tax basis when determining its purchase price, the seller may get a higher sales price.
2. Find the tax exposures that are invariably present
In my 18 years of tax due diligence, I have rarely seen a business that did not have some tax exposure, that is, unpaid taxes, whether income, property, payroll, sales, use, franchise tax, etc. It is almost inevitable. In fact, unless the business being sold is an accounting firm or a law firm, I’d say it is inevitable. Taxes are complicated – there are many different kinds of taxes and many ways to make a mistake in paying them, or to simply be unaware that they are owed – and you usually don’t find out about these exposures until your company goes through the rigorous due diligence process that a sale necessitates.
For example, if a service business does business in multiple states, more than 100% of its income could be exposed to taxation – due to the states varying methods of assigning service revenues. Most states follow an “all or nothing” approach when assigning service revenue earned in more than one state. Under the cost of performance method, the state with the greater proportion of the costs required to perform the service is assigned all of the revenue. The cost of performance rule was originally drafted in 1957, during a time when it was rare for a business to remotely provide services. Over the last few years, an increasing number of states have adopted market-based sourcing in lieu of the costs of performance rule. The market-based approach assigns service revenue to the location where the benefit of the service is received by the customer. This difference in methods often leads to distortive results for multi-state service companies.
To illustrate, assume a Tennessee-based service company has a client in California, and substantially all of the costs incurred to provide the service occur inside Tennessee. Because Tennessee follows the costs of performance rule, all of the company’s service revenues will be sourced to Tennessee. However, the analysis does not end there. Effective January 1, 2013, California adopted market based sourcing for service revenues. For California purposes, the company is required to assign the same revenue to California. Even though this results in double taxation, there is no relief provision among the states because each state’s rules are applied independently of each other.
Another trend in state taxation is the adoption of new nexus theories that are designed to target businesses with no physical activity inside the taxing state. Most companies realize they are taxable in another state if they engage in physical activities inside the state (e.g., they maintain an office, inventory, equipment, or a sales force inside the state). Most companies do not realize that simply earning revenue from inside a state can create an income tax filing requirement. For instance, effective January 1, 2011, California passed an economic nexus law which requires companies with California sales above $500,000 to file an income tax return – regardless of their physical activities within the state. In our previous example, the Tennessee based service company may be surprised to learn that it may have a California income tax filing requirement based on sales revenue alone.
In a similar manner, some states have adopted “click-through” nexus laws for sales tax purposes. These provisions are designed to require internet retailers (most notably Amazon.com) to collect sales taxes from their customers, even though the internet retailer has no physical operations within the taxing state. Under a “click through” arrangement, an internet retailer pays a commission to an in-state business (e.g., a newspaper) for sales generated by a link posted on its website. These states have insisted that “click-through” arrangements are no different than a sales force operating inside the state on behalf of the internet retailer, thereby fulfilling the physical presence requirement for nexus purposes. Most businesses would think this arrangement is similar to remote advertising, which would not create a sales tax obligation.
Also, very few businesses that have employees traveling to multiple states remit payroll taxes correctly. In fact, at least one state requires payroll tax to be remitted if a traveling employee works in its state as little as one day.
Many businesses also have tax exposures because they have misclassified personnel as independent contractors instead of employees. As a result, they don't properly withhold income taxes, Social Security taxes and Medicare taxes – for which they are liable. Aside from the tax issues, these misclassified employees may have been eligible for insurance benefits that they were denied, for which they might need to be reimbursed once the misclassification is identified.
These are just a few of many ways that your company could have tax exposures. Probably less than two percent of companies in America are completely up-to-date on taxes paid, whether income, franchise, property, payroll or many other special taxes.
3. Mitigate tax exposures found
Once due diligence uncovers a material tax exposure, it must be dealt with for the sale to proceed. One way to handle a tax exposure is for the seller to issue a note to the buyer that covers the tax exposure plus applicable interest and penalties. The term of the note should generally be equal to the number of years specified by the applicable statute of limitations.
Sometimes the buyer will assume the risk and reduce the purchase price accordingly. For example, if the business is priced at $100 million and due diligence uncovers $5 million in tax exposure, then the price might be reduced to $95 million and the buyer might assume the liability.
In addition to the above, sometimes a buyer will require a seller to amend tax returns to clean-up the exposure. Other times, the entity being sold might enter into a voluntary disclosure with a tax authority.
4. Conduct a pre-due diligence practice interview
Sellers should not walk into a due diligence interview with the buyer’s team without knowing the numerous tough questions that are likely to be asked – about taxes or anything else – and how to answer them. A typical tax due diligence interview generally lasts between one and three hours depending on the complexity of the Target.
There are different ways to answer questions honestly: one way allows you to answer the question and move on; another way can bring up many more follow-up questions.
The best way to prepare for a due diligence interview is to practice with your tax accountant or tax attorney – who has been around the block a few times. This coach must know your business well, warts and all, and know how to answer questions in a way that does not make a small problem look like a big one.
Again, I am not advocating any kind of shenanigans or less than honest answers – just smart answers that give the buyer a clear picture of the situation. Unprepared sellers, who seem unsure about their answers, do not, in fact, present a clear, honest view of their company precisely because they do not have a clear picture themselves.