Common Tax Exposures Can Complicate a Transaction
Although lenders are generally superior in priority of investment recovery to equity holders, they are not immune from consequence of large tax exposures. As such, they should not overlook the potential for tax to delay, alter, or even completely derail an otherwise profitable deal. A tax due diligence review can identify and assess the potential tax exposures leading to complications, impact on the quality of earnings, and overall value.
Here are some of the more common tax exposure issues that may be discovered during tax due diligence.
Federal Income TaxA corporation that has been a Subchapter S corporation since inception can, for the most part, focus its tax diligence on the initial and continuing validity of the Subchapter S election. Some relevant questions to ask include:
- Was the election properly and timely made by all shareholders at the date of election?
- Has the company had only eligible S corporation shareholders at all times?
- Have all income and loss allocations and distributions been made pro-rata to all shareholders?
If the election has been terminated for violating any of the eligibility requirements, the entity may be liable for corporation taxes for all open tax years (typically three).
For taxable (“C”) corporations, potential exposures exist not only in the timing or actual amount of any Net Operating Loss (“NOL”) carryforwards accumulated in prior years, but also in their ability to utilize them. Ownership changes (including partial changes) can trigger limitations on the use of NOLs to offset taxable income. NOLs utilized, notwithstanding a triggered limitation, create a potential exposure likely to be discovered on audit.
State and Local Income Tax
Some state and local jurisdictions do not recognize the Subchapter S election, imposing net income tax at the entity level as if the entity is a C corporation. Other jurisdictions impose various franchise or gross receipts taxes on Subchapter S corporations and partnerships. Many companies, mistakenly or otherwise, do not file income tax returns in states where their activities have established income tax nexus. Once nexus is established, if the company is a taxable C corporation it may have significant potential exposure for income tax liability. This will depend on the amount of net income apportioned to the state.
Many states have recently enacted economic nexus statutes that impose income or gross receipts taxes on companies that have no physical presence in the state, but whose revenue derived from the state, exceeds a specified threshold. Companies selling across the country are often blissfully unaware that their top line growth to a geographically diverse customer base has rendered them liable for state income taxes to which they were previously not subjected.
Sales and Use Tax
All too common is the failure to comply with sales tax requirements in states where independent contractors provide services to, or on behalf of, the taxpayer.
The growth of the internet has created traps for the unwary. Many states have enacted “Amazon laws” that attribute the physical presence of one otherwise unrelated business to another where certain online relationships, known as “click-through nexus,” exist between the two.
The other side of sales tax is use tax. Purchases of supplies and equipment to be used by the company in conducting its business are subject to sales tax because, for such purchases, the company is the end user. If (properly or improperly) sales tax is not collected on the transaction, the business is required to file a use tax return and remit the appropriate amount of tax.
Payroll and Employment Tax
One area of potential liability is the classification of service providers as independent contractors rather than as employees. Notwithstanding that the parties agree on independent contractor status, the IRS and state tax authorities analyze all of the attendant facts and circumstances in the relationship in accepting or rejecting the parties’ classification. Where a taxing jurisdiction is successful in asserting a reclassification of contractors as employees, a business may find itself liable for unpaid withholding, payroll, and employment taxes, as well as benefits attributable to prior years.
Unclaimed and Abandoned Property
The most common types of unclaimed property are uncashed payroll checks, old accounts payable, or customer credits, and gift cards. In recent years, the increased use of direct deposit has lessened the risk of having uncashed payroll checks, while conversely, the explosive growth of gift card usage has increased the occurrence and risk of gift cards as unclaimed property.
U.S. International Tax Information Reporting
Regardless of the U.S. taxability of foreign operations, the existence thereof may trigger information reporting and/or tax withholding requirements. The presence of foreign ownership, foreign subsidiaries, and foreign bank accounts all trigger information reporting requirements that carry penalties of $10,000 per required form, per year.
When transactions between U.S. companies and foreign related entities are not done based on arm’s -length pricing, potential exposures may exist in the U.S. or foreign country (or both). Companies that have not had proper transfer pricing studies prepared are at greater risk of exposure.
Tax due diligence will expose tax concerns during the transaction process, achieving the best possible post-transaction tax treatment. Many buyers and sellers rely on a long-time accountant to counsel them through these events. However, if that professional does not have specific and significant transaction- related experience, they may be doing themselves a disservice, which may adversely impact the transaction.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.