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.
- 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.
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.
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.
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.
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 specific to, among other things, your individual facts, circumstances and jurisdiction. 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 partners, 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.