Tax Considerations for Your Next M&A Transaction

AGENDA • Purpose of Tax Diligence

• Overview of Legal Entities & Tax Classifications

• Federal Income Tax Diligence

• State & Local Tax Diligence

• 2020 Election Update Purpose of Tax Diligence

• Due diligence is a process of investigation prior to signing a contract or starting an ongoing business or employment relationship

• The aim of due diligence is to identify any potential problems or unexpected liabilities

• It’s a process that takes many different forms

• Goal is to identify material unrecorded tax liabilities

• Required by third-parties who are sharing in the risk of the transaction

• Scope of tax diligence depends on what is being acquired Purpose of Tax Diligence • Transactions can be structured three ways:  Acquisition of assets

 Acquisition of legal entities

 Some combination of assets and legal entities • For tax purposes, taxpayers can conduct their affairs in one of four forms:  Corporation (or “C” corporation)

 S corporation

 Partnership

 Disregarded entity • Classification matters. It really, really matters • Just because you bought a legal entity, doesn’t mean you bought a legal entity for tax purposes Overview of Legal Entities & Tax Classifications

Limited Liability Companies • The most flexible of all legal entities from both a tax and legal perspective • Single-member LLCs default to being classified as disregarded entities  Can elect to classify as a corporation  A disregarded entity is viewed as an extension of its owner notwithstanding the LLC Member is regarded for state law purposes • Multiple-member LLCs default to being classified as partnerships  Can elect to classify as a corporation LLC • Tax classification drives the scope of diligence  If disregarded, focus is on non-income taxes  If partnership or corporation, focus is on both income and non-income taxes • But but but, I thought partnerships didn’t pay income taxes?!? Overview of Legal Entities & Tax Classifications

Partnerships • Can be either an LLC or state-law partnership (i.e., limited partnership) • Important point: a legal entity is not required to be organized for a partnership to exist for tax purposes

 Merely carrying on a business venture in a joint venture can be sufficient Partners • Partnerships not subject to federal income tax  BUT, effective January 1, 2018, the “centralized partnership audit rules” allow the IRS to assess partnerships for underpayments attributable to its partners • Partnerships (and in particular LLCs) are the preferred form for organizing business affairs since they generally provide the same Partnership limited liability benefits of corporations but allow for more flexibility in allocating profits and losses  And of course the single level of tax • Since CPAR was implemented, the focus of tax diligence is now on both income and non-income taxes Overview of Legal Entities & Tax Classifications

S Corporations • This is a state law corporation (or LLC that elects to be classified as a corporation) that elects to be classified as an S corporation • The popularity of S corporations has waxed and waned over the years

• S corporations have declined in number due to their inflexibility in how Shareholder profits and losses can be allocated and hypertechnical rules for qualification and maintenance:  Limits on the number (100) and types of shareholders (e.g., individuals, estates, certain trusts, ESOPs, etc.)  Prohibition on more than one class of stock S  No special allocations (per-share per-day rule) Corporation  Distributions must be pro-rata • Other than certain FICA planning opportunities, taxpayers can generally receive the same benefits from LLCs with fewer administrative requirements • The focus of tax diligence is on confirming the validity of the S corporation election as well as non-income taxes Overview of Legal Entities & Tax Classifications

Corporations • This is either a state law corporation or an LLC that elects to be classified as a corporation) • Subject to federal and state income taxes, so the focus of tax diligence is both income and non-income taxes • Dividends paid by corporations subject to preferential federal Shareholder income tax rate of 23.8% (assuming qualified dividend) • Prior to 2018, corporations were generally not an efficient vehicle to use to conduct business operations due to the relatively high tax rate (35% federal) Corporation • Post-2017, the federal income tax rate for corporations was reduced to 21%, so corporations are currently enjoying significant renewed interest • Of all the entities discussed, corporations are the most difficult to structure to allow a buyer to receive a step-up in the tax basis of the assets, due to the second layer of tax that shareholders must pay Federal Income Tax Diligence

List of federal income tax issues that are typically reviewed:

• Tax return filings and payments • Tax attributes and limitations (NOLs, amortizable intangibles, etc.) • Historical federal and state income tax audits • Historical transactions • Uncertain tax positions • Tax incentives (PPP loan, payroll tax deferral, etc.) • Reportable transactions • International operations • Accounting methods (deferred revenue in particular) • Transfer pricing • Intercompany transactions • Foreign bank account reporting Federal Income Tax Diligence Generally, there are two ways to structure a transaction, a Stock Sale or an Asset Sale. The following are some pros and cons of each transaction type. As a general rule, sellers want to sell stock and buyers want to buy assets!

Stock Sale Asset Sale

Benefits Benefits • Preferential capital gains tax rate for individuals • May allow the purchaser to receive a step up in the tax basis of the • One level of tax acquired assets, potentially resulting in enhanced depreciation and • Ease of implementation amortization deductions (e.g., goodwill) • Buyer generally inherits tax attributes (e.g., net operating • Buyer can pick and choose which assets to acquire and which losses, tax credits, etc.) of the acquired corporation, subject to liabilities to assume certain restrictions • Tax year-end generally terminates on the date of the transaction

Drawbacks Drawbacks • Step up (if any) reflected in stock basis, is not amortizable (and • Administrative complexity historical tax basis of assets carries over) • May result in ordinary income rather than capital gain, depending • Buyer assumes all historical liabilities of the acquired on the underlying assets being sold corporation (can be mitigated with appropriate indemnifications • May result in two levels of tax from seller) • Buyer generally does not inherit tax attributes (e.g., net operating • Tax year may not terminate on the date of the transaction losses, tax credits, etc.) of the acquired corporation • Transfer taxes (e.g., sales tax, real estate transfer taxes, VAT, etc.) State & Local Tax Diligence

Overview • Review generally encompasses state and local income and non-income taxes  Income/Franchise/Gross Receipts

 Sales/Use

 Property

 Payroll

 Unclaimed Property

• Deal structure matters for successor liability State & Local Tax Diligence

Income/Franchise/Gross Receipts Tax Diligence Considerations • Tax return filing profile

 Income/franchise tax

 City income tax

 Gross receipts tax

• Nexus positions

 Economic nexus

 Public Law 86-272 protection

• Apportionment review/sales factor sourcing

• Credit & NOL utilization

• Required non-resident partner withholding for flow-through entities

• Audits/open notices State & Local Tax Diligence

Common Areas of Concern in State Tax Diligence

Nexus Standard for Service Companies • Sellers of tangible personal property can rely on Public Law 86-272 protection from state income tax if activities in a state are limited to solicitation of sales

• Public Law 86-272 protection does not apply for service income  This means that any activity (including solicitation of sales!) in a state will create income tax nexus for a service company

• Many states now have a factor nexus standard in place for income tax  Sellers of tangible personal property can rely upon Public Law 86-272 to overcome factor nexus

 Service companies can’t rebut nexus if property, payroll or sales in a state exceeds one of the factor nexus thresholds State & Local Tax Diligence

Common Areas of Concern in State Tax Diligence

Sales Factor Sourcing for Service Income • Lack of uniform rules among the states  Greater cost of performance

 Proportionate cost of performance

 Market based . Customer location . Service location . Hybrid

• Active area for state legislative updates State & Local Tax Diligence

Common Areas of Concern in State Tax Diligence

Gross Receipts/Margin Taxes • States that have entity taxes on gross receipts or taxable margin include the following:  Nevada Commerce Tax

 Ohio Commercial Activity Tax

 Oregon Commercial Activity Tax

 Tennessee Business Tax

 Texas Margin Tax

 Washington Business & Occupation Tax

• General inclusion of pass-through entities as taxpayers

• Factor nexus standards in play here and Public Law 86-272 protection won’t apply State & Local Tax Diligence

Sales & Use Tax Diligence Considerations • Nexus determinations • Impact of Wayfair decision • Taxability analysis • Exemption certificate collection procedures • Review procedures for use tax on purchases • Bulk sale notification requirements • Occasional sale exemption applicability • Audits/open notices Sales & Use Tax

Common Areas of Concern in State Tax Diligence Taxability • Sales tax on service revenue is a very tricky area in terms of sales taxability as there is little uniformity across the states

• Many companies have not done a thorough analysis on which services are subject to tax and which are not

• Common areas of concern:  Bundled service transaction can cause otherwise exempt sales to be taxable

 Sales taxability of software must be very closely analyzed

 Labor sales taxability varies among the states but usually needs to be separately stated on invoices

• Many states are expanding the sales tax base to include more types of service income Property Tax

Property Tax Diligence Considerations • Filing profile  Real estate

 Personal property

• Comparison of book assets to personal property tax filings

• Payment confirmation

• Transfer tax

• Audits/open notices Property Tax

Property Tax Property Tax on Inventory • Thirteen states (AK, AR, GA, KY, LA, MD, MA, MS, NH, OK, TX, VA, WV) currently assess property tax on business inventory • This can be commonly missed by companies when self reporting assets subject to property tax State & Local Tax Diligence

Payroll Tax Diligence considerations • Filing profile  Income tax withholding

 State unemployment insurance

• Impact of home office employees

• Independent contractors

• Employee travel across state lines

• Audits/open notices State & Local Tax Diligence

Common Areas of Concern in State Tax Diligence Proper State Income Tax Withholding • Employee state income tax withholding should be based upon where the employee is working, not defaulted to state of residence • Many companies don’t properly conform to this standard

Independent Contractors • Many companies utilize independent contractors and issue IRS form 1099 but not all of them have competed proper analysis to determine if the independent contractor is an employee • Issues in this area can lead to exposure for required employer withholding and payroll taxes State & Local Tax Diligence

Unclaimed Property Diligence Considerations • Overall review procedures in place

• Past remittances to states

• Write-off history  Accounts receivable credits

 Payments due to vendors or employees

• Audits/open notices State & Local Tax Diligence

Common Areas of Concern in State Tax Diligence Unclaimed Property • Very few companies in diligence have a formal review process in place to determine state unclaimed property liabilities • Many states use contracted firms to handle the audit process and pay them a contingency based upon amount of liability found meaning there is high incentive for the firms to be very aggressive 2020 Election Update

President-Elect Biden Tax Plan Progressive Tax Plan • Raise $3.35 trillion to $3.367 trillion over decade if enacted in 2021

• Corporations account for $1.6 to $1.9 trillion

• Increase taxes on top 1% by 13% to 18%  Increasing other groups tax rate by 0.2% to 0.6% 2020 Election Update

Increase Corporate Income Tax Rate • Raise Corporate Income Tax to 28% • Currently Set at 21% • Prior to TCJA – 35% • Raising to 28% would result $1.1 to $1.3 trillion of additional revenue 2020 Election Update

Increase Social Security Earnings Cap • Current Law – 12.4% payroll tax

 Half by employers, half by employee

 Up to $137,700 wages (2020)

• Biden plan would subject wages above $400,000

 “Donut hole” would close over time

• Proposal would raise $800 billion to $1.04 trillion 2020 Election Update

Tax Capital Gains as Ordinary Income & at Death for Taxpayers with Over $1 Million in Income

• Current Law top rate of 20% for long-term capital gains & qualified dividends

• Biden plan would subject both to 39.6% for taxpayers earning $1 million or greater

• Remove stepped up basis for capital gains at death

 Unclear on whether basis would carryover or gains would be taxable at death

 Obama-era proposal was to tax gains at death with exclusions based on size

• Would raise $380 to $500 billion 2020 Election Update

Double the GILTI

• Global Intangible Low-Taxed Income (GILTI) currently requires 10.5% tax on foreign income derived from intangible assets • Biden Plan would double the GILTI tax from 10.5% to 21% • Would raise $300 billion 2020 Election Update

Cap Itemized Deductions For High Earners

• Current standard deduction $24,800 per couple

 10% of taxpayers itemize

 50% of top earners itemize

• Biden Plan limits in two ways  28% cap on rate . 39.6% marginal tax rate

• Reinstate Pease Limitation > $400,000  3% reduction in value of itemized deduction

• Would raise $260 to $380 billion 2020 Election Update

Cap Itemized Deductions For High Earners

• Biden Plan would impose 15% minimum tax on “book” profits

 Apply to Corporations > $100 million in annual income

• Corporations would be able to use losses and foreign taxes paid

• Functions as a replacement to AMT

• Would raise $160 to $320 billion 2020 Election Update

Phase Out QBI Deduction

• Current law allows 20% deduction on Qualified Business Income through 2025

• Biden Plan would maintain §199A for those making < $400,000

 Phase out completely for higher earners

• Would raise $200 billion, mostly through 2026 before sunset 2020 Election Update

Restore Top Individual Rates

• Current Law maximum tax rate 37% through 2025

• Biden Plan would restore 39.6% tax rate immediately

• Couples making over $622,000

• Would raise $100 to $150 billion, all through 2026 2020 Election Update Other Provisions 2020 Election Update

IRS Notice 2020-75 • Issued on November 9, 2020

• IRS to release proposed regulations clarifying that state and local income taxes paid by a partnership or an S corporation on its income are allowed as a deduction in calculating the entity’s ordinary income

• No addback required for individual partner or shareholder

• Will be applicable to “Specified Income Tax Payments” made on or after November 9, 2020

• Seven states currently allow an election to be made 2020 Election Update

Tax Items from November 2020 Election

California Proposition 15 – FAILED • Adjustment to property tax valuations  Commercial property assessed on market value  Residential property assessed on purchase price

California Proposition 22 – PASSED • App-based drivers will be classified as contractors, not employees

Illinois Fair Tax – FAILED • Removal of constitutional requirements for a flat individual income tax rate in order to allow legislature to create graduated tax rate Questions?

William B. Weatherford, CPA Jim Pierzchalski, CPA Director Director [email protected] [email protected] 312.300.0891 816.489.4323 Thank You!