There are several points in a business’s life cycle that represent increased risk. One prime example is the buying or selling of all or part of a business. Aside from the operational risks in such an undertaking, there are tax risks that can be complex but can also present opportunities to both the buyer and seller. State and local tax risks vary, based upon the type of transaction (i.e., stock or asset sale), type of entity being purchased or sold (i.e., partnership or corporation), and the type and history of the business being acquired. Understanding the tax profile of the buying and selling entities, the jurisdictions in which each business has operations, and the long-term goals of the parties is key to providing prudent advice. This article focuses on certain state and local risks that should be considered in any purchase/sale transaction.
Type of Transaction
Different levels of successor liability can exist depending upon the type of transaction that is ultimately undertaken in an acquisition. In an asset acquisition, successor liability is generally limited to trust fund taxes. Generally, trust fund taxes include those taxes that a business is collecting and remitting on behalf of other parties or that are directly related to the property being acquired in the transaction. Trust fund taxes include, but are not limited to, sales, payroll, and property taxes. In some states (e.g., Illinois, Pennsylvania), however, statutory language has been drafted to encompass taxes beyond trust fund taxes, including income taxes, for purposes of successor liability (ILCS section 5/902; PA Stat. Ann. section 1403). While the potential successor liability for asset acquisitions can be somewhat limited, successor liability for a stock acquisition includes all entity-level taxes (e.g., income tax, business registrations), in addition to trust fund taxes. Parties to acquisitions or divestitures should consider the legal and tax implications of a particular type of transaction, because these elements can vastly change the level of due diligence required or potential tax exposure relating to the specific acquisition.
Type of Entity Being Acquired
The type of entity that is the target in a transaction can affect the entity level taxes that are potential tax risk areas for the buyer. For example, when pass-through entities are acquired, entity level taxes based on income are generally not a significant concern because the majority of income taxes for pass-through entities are imposed at the owner level, not the entity level. As discussed below, however, one must still address whether there are any withholding taxes that a flow-through entity should have remitted and whether those risks would be assumed by the buyer. In addition, there are some jurisdictions that do not conform to the federal income tax entity classification of certain flow-through entities and impose entity-level income taxes regardless of entity type; for example, New Hampshire imposes a state income tax on entities regardless of the entity’s federal income tax classification. Similarly, several cities and localities, including New York City and Washington, D.C., impose income taxes at the entity level on nondisregarded pass-through entities.
Similarly, some states do not recognize or can require separate state elections to receive conforming federal treatment for S corporations. Several states do not differentiate between C corporations and S corporations and impose tax at the entity level regardless of the federal classification (e.g., Louisiana, Tennessee, Texas). In comparison, both New Jersey and New York require distinct state S corporation elections to receive pass-through treatment. If these elections were not made, the buyer might be liable for unpaid taxes that were historically due, regardless of whether the previous owner paid tax on the flow-through income.
In addition, some jurisdictions impose an entity-level tax in addition to subjecting the pass-through income to tax at the shareholder/member level. California (1.5% on income), Illinois (1.5% on income) and Massachusetts (1.83% or 2.75% on income, based on the level of gross receipts) have dual-layered tax regimes for S corporations, imposing an income tax on the entity and at the shareholder level. In addition to imposing an income tax on the flow-through of income to an LLC’s owners, California imposes an “LLC fee”, which is a graduated “tax” ranging up to $11,790 and is based on the California gross receipts of LLCs doing business in the state. The authors have seen many situations where lower-tier LLCs have been required to pay the LLC fee, but have not been aware of how the nexus rules work with respect to upper-tier LLCs in a multitier LLC structure.
Despite taxes for pass-through entities generally not being required to be paid at the entity level, several states do impose nonresident withholding taxes on the owners of multistate businesses that are required to file (i.e., have nexus) in a state. Therefore, a buyer might have successor liability for nonresident withholding taxes in any states where a business is not appropriately withholding or where the business has nexus and has not historically filed. While nonwithholding exposure can be mitigated by nonresidents appropriately filing personal income returns in such states, any potential nonfiling exposure in states where the seller has not filed will likely remain open until a return is filed. Note that the filing of a composite return by a business generally eliminates the need for nonresident withholding on behalf of included partners or members. However, states like California could require both quarterly nonresident withholding and estimated tax payments for the composite filings, based upon the different rates imposed for each filing.
Professionals representing a buyer in any transaction should review the multistate activities of the target entity to ensure that the buyer is aware of all potential tax nonfiling and related risks. Likewise, sellers should ensure that they understand the true tax risk related to potential non-filing (as well as other tax risks), because many jurisdictions offer “voluntary disclosure programs” that might mitigate tax risks identified by the buyer.
Type and History of Business
The type of business being bought or sold can greatly impact the potential state and local tax exposure. For example, service businesses typically have a very broad nexus footprint, and an increasing number of states are subjecting services to sales tax. The authors have found that sales and use (S&U) taxes are some of the most complex areas and can present a significant risk in any transaction.
Typically, S&U tax risks can be classified into three general categories:
- Nexus—did the selling entity have a filing obligation, either due to its own activities or the activities of its “representatives” ?
- Taxability—i.e., if the selling entity had nexus, were any of its products or services taxable?
- Compliance—were the required returns properly filed and taxes paid (including use tax), and did the seller have sufficient documentation relating to any exempt sales?
Even if the target is fully compliant with the sales tax rules as applied to its products or services, it is important to inquire about the target’s history of business acquisitions. As discussed above, many states impose successor liability for taxes on buyers—even when only assets are acquired. In order to avoid successor liability, a buyer generally must comply with notification and withholding requirements. Such requirements are often overlooked, creating an additional S&U tax risk in business acquisitions.
Transactional Tax Considerations
In addition to reviewing the acquisition history of a target, the purchaser of a business should be aware of potential exposures created by the current transaction. For example, while many states provide bulk sale exemption rules for the sale of the majority of business assets in a single transaction, some states (e.g., New York) provide an extremely small exemption amount (e.g., $600), which creates current S&U liabilities for the acquirer if the transaction is not properly structured. Similarly, a few states now impose transfer taxes on the value of qualifying assets sold as part of an acquisition. Such transfer taxes can be the responsibility of the buyer, seller, or both, and can often specifically be assigned to a particular party in the purchase and sale agreement. Transfer taxes can refer to documentary stamp taxes, including real estate conveyance taxes, controlling interest transfer taxes, or other taxes that are attributable to the acquisition. The authors have seen several states over recent years expand real estate transfer taxes or controlling interest transfer taxes to encompass a greater amount of qualifying assets or larger number of transactions.
Other Tax Exposure Considerations
In an effort to increase tax revenues, a few states have expanded their taxing regimes to include nontraditional tax types or taxing authority measures. Currently, a handful of jurisdictions impose statewide non–income tax regimes. Both Ohio’s Commercial Activity Tax (CAT) and Washington’s Business and Occupation (B&O) tax are based on gross receipts rather than income and are imposed based on “economic nexus” rules, rather than physical presence.
Similarly, some net income taxing states are making an effort to expand their potential taxpayer base by enacting economic nexus statutes. These statutes generally provide for the taxation of particular businesses based on sales or other factor presence within the particular state (i.e., $500,000 of sales or $50,000 of payroll or property in the state). The use of factor presence standards for income tax nexus can create tax risks for any business and should be reviewed in any due diligence engagement.
Despite presenting a host of state and local tax risks and obstacles, business acquisitions present significant opportunities and benefits when properly structured. Businesses looking to offset or eliminate tax on transactional gains should review the proposed acquisition structure to determine if any tax attributes (such as net operating losses or state tax credits) could reduce any potential tax due. Similarly, taxpayers should review the possibility of electing asset sale treatment pursuant to IRC section 338(h)(10) to increase the potential post-transaction depreciation base on the acquired assets. The increased tax cost on the seller of any such election today should be compared with the potential tax benefits to the buyer over the lives of the assets to determine whether such a planning opportunity is prudent under the specific circumstances.
Professionals advising buyers or sellers in any due diligence engagement must be aware of a multitude of tax risks—including international, federal, state, and local. This article endeavors to briefly discuss a few of the many state tax risks, but it does not address all potential risks. Professionals representing a party in a purchase/sale transaction should make sure that someone familiar with multistate tax rules is part of the engagement team.