Private equity firms are on a buying spree as they seek to accelerate portfolio company growth amid a relatively slow-growing economy.
However, correctly evaluating the tax situation at the target company can be the difference between popping the champagne cork and being left with a headache that lasts for years.
This is particularly true given the impacts of tax reform. In the case of a pure asset acquisition, the opportunity to immediately deduct tangible personal property could really affect how purchase-price allocations are structured. And given the steep drop in tax rates for C corporations from 35 percent to 21 percent for years beginning in 2018, the choice between using a pass-through entity — an LLC, usually, or a C corporation — is more complex than it has been in the past.
The goal of every private-equity firm in buying a company is to generate profits over three to five years that can be reinvested. However, the tax consequences of a poorly prepared-for acquisition or sale can be incredibly costly. For the selling company, it can tie up valuable capital for years to come in escrow accounts, while for the buyer, it can result in significant, unanticipated liabilities following the transaction.
The tax due-diligence process should inform buyers about what liabilities are being assumed. However, that’s not always the case.
Here are four areas private-equity firms should thoroughly assess before closing any deal.
1) State and Local Taxes
Noncompliance with state and local taxes is the No. 1 risk in the majority of deals, partly because our antiquated tax codes were written long before the tech and online companies that dominate our economy even existed.
While certain deal structures can protect buyers from federal tax liabilities, they don’t protect against potentially large successor liabilities related to noncompliance in past years for state income and franchise tax, sales and use taxes, wage withholding, and other non-income-based taxes. With state laws in constant flux and often given little attention by sellers, it’s a huge area for potential problems.
For example, a retailer selling through Amazon.com could have inventory warehoused in dozens of U.S. states, creating a tax presence, or nexus, in each of those locations. If noncompliance is found, buyers can require that the seller become compliant before closing or hold back sufficient funds from the purchase price to cover tax liabilities, penalties and interest.
An incredible 80 percent of deals in 2016, for example, had money held in escrow to cover potential tax liabilities, according to SRS Acquiom. The average deal withholds 10 percent in escrow, but 44 percent of transactions withheld even more, sometimes 15 percent or 20 percent. That capital can remain in escrow for several years while liabilities are negotiated with tax authorities.
Beyond income and sales taxes, there also can be problems with other state and local taxes, from severance taxes, fuel excise taxes, occupational taxes and lodging taxes, to the failure to report unclaimed property.
2) Deal Structure
In any deal, the structure of the deal has tax implications. Deals can be done either as a purchase of the assets of a firm or the equity. Typically, buyers prefer asset deals because from a federal income tax standpoint, asset deals have tax advantages due to step-up of value, and equity deals carry more risk.
Buyers favor asset deals, especially in capital-intensive firms, because that equipment can be stepped-up in value and depreciated, even if the original owner already fully depreciated it, allowing for deductions and lowering income tax obligations. Selling firms typically prefer equity deals because of favorable capital gains treatment and because the buyer assumes all historical, current and future liabilities, known and unknown. In an asset deal, sellers owe taxes at ordinary income tax rates on equipment that has already been depreciated.
Asset deals typically don’t carry significant federal income tax risk for a buyer since the seller’s historical tax liabilities accrue and stay with the seller. However, even in an asset deal, other tax liabilities (such as those from sales and use taxes, payroll taxes, and property taxes) typically transfer to the buyer.
3) Type of Entity
The tax classification of the selling company has potential tax implications. When buying a C corporation, which pays federal and state income taxes at the entity level, tax liabilities (including those from before the deal) remain with the buyer. That makes in-depth tax due diligence vital.
With flow-through entities (such as S corporations and partnerships), past tax liabilities tend to stay with the original owners. However, incorrect treatment of certain tax items by the seller are passed on as potential liabilities for the buyer.
Buying a partnership interest can also legally terminate the partnership, resulting in new accounting methods and resetting depreciation schedules. With C corporations, accountants should also look for companies that pay too much in compensation to its executives in the form of salary and bonuses to avoid non-deductible dividend treatment.
4) Employment Taxes
Federal and state employment tax can add significant risk for buyers. Beyond whether the correct amount of taxes has been paid at the right time, many companies, especially growing firms, classify workers as independent contractors when they should be employees — something the IRS has been cracking down on in the age of the “gig” economy.
It’s a chronic problem: One-third of businesses with 50 to 999 employees have been fined over the issue, according to an ADP Research Institute
Whether workers are contractors or employees depends on the services performed and the degree of control the company exercises over staff. If improperly classified, buyers can be on the hook for not only the employer portion of taxes, but also the employee portion and employee income tax withholdings.
Knowing what to look for during the due diligence process is the first step in making sure these potential problems don’t turn a great deal into a nightmare of red tape, tax liabilities and years of unpleasant interactions with taxing authorities.
This article was originally published in American City Business Journals
on February 7, 2018.
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