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State tax issues in mergers

This article originally appeared in The Kentucky CPA Journal / Issue 3, 2011 / Tax in the Bluegrass  

When two unrelated businesses merge, there are a lot of things to consider. State taxes certainly merit some attention because ignoring them has the potential to result in unknowingly taking on significant tax-related risks or incurring otherwise avoidable tax liability. 

Forms of Business Entities And Mergers 

To appreciate the importance of state taxes in a merger, it is first necessary to review some background regarding the several forms of business entities and mergers. 

A business generally operates in one of three basic types of legal entities - as a corporation, a limited liability company (LLC) or a partnership. In this same vein, there are two primary ways in which a business can be taxed for federal and state income tax purposes: [i] at the entity level (e.g., as a corporation) or [ii] at the owner level, where the business’ taxable income passes through to each owner (e.g., as a S corporation or partnership) and each owner pays tax on his respective share of income.

A corporation may be taxed as a corporation, or a qualifying corporation or LLC may elect to be taxed as a S corporation. A partnership may only be taxed as a partnership. A LLC is a quite flexible business entity as it may be taxed as a corporation, a S corporation or a partnership. 

While some businesses operate within a single business entity, it is not uncommon for a business to operate in multiple entities. An example of a basic multi-entity structure might be a retail business that operates several stores, each of which operates in a separate legal entity, all of which are owned by a holding company. There are an almost infinite variety of corporate organizations. 

Essentially, a merger is a combination of one business entity with another business entity, wherein only one survives. For example, a corporation can merge with another corporation. A LLC can merge with another LLC. A limited partnership can merge with another limited partnership.

An entity of one type can also merge with a different type, e.g., a corporation with a LLC. The accomplishment of a merger is governed by a written agreement. 

Sure, it is possible for a merger to take the form of a cordial combination of equals or affiliates. But, a merger can also occur in the context of an acquisition of one business (sometimes referred to as the target) by another (sometimes referred to as the purchaser). 

Avoiding Surprises   

One important goal in a merger of two unrelated businesses is to avoid surprises resulting from a general unfamiliarity with the merger partner’s business. This is accomplished by performing due diligence, which is essentially an investigation of the merger partner and involves asking questions that highlight potential issues, including state tax issues. 

State (and local) taxes come in three primary types: income taxes; sales and use taxes; and, property taxes. States and localities also impose variations of these, including gross receipts and balance sheet taxes. They also impose industry specific taxes, e.g., coal severance, cigarette and tobacco, and motor fuel taxes. 

Particularly in an acquisitive merger, it is common practice for a merger agreement to have a provision to indemnify the acquiring business for pre-merger tax liabilities. 

“Getting to Know You, Getting to Know All About You” by Oscar Hammerstein 

Part of due diligence entails gaining an understanding of the operations of the merger partner. This might be readily apparent to the operations people on the merger team, but the members of the team responsible for taxes must be up to speed as well. 

Due diligence is all about asking questions and the merger partner providing answers: 

  • How is the business organized? Is it a corporation? LLC? Partnership?
  • How is the business taxed for federal income tax purposes? C corporation? S corporation? Partnership?
  • Where are the businesses operations located? Where is the office? Where is the headquarters? Where is the factory? Where is the distribution facility? Where is the store? There could very well be more than one of each type of location.
  • What property does the business own? Real estate? Manufacturing equipment? Software? Trademarks? Patents? 
  • From where do the employees work? Do employees work in their homes? Do employees work from multiple locations? Are any employees mobile (e.g., pilots, truck drivers, crews on vessels)?
  • Does the business use independent contractors?
  • What does the business sell? Goods or services?
  • Who are the customers? People? Businesses? Governments? Non-profits? All of these?
  • In what states and localities have tax returns been filed and for what taxes? For how long? Obtain copies of tax returns. Obtain copies of available state tax accruals, provisions and related documents.
  • Has the business been audited by any state tax authority? Are there any audits that have not yet been resolved? Is the business involved in any litigation regarding state taxes?
  • Has the business entered into any agreements with any states? Agreements for economic development incentives? Agreements to settle tax disputes with tax administrators?
  • Does the business have any carryover state tax attributes? Net operating losses? Tax credits?

These are just some of many questions. The answers to these questions may provide some understanding of the merger partner’s business or prompt more questions. At some point, a relatively clear picture of the merger partner should emerge. 

Evaluating and Managing State Tax Risks 

Identification during due diligence of the merger partner’s known filing obligations is an important step in understanding state tax-related risks. One can expect that material risks that are known by the merger partner will be disclosed during the due diligence process. 

A review of the business partner’s tax returns and accruals/provisions should disclose known material state tax issues in states in which the business is filing. 

Comparing tax returns and accruals/provisions with the businesses’ locations and activities, if any, in states in which the merger partner has not been filing should disclose states in which non-filing could potentially, but not necessarily, be an issue. Once identified, techniques can be used to manage this nexus risk, which has the potential to be quite significant. 

It should be anticipated that the existence of an ongoing state tax audit or a settlement agreement may prompt a request for a specific indemnification provision related to the audit or settlement agreement. 

Minimizing State Taxes 

Given the potential significance of state taxes to the merged business’ bottom line, another important goal in a merger - regardless of whether the involved businesses are unrelated or affiliated - is to minimize the impact of taxes resulting from the merger transaction and those imposed on the newly merged company. This is, at least in theory, most efficiently accomplished by taking taxes into consideration when the form of the transaction is initially determined; that said, business considerations generally drive this decision. Though tax people (whether tax practitioners or administrators) might sometimes think otherwise, the business dog wags the tax tail and not vice versa. 

State Taxes on the Merger Transaction 

As to state income taxes, the federal income tax consequences of a merger are generally the starting point for determining the state income tax consequences. A “vanilla” statutory merger of two corporations is generally income tax free. When boot (e.g., cash or other property) is involved in the transaction, then income tax may apply. States, like Kentucky, generally follow the federal income tax treatment of a merger. When pass-through entities merge, it is generally income tax free.

For those not familiar with sales and use taxes, it can sometimes come as a surprise that such taxes potentially apply to a merger. Because there is a transfer of assets from the business entity that does not survive the merger to the surviving entity, the sales and use tax imposed by the taxing jurisdiction in which the assets are transferred may apply, absent an exemption. A state’s occasional sale exemption may, but not necessarily, apply so that the merger may be sales and use tax free - though a careful analysis should be undertaken to ensure that the contemplated exemption applies to the transaction as structured. Other exemptions may also apply.

A cursory analysis is often insufficient to identify and head off potential problems. But, careful planning can often be well worth the effort.

State Tax Planning Opportunities 

Envisioning how a merged company or companies will be subject to tax by the various state taxing jurisdictions in which the merged business will operate has the potential to add significant value. For example, the identity of the business entity that survives a merger can be a key determinant in certain states as to the availability and utilization of tax attributes such as net operating losses and tax credits. Many other examples exist and are limited only by the almost limitless and unique circumstances of each business and merger.

An experienced tax practitioner can be invaluable in identifying opportunities to enhance the tax efficiency of the business entity or group of entities resulting from a merger.



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