Key state and local tax considerations during sell-side due diligence

Source: RSM US LLP.   

ARTICLE | September 13, 2022

Executive Summary:

State and local tax sell-side due diligence has become more complex in the last five years. Preparation and proactivity are key to minimizing exposure and obtaining the most value on a transaction. RSM’s state and local tax specialists explain four important considerations when selling a business or engaging in the due diligence process.

The state tax landscape has changed dramatically in recent years due in large part to the U.S. Supreme Court’s decision in South Dakota v. Wayfair, Inc. 138 S. Ct. 2080 (2018), the corresponding legislation passed by the vast majority of states, and robust federal tax reform. These changes have had a significant impact on the focus areas of state and local tax due diligence, especially as it relates to businesses operating in the middle market. In this article, we address several key state and local tax topics that business owners should be aware of as they contemplate the potential sale of their businesses.

Evolving approaches to taxing remote businesses

The state and local tax due diligence findings that correspond with significant potential liabilities are often related to the target business having established nexus with a state, or group of states, but failing to register and file the necessary tax returns with those jurisdictions. States’ authority to assert nexus for sales and use tax purposes was significantly expanded by the U.S. Supreme Court’s ruling in Wayfair, which overruled the longstanding principle that physical presence was required to establish nexus for sales and use tax purposes. As a result, states are permitted to impose a sales and use tax collection obligation on out-of-state businesses and remote sellers based solely on their economic activity in a state. Within just three years of the decision, every state that imposes a sales tax has adopted ’economic nexus’ provisions which subject taxpayers to sales and use tax collection requirements when in-state sales activity reaches a certain bright-line threshold, either through quantity of sales or by exceeding a dollar threshold. Additionally, certain localities have imposed their own economic nexus standards. For more information on sales and use tax nexus generally, please read our article, Wayfair nexus turns three by celebrating near-universal adoption.

While the Wayfair decision specifically addressed sales and use tax nexus, it has already had an impact on the states’ authority and willingness to impose economic nexus for other types of taxes, including income and franchise taxes. With the concept of economic nexus emerged in the income tax world long before Wayfair, states have been issuing new guidance establishing economic nexus thresholds for income and franchise tax purposes at an increasing rate in recent years. Hawaii, Massachusetts, Pennsylvania, and Texas are just some of the jurisdictions that adopted ‘Wayfair-styled’ income tax nexus provisions following the decision. Taxpayers can likely expect states to become more aggressive in asserting nexus for such taxes prospectively.

Yet another development affecting the states’ ability to require income tax filings from out-of-state taxpayers came in August of 2021 with the Multistate Tax Commission (MTC) issuing revised guidance addressing the applicability of Public Law 86-272 (15 U.S.C. sections 381-384, ‘P.L. 86-272’) to activities conducted over the internet. Since its enactment in 1959, P.L. 86-272 has prohibited states from taxing the net income of an out-of-state taxpayer if the taxpayer’s business activities in the state are limited to the solicitation of orders of tangible personal property that are sent outside of the state for approval and, if approved, are fulfilled by shipment or delivery from a point outside the state.

In its new guidance, the MTC outlines a number of activities that would not be considered “protected activities” under P.L. 86-272, and thus would create income tax filing obligations for businesses engaged in such activities. Among other things, providing post-sale assistance through electronic chat or email or placing internet cookies on the computers of customers (in certain circumstances) would be considered unprotected activities. In effect, given the nature of electronic commerce, it is likely that most businesses engaged in the online sale of tangible property would no longer be able to claim protection under P.L. 86-272. Although states are not obligated to follow the MTC’s revised guidance, the expectation is that the majority of states will eventually adopt the guidance, in whole or in part; additionally, several states have already adopted the guidance or have formal plans to do so. California has since issued a Technical Advice Memorandum (TAM) providing several examples of internet activities that would not be protected by P.L. 86-272. Although California’s TAM does not specifically refer to the updated MTC guidance, it appears to have been issued in response to the publication, evidenced by the factual circumstances contemplated in the TAM. In addition to California, New York published draft regulations adopting the MTC guidance, and, as of the date of this article, both New Jersey and Oregon have expressed an intent to incorporate the MTC’s latest P.L. 86-272 updates. For additional information and analysis on the MTC’s recent guidance on P.L. 86-272, read our article MTC adopts new P.L. 86-272 guidance: What you need to know.

In light of the many changes noted above, sellers should be prepared to be asked pointed questions about their interstate activities and state and local tax compliance procedures. Given the expansion of what constitutes nexus-creating activity and limitations on protections afforded by P.L. 86-272, there is a far greater likelihood of state and local tax exposures being identified through diligence. Accordingly, sellers should consider proactively addressing such exposures to avoid surprises, minimize liabilities and expedite the closing process.

Broadening of the sales tax base

In addition to recent shifts in the state tax nexus landscape, changes to the taxability of various products and services continues to create complexity for businesses and associated risk that is often identified during the tax due diligence process. This is especially true as it relates to middle-market businesses who may not have the internal resources to monitor state sales tax law changes, perform broad taxability studies, or develop robust compliance protocols.

Many states have imposed sales tax on the sale of pre-written software, regardless of how it is delivered to a customer. In the last decade, while many states have imposed tax on popular technology offerings such as software-as-a-service (SaaS), platform-as-a-service (PaaS), and infrastructure-as-a-service (IaaS), the state treatment of such services remains fragmented and remarkably different depending on how the jurisdiction defines the activity. More recently, digital assets – assets recorded on a blockchain such as cryptocurrency, non-fungible tokens, and smart contracts – are becoming a popular target for state audits. Generally, states continue to take a piecemeal approach to taxing the digital economy and services.

It is important for sellers to consider whether their business’ offerings may be subject to sales tax in the various states in which they operate given the evolving and expanding state sales tax bases. Sellers should also be prepared for detailed questions regarding the nature of their offerings, as well as potential questions related to language addressing such offerings on the company’s website as well as in company contracts, statements of work, and invoices.

Transfer taxes in equity purchases

A common misconception is that state transfer taxes do not apply when the stock or equity of a business is sold, as opposed to its assets. It is generally true that sales and use taxes do not apply in this fact pattern; however, real estate transfer taxes can be triggered in certain circumstances, even if the underlying real estate itself is not sold directly.

Many states have expanded their real estate transfer tax provisions to impose tax on transfers of an ownership interest in a legal entity that directly or indirectly owns real property. More than 15 states have promulgated such controlling interest transfer tax (CITT) provisions. CITT rules can vary widely from state to state. For example, some states impose such taxes on ‘real estate entities’ – or entities that are engaged in the real estate business. Meanwhile, other states’ provisions expand the scope of the tax base to include not only owned property, but certain long-term leases, or leases that are deemed not to be at fair market value.

Given the nuances involved with state CITT rules, sellers should consult with their tax professionals and consider whether any such taxes may be triggered on a contemplated transaction before agreeing to be responsible for paying a portion, or all, of any such taxes pursuant to a purchase and sale agreement.

Current trends in transaction structures

In many transactions, buyers seek to obtain a ‘stepped-up basis’ in the assets of the target company. This can be achieved not only through a direct purchase of the target company’s assets, but also through certain federal income tax structuring mechanisms, including section 338(h)(10) elections and F reorganizations. Regardless of the mechanism utilized to achieve asset sale treatment, individual sellers will often seek a ‘gross-up’ (increase in purchase price) for the incremental taxes owed as a result of the transaction being treated as a sale of assets versus a sale of equity. Sellers should be cognizant of the consequences of these structuring options to obtain full and fair value on the sale of their businesses.

In certain circumstances, PTE elections made by a selling entity may result in a more tax-efficient structure overall, for both the buyer and seller. However, the states’ rules and regulations related to PTE elections are complicated and inconsistent across different state jurisdictions. Moreover, many factors must be considered when contemplating making PTE elections in a transactional context, including, but not limited to: the resident states of the shareholders/partners at issue, whether each state at issue provides a credit for PTE taxes paid, and the applicable PTE tax rates imposed by the states at issue. Nevertheless, such elections may present sellers with optimal tax consequences on the sale of their business and should be considered during the sell-side diligence process. For additional information on PTE elective taxes and associated considerations, please read our article: Pass-through entity elections are here to stay: What you need to know.

Takeaways

Recent and ongoing changes to the state tax landscape present challenges and opportunities for owners who are contemplating the sale of their business. With increasing complexity in areas ranging from nexus to taxability of transactions to available PTE tax elections, it is vital that business owners proactively work to understand and appropriately consider the state tax-related issues that will be examined during the tax diligence process and the tax impacts of the potential transaction itself. By addressing these matters well in advance of a potential sale, sellers may be able to avoid significant pitfalls and maximize value received.

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