Common Tax Due Diligence Issues for C Corporation Acquisitions
In-depth tax due diligence in a C corporation acquisition is vital. Since C corps pay federal and state income taxes at the entity level, unexpected tax liabilities (including those from before the deal) could remain with the buyer and can create very unpleasant surprises.
Here is a list of the common issues that should be reviewed during tax due diligence when acquiring a C corporation:
1. Federal and state income tax. Due diligence should include a very detailed look at differences between book and taxable income. A careful review of the target C corporation’s tax returns, financials and tax provision workpapers can help uncover unknown tax liabilities that may not be disclosed or booked properly and could affect the purchase price or structure of the acquisition.
2. Accounting methods. All accounting methods should be evaluated to ensure they are being utilized correctly, especially with respect to lease accounting and deferred service revenue. For example, are there long-term service contracts? Service revenue that is deferred longer than one year needs to be included in taxable income at year end for tax purposes. If there are accounting deficiencies, they must be identified before the close or the buyer will inherit and perpetuate them. Additionally, tax liabilities that should be the seller’s responsibility need to be identified and resolved prior to the close or they could succeed to the buyer.
3. Unreasonable executive compensation. The 2017 Tax Cuts and Jobs Act included significant changes to the “covered employee,” or executive, compensation deduction rules in Section 162(m) of the Internal Revenue Code. Under the new tax law, executive compensation now includes qualified performance bonuses in addition to base salary. As a result, any compensation paid to a qualifying executive in excess of $1 million could be considered by the IRS to be non-deductible. If the IRS concludes that wages qualify under IRC§162(m), non-deductible treatment will increase a C corporation’s taxable income and possibly subject the business to additional tax, penalties, and interest.
It’s also important to identify if owner related party payments are overstated. For example, an owner of the C corporation owns the corporation’s property through a separate tax entity and the C corporation is paying inflated rent so the owner can disguise the executive compensation as a rent payment to avoid payroll taxes. This could lead to payroll tax liability and penalties for the buyer as well.
4. Nexus for state income and sales tax. The historic U.S. Supreme Court Wayfair ruling last summer has increased the complexity of state income and sales and use tax. Prior to this SCOTUS ruling, nexus (tax presence in a jurisdiction) was based solely on physical presence. Now it can be based on economic activity as well. Additionally, over the last few years, more states have been adopting market-based sourcing rules for service income which allows the state to “claim” sales based on the location of the received benefit of a performed service. In short, states continue to expand their reach with respect to state sourced income through court rulings and new legislation. As a result, nexus is more complicated than ever and an important part of tax due diligence and should be addressed for every Target with multi-state operations.
5. Improper independent contractor classification. While some employers misclassify their employees as independent contractors in error, others do it intentionally to avoid paying state and federal payroll taxes by passing that responsibility onto the employee. Employers that are found to have misclassified their employees are subject to payroll tax and penalties that could then be passed on to the buyer. During due diligence it’s important to determine if independent contractors should actually be considered full-time employees. The IRS provides a 20-factor test to help make that determination with considerations related to direction and control.
6. Net operating loss limitation. In an effort to deter loss trafficking, Congress enacted IRC§382 to limit the use of corporate NOLs (net operating losses) following an ownership change. In the event of an ownership change, as defined by IRC§382, use of the loss corporation’s NOLs and certain built-in losses is limited to the value of the loss corporation multiplied by the adjusted IRC§382 federal long-term tax-exempt rate. In addition, states have varying rules on NOL limitations. Due diligence can uncover past ownership changes that could have created an NOL limitation which would affect the NOL value after the close as well as the validity of pre-transaction NOLs utilized in prior years.
7. Business Interest Limitation. Another significant change that came with the 2017 Tax Cuts and Jobs Act (TCJA) was the revision of the IRC§163(j) limitation. Previously, the limitation generally applied only to deductions on interest paid to foreign-controlled entities. As of 2018, however, the limitation on interest deductions has been expanded to include most US entities that have average annual gross receipts over $25 million (for the preceding 3 taxable years). Due diligence should ensure C corporations with significant business interest expense affected by this revision are calculating the deduction correctly.
8. Successor liability for indirect tax from prior acquisitions. Taxes on payroll, sales, property and unclaimed property remain with the tax ID of the company and may pass on to the buyer. These areas should be included in the diligence scope of every Target acquisition whether it be a stock or asset deal.
9. Unclaimed property. Each state has an unclaimed property statute governing when and what types of property must be relinquished to it. Examples of unclaimed property could be un-cashed or unclaimed refund checks, customer overpayments, insurance payments, payroll checks, vendor checks or even gift cards. If unclaimed after a certain period of time (dormancy period), those checks must be turned over to the state. To avoid possible unclaimed property liability, buyers should determine if the Target is properly addressing its escheatable property.
10. Golden parachute payment. Golden parachute payments, governed by IRC§280G, come into play when there is a change of control in a corporation. They impact the corporate entity and its executives, shareholders, and other highly-compensated individuals (“disqualified individuals”) associated with the corporation and can impose harsh tax consequences if not properly addressed. IRC§280G is triggered when any disqualified individual receives compensation payments in connection with a change of control in excess of three times his or her average annual compensation over the previous five years. The excess amount is subject to an additional 20% excise tax to the recipient and is non-deductible by the paying corporation. Due diligence should identify if these payments are being handled properly from a tax perspective, so liability doesn’t succeed to the buyer.
When it comes to acquiring a C corporation, thorough tax due diligence can help you avoid unknown liabilities, identify unrealized tax savings, and favorably structure your transaction. The experienced tax professionals at True Partners Consulting can guide you through the process. Contact Michael O’Connor at Michael.O’Connor@TPCtax.com or Michael DeRose Michael.DeRose@TPCtax.com.