Crucial Tax Due Diligence Issues for Acquisitions of Partnerships and LLCs
While Partnerships and LLCs are flow-through entities—meaning that items of income and loss are allocated and subject to tax on the members’ individual income tax returns—they still may come with adverse tax implications for the private equity or venture capital buyer. Conducting detailed due diligence on a target you’re considering acquiring is a must in today’s complex tax environment. Here is a list of some common issues that should be reviewed during tax due diligence of a Partnership or LLC:
- Non-resident withholding. State and local governments are permitted to tax not only the income of their residents but also the income of nonresidents if that income is derived from sources within their state or locality. It’s important to ensure that the Partnership or LLC is in compliance with state and local income tax regulations.
- Cash vs. accrual accounting method. The accrual method is preferred by the IRS, but if a company is on the cash basis of accounting, the buyer should determine if they meet the requirements to continue to use that method. The change in accounting method from cash to accrual may result in additional income that could be recognized in the post-closing period. By identifying the issue and quantifying the potential exposure, the buyer and seller can negotiate who will bear the tax on the additional income.
- Nexus for state income and sales tax. The historic U.S. Supreme Court Wayfair ruling last summer has increased the complexity of state 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 states have been shifting to market-based sourcing for services income. Typically taxes are due to the state in which the services are performed. Market-based sourcing rules also empower states to claim nexus if the benefit of that service was received by a customer in that state. Nexus has become incredibly complex and an increasing number of states are aggressively pursuing back taxes under these new rules. A thorough nexus analysis is critical.
- Unclaimed property. Each state has an unclaimed property statute governing when and what types of property must be remitted to the appropriate state authority. 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), these types of property must be turned over to the state. To avoid unexpected problems down the road, buyers should determine if the LLC or Partnership is properly addressing its unclaimed property liabilities.
- Successor liability for indirect tax from prior acquisitions. Usually entity level liabilities don’t succeed to the buyer because LLCs and Partnerships are flow-through entities. However, taxes on payroll, sales and use, property and unclaimed property remain with the tax ID of the company and may pass on to the buyer.
- Qualified business income deduction. With the passage of the 2017 Tax Cuts and Job Act, some LLC and Partnerships will be eligible for the new qualified business income (“QBI”) deduction starting in the 2018 tax year. In short, members can deduct up to 20% of their QBI or, if lower, 20% of their taxable income net of any capital gain. This deduction is claimed on the business partner’s individual return. During due diligence it should be determined if the company to be acquired is eligible for this deduction and their current QBI calculation process should be evaluated.
- Improper independent contractor classification. While some employers misclassify their employees as independent contractors in error, others do it intentionally to avoid paying federal and state payroll taxes. Employers that are found to have misclassified their employees may be subject to the employer’s share of payroll taxes in additional to penalties that could then be passed on to the buyer. During due diligence it’s important to determine if independent contractors should be considered full-time employees in order to identify the purchasers potential payroll tax exposure with respect to misclassification of employees. The IRS utilizes a 20-factor test to help make that determination with considerations such as employer control, schedule flexibility, method of compensation and whether or not the employee works for other employers.
When it comes to acquiring a Partnership or LLC, thorough tax due diligence can help you avoid 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.