Crucial Tax Due Diligence Issues for S Corporation Acquisitions
Thorough Tax Due Diligence is critical for private equity or venture capital acquisitions. Without it, buyers may risk finding themselves responsible for unexpected tax liabilities.
Though S corporations are flow-through entities—meaning that items of income and loss are allocated and subject to tax on the shareholders’ individual income tax returns—they still may create adverse tax implications for the buyer. Minor issues that may have flown under the IRS’ radar for years are much more likely to surface during a transaction. Here are some common issues that should be reviewed during tax due diligence of an S corporation:
1. Improper treatment of owner personal expenses. Is the S Corporation owner using a corporate account for any personal expenses? If so, these payments may be considered compensation and subject to payroll tax. If the employer’s share of payroll tax is unpaid, the buyer could be held liable for the amount owed after the acquisition.
2. Unreasonable owner compensation. Since an S corporation shareholder’s distributive share of income is not subject to self-employment or payroll tax, owners are often motivated to minimize their salary in favor of non-wage distributions. However, if the IRS determines an owner’s salary to be too low based on multiple factors including profits and the work being performed, non-wage distributions could be reclassified to wages subject to employment taxes. The buyer may be responsible for this tax if it isn’t resolved before the acquisition.
3. Related party transactions. A related party transaction takes place between two parties that hold a pre-existing connection prior to a transaction. There are many types of transactions that can be conducted between related parties, such as sales, asset transfers, leases, lending arrangements, guarantees and allocations of common costs. These transactions can become problematic when an S corporation utilizes them as a vehicle to get extra cash out of the business. For example, Company A and Company B (an LLC) are under the same ownership. Company A rents a building from Company B but is paying inflated rent to avoid compensation and additional payroll tax. Problematic related party transactions should be addressed during due diligence.
4. Valid S corporation qualification. The rules governing S corporations have strict standards for eligibility. If these are not continually met, a corporation’s S qualification is invalid and the corporation is treated as a C corporation. This can lead to substantial federal and state income tax as well as interest and penalties for tax years beginning with the election termination date. A purchaser could then be liable for any historic corporate income tax liabilities. Therefore, it’s essential to determine if the business you’re acquiring is indeed a valid S corporation.
5. Built-in gains tax. When a corporation has converted its status from C corporation to S corporation or has acquired assets from a C corporation in a tax-free transaction, and sells within 5 years, it may be subject to a corporate-level “built-in gains” tax in addition to the tax imposed on its shareholders as a result of the transaction. The buyer can leverage its knowledge of a potential built-in gains tax liability, as identified in the due diligence process, to negotiate with the seller such that the buyer would not inherit said liability.
6. 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.
7. 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.
8. Unclaimed property. Each state has an unclaimed property statute governing when and what types of property must be remitted to the appropriate state authority. For S-corporations, 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 S corporation is properly addressing its unclaimed property liabilities.
9. Successor liability for indirect tax from prior acquisitions. Usually entity level liabilities don’t succeed to the buyer because S corporations 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.
10. Qualified business income deduction. With the passage of the 2017 Tax Cuts and Job Act, some S corporations will be eligible for the new qualified business income (“QBI”) deduction starting in the 2018 tax year. In short, business owners 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 owner’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.
11. 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 an S corporation, 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 at Michael.DeRose@TPCtax.com.