M&A Structuring Opportunities Using State-Level Transfer Entity Tax Regimes – Tax

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State-level flow-through entity tax (TFTP) regimes provide structuring opportunities in M&A transactions involving S-corporate targets. TFTP regimes have been adopted by a growing number of states as a workaround the $10,000 limit imposed on the deductibility of state and local taxes from federal personal income tax (the SALT cap) as part of the 2017 federal tax reform (commonly referred to as the taxes and employment).1 TFEP regimes can provide significant tax savings opportunities to sellers of targets treated as S corporations in M&A transactions structured as asset sales for income tax purposes , thereby better aligning sellers’ after-tax goals with buyers’ traditional preference for the domestic tax base stage. -at the top.

Business acquisitions are often structured as the acquisition of equity interests in the target business entities rather than the acquisition of their assets. This practice has developed due to various business considerations (it could be very difficult to transfer significant assets, contracts, and employees relative to an entity’s ownership), including the often significant incremental tax costs. resulting from the sale of assets by entities treated as corporations for income tax purposes.

Even where transactions are structured as the acquisition of interests in targets for business purposes, it is sometimes possible that such transactions may be treated as acquisitions of assets for federal income tax purposes (treatment hybrid). In particular, where a target is treated as an S corporation for federal income tax purposes, certain tax elections and structuring alternatives (see below) provide the flexibility to achieve such hybrid treatment. Buyers would generally prefer the transaction to be treated as a purchase of assets for income tax purposes, as this hybrid treatment allows buyers to benefit from the increased internal tax base of the target’s assets. (thereby increasing potential deductions for depreciation and amortization) . However, such hybrid treatment often entails additional tax costs for sellers, in particular due to the fact that part of the gain is subject to tax at the least favorable income tax rates applicable to ordinary income, income taxes at the state level and, in certain circumstances, differences between internal and external. Therefore, the willingness of sellers to engage in such hybrid processing transactions is generally dependent on the buyers’ agreement to make gross-up payments to cover the sellers’ additional tax costs (the gross-up payment). The willingness of buyers to make increased payments generally depends on, among other things, the expected amount of cash tax savings resulting from the additional tax deductions attributable to the increase in the tax base of the underlying assets and the total amount of the increased payment.2

The acquisition of equity interests of a Company S target can generally be structured to allow for hybrid treatment (i.e. treatment like the acquisition of the underlying assets of that Company S target) by using one of two alternatives. First, the parties may agree to make certain federal income tax elections (ie, an election under section 338(h)(10) or section 336(e)).3 Alternatively, sellers may engage in reorganization steps relative to target that are intended to receive tax-exempt treatment under Section 368(a)(1)(F) (commonly referred to as reorganization F). Under the first alternative (an election under section 338(h)(10) or section 336(e)), the sale of the shares of Corporation S is treated for federal income tax purposes. income as a sale of the company’s target S corporation’s underlying assets. Under Reorganization Alternative F, the Sellers would generally contribute Company S Target’s interest in a newly formed holding company, elect to treat Company S Target as a “Qualifying Sub-Chapter S Subsidiary and then convert that entity into a limited liability company (Target LLC).4 Immediately prior to purchase, the Target LLC is treated for federal income tax purposes as disregarded by its sole owner (the newly formed holding company). Accordingly, when the purchaser purchases interests in Target LLC, the purchaser is deemed, for federal income tax purposes, to purchase the assets of Target LLC. While both alternatives should generally yield the same federal income tax result, Reorganization Alternative F provides better protection for the purchaser to obtain asset purchase treatment in the event that the statute of the target as an S corporation would later be challenged by the Internal Revenue Service. In either case, careful consideration must be given to the state and local tax treatment of the target for income tax purposes, as several states and localities (including the District of Columbia, Louisiana, New Hampshire and New York City) do not track federal income. tax treatment of S corporations.

In an attempt to ease the burden of the SALT Cap on their residents, a growing number of states (primarily those with higher tax rates, such as California, Massachusetts, New York, and New Jersey),5 have adopted TFW regimes. Under a typical TFWP regime, rather than having the shareholders of an entity treated as a partnership or S corporation for applicable state income tax purposes (a flow-through entity) pay the entity’s income tax on their respective tax returns, that flow-through entity may elect instead to pay state tax on its entity-level income (the TFEP).6 Because the flow-through entity (unlike its individual shareholders) is not subject to the SALT cap, the income attributed to its shareholders with respect to the entity’s income generally reflects deductions for state taxes paid by the entity. For state tax purposes, stock owners are generally entitled to a credit on their state income taxes equal to their share of the TFWP.seven When TFWP plans were first introduced, there was some uncertainty as to whether the Internal Revenue Service would challenge their deductibility for federal income tax purposes. In Notice 2020-75, issued November 9, 2020, the Internal Revenue Service announced its intention to issue proposed regulations that would generally confirm and clarify the validity of these TFWP plans.

TFWP regimes offer sellers potentially substantial tax savings on mergers and acquisitions transactions that are treated for income tax purposes as asset sales (as well as real assets). As a result, the amount of an up-payment required by S corporation sellers can be significantly reduced (and in some cases eliminated altogether), better aligning sellers’ after-tax goals with traditional corporate appetites. buyers for the tax basis. step by step. Although this may not be the result of all transactions, the effect of TFEP regimes (as a workaround to the SALT cap) should be considered in determining the desired structure for M&A transactions involving flow-through entities, including S corporations.

Under current law, the SALT cap is scheduled to expire for tax years beginning after January 1, 2026. The House of Representatives has passed a bill that would extend the SALT cap from 2025 to 2031.8 The same bill also proposed to increase the SALT cap from $10,000 to $80,000.9 An increase in the SALT cap may help reduce its impact on some taxpayers in the normal course. However, unless the SALT cap is completely eliminated, the benefit of TFWP regimes is expected to remain a very important factor in determining the structuring of M&A transactions involving FTEs.

Footnotes

1
See Section 164(b)(5) of the Internal Revenue Code of 1986, as amended (the Code). As currently in effect, the SALT cap applies to tax years beginning between January 1, 2018 and December 31, 2025.

2 In the case of a target corporation that is not treated as an S corporation, the additional tax cost of a sale of assets (or a sale of shares of that corporation with an election for hybrid treatment , in the limited circumstances in which such treatments are possible) is usually far too large (compared to the net present value of the cash tax savings) for a buyer to be able to afford.

3 Unless explicitly stated otherwise, all section references are to the Code.

4 The exact mechanical steps involved in such a conversion depend on the corporate laws of the applicable state in which target S and target LLC are organized. Some states allow a conversion to a limited liability company by filing articles of conversion (or similar form), while in other states “conversion” requires amalgamation of the former target company S into a newly formed limited liability company.

5 The list of states with the current TFWP regime includes Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, New York, New Jersey, Oklahoma, Oregon and Rhode Island. , South Carolina and Wisconsin.

6 While most TFW regimes adopted to date require a positive election in such a regime (eg, Massachusetts, New York), application of the TFW regime in Connecticut is mandatory.

7 The credit regime varies from state to state.

8See HR 5376, 117th Congress, Rules Cmte. Print 117-18 § 137601 (as passed by the House of Representatives, November 19, 2021).

9 See id. as modified by amendment printed in H. Rept. 117 – 173.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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