1) STATE AND LOCAL TAX DUE DILIGENCE: WHAT’S THE EXPOSURE? By Jon P. Skavlem, CPA and Phillip A.H. Roemaat, J.D., CPA A s the U.S. economy continues to recover from the last recession, the pace of business acquisitions, mergers, recapitalizations and venture capital transactions has accelerated. Globally and in the U.S., initial A key area of tax due diligence investigations involves state and local taxes income, franchise, sales and use, withholding, unclaimed property and other levies. It is no secret that state and local budgets were rocked by the recession. In an effort to close fiscal deficits, they passed aggressive new tax public offering activity in the first half of 2013 was laws and ramped up enforcement efforts, initiating more than double the first half of 2012. Private more nexus actions, bringing technology to audits, equity investors have been especially busy. A and adding new staff. 1 necessary outgrowth of this has been an increased As the owners of a company contemplate selling, demand for tax due diligence work on the part of the historical state and local tax filings and activities CPA firms and corporate tax departments. will be a focus of a sophisticated buyer. In the 1 16 Katz, “State Insecurity,” CFO Magazine (April 2011), www.cfo.com/magazine (click on “View Back Issues”). On Balance November|December 2013 Reposted with permission from On Balance, the magazine of the Wisconsin Institute of Certified Public Accountants www.wicpa.org 

2) past, the potential buyer focused primarily on the and warranties such that the seller continues to entity’s federal return positions. With the advent of have responsibility to pay prior state and local tax FIN 48 (now ACS 740), it became clear that state and obligations. In most states but not all, past income local tax exposures often exceeded federal exposures. and franchise tax liabilities remain with the entity if Professional due diligence teams now routinely inquire the buyer acquires an ownership interest, e.g. stock about such issues as sales and income tax nexus, acquisition. combined reporting, pass-through entity taxes and compliance with unclaimed property laws. It’s important for both the buyer and seller to To help mitigate risks for both the buyer and the seller, the agreement may include baskets and caps. Baskets provide a minimum amount before the understand all material state and local filing positions purchaser can recoup funds from the seller for the tax before concluding a sale. If a substantial liability is liabilities it assumed. Caps define the maximum amount identified, it can threaten the viability of the deal or that a buyer would have to return to the seller for its drastically reduce the sale price. Given that the price exposure. Additionally, an escrow fund may be provided is often pegged to a multiple of earnings, changing so that the tax claims of a purchaser will be satisfied the earnings to reflect unrecorded taxes that would after the transaction closes. However, the due diligence otherwise be assumed by the buyer can have a substantial impact. If the deal is cancelled, the buyer and seller are both at a loss given the amount of professional fees incurred during due diligence and negotiations. During the sale process, sell-side risk identification of state and local tax issues should commence well in advance of sale, typically six to 12 months before engaging investment bankers, attorneys and other and negotiation processes are not exact and amounts put in escrow for potential state and local tax exposures may prove inadequate or the terms of the warranty period too short. State and local tax: Areas of risk State and local tax exposures can be many in number and varied in nature. This article is the first of two articles. This article focuses on tax due diligence key professionals. For the buyer, a due diligence team generally and how it relates to state income and normally reviews the historical prior year state and franchise taxes. The second article, which will appear in local filing positions after a letter of intent (or a similar the January/February 2014 On Balance, will highlight document) and nondisclosure agreement are executed. sales and use taxes and ways to remediate state It should not be assumed that state and local tax exposures can be side-stepped by the buyer if the deal is structured as an asset purchase. Sales and use tax and withholding taxes are treated as successor liabilities and local tax exposure that might affect a pending transaction. Income, franchise, and gross receipts taxes in many states. They can be pursued against either the When assessing a company’s state and local tax buyer or the seller unless a tax clearance certificate is risk, income, franchise, and gross receipts taxes are obtained or similar procedure is followed. the conventional starting point. Due diligence efforts Another way to deal with this risk is to carefully craft the buy-sell agreement’s tax representations www.wicpa.org should focus on where the company’s activities are versus what states and localities it files returns in. The On Balance Reposted with permission from On Balance, the magazine of the Wisconsin Institute of Certified Public Accountants November|December 2013 17 

3) operational territory of employees and location of the Business Tax, which imposed both an income and a company’s property is a good first indicator of where gross receipts tax.11 Since these are not income taxes, the company should be filing. For companies that sell they generally have different nexus thresholds and can tangible personal property, e.g., retailers, manufacturers, create liabilities even if the company posts a net loss for distributors, etc., Public Law 86-272 can provide the year. protection, although limited in nature, from income taxes nexus.2 An emerging jurisdictional concept among states is that of “economic nexus.” Under this concept, a taxpayer is deemed to be doing A growing number of states, including California, Illinois, Michigan, Massachusetts, Minnesota, New York, Texas and Wisconsin, require corporations that conduct a “unitary business” to file a combined return. business in a state based on the amount of economic In some cases, combination on a worldwide basis is activity, e.g. sales, it has within a state even if the necessary in the absence of a proper election to exclude taxpayer lacks traditional measures of nexus such as foreign affiliates. Proper due diligence requires a target physical presence. Businesses dealing in intangibles, company’s filing position be examined to determine if a e.g. software, or providing services, are particularly return should have filed on a combined basis and if so, exposed to economic nexus risk. State and local tax what entities were includible under state law. 3 due diligence should focus on states like California, Colorado and Connecticut if investigation reveals activity but no returns have been filed. Multistate apportionment can also entail state tax exposure risk. Sales factor sourcing rules for service and intangibles companies are complex. Failure to understand when to apply the cost-of-performance approach, e.g., proportionate method and the plurality method4 versus benefits derived5 can lead to material income, franchise and other business entity tax liabilities. Do not overlook local tax filings in the due diligence process. Many municipalities have income or other business entity taxes that can be material. New York City, Philadelphia, Louisville and various communities in Ohio impose such taxes. If available, the target’s tax calendar of due dates provides a convenient roadmap for someone outside the company to understand where it files and due dates to be aware of. Reviewing on-going and prior year audits can bring other state exposures to light. Organizing these documents in advance of a buy-sell transaction While income taxes often create state and local tax (both in a paper and electronic format) is recommended. exposure, a number of states impose taxes based on stock.7 Other taxes that can come into play include gross receipts taxes, like Washington’s Business and Occupation Tax8, Ohio’s Commercial Activities Tax9, the Texas Franchise Tax10 and the now defunct Michigan Jon P. Skavlem, CPA is a director in the State and Local Tax group at Baker Tilly Virchow Krause, LLP in Milwaukee. Contact him at 414-777-5333 or jon.skavlem@bakertilly.com. Phillip A.H. Roemaat, J.D., CPA is a manager in the State and Local Tax group at Baker Tilly Virchow Krause, LLP in Milwaukee. Contact him at 414-777-5445 or phillip.roemaat@bakertilly.com. Interstate Income Law, 15 U.S.C. §381 through §384 (known to state and local tax practitioners as P.L. 86-272), 3 See Cal. Rev. & Tax § 23101 Compare, N.C. Gen. Stat. § 105-130.4(l)(3) and Tex. Tax Code Ann. §171.103(a)(2) with Cal. Rev. & Tax § 25136 for taxable years beginning prior Jan. 1, 2013 and 72 Pa. Stat. Ann.§ 7401(3)(2)(a)(17), 5 See, e.g. Wis. Stat. § 71.25(9)(dh)(1); 18-125 ME Code R. § 801.05E(1); Cal. Rev. & Tax § 25136 for taxable years beginning after January 1, 2013, 6 Ga. Code Ann. § 48-13-72, 7 Pa. Stat. Ann. § 7602, 8 Wash. Rev. Code § 82.04.220 a, 9 Ohio Rev. Code § 5751.02, 10 Tex. Tax Code. Ann § 171.001, 11 Mich. Comp. Laws Ann. §§ 208.1201, 208.1203 2 4 18 On Balance November|December 2013 Reposted with permission from On Balance, the magazine of the Wisconsin Institute of Certified Public Accountants www.wicpa.org shutterstock.com the corporation’s net worth6 or the value of its capital