11 key tax M&A considerations for the technology industry
Areas of tax focus when selling a technology company
INSIGHT ARTICLE |
Technology businesses continue to strive for innovation while increasing value and driving growth. As these companies begin to consider potential transactions or an IPO, they may not be prepared for the challenges of the process. If the company’s exit strategy is a sale, the structure can significantly affect the net-of-tax cash proceeds that sellers receive from a transaction. Companies should also consider what tax benefits the buyers and sellers would receive from the transaction. Lastly, companies need to determine if tax risks have been property evaluated prior to seeking buyers and entering into a diligence process. To that end, we’ve compiled some important tax related concerns and opportunities that all technology organizations need to consider for a transaction.
- Identification and resolution of historical income tax liabilities: Sellers need to be aware of any tax risks that the business may have. Not knowing the tax exposures before the sale could lead to surprises during the diligence process, potentially causing delays or, at worst, undoing the entire transaction. Companies should review their overall tax landscape including federal and state income tax, sales and use tax, franchise tax, payroll tax, property tax, and international tax, if applicable. Remediation efforts can be initiated for any exposures identified before buyers conduct their own diligence. In addition, sell-side tax diligence reports are prepared and act as a valuable tool to be shared with prospective buyers, resulting in a more efficient sales process.
- Pre-sale structuring: An initial step taken by a technology company should be to understand the current tax structure of the business and calculate and model the business entity's specific tax consequences resulting from a possible transaction. This will help a company identify optimal structures that could maximize the seller’s post-tax cash proceeds from a transaction.
- Tax attributes: Quantifying a company’s tax attributes in a transaction is often something that technology companies may not initially consider. Research credits and net operating loss carryovers can be a valuable asset but may be limited in a transaction. Often, companies that have generated tax losses don’t want to spend money for research studies to quantify the amount of tax credits that may be available. In addition, these companies may also have undergone changes in their equity structure over time that could limit the amount of net operating losses and tax credits that are available post-transaction. It is important for both the sellers and buyers to understand what tax attributes exist, and the availability of those attributes subsequent to a transaction.
- Deferred revenue: For financial statement purposes, technology companies have adopted the new ASC 606 guidance to recognize revenue, depicting the transfer of goods or services to customers in an amount that reflects consideration to which the entity expects to be entitled in exchange for those goods or services. This adoption has led many technology companies to review their accounting methods for tax purposes as well. For U.S. federal tax purposes, Rev. Proc. 2004-34 generally allows a taxpayer to defer (to the next succeeding taxable year) the inclusion in gross income for federal income tax purposes of advance payments to the extent the advance payments are not recognized in revenue in the taxable year of receipt. Companies can defer revenue in a manner consistent with GAAP in year one, and the remaining balance would be recognized in the succeeding tax year. In addition, under the amended section 451, all revenue for tax purposes shall be recognized into income no later than when taken into account within the company’s applicable financial statements. These items should be closely reviewed prior to a potential transaction to ensure the company is on a proper tax accounting method as this can affect a buyer post-acquisition. In addition, depending on the structure of the sale considered, certain transactions may result in the immediate recognition of all previously deferred revenue, such as when a transaction results in the company ceasing to exist or joining a consolidated C corporation group.
- Section 280G (golden parachute payments) analysis: Technology companies structured as C corporations must consider the change-in-control provisions under IRC section 280G when anticipating a transaction. Golden parachute payments are meant to provide management a soft landing when their company has a change-in-control event. When a change in control occurs, section 280G limits the corporation's deductions for excess parachute payments, and an excise tax could be imposed on the individual recipients of the payments based on the amount of any excess parachute payment received. A section 280G analysis determines (1) if excess parachute payments exist, (2) the section 280G deduction limitation and (3) potential excise taxes applicable to disqualified individuals receiving change-in-control payments. Private companies have the opportunity to avoid the adverse tax consequences by taking certain actions and securing shareholder approval of the excess parachute payments through a shareholder vote. However, a section 280G analysis must still be completed to support the required actions and the necessary disclosures.
- Credits and incentives: Technology companies, particularly in the software development realm, may be generating estimated research and development credits yearly. However, often no formal study has been completed. These companies should consider performing an R&D tax credit study to document and support the historical federal and state research tax credits that could be valuable to a buyer in a potential transaction. Companies considering potential M&A activity should also review state and local credits and incentives available such as sales and use tax exemptions and refunds, opportunity zones and capital investment credits that they could potentially be eligible for and therefore create more value to the business upon a sale.
- Sales and use taxes: Historically, software businesses required physical presence in a state to have sales tax nexus. The 2018 U.S. Supreme Court’s decision in South Dakota v. Wayfair set a new precedence for economic nexus that no longer requires physical presence. The Wayfair decision will have a far-reaching impact on technology businesses, as states will be able to assert economic nexus over the industry. Some states already have economic nexus sales tax provisions in place, while many other states will likely begin to enact such provisions in the near future. Sales and income tax nexus has therefore become one of the more significant areas of exposure in the diligence process.
- Transaction costs: Companies can incur significant expenses in connection with a transaction. It takes both planning and proper analysis for a party to a transaction to maximize the tax benefits from transaction costs incurred, including a determination of which party receives the benefit of any costs. When a company engages in a transaction, the IRS requires that costs incurred to facilitate the transaction be capitalized. With stock transactions, these costs are capitalized into stock basis and are not recoverable until such stock is sold. Alternatively, with asset transactions, these costs are capitalized and generally amortized over 15 years on a straight-line basis. In contrast, costs that do not facilitate a transaction can generally be deducted as incurred or amortized over 15 years. By performing a transaction cost analysis, a company can identify nonfacilitative costs and maximize tax deductions. Without proper documentation, all costs must be capitalized, and no immediate tax deductions can be recognized.
- International presence: Many companies in the technology industry begin to expand internationally to increase growth and reach customers outside of the United States. Companies should review their international presence before a potential transaction and understand the company’s position, and potential exposures, in the following areas: cross-border employees, foreign earnings and profits, including tax pools, permanent establishment, subpart F and cash repatriation strategies, transfer pricing, withholding taxes, and foreign bank account reporting.
- Worker misclassification: Technology companies often employ independent contractors in areas such as sales and software development. Businesses often prefer to shift the responsibility for payroll taxes and employee benefits to their workers to save money and lessen the company’s administrative burden. However, the IRS closely reviews worker classifications (employee vs. independent contractor) and businesses need to review their independent contractor agreements to ensure their workers are properly classified. It is important to be sure their independent contractors should not ultimately be treated as employees, with proper payroll taxes and benefits withheld.
- Abandoned and unclaimed property: Unclaimed property is defined as any tangible or intangible property that is held, issued or owned by a company in the course of its business that has remained unclaimed for a specific period of time (dormancy period) by the rightful owner. Unclaimed property can be in the form of outstanding transactions such as accounts payable, accounts receivable, payroll checks, customer and credit balances, unclaimed property, or escheat, is not a tax. However there is no statute of limitations for unclaimed property unless a state enacts special legislation. This ultimately means a state unclaimed property audit could potentially go back 20 years, where states may determine a year of exposure and extrapolate that exposure over an extended period of time as many companies do not keep the appropriate records. There are voluntary disclosure programs companies may enter into prior to a transaction to rectify any potential exposures that arise in this area.
If your technology company is considering a transaction or an initial public offering, the tax implications of the sale should not be overlooked. Proper due diligence should be performed in order to maximize value.