Here in the Northeast, this Fall season has been filled with tranquil weather that invites us to get out for that last round of golf, long bike ride or outdoor exercise without being concerned about bundling up. However, Northeasterners know that this Fall’s tranquility should not lull anyone into complacency about how demanding the upcoming Winter might be.
Neither should multistate business tax advisors nor management be lulled into complacency about the potentially significant immediate and long term state tax ramifications that may arise from not timely and comprehensively planning the state tax process around the liquidation or merger of related entities.
In this post, we will continue our discussion from our previous Fall Clean Up – SALT Considerations are Crucial When Merging or Liquidating Corporate Entities.
Loss of State Income Tax Attributes
In reviewing the potential state tax ramifications that may result from merging or liquidating one or more entities, the following should be completed before taking the plunge:
- careful identification, review and analysis of potential loss of state income tax attributes, i.e.
- net operating losses
- state versus Federal tax basis differences
- eligibility for industry specific state tax benefits
For example, in some states a corporation’s Net Operating Losses (“NOLs”) may be lost if the corporation that generated the NOLs is not the surviving entity in a corporate merger.
The loss of such attributes may have immediate and significant financial statement consequences. For example, let’s assume that:
- Corporation A files in 20 states and has a $10 million net operating loss carryover attributable to State X.
- For financial statement purposes, there is not a valuation allowance established for the deferred tax asset attributable to Corporation A’s net operating loss in State X.
- Parent Company seeks to merge Corporation A into its affiliate Corporation 1 or liquidate Corporation into Parent Company.
- State X’s corporate tax rate is 9%.
- State X’s statutes, regulations and administrative guidance indicate that if a corporation that has a net operating loss carryforward is merged out of existence or liquidated up into its parent, that corporation’s net operating loss is not an attribute that survives to the successor entity to the merger or to the parent.
Result: Merging Corporation A into Corporation 1 or liquidating Corporation A into Parent Company will result in a $900,000, pre-Federal benefit, state tax cost on Corporation A’s financial statements. Why? Because Corporation A’s net operating loss in State X will disappear upon its merger into Corporation 1 or liquidation into Parent Company. Once either is done, the state tax benefit of Corporation A’s net operating loss in State X is gone forever!
State Income Tax Filing Methodology and Apportionment Considerations
Merging or liquidating related corporations into affiliated entities may have significant costly state income tax filing methodology and apportionment ramifications. Such ramifications may not be limited to only separate return state filings.
Let’s look at the following example and assumptions:
- Corporation A files in 5 states in which it has locations and employees.
- Corporation A’s sales into State X are $50 million. Its total sales are $100 million.
- Corporation A’s state taxable income is $10 million
- Corporation A does not have any nexus in State X as its activities are limited to those protected under Public Law 86-272.
- State X applies a Receipts factor only to apportion income to the state.
- State X is a separate return state for corporate income tax purposes.
- State X’s corporate tax rate is 9%.
- Corporation B files in State X. Corporation B’s total sales are $50 million of which $40 million are in State X.
- Corporation B’s state taxable income before apportionment is $1 million.
- Company management wishes to merge Corporation A into Corporation B – which we will call Bigger Corporation B.
The merger of Corporation A into Corporation B results in an increase in Bigger Corporate B’s tax in State X of $522,000. Why? Because prior to the merger, Corporation A’s income was not subject to State X corporate income tax as Corporation A did not have corporate income tax nexus in State X. Post- merger, the Bigger Corporation B’s income increased by $10 million to $11 million. Although Bigger Corporation B’s receipt factor decreased from 80% to 60%, legacy Corporation A’s income of $10 million was now apportioned to State X at a 60% apportionment factor and subject to State X tax of 9%.
As the above example demonstrates, merging or liquidating a related entity may increase the organization’s corporate income tax in separate returns states.
However, in addition, such mergers or liquidations my also increase the organization’s corporate income taxes in combined states that follow the Joyce rule with respect to combined member entities. A concise summary of the Joyce rule versus the Finnigan rule may be found at an article in martindale.com titled Franchise Tax Board Adopts Regulations to Implement the Finnigan Rule.
Proper Fall Preparation Facilitates Winter Ease Of Mind
Just as indicated in Kiplinger’s 15 Ways to Prepare Your Home For Winter, comprehensive state tax due diligence and analysis done in the “lull” of the pre-merger time should minimize post-merger and liquidation sleepless nights.