Fall is a beautiful time of year – a time for cleaning up our gardens and preparing for the rigors of winter. It’s also when many organizations review their budgets in preparation for their next fiscal year – which is where they can run into state and local tax trouble.
One of the more common corporate activities at this time of year is the “cleaning up” of a company’s legal organization chart. During this time, management reviews its entities and decides whether the organization should consolidate its operations – often leading to the liquidation or merger of several entities.
Such consolidations can result in significant and onerous state and local tax consequences and costs. This post is the first of a series that identifies some significant and immediate state and local tax considerations that multistate taxpayers and their advisors must consider before their organization merges, liquidates or forms new entities within their organization structure.
Future posts will do a deeper dive into other SALT issues that can crop up when companies clean up their legal entity charts.
Multistate Tax Organizational Considerations
Despite the very real state and local tax effects of these kinds of entity cleanups, countless management, corporate counsel, external business “consultants” and IT executives have innocently asked me, “What could possibly be the state and local tax costs of liquidating or merging two or more commonly owned entities?”
I usually take a deep breath and then inform them that there are significant considerations and ramifications they need to address before an organization with multistate operations merges, liquidates or modifies their organization or operations. Perhaps the most important of such considerations is Nexus.
Careful analysis of the state income, gross receipt, sales and use tax nexus ramifications arising from the merger, liquidation or modification to an organization’s entity structure chart should be completed prior to any change in operations or organization structure. A merger or liquidation may result in significant change in an organization’s state tax compliance responsibilities as well as tax increased state tax costs.
Consider Company A, which has sales tax nexus in 30 states but sells its product exclusively to exempt entities, i.e. non-end-users, for which it has all of the appropriate exemption certificates in its files. Company B (its parent or sister entity) only files in five states common to Company A. Company B sells its products to taxable customers as well as exempt customers. The organization seeks to merge or liquidate Company A into Company B.
Prior to merging or liquidating Company A into Company B, a thorough analysis of Company B’s new sales tax compliance requirements must be undertaken – most notably, Company B may be required to register in each of the additional 25 states where Company A has sales tax nexus. Company B may be required to charge sales tax in each of those additional 25 states. Finally, more likely than not Company B will be required to get new exemption certificates from all of Company A’s legacy customers. Why? Post-merger or liquidation of Company A into Company B, Company B will be the vendor and the resale certificates received by Company A’s customers were issued with Company A as the vendor.
State and Local Transfer Taxes
States and localities have specific transfer tax, recording fees and registration costs that may be triggered when a related entity is merged or liquidated into a sister or parent entity. The most common of such transfer taxes is sales tax. The potential sales and use tax ramifications must be thoroughly reviewed prior to the merger or liquidation of commonly owned or controlled entities.
In addition, a thorough analysis and careful consideration of the potentially numerous state and local transfer taxes, recording fees and real property lien or mortgage taxes should be completed prior to the commencement of any merger or liquidation of any entity into its sister or parent entity.
Timing Is Everything!!!
Each of these considerations has a common and potentially costly common concern – timing. The state and local nexus and transfer tax considerations must be undertaken before the liquidation, merger or consolidation of related entities.
The following illustrates the potential danger and significant cost of delaying the analysis. Let’s continue with our earlier example’s assumptions.
- Company A is a registered vendor and files sales and use tax returns in 30 states.
- Company A will be merged into Company B that files sales and use tax in only 5 states in common with Company A.
- Company A has $10 million of inventory, therefore has nexus, is registered as vendor for sales tax and files sales tax returns in State X.
- Company B does not have nexus nor is it registered as a vendor for sales tax in State X.
- As part of the merger, Company A will be transferring its $10 million of inventory located in State X to Company B – remember Company B is not registered as a vendor in State X.
- Let’s assume that State X’s sales tax rate is 8%.
If Company B does not become a registered vendor in State X before Company A transfers its inventory located in State X to Company B, the transfer of the inventory may become subject to sales tax even though Company B will be reselling all of Company A’s inventory!
Why? State X could successfully assert that Company B is not eligible to rely on the State X’s resale exemption provisions. Why? First, State X’s exemption provisions require that in order to be eligible to rely on a resale certificate, the “purchaser” or transferee entity must be registered as a vendor for sales tax in State X. Company B is not registered as a vendor in State X. Secondly, State X has “non cure” provisions that do not permit retroactive documentation of an exemption – so Company B can’t register after the transfer takes place and “retroactively” cure the deficiency. Lastly, State X does not accept another state’s resale certificate or the MTC UNIFORM SALES & EXEMPTION /RESALE CERFICIATE – MULTIJURISIDICTION exemption certificate.
Result: This “tax-free” merger just cost Company B $800,000 in sales tax because the necessary SALT analysis was not completed before the transaction!
As with a tree, pruning an organization’s legal entity structure is valuable, if not essential, to the long term heath of the organization. Great care and consideration of the many state and local tax consequences should be completed prior to undertaking the “pruning” of an organization’s legal entity structure.
Make sure you coordinate your organization’s legal entity pruning with your state tax experts. Failure to do so may be extremely costly and hurt the organization as a whole.