Business mergers, acquisitions and restructurings involve legal, regulatory and tax components. Important among the tax components are various state tax issues that may include corporate income and franchise taxes, sales and use taxes (“sales tax”), as well as other taxes. In addition to considering taxes on the transactions, other state tax issues to be considered include potential liability for a seller’s unpaid taxes, changes to a company’s nexus and changes to reporting income. In this article, we highlight six state tax issues to consider: (1) tax bulk sales laws; (2) nexus; (3) instant unity; (4) state treatment of Internal Revenue Code (“I.R.C.”) Section 338(h)(10) transactions; (5) sales taxes; and (6) real estate transfer taxes. The foregoing six considerations are several, but not all, of the myriad state tax issues to consider when engaging in such transactions.1
Tax Bulk Sales2
Many states have adopted tax bulk sales laws that may hold a purchaser of assets liable for a seller’s unpaid state tax liabilities.3 Such laws are intended to: (1) minimize the risk that a seller will sell some or all of the company’s assets without paying its outstanding state tax liabilities; and (2) provide an alternative means of recovery against the assets that may have contributed to the unpaid liability of the seller. The tax bulk sales laws should not be confused with the Uniform Commercial Code’s bulk sales laws that address non-tax liabilities.4 Under the tax bulk sales laws, purchaser liabilities can include sales taxes, corporate income taxes and property taxes that remain unpaid by the seller. However, mechanisms exist to reduce a buyer’s potential tax liability.
State Variations in the Types and Amount of Liability
For the most part, bulk sales laws operate by requiring an asset purchaser to withhold from the purchase price an amount equal to the seller’s unpaid state tax liabilities for taxes that are subject to that state’s bulk sales laws, including penalty and interest.5 If such amounts are not withheld (typically in escrow), the purchaser will be liable for the unpaid liability.6 The amount of a seller’s liability that a purchaser may inherit varies by state. Some states limit a purchaser’s liability to the amount of the purchase price, while in other states the liability for unpaid taxes may exceed the purchase price of the purchased assets.7 Some states apply bulk sales laws to “trust fund” taxes, e.g., sales taxes or withholding taxes.8 Other states apply bulk sales laws to additional taxes, including corporate income taxes.9 Moreover, the states are not uniform in their triggers for bulk sales laws. Some states’ bulk sales laws apply when a business transfers a substantial amount of assets.10 In other states, the bulk sales laws are triggered if even an insubstantial amount of a company’s assets are sold.11
Containing or Reducing Transferee Liability
States provide mechanisms for protecting a purchaser from becoming subject to the seller’s liabilities. Complying with these mechanisms may be the responsibility of the purchaser or seller of the assets, but typically is not imposed on both the buyer and the seller. If the state imposes the filing duty on a purchaser, the purchaser may be able to avoid liability by timely filing a notice of the transaction with the state and withholding an amount equal to the seller’s unpaid state taxes from the purchase price.12 In Colorado and Mississippi, the responsibility is imposed on a seller, yet the purchaser can also be liable for the seller’s unpaid state tax obligations if the purchaser does not obtain a receipt from the seller showing that the seller has paid its tax obligations.13 Moreover, deadlines for complying with such mechanisms vary and may precede the closing date of the transaction, making it important that bulk sales issues be addressed as early as possible in a transaction.14
Nexus – Corporate Income, Corporate Franchise and Sales Taxes
Business transactions may result in changes to the states with which a company has nexus or is subject to tax. Inasmuch as the corporate income, corporate franchise and corporate gross receipts taxes have similar considerations, they are referred to together as “corporate income taxes.”
Business Form May Affect the Nexus Consequences
The decision to operate a newly acquired company as a separate entity or as a division of the acquirer may have significant nexus consequences for purposes of corporate income taxes and sales taxes. For instance, take the example that prior to a transaction, Company A does not have nexus with State X, a separate entity reporting state. Company A acquires Company B, which has employees located in State X. Outside of the agency or affiliate nexus context, choosing to operate Company B as a division of Company A would result in Company A having nexus with State X.15 On the other hand, operating Company B as a separate entity should allow Company A to continue to not have nexus with State X.
The nexus consequences of operating a newly acquired business as a division or as a separate entity may affect corporate net income tax or gross receipts tax apportionment in combined reporting states. For instance, assume that under the above facts, Company A makes sales into State X, but is not subject to tax in State X because of Public Law 86-272. Assume for this example that State X is a combined reporting state, Company B is subject to tax in State X and when Company A acquires Company B the two companies conduct a unitary business. If State X uses a Finnigan rule, State X would require inclusion of Company A’s sales into State X in the sales factor numerator, regardless of whether Company B was operated as a division or separate entity.16 However, if State X uses a Joyce rule, Company A’s sales would not be included in the State X sales factor numerator if Company B is operated as a separate entity.17
Agency and Attributional Nexus Principles May Override Separate Entity Structures
The nexus consequences of operating a newly acquired company as a division or a separate entity may also depend on the extent to which agency or affiliate nexus principles apply. Several states assert agency or affiliate nexus theories as the basis for requiring a company that is not physically present in the state to collect sales tax or pay corporate income taxes. For instance, some states’ taxing authorities have asserted that certain activities conducted by third parties with whom a company had no contractual relationship established a sales tax collection requirement for a company that was not physically present in the state.18 One of the broadest sales tax collection statutes was enacted in Oklahoma, which provides that an entity is presumed to have a sales tax collection requirement if the entity is a member of a controlled group of corporations (as defined for federal income tax purposes) where that controlled group of corporations has a component member (as defined for federal income tax purposes) that is a “retailer engaged in business in [Oklahoma].”19 The Oklahoma statutes define a retailer engaged in business in Oklahoma broadly to include:
[a] retailer [that] holds a substantial ownership interest in, or is owned in whole or in substantial part by, a retailer maintaining a place of business within this state, and . . . the retailer sells the same or a substantially similar line of products as the related Oklahoma retailer and does so under the same or a substantially similar business name, or the Oklahoma facilities or Oklahoma employees of the related Oklahoma retailer are used to advertise, promote or facilitate sales by the retailer to consumers,20
as well as:
[a] retailer [that] holds a substantial ownership interest in, or is owned in whole or in substantial part by, a business that maintains a distribution house, sales house, warehouse or similar place of business in Oklahoma that delivers property sold by the retailer to consumers.21
Franchise Tax Consequences
Franchise tax issues are also important to consider. For income tax purposes, a state’s combined reporting rules may reduce the effects of exposing a company’s income to tax as a result of a merger or acquisition, e.g., through statutes that eliminate intercompany transactions or assign sales under a Joyce rule. Unlike corporate income taxes, however, many state franchise or net worth taxes are imposed on a separate entity basis.22 Accordingly, intercompany elimination statutes and Joyce principles would not apply to mitigate exposure of the value of the merged companies to taxation in such a state.
Instant Unity – When, If Ever, Does an Acquired Company Become Unitary?
Another issue to consider in mergers and acquisitions is whether a newly acquired company has “instant unity” with the acquiring company. Two merged companies could become unitary the day of the merger or at a later date, depending on when the companies have functional integration, economies of scale and centralized management.23 Importantly, state statutes that provide a list of activities that necessitate a combined report, or contain elections to file combined or consolidated reports, may allow companies to achieve increased certainty with respect to their reporting positions.24
Statutory mechanisms that permit increased certainty with respect to the question of instant unity include a Colorado statute that permits combination only when at least three of the six statutorily enumerated criteria are satisfied for the current tax year and the two preceding years.25 These criteria allow taxpayers to size up their operations against a specific list before filing returns. Also, some states, such as Massachusetts, allow taxpayers to elect to file a consolidated return that is based, at least in part, on the taxpayer’s federal consolidated group regardless of whether a unitary business is conducted.26 Such elections also allow companies to achieve certainty with respect to their positions, but such elections may be accompanied by certain requirements regarding inclusion of nonapportionable income and duration of the election that merit consideration.
Unity disputes tend to be highly fact intensive. Due to the timing question, instant unity cases tend to be even more fact dependent. For example, in Appeal of Dr. Pepper Bottling Company, a bottling company and Dr. Pepper Co. (“DPC”) were found to be instantly unitary when, for many years preceding the acquisition, the bottling company had been a licensee of DPC, had purchased a majority of its concentrate and syrup from DPC, more than half of the bottling company’s sales were of Dr. Pepper and DPC replaced all of the bottling company’s officers and directors with DPC personnel immediately after the acquisition.27 By contrast, in Appeal of ARA Services, Inc., a service management corporation was not instantly unitary with a trucking company, child care center and coinoperated laundry service that it acquired at different times, because the parent did not participate in the acquired companies’ day-to-day operations and the businesses of the subsidiaries were substantially different from those of the parent at the time of acquisition.28
Because of the fact intensive nature of the instant unity question, companies should consider analyzing and documenting pre-merger and post-merger activities to sufficiently support their positions. Such analyses and documentation could demonstrate both whether the companies intend to operate as a unitary business as well as the actions taken towards or opposed to that objective. Alternatively, such documentation could explain business reasons and memorialize decisions to allow newly acquired businesses to continue to run independently. Careful memorialization of such activities should assist companies in defending their positions at a later date with respect to instant unity.
I.R.C. Section 338(h)(10) Transactions
Another issue to consider is the state treatment of transactions that qualify for the I.R.C. Section 338(h)(10) election. I.R.C. Section 338(h)(10) provides for a joint election when 80% or more of the stock of a corporation is purchased by another corporation. For federal income tax purposes, the actual stock sale is “deemed” a fictional sale of assets by the target corporation to a deemed “new” fictional corporation, with the fictional asset sale deemed to occur while the target was still owned by the selling shareholder. The buyer then purchases and owns the “new” fictional corporation, which has “purchased” all of the assets of the target corporation at fair market value, thereby resulting in a step-up in the basis of the assets.
State treatment of the gain from an I.R.C. Section 338(h)(10) transaction varies. Some state courts have held that such gain is nonapportionable income, reasoning that such transactions are equivalent to actual liquidations of a business or because the income was considered investment income.29 By contrast, in at least one case, the California State Board of Equalization has held that such gain was business income that was apportionable.30
Additionally, the New York State treatment of an I.R.C. Section 338(h)(10) election for purposes of S‑corporations has recently changed. In 2009, the New York State Tax Appeals Tribunal held that a sale of S-corporation stock by the individual non-resident shareholders should be treated as the sale of stock (as the transfer is in actuality) rather than a fictional deemed sale of assets and, consequently, the individual shareholders were not required to treat such gain as New York source income for income tax purposes.31 However, unhappy with the consequences of that decision for purposes of taxing non-residents, the New York Legislature subsequently amended New York law so that I.R.C. Section 338(h)(10) stock sales would be treated as asset sales (as the transaction is deemed as a matter of federal tax law fiction) and gain or loss from such sales would be allocated by non-residents to New York accordingly.32
Many sales tax statutes are broadly written and could encompass mergers, acquisitions or restructurings unless a specific exemption applies. States may exempt sales made as part of such transactions from sales tax either by excluding such transactions from the definition of the word “sale” (on which the tax is imposed) or by exempting certain “sales” from the imposition of sales tax. For instance, California exempts “occasional sales” from the sales tax and defines occasional sales to include a “sale of property not held or used by a seller in the course of activities for which he or she is required to hold a seller’s permit or permits or would be required to hold a seller’s permit or permits if the activities were conducted in this state.”33
Some states exempt transactions that are related to federal income tax‑free reorganizations, mergers or restructurings. The mechanisms for exemption vary by state. For example, the Maryland statutes exempt all transfers pursuant to transactions that are tax‑free reorganizations for federal income tax purposes under I.R.C. Section 368.34 Oklahoma exempts transfers of tangible personal property in a “reorganization” and defines “reorganization” as “a statutory merger or consolidation or the acquisition by a corporation of substantially all of the properties of another corporation when the consideration is solely all or a part of the voting stock of the acquiring corporation, or of its parent or subsidiary corporation.”35
The states have varied positions on whether and the extent to which sales of tangible personal property are exempt from sales tax. Illinois exempts sales of tangible personal property of a type that the seller is not engaged in the business of selling.36 Under this statute and its accompanying regulation, it is possible that all of the seller’s tangible personal property except its inventory qualifies for an exemption to sales tax, because only the inventory would be the type of property that a business is engaged in the business of selling. However, inventory may nevertheless qualify for exemption to the sales tax as a sale for resale.37 By comparison, some states may exempt sales of assets occurring as part of the “liquidation” of a company.38
Real Property Transfer Tax Considerations
Another set of taxes to consider are state and locality transfer taxes on sales or transfers of real property that is located in a state. Such taxes may be based on the amount paid for, or the value of, the property.39 A transfer tax may be primarily imposed on a seller; however, buyers of real property should be aware that a jurisdiction may impose secondary liability for the tax on the buyer.40 Because some states do not impose transfer taxes on sales of an interest in a business entity that owns real property, a sale of an entity owning real property may be treated differently from the sale of the property itself. Some states impose transfer taxes on transfers of controlling interests in entities such as corporations and partnerships that own real property.41 Still others will strictly scrutinize transfers of real property to separate entities for purposes of the sale of the real property.
Sales to third parties are not the only triggers of some real property transfer taxes. Internal reorganizations can create opportunities for “foot faults” and should be specifically considered. For example, although New York expressly exempts sales from real estate transfer tax when there is no change in the beneficial owner of the real property, the New Jersey statutes have no such express exemption and the New Jersey Division of Taxation interprets its law to have no such exemption.42
The above considerations are just food for thought with respect to the many state tax issues that can arise in the context of mergers, acquisitions and restructurings. The number of, complexity of and potential liability from such state taxes make such issues important to consider throughout the process of a merger, acquisition or restructuring particularly because many of the potential liabilities can be reduced or eliminated with careful forethought.