Every company should review annually its methodology for determining where it has nexus and where it should consider filing state income tax returns. It is noteworthy, that even if the company generates losses, a state filing may still be required. The Company should consider both physical nexus such as; property, inventory, employees, or office/warehouse space and economic nexus standards, which establishes nexus if certain sales thresholds are exceeded. All revenue streams of the business should be reviewed since each state has different rules on how to source revenue to a state. For example, a state may source software as a service, e-commerce, or professional services all differently.
In addition to income taxes, many states also impose non-income business taxes, such as gross receipts tax, net worth taxes, and the like. Some of the more prominent gross-receipts-based taxes for business to monitor include the Ohio Commercial Activity Tax, Washington Business and Occupancy Tax, the Oregon Commercial Activity tax, the San Francisco Gross Receipts and Payroll Tax, and the Los Angeles Business Tax. Companies should also keep track of disregarded entities they own to identify any LLC filings in states such as New York or California. In addition, companies that pay rent in New York City should comply with commercial rent tax filings. If a company is headquartered in Delaware, there is an annual franchise tax return that must be filed.
Companies should also confirm all outstanding tax notices have been addressed and assessed balances have been settled in order to remain in good standing with the state.
The sales and use tax landscape has changed drastically since 2018 and is now perhaps the most significant tax exposure uncovered in the due diligence process. Thus, neglecting sales and use taxes can result in an unpleasant surprise for the company for which it will then need to quickly identify, quantify, and remediate the exposure. As a result of the 2018 U.S. Supreme Court decision in South Dakota v. Wayfair, Inc., the longstanding “physical presence” rule has been replaced with an “economic nexus standard”. Currently there are over 43 jurisdictions that have enacted economic nexus legislation requiring remote sellers to collect and remit use tax based on certain sales or transaction thresholds even if they have fixed physical presence in the state. Given the inconsistent economic nexus thresholds that exist in the various states, it is becoming increasingly important to conduct a nexus analysis, and undetected nexus issues are cropping up in more and more transactions.
If prior period sales and use tax liabilities are identified, there are several mitigating options that can be considered. Some include participating in a voluntary disclosure agreement (VDA), prospective registration and compliance as well as remitting taxes collected or tax liabilities on a current or prospective return. Often taxpayers choose to enter into a VDA as it limits the look back period and offers abatement of penalties and in some cases interest. In instances where a taxpayer has collected tax and failed to register to file and remit sales taxes, the limited look-back period doesn’t apply and all tax collected must be remitted. An important qualification to participate in a state VDA program is that the taxpayer has not already been contacted by the jurisdiction to audit the Company.
Another complication companies often face with sales tax due diligence is when they operate under a Fulfillment by Amazon (FBA) business model. As an FBA seller, the Company is required to collect sales tax in states where they meet the criteria for sales tax nexus, as well as product taxability. It’s important to note that if any inventory is stored in an Amazon fulfillment center, sales tax nexus may have been created in that applicable state.
Many States have also recently passed marketplace facilitator requirements, whereby the states require that the marketplace facilitators (i.e., amazon, ebay, and etsy) collect and remit sales tax on the marketplace sellers behalf. As a result, this shifts the responsibility to collect and remit sales tax from the seller to the marketplace facilitator for transactions occurring on the platforms.
In the due diligence process, the target company will often need to discuss its policies, procedures, and compliance with respect to payroll taxes. Typical items subject to review include compliance with reporting to independent contractors (Forms 1099), payroll tax returns to all relevant jurisdictions, as well as other information reporting requirements including stock compensation. Perhaps the most pressing issue facing companies today is remaining compliant with payroll taxes in light of the COVID-19 pandemic. It is imperative that companies monitor each jurisdiction’s guidelines on how to treat remote employees and whether payroll taxes are required to be withheld. For example, the State of New York recently issued guidance on its position on the “Convenience of Employer” rule, stating that if a nonresident’s “primary” office is in New York, then the days an employee telecommutes from out of state during the pandemic would be considered days worked in New York, unless the telecommuting location is established as a “bona fide employer office”. Furthermore, New York takes the position that unless there is a bona fide employer office in the other state, an employer and employee would still be responsible for New York State income taxes while telecommuting.
The international filing requirements both from a US reporting perspective and a local country perspective can be quite complex. Some requirements to consider include information relating to transfer pricing, foreign bank accounts, and ownership filing requirements. Companies should maintain updated organization charts to identify all international tax reporting requirements because significant penalties can apply to reporting failures. For example, Form 5471 should be filed for foreign companies in which the business owns more than 10% of the outstanding stock. If the company transacts with one of its shareholders that owns more than 25% of its stock, then Form 5472 is required. Businesses also need to annually disclose all foreign financial bank accounts in which they have a financial interest or signature authority over a certain threshold. Companies should also review annually their transfer pricing procedures to ensure transactions are conducted at arm’s length with their related-party affiliates. Finally, companies should review local country filing obligations and compliance for all taxes including income tax, VAT/GST tax and payroll tax filings.
Often times a company has significant net operating losses (NOLs) or tax credits such as a research & development tax credit. An equity investment or a sale could potentially limit the amount of the NOLs that can be used and often times a buyer/investor will want to understand if such limitations exist. A limitation may exist if there is more than 50% change in ownership within a 3-year rolling period. Companies should monitor previous capital raises and ownership changes to identify whether an annual limitation exists. This is a critical component of the due diligence process because the limitation could restrict the value of the company’s tax attributes in the hands of the potential acquirer.
During the due diligence process, buyers/investors will often ask what the companies policy is relating to unclaimed property. Unclaimed property generally consists of uncashed checks of any type whether to a vendor or employee, and items such as unclaimed gift cards. Escheat is state’s right to property after a certain period of time which is generally 3 to 4 years depending on the state. Sometimes there is uncertainty which state holds the right to the property. For example, a company may be incorporated in Delaware, but the gift card is sold in New York. Companies should develop a policy depending on the specific facts and circumstances.
Even if your business isn’t currently contemplating a capital raise or sale it’s always a best practice to be due diligence ready since you never know when an opportunity will exist and some of the issues mentioned above can take time to mitigate. Please consult with your Withum tax advisor to best prepare for the due diligence process.