M&A Transactions: How to Avoid Consequences & Save Money

The state and local tax (SALT) treatment of M&A transactions can have a major impact on negotiated sales prices and after-tax values of deals. Whether you are contemplating a buy-side or sell-side transaction—or reorganizing your existing corporate structure— planning for the potential SALT consequences at the beginning of the process is crucial. Failure to consider these consequences until the tax return preparation stage often leads to unintended and expensive results that reduce the return on the investment.
 

New York S Corporation Elections

Many states have nuanced rules that need to be identified up front to help prevent unwelcome surprises in the future. One example is the New York state S corporation election. A federal S corporation that wishes to be treated as an S corporation for New York state income tax purposes must make a separate New York S corporation election. However, even if the New York state S corporation election is not made, the corporation may still be deemed to be an S corporation under New York state tax laws if an often overlooked “investment ratio test” is satisfied. 
 
A recent New York State Tax Appeals Tribunal decision highlights the importance of understanding the New York S corporation rules. In Matter of Lepage (May 17, 2021), the shareholders, all nonresidents of New York, sold their stock in a federal S corporation that did business in New York but that did not make a separate New York S corporation election. At the time of the sale, the shareholders and the buyer jointly made an election under the federal tax code (a Section 338(h)(10) election) to treat the stock sale as a sale of the S corporation’s assets for federal income tax purposes. 
 
Since no separate New York state S corporation election was made, the shareholders treated the transaction as a sale of stock for New York state income tax purposes. Further, the shareholders sourced their capital gains outside of New York (i.e., to their respective states of residence). However, the Tax Appeals Tribunal deemed the corporation to be a New York S corporation by applying the investment ratio test. The deemed New York S corporation election caused the transaction to be treated as a deemed asset sale for New York tax purposes with the shareholders’ gains sourced to New York, resulting in additional tax for the shareholders.
 

Other Traps for the Unwary

There are other jurisdictions that do not conform to federal pass-through entity tax treatment (e.g., D.C., New Hampshire, New York City, Tennessee, and Texas) or that also require a separate state-only S corporation election (e.g., New Jersey). Here are additional state-specific considerations when analyzing the tax effects of M&A transactions:
 

  • The effect of an acquisition on the acquirer’s state tax liabilities (in particular, the acquirer’s pre-transaction state nexus and apportionment factors);
  • Whether gain on a sale is treated as business income or nonbusiness income;
  • Given differences between federal consolidated stock basis and E&P calculations compared to separate return states, whether intercompany distributions qualify as dividends and possibly exceed separate entity stock basis and result in gain;
  • Whether a post-transaction dividend distribution qualifies for intercompany elimination in a state that requires unitary combined reporting;
  • Whether a state requires gain to be recognized currently or deferred on intercompany transactions that take place in an internal reorganization;
  • Whether a state imposes sales tax on a transaction and which party is liable for the payment; and
  • Whether there are state-specific rules that limit net operating loss and other tax attribute carryovers.

We understand state taxation of merger and acquisition transactions can be complex, and the rules vary from state to state. State rules and elections do not necessarily follow federal tax treatment and should be carefully reviewed when analyzing the tax consequences of a potential transaction. Further, depending on the specific circumstances, acquiring a new business can change where and how the acquirer’s income is taxed. Reorganizations of existing corporate structures can also have current or deferred state tax consequences. Our experienced team of advisors are here to help guide you through this M&A transaction process so that these state and local tax consequences can be avoided.