Key issues facing corporate clients and potentially impacting transactions

The current year has developed in surprising ways for most of us. With an election looming and governments dealing with the effects of the pandemic, the tax landscape is even more uncertain. With so many companies in adaptation mode, addressing to the realities of a pandemic and working from home, important planning opportunities and protective actions can be missed. Below are a few areas of interest for the right client and provide a good reason to reach out to them directly.

1. Review credit agreements

Many companies are breaching covenants in credit and other agreements during this COVID-19 environment. Credit lines and lease agreements could also be at risk. Banks are tightening credit across the board, and are not taking such breaches of covenants lightly. Companies should be reviewing all agreements which are driven off of revenues, asset values, profitability (EBITDA and any other metric) and receivables, or which are cross collateralized. Transactional due diligence should include a detailed review of agreements in this area and covenants to protect the buyer.

2. Potential sales tax liability arising from certain transactions

South Dakota v. Wayfair, Inc., decided in 2018, has created much uncertainty with respect to when a state can tax the in-state sales of out-of-state sellers. We are still watching the fallout from the ruling, which allowed for destination-based taxation (even when a seller has no physical presence in the taxing state -- a big shift). With governments in desperate need of revenue, many anticipate that many states will become increasingly aggressive in attempting to collect sales taxes on out-of-state sellers. As a result, for anyone contemplating a transaction (such as an acquisition) with a company that could get ensnared in the state sales tax net, the lack of clarity and finality in this area must be addressed. Tight covenants, targeted due diligence and well-crafted indemnities are key. And, any documentation must be adaptable, when possible, with respect to this issue as it continues to evolve, state by state. Indeed, any risk in this area could be retroactive, potentially looking back for two years pre-closing (based on the timing of the ruling).

3. Net operating loss rules have changed and can have potential benefits and burdens that did not exist under prior law

The Tax Cuts and Jobs Act changed the limits related to NOL carrybacks and carryforwards (for entities above a certain size). Under the TCJA, losses could be carried forward for an unlimited number of years, but carrybacks were disallowed. This new limitation prevented entities from taking losses realized during a current year and using them to deduct the loss from a previous year's income. However, the Coronavirus Aid, Relief, and Economic Security Act, aka CAREA Act, temporarily reversed the prohibition on carrybacks and allowed a provided a five-year carryback for losses earned in 2018, 2019, or 2020, which allows firms to modify tax returns up to five years prior to offset taxable income from those tax years.

The TCJA also limited how much taxable income could be offset using an NOL deduction in each tax year. Entities could only deduct up to 80% of their taxable income, and were required to carry forward any NOL beyond that limit to future tax years. The CARES Act suspended the NOL limit of 80 % of taxable income for the 2020 tax year. It remains to be seen if there will be any further legislation that may extend the suspension of the 80% limitation.

Finally, the TCJA placed limits on losses for pass-through businesses, set at $250,000 for single filers and $500,000 for joint filers. Active business owners of pass-through entities could only use losses up to those limits to offset taxable income earned outside of the business. The CARES Act allows pass-through business owners to use NOLs to offset non-business income above the previous limit of $250,000 (single) or $500,000 (married filing jointly) for tax years 2018, 2019 and 2020.

Many states have not conformed to the TCJA or CARES Act and have enacted additional legislation concerning the use of NOL's. For example, California recently suspended the use of NOLs for taxpayers with income greater than $1 millino. Taxpayers should be mindful of the changing state tax landscape and how it will impact NOL tax planning.

Calculations with respect to these changes must take into account numerous factors, especially the lower individual income and corporate income tax rates arising out of the TCJA. The carryback provisions enable taxpayers to deduct losses from tax years with these lower rates (such as the 21 % corporate tax) and apply them to tax years before 2018 (at the 35 % corporate income tax), a favorable outcome for taxpayers who can take advantage of this option.

The ability to utilize NOLs can have a big impact on the possible purchase price for a purchased company. The current crisis have hit various sectors, and companies in those sectors, in widely divergent ways. The ability to effectively utilize NOLs can be determinative as to whether a potential acquisition makes sense. Uncertainty in this area due to governmental changes in deductibility should be addressed at the early stages of a transaction or revisited in recently closed deals.

4. Payroll taxes

Payroll taxes are taxes imposed on employers or employees, and are typically calculated as a percentage of the salaries paid by employers to their staff. At the federal level, employers and employees each pay 6.2 % for Social Security and 1.45% for Medicare, and an additional 0.9 % is levied on the highest earners. Payroll taxes cannot be avoided, including by startup (not yet profitable) companies. Employers must report payroll taxes and file reports of aggregate unemployment tax both quarterly and annually with each applicable state, along with annually at the Federal level. Reporting is a key requirement of payroll taxes. Penalties can be expensive and quite severe.

Last month, President Donald Trump signed an executive order which defers the employee's obligation to pay a 6.2% Social Security tax per paycheck, usually withheld by the employer. Under the executive order, employers would refrain from withholding the 6.2% from employees for Social Security, but would still contribute their own portion for each worker. The order applies to those employees who make less than $4,000 every two weeks, which is an annual salary of $104,000. While the government is exploring ways of forgiving the deferred amount, for now it must eventually be paid to the government as originally required. The order was to go into effect on Tuesday and continue through Dec. 31 of this year, but lacked clarity in implementation. On Aug. 28, 2020, in Notice 2020-65, the IRS clarified that the withholding and payments of taxes on wages below $4,000 on a biweekly pay scheduled is postponed until the period beginning on Jan. 1, 2021, and ending on April 30, 2021. Tax will begin to accrue on May 21, 2021 on any unpaid tax under the order.

When entering into a transaction, these deferred (under the Trump executive order) or potentially mishandled obligations could end up impacting the ultimate real purchase price of the seller. Any earnouts based on a net number could also be impacted by the deferred taxes, which are paid later. Transaction documents should provide for full disclosure and solid reps and warranties to cover any potential future payroll tax liabilities.

Conclusion

Planning opportunities remain in flux as the unpredictability of tax legislation, related regulations and the governmental response to the COVID 19 crisis continue to impact client companies. Right now is the best time to reach out to such clients and ensure that important opportunities are not lost due to inaction. Given the environment, most clients are eager to seek out every option in hopes of retaining strong throughout these troubling times. 