Tax Due Diligence: It’s Not Just for Acquisitions

11-1-13-Crowe.pngWhen you hear the phrase “tax due diligence,” you probably think about investigating the tax situation of a target company in a potential acquisition transaction. But what about performing due diligence on your own management’s ability to accurately administer, account for, and report your company’s tax positions? Taxes are typically one of a bank’s largest expenses. Deferred tax assets are often a sizable balance sheet asset and regulatory capital component. Taxes also are a key focus of Securities and Exchange Commission financial statement reviews and a frequent cause of financial statement restatements and material weakness citations. So perhaps a bank’s board of directors, or at least its audit committee, should perform periodic tax due diligence on its own organization.

But what questions would you ask, particularly given a board’s role is one of policy-setting, strategic direction, and high-level oversight rather than daily management? If you understand what management should be doing to control risk in this area and where or why controls malfunction, you can tailor your queries to effectively address your organization’s tax complexity profile.

What Should the Controls Be?

Consider these four areas of risk and control in the administration and financial reporting of income taxes:

  • Are the bank’s tax expense and balance sheet positions accurately computed?
  • Are these positions recorded in the general ledger and reported in financial statements accurately and adequately?
  • Are tax payments and tax filings made timely and accurately? Are tax notices responded to promptly?
  • Are the individuals involved in tax administration staying abreast of and adequately addressing developments in tax law, accounting rules, and the company’s own activities?

Critical to the first three items are adequate checks and balances. That means management should be making sure that tasks are actually completed and completed correctly, and that there is a reconciliation of general ledger tax activity to the financial statement computations and to the return filings, particularly if the three areas are handled by different people or groups.

Vital to the fourth item is knowledge about changes in tax or accounting rules and the firm’s activities. For instance, the bank might have opened a loan production office in a new state or bought an investment banking firm in a new country that will affect the company’s taxes. Do the relevant people have a process to discover the event, the requisite skills and resources to understand how it affects the company’s taxes, and the ability to incorporate those effects into tax computations and returns?

Another due diligence focus for the board is oversight of the company’s internal controls.

Where or Why Do Internal Controls Malfunction?

There are myriad reasons controls break down, but consider these three factors:

  • Personnel turnover might lead to replacements who might not bring the same level of tax knowledge and who need time to learn the company and establish internal communication channels. Additionally, balls could drop while vacated positions are being filled.
  • The company is large and dynamic, has many personnel in many divisions and locations, is taxable in many jurisdictions, and undertakes numerous acquisitions or other changes in processes, service offerings and markets. It has a complex tax profile where application of the law is not always clear and tax authorities could easily disagree.
  • Internal auditors, whose job it is to test the effectiveness of company processes and controls, might lack the requisite specialized tax knowledge to adequately assess the tax function and controls, thus missing potential warning signs.

Tailoring Queries to Your Organization

For a smaller community bank, the personnel issue might be most critical and the board more hands on about tax matters. Ask about the tax qualifications of the people performing the work, particularly those reviewing it, and what management’s process is for making sure there is adequate internal tax knowledge and coverage. Ask whether outside experts are involved if needed.

For a large organization with sizable tax and finance departments, the ever-changing and complex environment might lead you to ask about management’s process for identifying and determining whether to take any aggressive tax positions and how tax personnel learn of corporate developments.

For an organization of any size, you might inquire how comfortable the internal auditor is with assessing the effectiveness of the tax function and its controls and whether a third-party expert should be used for this purpose. Don’t hesitate to ask the financial statement audit team for comments on management’s tax processes and abilities.

Consider the potential for sizable error in your company’s tax positions, and don’t hesitate to perform a little in-house tax due diligence.

Tax Conundrum: How to Handle the Purchase of an “S” Corporation

treasure-chest.jpgApproximately one-third of all banks in the United States are organized as subchapter S corporations. Since a potential buyer is likely to encounter a seller that is a subchapter S bank, it is important to understand the unique tax consequences to the selling corporation and its shareholders. For example, the selling shareholders may seek concessions, in the form of additional consideration, to reimburse them for any additional tax liability they might incur based upon the chosen structure. Board members, whether representing the seller or buyer, will need to consider these tax issues in order to properly evaluate a proposed acquisition structure and obtain the desired results.

Any buyer purchasing a corporation at a premium typically prefers to structure the transaction in a way that allows the buyer to receive a “stepped-up basis” in purchased assets. In other words, the buyer wants to directly allocate the amount paid for the corporation’s stock to the acquired assets for tax and accounting purposes. While this treatment may be required under U.S. generally accepted accounting principles, it does not automatically apply for federal income tax purposes. In fact, a buyer acquiring the stock of a corporation generally will take a carryover tax basis in purchased assets, as opposed to a stepped-up tax basis, thus potentially leaving tax dollars on the table. While a buyer can purchase assets directly without purchasing stock in order to receive this stepped-up tax basis, it might not always be practical (or permissible) to structure a transaction this way. So what’s a buyer to do?

Internal Revenue Code Section 338(h)(10) provides a special election for “qualified stock purchases,” which are defined as any transactions, or series of transactions, in which at least 80 percent of the stock of one corporation (the target corporation) is purchased by another corporation (the acquiring corporation) during a 12-month period. If the election is made, a purchase of target corporation stock is treated as though the acquiring corporation directly purchases the assets of the target corporation. In other words, the purchase of the stock is disregarded for tax purposes—and for tax purposes only.

There are two situations in which a Section 338(h)(10) election can be made:

  1. The target corporation is a subsidiary in a consolidated group; or
  2. The target corporation is a subchapter S corporation.

It is the latter of these two situations that is more common among bank holding company acquisitions.

It should be noted that a Section 338(h)(10) election can be made only if all parties involved in the transaction agree to the election. If the target is a subchapter S corporation, the approval of every shareholder of the S corporation must be obtained—no exceptions. A single dissenting shareholder can disrupt the entire process (although there are some strategies to avoid that). It should also be noted that the acquiring corporation assumes all liabilities of the target corporation, including tax liabilities.

Now that we have set the table as to why, and under what circumstances, a Section 338(h)(10) election can be made, let’s take a look at the tax consequences for the parties involved, assuming the target corporation is an S corporation bank holding company with a single 100 percent-owned qualified subchapter S bank subsidiary.

For the target corporation:

  • All holding company and bank assets are sold in a taxable transaction.
  • All holding company and bank liabilities are assumed by the acquiring corporation.
  • Corporate-level S corporation built-in gains tax could apply.
  • Corporate-level state income tax applies to net gains from taxable sale of assets (presuming the relevant states follow the federal Section 338(h)(10) treatment).
  • Holding company is liquidated.

For the selling shareholders:

  • Gains (and losses) from the sale of assets pass through to shareholders and are reported on the shareholders’ personal income tax returns; the tax basis in the S corporation stock is increased or decreased accordingly.
  • Shareholders recognize the gain or loss upon liquidation of holding company shares.

For the acquiring corporation:

  • Tax basis of purchased assets, including intangible assets, is stepped up (or stepped down).
  • Premium paid above fair market value of hard assets generally is converted into a tax-deductible intangible asset that can be deducted on a straight-line basis over 15 years.
  • No tax attributes of the target corporation carry over, which would commonly occur in the context of a stock purchase without a Section 338(h)(10) election.

As discussed earlier, subchapter S corporations make up about one-third of all banks in the United States. Because potential buyers are likely to encounter a selling S corporation, it is important to understand the unique tax consequences affecting the parties involved, including the target corporation, its shareholders, and the acquiring corporation. The Section 338(h)(10) tax rules are detailed, and there might be exceptions to the general rules described here. Taxpayers should review their specific fact patterns before deciding on a course of action.

Taxes and M&A: Five Things to Think About

taxes.jpgTaxes typically are one of the largest expenses on a bank’s income statement and often represent a substantial balance sheet asset or liability. When considering a merger or acquisition of a bank or bank assets, it’s critical to review not just the target’s tax situation but the potential resulting tax situation of the acquirer. Following are five key areas to consider.

1. Can the deal be structured to achieve a better tax result?

You can buy a target’s stock or assets or, under some circumstances, buy its stock and treat the transaction as an asset purchase for tax purposes. In an asset purchase, the tax basis of the acquired assets is adjusted to the purchase price. When paying a sizeable premium, asset treatment allows a tax deduction of resulting intangibles like goodwill. In a stock transaction, the target’s tax basis in its assets carries over to the acquirer; if that basis is higher than the price to be paid, stock treatment might be better, particularly if the target has any tax loss or credit carryforwards. Carryforwards are obtained only in a stock transaction, however an acquirer’s ability to use the carryforwards (and potentially other deferred tax deductions) is limited under the “ownership change” rules of Internal Revenue Code Section 382. So carryforwards might not be as valuable as you think. (For more information on section 382 and related issues, read “Will Your Target’s Tax Attributes Survive the Acquisition?”)

2. Are you inheriting target tax liabilities?

When buying an entity’s stock you acquire its known and unknown liabilities, including its tax liabilities, even if the deal is treated as an asset purchase for tax purposes. So in a stock deal, it’s critical to confirm that the target is up to date on filing and paying all required taxes. This includes income taxes as well as backup withholding; payroll, property and use taxes; and any other taxes particular to a state or local jurisdiction. Be sure someone in your organization is investigating all these non-income taxes. Review the accuracy of all tax filings and the positions taken in returns to determine if a tax authority audit would subject you to unexpected tax, interest and penalty assessments.

3. How will the deal affect your own tax situation?

If you are issuing stock as deal consideration, you’ll want to consider whether you’ll cause yourself, not just the target, to trigger a tax ownership change. These days it’s more common for acquirers to have tax loss or credit carryforwards of their own, which make the acquirer subject to the tax ownership change rules and, potentially, their limitations. Your resulting state and local tax profile should be carefully considered, especially if the target has tax filings or business activity in states you currently do not. Will you leave acquired entities as free-standing subsidiaries or merge them into other group members? Such moves could substantially increase or decrease state and local tax expense. If you, or the target, employed any tax minimization strategies, the effect of the transaction on these strategies should be considered.

4. Will your tax administration burden increase?

Will the burden (and expense) of administering your tax-related responsibilities increase or decrease once the transaction is complete? Consider changes in the number of returns to be filed or additional data tracking and tax calculations required due to inherited or resulting tax positions. Sizeable acquisitions, in particular, can quite literally tax the capacity, skill and knowledge level of the staff currently responsible for tax matters. Factor anticipated additional costs or efficiencies into your deal analysis.

5. Have you covered all the miscellaneous bases?

Be sure the transaction agreement protects you from as many contingencies as possible. For example, if buying a single bank entity from a multibank holding company, make sure the agreement clearly states who is responsible for the target bank’s tax filings and liabilities up to and through the date of closing, particularly if pre-closing tax filings are audited and adjusted. Is it clear who is responsible for information reporting related to the acquisition year? Address responsibilities and deadlines for sharing information, wrapping up any final tax returns, and filing any deal-related tax elections or forms. If the target is an S corporation, address the unique issues that can arise. Last, consider the effect of any nondeductible transaction costs or change-in-control payments.

Taxes can be a big deal in any merger or acquisition transaction. Do your homework upfront to avoid surprises.

Will Your Target’s Tax Attributes Survive the Acquisition?

percentage.jpgSince the advent of the financial crisis, many financial institutions have accumulated significant amounts of tax attributes in the form of net operating loss (NOL) carryforwards, tax credit carryforwards, and other forms of built-in tax losses. While these attributes may be attractive to potential acquirers or investors, the application of Internal Revenue Code (IRC) section 382 may significantly reduce the benefit of these tax attributes.

A thorough analysis of the existing tax attributes and their value going forward under IRC section 382 is an important step in determining the appropriate value for any target institution. This determination is certainly necessary for an outright acquisition of a target institution but is also relevant to those seeking to participate in a significant stock offering by such an institution.

Section 382 in a Nutshell

Section 382 applies when a corporation experiences a significant ownership change while it is a loss corporation. The provision limits a corporation’s, or its successor’s, ability to deduct any realized built-in losses and use tax loss or credit carryforwards. Due to statutory time limits on the carryforward of these items, the limitation imposed under Section 382 can lead to a permanent loss of tax benefits and a negative impact on a bank’s financial statement.

Will Ownership Change?

An acquisition, any form of stock issuance (such as public offering, private placement, or recapitalization), or a shareholder’s purchase of a significant number of shares from other shareholders can trigger an ownership change.

An ownership change generally occurs when the collective ownership of the major shareholders of a loss corporation (specifically those owning 5 percent or more of the stock) increases by more than 50 percentage points over a three-year testing period. The percentage point increase for each major shareholder is computed separately and then aggregated to determine if it is an ownership change of at least 50 percentage points. The corporation is responsible for monitoring the ownership changes among its shareholders, and the rules for determining these ownership changes are numerous and complex.

Is Your Target a Loss Corporation?

A loss corporation is any corporation with a carryforward of net operating loss, capital loss or tax credits or with net unrealized built-in loss (NUBIL)—collectively referred to as “tax attributes”—at the time of an ownership change.

NUBIL is basically the fair market value of a corporation’s assets less its tax basis in those assets, determined immediately before the ownership change. Economic losses not yet recognized for federal income tax purposes can create NUBIL. Examples of NUBIL include loan and receivable loss reserves not yet charged off for tax purposes; and impairments, or unrealized losses, of securities recorded for financial statement purposes but not tax purposes.

The provision does recognize a de minimis exception: If NUBIL does not exceed the lesser of $10 million or 15 percent of the fair market value of total assets, it is disregarded for purposes of determining if an entity is a loss corporation.

Keep in mind that a decline in asset values can create a loss corporation, as built-in losses can result from loan and receivable loss reserves not yet deducted for tax purposes, unrealized securities portfolio losses or impairments, or unrealized losses on other assets that have declined in value.

Computing the Section 382 Limitation

When an institution that qualifies as a loss corporation experiences an ownership change, it must compute its Section 382 limitation by multiplying the fair market value of its stock immediately before the ownership change by the applicable federal long-term tax-exempt rate.

The limitation determines how much of the tax attributes that existed at the date of the ownership change can be used by the institution or its successor annually after the ownership change. If NUBIL exists, any assets with built-in losses that are sold at a loss within five years of an ownership change will be subject to the annual Section 382 limitation on deductibility. Losses exceeding the annual limit may be carried forward and deducted in future years—within the confines of the annual Section 382 limitation—but could end up expiring unused.

Proceed With Caution

Section 382 can substantially limit the use of tax attributes and might be a trap for an acquirer or the unwary institution trying to increase its equity capital. The tax attributes at issue often exist on the target’s balance sheet in the form of deferred tax assets for NOL carryforwards, tax credit carryforwards, or allowance for loan losses (which can represent NUBIL). While these deferred tax assets may be offset to zero with a valuation allowance, they likely have some value. The key is to determine the precise value of these tax attributes to the acquirer to make sure this value is properly considered in determining the purchase price. The same concept holds true for investors seeking to participate in a significant stock offering that would trigger an ownership change for the issuer.