We’re going to be up-front with you here: it’s time to talk taxes. Don’t run away yet, unless you like leaving money on the table. When you’re building your business to sell, taxes are one of the areas that will have the largest impact on you. Strategic tax analysis can improve your margins and cash flow along the way, and when you go to sell, careful tax planning can make a 20-50% difference in your after-tax earnings(!). There – now that we’ve sufficiently scared you into paying attention, let’s talk about how you can manage tax risk and, where possible, seize tax opportunities.
Taxes are kind of a murky, amorphous area that often flow into other categories, like legal and HR. The decision of what type of legal entity to use for your company has significant tax ramifications, as does deciding where you’ll organize the entity. Many tax filings are related to payroll or other compensation and can overlap with HR.
The two biggest questions when you’re building your company to sell (especially when you’re close to an acquisition) are:
- Have you filed all of the required tax returns and paid any amounts due?
- How can the deal be structured in the most tax-advantaged way for you?
There are so many different types of tax returns or forms that are required to be filed, and it’s difficult for business owners who don’t have a tax background to stay on top of the requirements. If you’ve done your own taxes, are you comfortable with them? Keep in mind that as part of the deal you may be legally representing that they are complete and accurate, so if you’re not confident it is worthwhile to have a CPA review prior filings. Consider the following types of returns that may be applicable to your company:
- Sales tax
- Income tax
- Franchise tax
- Payroll tax
- Informational returns
Sales tax is a VERY tricky area, as states and local jurisdictions follow different rules for nexus (the determination of when you are subject to tax in that jurisdiction). If you are selling a product (or even if you’re providing services, depending on the type of service and where it’s performed), your company may be subject to sales tax. If there’s a single area of tax where the cost of doing it yourself outweighs the benefit, this is probably it. While hiring a CPA firm to perform a sales tax study is certainly one option, if you’re looking for a lower-cost alternative, using a sales-tax specific system might be a good choice. TaxJar and Alvalara provide relatively low-cost solutions for small businesses who can’t afford sales tax analysis from a CPA firm. The benefit of using one of these services is the synergy between human knowledge and machine processing: these companies have probably seen more sales tax transactions than a traditional CPA firm.
Given that the tax rates for sales tax are often (but not always!) lower than income taxes, you may wonder how big of a deal they really are. Without taking you completely down the sales tax case law rabbithole, we’ll just say that a recent case heard by the Supreme Court (South Dakota v. Wayfair Inc.) has potentially changed the way that states are allowed to determine who must collect and remit sales tax. Spoiler alert: it’s not a good change for most businesses. Given how quickly a company can establish sales tax nexus in multiple jurisdictions, if you’re not ensuring that your company is compliant you may find yourself in a situation in which multiple states come calling for unpaid taxes.
Depending on what type of entity your company is taxed as, you may or may not be subject to income taxes at the entity-level. Even when taxes are not due, however, tax returns still are (like Form 1065 for partnerships). If your company pays taxes at the entity-level, it is essential that you’ve properly reported, filed, and paid taxes. Acquirers will review the tax returns as part of due diligence, because they could open themselves up to huge potential liabilities if they acquire a company that has unpaid taxes.
What happens if you forgot to file returns or you later realize that you were subject to income taxes in a state that you never filed in or paid taxes? The good news is that these issues can almost always be rectified. The bad news is that it comes at a cost. If you have delinquent tax filings or payments, it’s generally best to get in touch with a CPA who can guide you through the process of returning to compliance. Most jurisdictions offer VDA (“Voluntary Disclosure Agreement”) programs that waive penalties and/or interest if you file all missing returns and pay the taxes. An important thing to note: you have to approach the state first – if they send you a notice of failure to file or pay, it’s too late to do a VDA.
Some states impose a fee on businesses for allowing them the right to do business within that state. These fees are “franchise taxes,” and many small businesses may overlook the fact that they are subject to them. Unlike income taxes, franchise taxes may be owed even if a company is operating at a loss. For startups, this can be particularly painful, as you might have to pay franchise taxes in multiple jurisdictions, even though your company has no profit.
We discussed payroll taxes as part of the HR section of the “Built to Sell” series. As we mentioned in that post, using a full-service payroll provider is the easiest way to ensure that you are compliant with respect to payroll taxes. Because of the frequency with which payroll taxes may be due (anywhere from quarterly to semi-weekly, depending on your total annual liability and the type of tax remitted), if you fail to make a single payment, all following payments may also be considered late. We’ve worked with clients who failed to properly handle payroll taxes at the beginning, and by the time we arrived to help them, all of their “current” payments they made were being applied to earlier missed payments. Without making “catch-up” payments, the client would have constantly incurred interest and penalties on each successive reporting period. If the company had been in deal negotiations, the acquirer would have likely not only discounted the value by the actual interest and penalties, but also for other tax liabilities that this kind of lack of oversight suggests might exist.
One timing matter to note: the frequency and timing of required tax deposits does not necessarily correspond to that of required tax filings. A number of payroll tax reporting forms are submitted quarterly or even annually.
If it’s just an “informational” return, how important is it that it’s filed? Well, it turns out that the IRS and other governmental agencies really don’t like not receiving what they’re supposed to. Even if no taxes are due, if a form is required, there will most likely be a penalty if it isn’t filed in a timely and/or correct and complete manner. There are too many different types of informational forms and returns to mention here, especially as it’s heavily dependent upon the type of business that you’re running, as well as where and how you’re running it. Form 1099-MISC is probably the most commonly filed informational form by businesses, so we’ll dedicate a post in the future to a deeper dive, including how to handle payments for advisory services or other non-standard relationships and payments.
Forms 1099 are easy to file – if your company uses bookkeeping software like Quickbooks Online or Xero, they can be filed directly through their system using all of the information that’s already captured. Other bookkeeping systems, like Freshbooks, allow you to run reports on the information that would be included on Form 1099, but the forms themselves must be completed in different systems.
Given the risk surrounding improper reporting of these forms, it’s a good idea to take the time to make sure it’s done right each year. If you’re building your company to sell, the last thing you want hanging over you is the possibility of the IRS coming after you.
Structured to Sell
As you move from the “Building to Sell” stage of your company to the actual selling stage, taxes are going to become a significant area of consideration for you. As the seller, one of your top concerns will be how the deal is going to be structured, since the tax consequences can be substantial.
Engage a CPA (ideally one who specializes in transactions) early on in the deal process to ensure that you understand the tax implications of various structures. You might choose to begin working with the CPA before you have a letter of intent, as this would give you time to discuss possible strategic tax structuring before the stress of negotiations begin. There’s a clear monetary cost to doing this, and if you have little say over the deal terms, then it may be an unnecessary and frustrating exercise. Another option is to wait until you see terms to engage tax assistance, but depending on how quickly you or the buyer wants to move, you might want to have an idea ahead of time.
Transactional assistance is one area where you don’t want to try to cut corners to save a couple bucks, as you could end up much worse off if the deal isn’t structured advantageously. For example, the acquirer could offer to purchase the assets of your company, rather than acquiring the equity of your company. If your company is a C-corporation, you could end up being double taxed on the transaction in this scenario.
If an acquisition is still only on the horizon, you have time to plan. One question that you might ask is whether you should re-organize your entity or engage in other tax planning strategies. This is a good discussion to have with a CPA with transactional experience. The benefit of making adjustments before a deal is that it allows you to make any changes without the pressure of a ticking deal clock. If you want to convert your LLC to a C-corporation, in addition to the actual paperwork and logistics of making this entity change, your tax strategies will need to change.
Unfortunately, with taxes there are many ways to get things wrong. It’s important to make sure your company is filing the right forms at the right time and making all required payments. Acquirers and investors know the risks to companies who are lax with their handling of tax matters, and corresponding discounts will be applied to the valuation of these companies. Make sure that your company is valued at top-dollar by staying on top of your tax compliance. When it’s time to sell, use careful planning with a transactional specialist to optimize after-tax cash that ends up in your pocket.