Trending Tax Issues in Middle Market Deals
One of the more common issues with substantial tax impacts that is discovered through tax due diligence in an M&A transaction is a failure to file a “Check-the-box” election form with the IRS. Surprisingly, these issues are rarely the result of an aggressive tax position or misinterpretation of the rules; this usually becomes an issue because of a mistake made by an attorney, a CPA or the company.
A “Check-the-box” election is a form that tells the IRS whether a legal entity intends to be treated as a corporation (either an “S” or a “C”), a partnership, or a disregarded entity for federal income tax purposes. Once an election is made by a legal entity, generally, that election remains in effect until a subsequent, valid replacing election is made.
While there are specific situations where no election is required to be filed, these are rare, and should be scrutinized carefully. The election itself is a short form, Form 8832, that simply requires the company to elect how it wants to be treated for tax purposes, and files the form within 75 days of the intended effective election date. The IRS allows for late relief if the company failed to file the form timely. However, the late relief must be filed within 3 years and 75 days (and meet certain other requirements as well).
Simply failing to file the election form often gives rise to some of the more burdensome tax exposure concerns on buy-side tax due diligence, where the resulting tax exposure could be as much as 50 percent of the deal value, or more. The effect of failing to file the form usually results in one of the following unintended consequences:
- S corporation intended to convert to a disregarded entity, but failure to file the election resulted in a C corporation.
- Partnership intended to be a C corporation, but the failure to file causes a non-US investor to be invested in US activities without a blocker corporation.
- C corporation intended to convert into a flow-through at a time when the company had low value, but failure to file the form resulted in a subsequent conversion at a much higher value.
Parties to an M&A transaction can avoid these egregious consequences by (1) clear communication as to the responsibilities between the attorneys, client and tax advisor, and (2) regular review of the transaction detail step-plan with the responsible parties.
The check-the-box election is a routine part of most transactions, yet failure to complete this form can present extremely onerous tax consequences. Given the relative simplicity in completing this form, buyers and sellers should be extremely diligence in communication and roles related to the elections to eliminate such risks.
Insight Tax Advisors is a specialized M&A tax advisor. Should you be engaged in a transaction and need assistance in addressing issues related to the above or any other transaction related tax issue, please reach out to info@insighttaxadvisors.com.