Issue 15-2014 —This edition of Tax Advisor Weekly is a follow-up to an article previously posted, “Entity Simplification: Not So Simple (But Likely Beneficial).” When we published that article, the economic environment was fairly uncertain, and most tax and finance groups were actively seeking ways to reduce costs. Fast-forward to today and, in many ways, not much has changed. There is still increased pressure on companies to reduce costs. Our original article on this subject focused generally on how to approach entity simplification projects and the common issues encountered. For many companies, while the concept is well received, the undertaking of the effort is often put off in favor of more pressing endeavors. This article focuses on the execution strategy and the very real upside that might be available if the effort is undertaken.
Entity Simplification — Who & What
“Entity simplification,” “entity rationalization” and “structural streamlining” are all terms used to describe both large and small projects involving the review and evaluation of the legal entities that make up a company’s corporate structure, with the goal of merging, liquidating or otherwise eliminating unnecessary entities. The intended result is a streamlined structure, with greater business, operational and tax efficiencies. Such an analysis tends to be relevant for any company with an overly complex organizational structure, particularly:
- Companies with material mergers and acquisitions activity (i.e., serial acquirers, companies with cross-border transactions, spin-offs, complex structures, inherited structures, etc.);
- Entities that held assets that have subsequently been sold;
- Legal entities formed for tax planning, regulatory or legal reasons;
- Historical multi-state or international structures (sandwich structures, structures with cash inefficiencies);
- Entities with redundant or repetitive functions (accounting, tax, treasury, procurement, etc.); and
- Otherwise dormant entities.
Entity Simplification — Why?
The primary reason that companies undertake an entity simplification review is to achieve cost savings. Fewer entities will necessarily result in lower financial reporting costs, tax return preparation costs, annual filing fees and maintenance costs. It is usually an important exercise to produce a cost-benefit analysis in order to obtain buy-in for such projects. There are many ways to ballpark the amounts saved by eliminating entities (both direct and indirect costs) and, depending on the number and complexity of the entities, over time, such savings could be quite material.
In addition to the obvious compliance and maintenance cost savings, consideration should be given to quantifying the costs to be realized by changing certain processes and practices. For example, if a procurement function is centralized, this change to the way in which business is conducted will surely result in incremental savings. There may also be cost savings associated with improved data management, possible reduced reliance on outside providers and reduced costs to defend on examination by the various taxing authorities. Having fewer people generally equates to a lower cost model (e.g., fewer employees to pay, less management time spent attending to such entities, eliminating the need to maintain the physical address of certain entities, etc.). In addition, reporting becomes far more transparent and straightforward when you are not caught in the mire of a complicated legal structure.
On the other hand, there are labor costs associated with undertaking such a project, as well as possible one-time costs that should be weighed. For example, consideration should be given to severance costs, relocation costs, overtime costs, lease cancellation costs, etc. Depending on the size and scale of the proposed project, such costs may or may not be worth incurring to achieve a tighter structure.
Another potentially significant benefit of undertaking such an analysis may be the identification of tax planning opportunities such as loss planning. For example, a loss from worthlessness of stock/security issued by a subsidiary corporation that is affiliated with a taxpayer is an ordinary loss, even though the security would otherwise be treated as a capital asset (Section 165(g)(3)). There are stock ownership and gross receipts tests that must be met, but there is also an important issue of timing. Such an ordinary loss deduction is allowed only where the stock becomes wholly worthless in the year in which the worthlessness is being claimed (there is an identifiable event leading to the worthlessness). Depending on the circumstances, there may be an opportunity for a parent company to claim a worthless stock deduction when, under the entity classification (check the box) rules, an election is made to change the classification of the subsidiary from a corporation to a disregarded entity. Such a conversion may be treated as an “identifiable event” under IRC Section 165(g)(3) and Rev. Rul. 2003-125. Of course, many factors would need to be considered (reportable nature of transaction, satisfaction of gross receipts and ownership tests, timing and value considerations), but the bottom line is that without undertaking a detailed review, the opportunity to take advantage of such events may be missed.
Another area that comes up frequently is the question of debt versus equity. On a recent entity simplification project, we encountered a subsidiary that had a material intercompany debt obligation with its parent company. The initial analysis was that the subsidiary was insolvent and therefore ineligible for Section 332 liquidation. Upon further inquiry and review, we determined that the balance was really more in the nature of capital contributions. No interest was paid, no note was maintained, the advances were to fund operations, and there was no expectation of repayment. This resulted in a much better answer for our client, and was a more genuine reflection of the nature of the transaction.
The point is, without a detailed review, the likelihood of stumbling across planning opportunities becomes more and more remote.
Entity Simplification — How?
Once the decision has been made to undertake an entity simplification project, there are two important components that often do not receive appropriate attention: (1) the front end — the strategic design of the plan, and (2) the back end — the actual execution and follow-through. These are the two areas that most often lead to failed or incomplete attempts to achieve full results from an entity simplification program.
The Front End — Strategic Design
To achieve optimum rationalization results, it is important to understand the “end game” or goal for the business. For example, is the goal to simply eliminate dormant entities? If so, it might be a fairly straightforward exercise to identify shell entities and run them through an analysis to confirm that they are ready to be unwound. If, however, your effort is intended to be broader than just attacking the “low-hanging fruit,” then you might need to take a step back, form a multidisciplinary committee and agree upon the overall goal.
In an ideal world, a company would undertake the “tabula rasa” approach — i.e., given a blank slate, what would the structure look like? In this instance, the analysis should certainly extend beyond tax such that the ideal structure would more closely align with the operations of the business. For example, a multinational company that has experienced significant growth through acquisitions is likely to have a number of legacy entities that are not structurally aligned in an efficient manner. Depending on how the acquisitions were integrated (or if they were integrated), there could be duplicative or overlapping functions, as well as inefficiently located operations (sandwich structures, etc.). By taking a critical look at how the structure of the business would have been designed from inception, a much more aggressive approach might be taken to determine which entities “make the cut” — literally and figuratively!
Specifically, a design phase is needed. To come up with the design, the steering committee should set strategic guidelines, priorities and ground rules. For example, the team should identify core business lines for which failure would result in a material loss of revenue, profit or other value. It is also important to identify material legal entities that are significant to the activities of the core business lines and/or are needed for tax, regulatory or other legal or business reasons. For example, certain entities might need to be maintained to preserve tax-efficient profit management. In any event, during this phase, cost, timing and other priority guidelines should be established.
The Back End — Implementation
Once the team has organized itself, gathered the appropriate data, vetted the target entities and developed a plan (see detailed discussion of this process in 2010 (Issue 6): “Entity Simplification: Not So Simple (But Likely Beneficial)”), the single most important element to ensure that the simplification effort yields the intended results is to have a dedicated team that has been tasked with, and is held accountable for, implementing the plan. Team members should have assigned roles and stick to a detailed workplan with agreed-upon timing. Too often, these projects are put on the back burner, with no one driving the process. Without a commitment from management, companies might find themselves several years down the road, with the same cost burden, possible lost planning opportunities and even increased risk.
It is also critical that the team be in regular consultation with legal, accounting, tax and other advisors — whether internal or external — to make sure issues are properly vetted, as hasty decisions could have a disastrous impact on a company (e.g., loss of legal protection, elimination of an entity key to tax planning, possible officer/director (responsible person) liability, violation of regulatory requirements, loss of key tax attributes, basis, triggering of deferred intercompany gains, etc.).
Alvarez & Marsal Taxand Says:
While the implementation of an entity simplification process takes planning and consideration, for companies with heavy legal structures and significant cost burdens, the savings and opportunities may far outweigh the effort.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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