Admittedly, I am not a big consumer of social media. I don’t have a Facebook page; I have never used Groupon; I have been scolded by colleagues for not effectively leveraging the business potential of LinkedIn; and I’m not exactly sure what Zynga is. While I am most certainly behind the times on these trends, I am acutely aware of the impact these businesses are having on the economy, society and even politics, as we saw last year in Egypt and other parts of the Middle East.

And, while so much of the financial press over the last year has been dedicated to economic troubles — stubbornly high unemployment, lack of a sustained housing recovery, European debt woes and the like — there has been a relative bright spot: initial public offerings (IPOs) of social media enterprises. The biggest headline grabber of them all — Facebook — will likely become one of the largest IPOs in U.S. history. Although the appropriateness of the lofty valuations placed on these companies has been the subject of much debate, one thing that is not debatable is that pre-IPO companies must spend significant time and effort making sure they are prepared for the many challenges inherent in transforming a privately owned company into a successful public enterprise.

While the rewards of an IPO can be great, these challenges should not be underestimated. One such challenge is to understand the tax implications and make informed decisions early to minimize unfavorable tax consequences later. Taxes have a material impact on a company’s cash flow and profitability, create new financial reporting requirements and present unforeseen financial statement risks — all factors that must be analyzed in-depth prior to an IPO. This article provides an overview of the state income tax considerations of IPOs, including increased financial reporting requirements, the impact of a new organizational structure on state tax posture and attributes, increased tax compliance issues and new demands on the department.

Financial Reporting Requirements — New Stage, New Rules

Public companies have always been held to a high standard with regard to reporting of financial information. And with the passage of the Sarbanes-Oxley Act of 2002, public companies have become subject to far more strenuous financial reporting requirements than their private counterparts. Public companies must establish and maintain strong internal controls on all aspects of financial reporting, including reporting of income taxes. To establish an adequate internal controls framework for the tax function, it is important to get a complete understanding of your company’s current tax posture and identify areas of potential tax exposure. Management must consider how to quantify current risks associated with the tax function, design appropriate internal controls to manage those risks, and equip the department with adequate tools and resources to carry out these duties.

SEC Focus — Accounting for Income Taxes

The road to an IPO is a long one. For the tax department, it often begins with the Securities and Exchange Commission’s requirement for three years of audited financial statements, including the need for adequate tax disclosures. In our experience, the SEC has been focusing on public companies’ need for and release of valuation allowance (or reserves) related to deferred tax assets. Guidelines for valuing state tax assets are set forth in ASC 740, Accounting for Income Taxes (formerly FAS 109).

For example, if a company has state net operating loss (NOL) carryforwards, the NOLs must be appropriately valued for financial reporting purposes. If the state NOLs were previously acquired in a transaction to which the federal attribute carryover rules applied, state conformity to the federal rules must be examined. Management must also determine whether the state NOLs may be used to offset taxable income in a future period prior to the NOLs’ expiration. If the NOLs may not be used, it may be necessary to set up a valuation allowance for all or some portion of the related deferred tax asset. The valuation of deferred tax assets and establishment of valuation allowances could be materially impacted by a new organizational structure that the company might implement prior to the IPO. Additionally, evidence of taxable income in the future may be different based on revised forecasts prepared in connection with the IPO event. Going public has a way of making finance executives more conservative. In addition, the IPO itself and the costs of being a public company can change management’s thoughts on future earnings and strategic planning. All of this impacts valuation allowances and must be managed closely to avoid scrutiny from the SEC.

Analysis and Documentation of Uncertain Tax Positions

In accordance with ASC 740-10, Accounting for Uncertainty in Income Taxes (formerly FIN 48), a tax benefit from an uncertain income tax position may only be recorded if it is more-likely-than-not that the position is sustainable, based on its technical merits. If a tax position meets the more-likely-than-not recognition threshold, management must then measure and record the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. If the tax position does not meet the more-likely-than-not threshold, then no tax benefit can be recorded for that position in the financial statements. This rule applies to all tax positions accounted for in accordance with FASB’s ASC 740-10, including tax positions in previously filed tax returns or tax positions expected to be taken in a future tax return. The decision not to file a tax return in a jurisdiction is also a tax position that falls under ASC 740-10 rules.

Some primary state tax issues that may impact a company’s ASC 740-10 analysis are:

• Economic/affiliate nexus;
• Combined/consolidated reporting;
• Apportionment/single sales factor;
• Limits on NOL utilization;
• Disallowance of intercompany expenses; and
• Business/nonbusiness income classification, particularly in connection with significant transactions.

The IRS now requires taxpayers with reserves for uncertain tax positions to disclose such tax positions on Schedule UTP as an attachment to their federal income tax return. Some states are considering whether to require the same or similar disclosures for the reporting of uncertain tax positions. The recent but untested economic substance statute also provides some interesting uncertainty to tax planning. As states may adopt the federal statute or develop their own approach, we have yet to fully understand how this law will impact planning and reserve positions.

State Tax Audits

Prior to the IPO, companies should document all open audits and identify a timeline to completion for each. Depending on the underlying tax issues and related exposure, management should consider whether it makes sense to try to speed up the audit process through settlement offers or other means. If the company is currently under IRS audit, remember to consider the state requirements for reporting changes to federal taxable income.

Choice of Organizational Structure

Determining the new organizational structure for the enterprise is one of the most important pre-IPO planning steps. If the company has existing state tax attributes, such as NOLs or tax credits, the new structure should allow for the utilization or carryover of these attributes where possible. The new structure should also attempt to minimize the company’s cash taxes with the appropriate amount of risk. Depending on the pre-IPO state tax posture and legal entity structure, management may want to consider moving certain operations or functions to existing or newly formed entities to take advantage of more beneficial state apportionment formulas and/or lower statutory tax rates. In deference to my international tax colleagues, this is also an appropriate time to consider the potential benefits of locating certain operations outside the United States.

In addition to the desired tax consequences, management has to weigh its desire for a simple structure against the new investors’ desire for a low tax rate with low potential to fluctuate. A simpler structure will likely require some internal mergers or dissolutions prior to the IPO. When analyzing the tax consequences of potential mergers & acquisitions transactions, a company cannot simply assume that the state tax treatment will follow the federal tax treatment. For example, Massachusetts and New Jersey, among others, do not conform to the federal attribute carryover rules that allow for the succession of tax attributes to an acquiring corporation in certain liquidations and corporate reorganizations. In the event that a loss company experiences an ownership change and is subject to an annual IRC Section 382 limitation on the amount of taxable income that may be offset by NOL carryforwards, state conformity to the federal NOL limitation rules must also be considered.

Generally, with more specific state tax planning involved, there could be more complex compliance and accounting obligations. Conversions from a flow-through entity, such as an S corporation or partnership, to a new corporate entity may require the filing of short-period tax returns. Utilization of partnerships or limited liability companies may give rise to partnership filings and partner statements. Companies must anticipate the effect these new requirements will have on existing tax (and non-tax) department processes and resources.

The bottom line for public companies is that investors generally prefer structures that generate predictable earnings and yield consistent effective tax rates. If management decides to pursue legal entity restructuring, the restructuring should be completed before the IPO to ensure that there are no surprises that could adversely impact the company’s earnings or tax rate after the offering.

Capital Structure

A key consideration in pre-IPO tax planning is the capital structure of the new enterprise. Generally, having operations and employees in the public company is not desirable. Determining which legal entity will hold third-party debt, how interest payments will be made and how intercompany cash flow will be managed can have a significant impact on state tax expense. New and existing intercompany debt arrangements must be adequately accounted for and documented to limit any resulting state income tax exposure and maximize related benefits.

Tax Department Requirements and Resources

Converting to a public company challenges even the most experienced of tax departments. Whereas a private company may choose to take cost-savings measures in its accounting or tax functions, a public company must be prepared for increased scrutiny and low tolerance for errors, and cannot afford to take shortcuts. In addition, because of audits and potential litigation, the documentation requirements for public companies can be more onerous than for a private company.

When analyzing the tax department impact of increased financial reporting and compliance requirements, several key items must be addressed:

1. Determine additional requirements of your tax department (increased compliance and financial reporting, systems and process upgrades, etc.).
2. Assess the abilities of current tax department personnel and the tools and resources you provide to them to carry out their obligations.
3. Consider hiring additional internal resources (preferably with public company experience).
4. Consider using an external provider to help develop and implement a tax strategic plan that lines up with management’s priorities and plans.
5. Adopt a risk management style that approximates the overall risk management style of your finance department.

Alvarez & Marsal Taxand Says:

The key to a successful IPO is to start planning well before the initial offering. The state tax consequences of an IPO can have a material financial statement impact and should be given consideration early in the process. The tax department must have adequate internal and external resources to meet the increased financial reporting and compliance requirements that go along with performing on the public stage.

If you like this article, you can follow me on Twitter. (Not really.)

Author

Donald Roveto III
Managing Director, New York
+1 212 763 9632
 | Profile

Kristen Gray, Senior Associate, contributed to this article.

For More Information:

Craig Beaty
Managing Director, Houston
+1 713 221 3933
| Profile

Benjamin Diaz
Managing Director, Miami
+1 305 704 6650
| Profile

John Easterday
Managing Director, Chicago
+1 312 288 4015
| Profile

Anthony Fuller
Managing Director, San Francisco
+1 415 490 2256
| Profile

Mark McCormick
Managing Director, Atlanta
+1 404 260 4081
| Profile

Brian Pedersen
Managing Director, Seattle
+1 206 664 8911
| Profile  

Kelly Peele
Managing Director, Seattle
+1 503 442 3625
| Profile

Matthew Polli
Managing Director, Atlanta
+1 404 260 4078
 | Profile

Carolyn Campbell Shantz
Managing Director, Houston
+1 713 221 3919
| Profile

Other Related Issues:

12/07/2011
 

10/18/2011

06/22/2011

Disclaimer

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.  

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.

About Alvarez & Marsal Taxand
     
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.

Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in nearly 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.

To learn more, visit www.alvarezandmarsal.com or www.taxand.com