SALT DEDUCTION WORKAROUNDS CREATE M&A STRUCTURING OPPORTUNITIES

Any company engaging in sell-side M&A activities should consider the potential tax savings stemming from the recent enactment of state tax laws that allow entities classified as partnerships or S corporations for U.S. federal income tax purposes (“Pass-Through Entities”) to elect to pay entity-level state income tax (“PTE Tax”). In addition to the potential U.S. federal income tax savings that may arise as a result of such an election to pay PTE Tax on a Pass-Through Entity’s ordinary course operating income, such an election, under the right set of facts, may provide significant tax savings to owners of a Pass-Through Entity that disposes of its business in a transaction treated as an asset sale for U.S. federal income tax purposes.

Section 164(a)(3) of the Internal Revenue Code of 1986, as amended (the “Code”),^[1] generally allows a taxpayer to deduct state and local income taxes paid or accrued by the taxpayer within a taxable year. The Tax Cuts and Jobs Act,^[2] however, added Section 164(b)(6) to the Code, which imposes a $10,000 annual limitation on an individual taxpayer’s deduction of certain taxes (including state and local income taxes) for taxable years beginning after December 31, 2017, and before January 1, 2026 (the “SALT limitation”). Notably, in enacting Section 164(b)(6), Congress stated that “taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.”^[3]

In response to the SALT limitation, more than a dozen states (including Alabama, Arkansas, Arizona, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oklahoma, Rhode Island, South Carolina and Wisconsin) have enacted a mandatory or optional PTE Tax on Pass-Through Entities that do business in, or have income derived from, sources within the jurisdiction, or are otherwise required to file state income tax returns in the jurisdiction. If the Pass-Through Entity is subject to, or elects to be subject to, the PTE Tax, its owners, in preparing their state income tax returns, are generally permitted to claim an exclusion or credit for the owners’ shares of the PTE Tax paid by the Pass-Through Entity.^[4]

Until the issuance of Internal Revenue Service (IRS) Notice 2020-75, however, there was considerable uncertainty regarding whether state and local taxes imposed at the Pass-Through Entity level pursuant to a mandatory or elective PTE Tax regime were subject to the SALT limitation at the individual owner level. Notice 2020-75 clarified the IRS’s position by announcing that forthcoming proposed Treasury regulations would provide that (1) amounts paid by a Pass-Through Entity to satisfy its direct liability for state and local income taxes would be deductible by the Pass-Through Entity, (2) such amounts would be reflected in an individual owner’s distributive or pro-rata share of the Pass-Through Entity’s non-separately stated income or loss and (3) state and local income taxes imposed on, and paid by, a Pass-Through Entity would not be subject to the SALT limitation at the level of the individual owner of the Pass-Through Entity. Taxpayers can rely on the Notice prior to issuance of the proposed regulations, and on the proposed regulations prior to their finalization. Such guidance applies regardless of whether the imposition of PTE Tax is mandatory or elective, or whether the Pass-Through Entity owners receive a partial or full exclusion, credit or other state tax benefit that is based on their respective shares of the PTE Taxes paid by the Pass-Through Entity.

Given the growing number of states that have adopted (or are considering) PTE Tax regimes and the IRS’s guidance in Notice 2020-75, taxpayers may, in certain situations, find it to be more tax-efficient to structure a sale of a Pass-Through Entity’s business in a manner that is treated, for applicable income tax purposes, as a sale of the assets of such Pass-Through Entity (and not the equity interests of such Pass-Through Entity). In such a transaction, the applicable Pass-Through Entity would pay, or elect to pay, PTE Tax in the applicable states on any gain resulting from such asset sale in order to pay the state and local income taxes at a level where the deduction under Section 164 is not subject to the SALT limitation. As a result, changing the structure of such a sale could create substantial tax savings to the owners of a Pass-Through Entity (particularly to those who are residents of states with a high state income tax rate, such as California and New York).

However, taxpayers should be careful to ensure that any changes to the structure of the sale of a Pass-Through Entity’s business do not create adverse U.S. federal, state and local income tax consequences to the owners of the Pass-Through Entity that outweigh the U.S. federal income tax benefit of escaping the SALT limitation. For example, changing the transaction from a sale of equity interests to a sale of assets may change the character of the gain recognized by the owners of the Pass-Through Entity as a result of the sale (i.e., by converting capital gain into ordinary income or by converting long-term capital gain into short-term capital gain). Additionally, an asset sale may create state income tax obligations that would not have arisen (or are higher than the obligations that would otherwise have resulted) had the equity interests in the Pass-Through Entity been sold by its owners. Finally, taxpayers that determine it would be beneficial to avail themselves of the SALT limitation workaround should try to structure their transactions as the sale of equity interests, from a legal perspective, in order to avoid the imposition of state sales or use taxes and the need to obtain counterparty consents to assign contracts, licenses or permits to the buyer, while also achieving asset-sale treatment for U.S. federal income tax purposes (e.g., by relying on elections under Section 336(e) or Section 338(h)(10), in the case of an S corporation, or pre-sale restructuring transactions that result in the target being treated, for U.S. federal and applicable state and local income tax purposes, as disregarded as separate from a Pass-Through Entity).