Smart Income Tax Strategies for Ecommerce Businesses - PART 2

0:18 Stephen Brown

If for some reason you did not attend the first part of this webinar, you can watch that on LedgerGurus' YouTube channel. We talked heavily around company structures, state and local tax. But we just got an overwhelming amount of questions on that.

0:33 Stephen Brown

And today we'll be following up and talking more around due diligence, and what happens from a tax perspective when you go and sell your company.

0:52 Stephen Brown

As with last time, if you have questions, feel free to ask them in the question and answer manager, which is a little in-app thing that you can click on at the bottom of your Zoom screen. You're also welcome to put in questions in the chat if you'd like to.

1:03 Stephen Brown

I'm Stephen Brown, I'm the COO of LedgerGurus and I'll be moderating. With me I have Heather Allen and Steve DeWitt from Tanner, and I will turn it over to you two to pick up the conversation.

1:20 Heather Allen

Great, thank you.

Yeah, again, hopefully getting back together to finish the conversation that we left off a few weeks ago. These are some quick bios for me and Steve, and then also at the end we'll have some contact information we'll put up. So as additional questions or anything else pops up after, please feel free to reach out to us.

1:44 Due diligence on the income tax side

Heather Allen

But we're going to just jump right in where we left off last time.

The next section that we really wanted to talk through, and what we see a lot of our clients, growing companies, what they're getting ready for, is an eventual exit. So it's never too early to start thinking about that, and to know what's going to come up in due diligence, what buyers and their advisors are going to be asking for.

2:13 Heather Allen

You don't ever want to get surprised by that. So having these things in the back of your mind as you're starting your company, as you're growing, even if that's a couple of years out, that's really the best time to start thinking about this.

2:25 Heather Allen

So some of the items we wanted to point out. When you get into this potential transaction phase, the LOI that you get is what really sets the stage. So for large items that you are wanting to negotiate, doing that before signing the LOI, you're setting yourself up in the best position.

2:46 Heather Allen

There'll still be negotiations after for some of the smaller pieces, but as Steve's going to get into in a few minutes, things like, is this an asset sale or is this a stock sale? Negotiating those large items before you sign the LOI will really set the stage and help the process go a lot smoother.

3:03 Heather Allen

Another item you'll want to do is to calculate your own exposure before the buyer does. Just being prepared for any of those items that you think are out there, so that you aren't surprised if they bring up something that you haven't thought about before.

3:22 Heather Allen

So getting your arms around all those state and local tax items that we talked about last time, any other exposure areas, risk management, and maybe they're items that aren't a big deal and that's why you hadn't taken a certain position the years before. But just having those on your internal checklist and being prepared for those before a buyer asks helps the process go a lot more smoothly.

3:52 Heather Allen

Another item to look at is all your federal and state income tax returns. So the positions you've taken on state apportionment, nexus considerations for remote employees or independent contractors, or location of your inventory. Some of the items that we talked about last time that might even be out of your control.

4:09 Heather Allen

If you're using Amazon and their warehousing, you don't have control over where that's going to be, but that may be creating state nexus issues for you. So those are the types of things to have your arms around, and understand what you expect a buyer might ask. Maybe they won't, but then if they do it won't be a surprise to you later.

4:34 Heather Allen

And then lastly, this isn't a lot, but always comes up on a due diligence checklist, is if you have any previous audit, income tax or sales tax. A buyer is always going to ask about that, or any that are in process, as well as any statute extension.

5:01 Heather Allen

So if anyone has had the experience of going through an IRS audit, many times the IRS is behind, and so when they start the audit they immediately ask you to sign a statute extension to give them time to get through the audit. A buyer is going to want to be aware of any of those agreements that are out there, just for any pending liabilities that they may be taking over with the company.

5:19 Heather Allen

Stephen, I'll just stop there for one minute if there's anything that's come up regarding that slide, or let me know if I'm good to move on.

5:31 Stephen Brown

I just want you to explain one concept. What does LOI stand for, and what exactly is that?

5:37 Heather Allen

Yeah, thank you for that. So LOI stands for letter of intent. So that is generally the first type of binding agreement that is entered into in a transaction.

5:49 Heather Allen

It can be maybe just a couple of pages long, but it's the general letter of intent signed by the potential buyer and the seller. Just a very high level overview of what the transaction is, how it may be structured, even items such as, this is the price that we're starting from. There may be negotiations or EBITDA calculations or things after that that may adjust that, but it really sets the general terms that that transaction is going to follow.

6:23 Heather Allen

And generally it has exclusivity with it. So before you sign an LOI you may be talking to multiple buyers, or working with an agent to vet out some different offers. But you're generally only under one LOI at a time, because then that buyer wants exclusivity as you're working through the process before closing the deal.

6:51 Stephen Brown

Awesome, thanks for that explanation. No questions at this time, so let's keep going.

6:51 Non-income tax exposure

Heather Allen

Okay, great. Then on the non-income tax side.

So sales tax. That's a very big one, we see that come up all the time. So going back to what we talked about a couple of weeks ago, really getting your sales tax processes set up correctly at the beginning is what's going to be most helpful when you get to a potential exit at the end.

7:19 Heather Allen

If that hasn't happened, then doing your own internal analysis, getting an expert involved to really look at your nexus issues, if there are states where you haven't been filing and do have nexus, or the taxability of the products, and looking at all of your services and products, whether those should have been taxed or not.

7:38 Heather Allen

Doing those calculations internally needs to be done. If you don't do that, they have whatever the buyer calculates as your exposure. And a buyer's going to want to have a calculation be as large as possible about exposure, to increase any type of escrow or holdbacks. So having some internal calculations on your own, that at least you can negotiate then with the buyer, is going to be really helpful.

8:09 Heather Allen

Payroll tax. The biggest issue we've seen the last few years is remote workers, with COVID, and people have either moved away to somewhere that they wanted to live before, now that they can work remote. Or in order to find those certain individuals with certain skills, you're hiring people in remote locations.

8:28 Heather Allen

So just being aware of any payroll tax exposure. And that includes, I would throw in independent contractors. You can't just put somebody on a 1099 and then avoid any type of payroll tax exposure. Sometimes the buyer, they're going to get very granular on, is this really an employee that should have been on a W-2, or are they okay to be on a 1099?

9:02 Heather Allen

Property tax. This definitely isn't my area of expertise, but it always comes up on a due diligence checklist. So just looking at any of those owned or leased properties and making sure all those filings are up to date. There can also be some transfer taxes and things that apply upon closing a deal, so you want to have generally an attorney making sure they're looking at all of that.

9:29 Heather Allen

And then lastly, I've actually seen some billboards around the Salt Lake area about this, but unclaimed property. Just on the state website, double checking anything connected to the company, for uncashed payroll checks, gift cards, AR credits, and just making sure that gets cleaned up.

9:47 Stephen Brown

Yeah, and I would add to what you've outlined here. We saw a lot of our customers, there were a lot of sales of ecommerce businesses through the beginning of last year. It's slowed down significantly since. But a lot of this stuff goes into how you run your finance and accounting day to day.

10:09 Stephen Brown

There were a number of businesses that we saw where they deprioritised what we had advised them, and then all of a sudden when they went to the sale, the buyer and the accounting firms, the lawyers that were supporting the buyer, also put a lot of emphasis on these things. And what ended up happening in some cases was the price gets impacted.

10:39 Stephen Brown

One of the things we see that doesn't affect tax, but one I would add here, is inventory. If you don't do your inventory counts very frequently, you may have inaccurate inventory amounts that are accounted for, your loss of inventory or leakage, there are different things that will happen.

11:11 Stephen Brown

And from a tax standpoint it's okay to kind of drag that out. But if you decide to take that during the sale, that will usually require a one-time adjustment that usually affects the price of the deal.

11:29 Stephen Brown

So on top of everything else here, I would say all the things that your accountant, whether it's in-house or working with a partner like us, is telling you to do, remember that those things will come to fruition at the time of a deal. And you will pay for that, not only in terms of the work that needs to get done, but oftentimes in the price of the sale of your business.

11:53 Heather Allen

Yeah, I agree. That comes down to, if you're having to push a big adjustment through that lowers your EBITDA, maybe the multiple hasn't changed, but now your overall price has just been lowered.

12:06 Heather Allen

And even some of the intangible consequences of just lowering confidence. As these things come out through due diligence, if the buyer starts to have their confidence in the seller's teams and processes eroded, any of those cracks in the system are there then to be exploited. And we've seen deals get soured by some of these issues coming up later.

12:30 Stephen Brown

I had, let me see if I can get Diana, she raised her hand. Diana, if you want to ask your question over the audio, you're able to, but you'll need to unmute yourself to do so.

12:58 Stephen Brown

All right, Diana, if you have that question, maybe we can wait till a break, or feel free to write it in the question and answer manager. But for now let's keep going.

13:10 Asset sale versus stock sale

Heather Allen

Okay, great. Well, I'm going to pass over to Steve on the different types of sale that you can be faced with on that exit.

13:24 Steve DeWitt

All right, yeah, thanks, Heather.

As you're going along and you're in the due diligence process, and you've built up your really successful business and you're getting ready to sell it to a potential buyer, a lot of times the question that's asked of us is, hey, should I sell the assets of my business, or should I sell the stock that I own?

13:43 Steve DeWitt

And each of those different types of sales structures does come with its own pros and cons. And they have different tax treatments and different legal treatments to the buyer and also to the seller.

14:03 Steve DeWitt

And so I'm going to outline some of the differences that arise. And also, if you were part of the initial presentation that we had, we talked about the different types of entity structures. And so that also plays a role in how you sell your business, and what type of entity that you have, because there are different treatments depending upon the type of entity as well as if you sell stock or sell assets.

14:29 Steve DeWitt

So first we'll cover the proceeds that you're going to receive in your sale. When you have an asset sale, generally the proceeds are received by the company itself, and then those proceeds are allocated to the different assets that the company owns.

14:47 Steve DeWitt

You'll usually go through a negotiation with the buyer and have a purchase price allocation, to assign different fair market values to the assets that are being purchased. So if you go through your balance sheet, you're going to have cash and AR, inventory, fixed assets. And then generally you're going to have this big intangible asset that's not on your books, but that's what the buyer is really trying to get at, is this goodwill that you generated internally over the years, where a lot of the purchase price is also going to be allocated, depending upon the type of business that you have.

15:19 Steve DeWitt

And then that purchase price is allocated to those assets, and then you look at your tax basis, what you paid for those assets, and you calculate a gain on each of the assets.

15:31 Steve DeWitt

And then that gain, depending upon the type of entity you have, would be passed through to the owners if you have an S corp or if you have a partnership. If you have a C corp, then that gain is recognised at the C corp level and taxes paid by the C corp for any gain that's recognised on the sale of those assets.

16:02 Steve DeWitt

And then any residual cash that's left can be distributed out to the owners of the C corp, where tax is then again paid. So that's the downside of an asset sale in a C corp. If you want to get the cash out to the owners, there are two layers of tax that you're going to be dealing with, with dividends and with capital gain treatment, and then also the tax that's paid at the C corp level.

16:26 Steve DeWitt

However at the partnership or S corp level, you just have the one layer of tax. And generally that layer of tax is going to be a mixture of capital gain and ordinary gain, depending upon how the purchase price was allocated to the various assets.

16:39 Steve DeWitt

If you have ordinary type assets like inventory, or fixed assets that have been depreciated, then you could have ordinary income arising from the sale of those assets. And then any kind of goodwill that you've generated internally would be treated as a capital gain to the owners.

17:04 Steve DeWitt

For a stock sale it's a little bit different. If you own a C corp and you sell your stock, then generally that's just going to be a capital gain to the owners of the stock. Similar to if you just own Apple stock or Microsoft stock, you go and sell that, you'll have capital gain treatment. As long as you've been holding it a year or more it'll be a long-term capital gain. If it's less than a year then it'll be a short-term capital gain, which has significantly higher rates.

17:34 Steve DeWitt

And like I said, with a partnership it would be a mixture of capital gain or ordinary gain. And that would also apply if you sell your LLC units. That's something important to remember. If you're in a partnership and you sell your units, it's still treated as an asset sale for tax purposes, and there is the potential to have some ordinary gain to recognise that will be taxed at those higher rates versus capital gain.

18:00 Steve DeWitt

And so there still is a little bit of a mixture on that. That's something that kind of surprises people sometimes, when they sell their LLC interests. It's not all capital gain, it's still a function of the underlying assets that are inside of that partnership when you sell.

18:12 Steve DeWitt

So I'll pause there on the treatment of proceeds and the nature of the gains that happen for the seller, if there are any questions on that. Or Stephen, if you have anything you want to follow up on there.

18:29 Stephen Brown

Yeah, I think this goes back to part one of our webinar, but Steve, correct me if I'm wrong. We spent a lot of time on the setup of the structure, because how things are treated from a tax perspective are very heavily influenced by how you set things up in the beginning. Would you say that's an accurate way to summarise what we've said here?

18:49 Steve DeWitt

Yes, definitely. The way you set it up is going to dictate a lot of what happens down the road when you sell your business.

19:03 Steve DeWitt

And so it's really important, with your goals in mind and the future prospects that you have, that you set it up how you want, to help minimise any potential taxes that could arise down the road when you sell the business.

19:16 Stephen Brown

What are the biggest issues you have seen as customers have come to a sale of their business, things that you're like, oh man, they're asking you a question that they should have addressed years ago? What are the things that you would say are the most common issues or common questions that could be addressed before they get to that point?

19:47 Steve DeWitt

I think recently we see more of maybe issues with 1202 stock. We talked a little about that in our last meeting, where if you had started up as a C corp and had that five-year holding period, there's potential to exclude all or part of the gain under section 1202.

20:05 Steve DeWitt

And so people not realising that that avenue is available to you, and then they get to the point where they're still a partnership or an S corp, and they're looking to sell their business, that opportunity is pretty much closed to them at that point. So that's something to consider when you're first starting up, especially because you have that five-year holding period that you need to worry about.

20:33 Steve DeWitt

And I think too, the sale of a partnership interest, where you have potential for both ordinary recapture or ordinary gain and capital gain, that's some issue that could come up as well that we've seen, where people aren't aware of that mixture of gain that can be there.

I don't know, Heather, anything you want to add on to that?

20:57 Heather Allen

I would just add, I think the S corp election, we talked about this a little bit, but the potential for savings to save self-employment tax, that may be enough to make the S corp election be the right answer. But on a sale, an S corp is harder to deal with, and you're pretty much limiting yourself to just do an asset sale, because the buyer, if they're buying, they may not be able to buy the stock, they definitely can't keep it in an S corp. So that sometimes can pose some additional challenges to work through.

21:39 Heather Allen

I believe Steve mentioned last time, there is some restructuring that can happen around an S corp to make that deal still work. But I think we hear from a lot of clients we pick up a few years into it, maybe then they're a couple of years away from an exit, is, oh man, I wish I would have had this conversation before I made that selection, just to make sure I understood.

22:01 Qualified small business stock

Stephen Brown

All right, we've got some questions now. Let's start with, would it be possible to go back to the 1202 slide, and just briefly reiterate what the 1202 potential is?

22:16 Heather Allen

Yes. Sorry if I'm going to give anybody motion sickness by flipping back really quick to find that slide.

22:28 Steve DeWitt

There you are, right there.

22:39 Steve DeWitt

There is a code section in the Internal Revenue Code that's been around for quite a while. It's mostly come into vogue in the last, I don't know, five to ten years, mostly because of a change that was made about 2010, 2011. So about 10, 12 years ago.

23:01 Steve DeWitt

Where if your stock qualifies as qualified small business stock, you have the potential to exclude 100% of the gain on that stock when you sell it.

23:07 Steve DeWitt

There are various requirements that need to be met in order to have it be considered qualified small business stock. One of them is it has to be originally issued from a domestic C corporation, that's probably the most important aspect of it. There's a five-year holding period, so you have to have the stock issued to you and then hold on to it for five years before you sell it.

23:33 Steve DeWitt

And then when the stock is issued to you, the gross assets of the company have to be under 50 million dollars, hence the small business stock nomenclature that's given to it.

23:48 Steve DeWitt

And it only applies to certain types of business activities. It's actually pretty broad, there are very narrow exceptions to the types of activities that aren't included. Ecommerce is one that is included in the definition of a qualified business. But generally professions such as legal services or accounting services, anything where individuals are performing most of the services, a lot of those are excluded from being qualified for the small business stock exclusion.

24:25 Steve DeWitt

And there are also some rules related to redemptions that I don't think we really need to get into in too technical detail. But the biggest things are, it's got to be a C corp, you've got to hold for five years, and when you get the stock the business has to be under 50 million dollars and be a qualified business.

24:42 Steve DeWitt

Generally if you meet all those requirements, hold on to your stock for five years and then sell it, you're able to have the gain completely excluded from taxation. So that'll save you both a 20% capital gain tax, a 3.8% net investment income tax. And generally most states conform to section 1202, and so usually you save state tax as well.

25:02 Steve DeWitt

I know Utah is one that conforms, I don't think California does from what I remember. So with Utah you're looking at saving about 28.8% tax on that gain if you're able to meet all the requirements. So that's a big benefit of structuring as a C corp if you're looking for a sale down the road.

25:26 Stephen Brown

So you trade off potentially paying more taxes during the operations of the C corp, with being able to keep more of the proceeds during the sale?

25:38 Steve DeWitt

Exactly, yeah. If you have a profitable business and you're trying to get cash out of that business, you're going to be subject to two layers of tax, because the company is going to be paying tax and then you're going to be distributing dividends out which are also generally taxable.

25:55 Steve DeWitt

There are ways around that, maybe you increase wages, but then that's still higher taxes that you're paying on those wages. Whereas if you're a partnership or an S corp and you're profitable, you're able to only have one layer of tax, and so that previously taxed income, those profits, can be distributed tax-free because you've already paid tax on them.

26:12 Steve DeWitt

And so it kind of cuts both ways, and it just depends upon your goals and what you're looking for, for your business and how you want to structure it.

26:26 Stephen Brown

Okay, follow-up question on this topic. RJ says he's selling a single member LLC treated as a C corp since 2013. What do I need to get the 1202 tax benefit? Do I need to have issued the stock years before the sale?

26:49 Heather Allen

So if it's an LLC that made a C corp election in 2013, you're deemed to have issued that stock in 2013. So you have been holding C corp stock since then.

27:08 Heather Allen

So you would just be looking at these other tests. What was gross assets? If you made the C corp election right upon startup, then you shouldn't have an issue at all with the gross asset test. If maybe the LLC was formed a couple of years earlier, then you made the C election in 2013, you'd have to look at value at that time to determine, make sure you're under the 50 million dollars.

27:26 Heather Allen

And then Steve had touched on the redemption issues, but just what else has happened with your cap table over those last 10 years, to make sure there's nothing else that would have potentially disqualified it. But an LLC making a C corp election is deemed to have issued stock on the day that that election was made.

27:47 Steve DeWitt

Yeah, and one thing I should note. I said exclude all the gain, there is a limitation on that. The first bullet point there, I think I skipped over that, but there is a 10 million dollar, the greater of 10 million or 10 times your basis upon the sale.

28:04 Steve DeWitt

So generally you're looking at 10 million dollars, assuming you have a very low basis in your stock, and so the first 10 million dollars of sale, that piece would be excluded.

28:11 Steve DeWitt

Now if it's something where you converted your LLC over to a C corporation, that 10 times basis number actually becomes a bigger avenue to exclude even more gain, because the basis they look at is the fair market value of those assets on the date you converted your LLC.

28:35 Steve DeWitt

So if your business was worth 10 million dollars on the date that you converted, then you could exclude up to 100 million dollars of gain from the date you convert until the date you sold. Because that pre-conversion gain is still not eligible, you'd still be taxed on that, but everything from the date you converted and any increase from there is what's able to be excluded.

29:06 Steve DeWitt

And so there's potential to exclude even more than that 10 million dollars, if the fair value of your assets are even higher on that date that you converted. Sorry, that was kind of jumbled together, but in the long run, if you convert over there's potential to exclude even more because you have a higher basis that you're looking at.

29:24 Heather Allen

And that exclusion is per shareholder. So if maybe two spouses own the company, they each have that potential for the 10 million or 10 times basis exclusion.

29:37 Heather Allen

So there are a lot of planning opportunities as well before sale, if you want to give some stock to family members or that type of thing, and really stack that exclusion, because each shareholder can take that exclusion.

29:50 Stephen Brown

All right, one more question on this topic, not related to 1202 but to that slide. Some clarification on what you said around an S corp being limited to asset sales only.

30:11 Stephen Brown

Let me see if I read what you said. It's harder to do a stock sale with an S corp. It's not impossible, but you're more likely going to have to do an asset sale, is what I heard. Is that correct?

30:22 Steve DeWitt

Yeah, that's right. And it mostly goes back to what we talked about earlier, where there are very strict rules related to who can own an S corporation.

30:35 Steve DeWitt

Generally it's US individuals, certain trusts can also own an S corporation, but you're really limited in the types of owners you can have. And so a lot of times buyers are coming in, they might already be structured as a C corporation or as a partnership, and so they really can't buy S corporation stock because they're not allowed to be an owner of an S corporation.

30:59 Steve DeWitt

And so there are some things that you can do to get around that, and generally it involves selling your assets. Or there are certain elections you can make where you can have an asset sale treated as a stock sale for tax purposes.

31:24 Steve DeWitt

Or did I say that backwards? Legally treated as a stock sale, but for tax purposes treated as an asset sale. So you're just back to having an asset sale, unless you're selling your S corporation to another individual, then you can do a stock sale of your S corporation. But generally in the transactions we see, it's not that situation.

31:48 Heather Allen

And to add a little bit more onto that, the buyer can purchase the S corp stock, it just means the S election is immediately revoked. They can't keep that S election in place if they are not a qualified shareholder or a US individual. So then the company just automatically converts to a C corporation.

32:13 Heather Allen

Most buyers don't want to do that, because they don't want to own the entity that may have prior liabilities. They don't know for sure if the S election was done correctly, they don't want to come in and own that entity with all that prior history as the S corp.

32:26 Heather Allen

So they would rather buy the assets, both for getting the step up in basis, but also to not have any of those carry over legal liabilities that may be attached to that entity. So they could come and buy the stock, it just means the S corp election immediately goes away, but generally buyers are very hesitant to do that.

32:45 Heather Allen

So they either want to buy the assets directly out of the S corp, or they want some of this other restructuring to happen, drop the assets into a new LLC or something like that that they can buy, so that they're not owning that corporation with all the S corp history from before.

33:03 Steve DeWitt

Yeah, and like we mentioned, there are a lot of rules that S corps have to follow, and so that company that's buying that S corporation kind of inherits all those problems. Like Heather said, there could be prior issues with their status as an S corporation, and if there are, there could be big liabilities hanging out there just because of how they were operating as an S corporation in the past.

33:27 Stephen Brown

All right, that's everything, let's move on.

33:27 Consequences to the buyer

Heather Allen

Alrighty. I think we are on consequences to the buyer in a sale.

So when a buyer buys the assets, they are generally able to step up the basis of those assets for the fair value that they purchased them for.

33:52 Heather Allen

So that's where that negotiation comes in on a purchase price allocation. Because if there's going to be an asset sale, the buyer is going to want to allocate more of the purchase price to assets that have a shorter life, maybe to inventory, or maybe to fixed assets that they can take accelerated depreciation on. But the seller wants to allocate more of the purchase price to that goodwill intangible that's going to have capital gain treatment.

34:11 Heather Allen

And so there's going to be some negotiation there on how that purchase price is allocated, because the buyer is going to want to recover their purchase price a lot quicker through having shorter lived assets, while the seller is going to want it more towards the longer lived assets, because they're going to be able to get capital gain treatment.

34:33 Heather Allen

In a stock sale the buyer doesn't receive a step up in basis of the assets. This is really going to be your S corp or your C corporation. Those assets are still locked in there at their historical values, and the basis that the buyer has is all locked up in their stock.

34:51 Heather Allen

And so they'll have a higher basis amount in their stock, and if they go and sell the stock in the future they'll have a lower gain that way. But they're not able to recover really any of their purchase price up front through depreciation or any amortisation, because you can't depreciate or amortise stock, and the assets inside the company haven't been adjusted for any of that purchase price.

35:17 Heather Allen

In an asset sale you're able to cherry pick the assets that you want, and also the liabilities. You can exclude all the liabilities of the target and just go in and buy the assets. Or if there are other liabilities that you do want to take on, you can do that as well. And so it gives you a lot more freedom if you're the buyer, to get exactly what you want out of the company.

35:41 Heather Allen

With a stock sale the buyer is going to be buying the whole enchilada. They're going to be getting all the assets, all the liabilities, all the skeletons in the closet. And so there's a lot more risk for the buyer in a stock sale, so there's going to be a lot more due diligence involved, because of all the potential unknown risks and undisclosed liabilities that might be hanging out there.

36:06 Heather Allen

And a lot of that goes back to what we covered with the due diligence checklist, is to make sure that you've covered all your bases and look at those different liabilities that could be hanging out there, and know your tax exposure before the buyer does, so that you can either fix things, or you have that at least as something in your back pocket when you're going into negotiations with the buyer.

36:31 Heather Allen

When you have a stock sale versus asset sale, there are these things called tax attributes. So these are going to be like your net operating losses, R&D credits that you haven't used, different things that are carrying forward within your company.

36:42 Heather Allen

So if you have a stock sale, those tax attributes generally carry over. So the buyer is going to be able to inherit those net operating losses and those R&D tax credits. So those might be something of value to the buyer when you go into negotiations, because they might be able to offset some of their income with those NOLs and R&D credits that they've purchased as part of purchasing the company.

37:07 Heather Allen

But in an asset sale, none of that stuff carries over to the buyer, and so those just remain with the old company. Which can then be used, if you have an asset sale, to offset that gain from the asset sale. Both the NOLs and the tax credits can help mitigate some of the tax that is generated from an asset sale within something like a C corporation.

37:40 Heather Allen

And then some legal issues that come up. Generally when you have a stock sale, a lot of times the buyer wants to do a stock sale because they want to have important key contracts, key customers, that can come over when they're legally buying the stock of the corporation or of the entity. A lot of times those will transfer over, where in an asset sale they might not.

38:05 Heather Allen

And so that might be the reason that, even though the buyer is not going to get a step up in basis, they still want to do a stock purchase, because they will get those key contracts and customers from the entity that they're buying.

38:16 Heather Allen

And I think that covers all of this slide. Any more questions, Stephen, or anything to follow up on?

38:29 Stephen Brown

Nope, no questions on that topic, and I think we covered the 1202 stuff already, so I think we're good to move on.

38:36 Heather Allen

Yeah, on the 1202, just to make sure, I'm not sure if we had said this already, but in an asset sale, if your C corp is selling the assets and then immediately liquidates, those proceeds coming out to the owners are treated as a redemption distribution upon liquidation of a company. That can actually be excluded under 1202 in the same way as if the seller had just sold their stock.

39:00 Heather Allen

So that's a nice way where buyers still get a step up in assets, seller may still be able to have that gain exclusion. So again, in a C corp setting that's always something that we want to, if that applies, it's a great exclusion for the seller.

39:25 Favourable tax elections and the ERC

Heather Allen

Okay, this information jumps from bullet point to bullet point, but just items that Steve and I wanted to make sure we threw out there. If they're applicable to you, or if you think they might be, it's definitely something to discuss with your tax preparer, just to make sure that you are taking advantage of some of these favourable tax elections that are out there.

39:51 Heather Allen

So in general, businesses are either a cash method taxpayer or an accrual method taxpayer. Probably for your books you're using accrual, just because that's a better reflection of outstanding liabilities as well as receivables. But even if you're using accrual for your books, you can potentially be on a cash method for tax.

40:16 Heather Allen

So in general, if your receivables are higher than your payables, being on a cash method for tax is going to defer that income from your AR until it's collected.

40:35 Heather Allen

So that's something Steve actually just mentioned to me yesterday, a client he was looking at where this year that flipped, so that they're going to do a change of method to get on the cash method and just be able to defer that income.

40:44 Steve DeWitt

I was going to say, they went from about three and a half million taxable income down to about a fifteen thousand dollar loss. So they're able to defer tax on three and a half million dollars of income this year, just by changing to a cash method.

41:00 Heather Allen

Yep. And it's generally something you elect on your first return, but then you can do a change in method later if circumstances have changed.

41:12 Heather Allen

Another one out there, it's been out there for a while so it may not be new, but bonus depreciation, or this accelerated depreciation you can use for tax. It's been at a hundred percent for a number of years.

41:23 Heather Allen

Basically saying, any assets that are required to be capitalised, you may be using a straight line approach over three or five or seven years for your book, but for tax you could take all of that cost as a bonus depreciation deduction in the first year.

41:42 Heather Allen

It's still out there, but starting in 2023 we're on a step down approach due to the 2018 TCJA tax law that was passed. So this year 80% bonus depreciation is available for any new assets acquired.

42:02 Heather Allen

This may be one that is interesting to most people on the call, just being in ecommerce, but the method that you're using to account for inventory changed quite a bit with the 2018 tax law that was passed.

42:19 Heather Allen

It basically has said that small businesses, which is defined in this sense differently than 1202, there are a bunch of different definitions for small businesses in the code, but in this section a small business is defined as a business with less than 27 million dollars currently in average gross receipts over the prior three years.

42:45 Heather Allen

So if you're in that category, you can treat inventory potentially as non-incidental materials and supplies, allowing for accelerated deduction. There's some coordination that needs to happen with how you're keeping your books under this election, but it is something that is new since 2018.

43:06 Heather Allen

Location of fulfilment centres. So we've talked a bit before, if you're using Amazon or a platform like that, you may not have control if they are really deciding where the inventory is being held and shipped from. But if you're using your own warehouses, or you are in control over that.

43:27 Heather Allen

I had a client that moved their fulfilment centre from California to Nevada. Nevada doesn't have a state income tax, so that meant all of their shipments that were going to states where they didn't otherwise have nexus were Nevada sourced, and were not taxable from a state perspective. So everything's still taxable from a federal perspective, but going from California to Nevada, that saves 8.84% for them on all those leftover sales that weren't already going to a state where they had nexus.

44:05 Heather Allen

So again, if you're in control of where your inventory is being held, just looking at that. Or if you're considering a new warehouse location, being aware of what that state's rules are and the state rate. It may either be increasing or potentially decreasing your overall effective state rate.

44:23 Heather Allen

Okay, the last one up here. This is pretty new the last couple of years, but if you hear the acronym PTET, or pass-through entity tax, being thrown around. In Utah this was new for 22, so it's something that many businesses based here have been looking at.

44:41 Heather Allen

It's coming about in reaction to the 2018 tax law that was passed, where if you have a flow through entity that is not taxable at the entity level, so an S corporation or a partnership, all of that income flows through to you as the owner.

45:03 Heather Allen

If you're paying all that tax on your individual return, your state taxes have been limited on your itemised deduction schedule, limited to a total of ten thousand dollars, which includes property taxes on your home as well as any state income tax.

45:19 Heather Allen

So with that cap, there have been a lot of state taxes that have not been eligible for federal deduction the last few years. And this started with states with high rates, California, New York, where their residents, that's impacted them the most by having this cap on their state tax deduction.

45:44 Heather Allen

So as a workaround, many states have now implemented these pass-through entity tax elections, which say for a partnership or an S corporation you could elect to pay your state tax at the entity level, rather than having your individual owners paying that tax at that level. Which gets it off of the individual itemised deduction schedule and out of that ten thousand dollar cap.

46:16 Heather Allen

So say you have an S corporation with a million dollars of net income. I'm going to say you're in Utah just to make it easy, and we're going to pretend that the Utah rate is five percent. That five percent tax that you're paying before would have been limited and you would have lost a deduction for that. But if you choose to pay that at the S corp level, it just reduces your income that's coming through on your K-1 from a federal perspective.

46:40 Heather Allen

So now you just have less income that you're paying on your federal tax return. And then your Utah return, the net tax is the same, Utah's just received it from your S corp instead of from you as the individual. So states don't really care either way that that is paid, but this is getting around the federal limit and allowing for a federal deduction there.

47:05 Stephen Brown

I would just highlight what Heather just talked about. This is a rapidly changing thing that's rolling out throughout the states, and it's a strategy that affects all of your businesses today. So if you haven't had this conversation with your tax accountant, or you need to talk to somebody like Tanner about this, this is something that's very easy to execute and will give you immediate tax benefit today.

47:35 Heather Allen

Yeah, and like all state and local income tax issues, every state is different.

So in Utah it's a little bit of a strange rule, but even if you're an accrual method taxpayer, you had to make this payment in cash by the end of the year to get the benefit. California, you have to make an estimate by June of the current year to elect in, and then you true it up when you pay your extension or your return.

48:07 Heather Allen

So every state is a little bit different. Definitely talk to your tax preparer to make sure you're taking advantage of this. Generally in the resident state of the owners is where that biggest benefit is going to be.

48:20 Stephen Brown

We have a question, Heather. When you're talking about accounting for inventory, accelerated deduction, this is a clarification. Does it mean that COGS can be written off upon purchase, not when it is sold? Is that correct?

48:38 Heather Allen

A portion of that. So generally the actual cost of the inventory item is going to have to still be capitalised, just because inventory, under the IRS rules, even if you're on a cash method, it's still an item that has to be capitalised.

49:00 Heather Allen

But those extra costs, more the G&A costs that are being allocated to your inventory, those are the types of expenses that potentially could be just deducted as incurred, rather than being allocated to the inventory, capitalised and not run through cost of goods until it's sold.

49:18 Stephen Brown

All right, I think we're good to move on.

49:24 Heather Allen

Okay, great. I think we are about on our last slide.

So as Stephen mentioned last time, we just wanted to hit on the employee retention credit, because this is a hot topic. Probably everybody is getting emails and calls and LinkedIn messages from firms popping up all over the place saying, you're eligible for the ERC, have you claimed it yet?

49:44 Heather Allen

So we wanted to touch on the high level qualifications, how you qualify for this, what periods it is in effect for, just to help clarify maybe some of the confusion that's out there.

50:02 Heather Allen

So the employee retention credit was part of COVID relief legislation passed in 2020. So it's effective for all of 2020, and then for the first three quarters of 21. So only through September of 2021.

50:22 Heather Allen

And the credit amounts are different for each period. So for 2020 the maximum credit is five thousand dollars per employee for the whole year. For 2021 the maximum credit is seven thousand dollars per employee per quarter. So it's much larger.

51:07 Heather Allen

Sorry, hopefully I'm back, just been working through a little bug in my throat.

51:13 Heather Allen

So yes, very much a higher opportunity in 2021, and it is on a per quarter basis, so you're not having to look at per day or the whole year at a time.

51:31 Heather Allen

Okay, so the eligibility. The first bullet point here is definitely the most black and white way to claim this credit.

So we're looking at gross receipts, and what the IRS has pegged as baseline is your activity for 2019. So when you look at any quarter in 2019 and then compare that to the same quarter in either 2020 or 2021, if you have a significant decline in gross receipts then you qualify for that quarter.

52:04 Heather Allen

Now significant is defined differently for each year. So for 2020 a significant decline would be a 50% reduction in gross receipts for any quarter as compared to the same quarter in 2019. But for 2021 that threshold increased, right, more companies can qualify, because that significant decline is defined as just a 20% reduction.

52:32 Heather Allen

Or you can qualify by having a full or partial suspension of your business operations during any of those calendar quarters, due to local government orders affecting travel, meeting spaces or anything like that during COVID.

52:48 Heather Allen

So that gets to very local rules in place, so different by state, can even be different by county, or different rural or urban areas.

53:00 Steve DeWitt

And it's important to note too, that if it affects you, say in California, it does apply to your whole business even if you have operations everywhere. So it's not like it would just be for whatever you're doing in California, it would apply to your whole business.

53:19 Heather Allen

Right. And so if you can support that for any part of that quarter, then you qualify for the whole quarter to claim that credit. Which means you'd be going back to amend your quarterly payroll report to claim those credits.

53:33 Heather Allen

So again, this is outside of income tax, but is a payroll tax credit. And it's a refundable credit as well, so if you paid less payroll taxes than the amount that you can get back with the credits, then you'll get that amount back as well.

53:53 Steve DeWitt

And then the other important thing to remember too is that it's basically a reduction in your payroll tax expense, and so the credits are taxable that way, because it's reducing your expense. Where there are other programs like the PPP loan where those generally were not taxable once they were forgiven. These will increase your tax, but you still come out ahead since you're getting a reimbursement of payroll taxes that you paid.

54:16 Steve DeWitt

And generally, in addition to amending your 941s, your payroll tax returns, you likely will need to amend your 2020 and 2021 income tax returns, to reflect the reduced amount of payroll taxes on those returns for the credits that you're going to be getting back. The IRS has said that they need to correspond with when those wages were paid, that's when those credits need to be recognised, and so you really shouldn't be pushing them through when you get the refunds. You need to go back and amend the income tax returns.

54:52 Heather Allen

Right. And those refunds, we've seen them take six months, 12 months, it may be longer than that. So depending on the size of the claim, the refund can take quite a long time.

55:05 Heather Allen

This needs to be coordinated with any potential PPP loan that you received. So you can't claim a credit under the employee retention credit program for the same wages that you got a PPP loan for.

55:25 Heather Allen

Now a lot of people with their PPP loans, it was just easiest to submit their wage details on their forgiveness application. There is the opportunity to go back and say, well, were there other qualifying expenses that weren't wages that we could have used to support our PPP forgiveness, which then frees up those wages to be claimed for ERC.

55:47 Heather Allen

So just keep in mind that that needs to be coordinated. Anybody that's looking at an ERC calculation should be asking you for any PPP documentation as well, to make sure that there's not double dipping taking place.

56:00 Heather Allen

Our last point on here is just to watch out for all of those phone calls and emails that you're getting. If you believe that your business applies under one of those two bullet points in the eligibility section, just make sure that you're working with a firm that didn't just pop up six months ago, that doesn't only do ERC claims. One that is going to be reputable and be around for any future audit support.

56:33 Heather Allen

The statute of limitations on an ERC claim is five years, so it is longer than an income tax return. And so you want to be working with professionals that are still going to be here at least five years, in case within that five years your claim gets pulled for audit.

56:52 Heather Allen

We have a credits and incentives team that looks at this. There are other reputable firms out there as well, but we've just seen a lot of fly by night places that you think are probably not real, and scams out there.

57:04 Heather Allen

And this is actually, the IRS has put out warnings about this. In Utah recently there was a big criminal case that indicted a firm that was just fraudulent companies and claiming fraudulent claims. So just make sure that you're vetting whatever potential provider, if you believe that you have some opportunity here to go back and claim that refund.

57:29 Heather Allen

And that's getting back to our due diligence thing. This could be another item that comes up in due diligence that a buyer is going to want to see, know that you have good support for any ERC credits that you've claimed. Because if they're buying the entity it could come back on them, and so it's something to even keep in mind for something like that.

57:53 Heather Allen

Okay, I'm going to flip to our last slide, which just has our contact info.

57:59 Stephen Brown

To summarise the ERC, I'd say definitely take a look at it, but be careful with who you work with. A lot of the people that are out there advertising hard are not going to be here in six months, and if you're under any issues with how it was prepared, you're up a creek. So be wise, is what I would say on that credit.

58:27 Stephen Brown

All right, let's wrap it up. So if you want to talk to Heather or Steve, we've got their contact information here. Any final questions from the audience before we wrap this up?

58:40 Stephen Brown

All right, we don't have any questions. So thank you again for joining us for this second part. Heather and Steve, lots of great information. Hopefully it's been beneficial for those that have attended, and for those who will be watching this later.

Again, thank you for attending, we'll talk to you later.

59:01 Heather Allen

Thanks.