Case Study

The Curious Case of an Expensive Tax Credit

SUMMARY/OVERVIEW

Navigating Complex State Tax Credits

When is a tax credit not what it appears to be? It's a question that might seem peculiar on the surface, but it's one that had major implications for a Northeast-based software company. In preparing to sell the business, the company reached out to BDO. In providing guidance to the client on calculating the potential state income tax implications of the sale, our team of experienced professionals identified $500,000 in savings that might not otherwise have been discovered. We also uncovered a hidden risk in the client’s initial analysis: Although the client’s modeling showed the pass-through entity tax (PTET) election as beneficial, the proposed application of state credits in this situation would have resulted in a significant tax liability.

Key Takeaways

$500,000 in tax savings for the client

Advised on PTET elections to avoid increase in federal income tax 

Work completed within one week

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The Challenge

Navigating Tax Laws in Dozens of States

With operations in 36 states, the sale of the partnership interest would generate significant state tax for its individual owners. Because of unique sourcing rules in the company’s state of commercial domicile, as much as 90% of the gain could be taxed there, and the state had one of the nation’s highest tax rates. Most of the individual owners were residents of the company’s headquarters state and already had substantial state tax credits there, including credits for taxes paid to other states where the business operated.

To report the sale correctly, the client asked BDO to determine how each state sources gain from the sale of a partnership interest. The client also asked whether the owners could benefit from a PTET election to create a deductible expense and mitigate the federal $10,000 cap on the individual state and local tax deduction. After factoring in credits for taxes paid to other states, our team also noted that additional credits generated by a PTET election could trigger substantial federal income tax for the individual partners.

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The Approach

A Strategic Approach to Multistate Tax Credits

Many of the states where the company had nexus required entity-level income tax withholding on behalf of nonresident partners based on their apportioned share of taxable gain. With the sale set to close in a matter of weeks — and with the investors looking for a prompt, proper cash distribution from the transaction gain — we worked to quickly identify an approach that would help the client withhold the appropriate amount of state income tax, while also performing a deeper dive to identify substantial savings for some partners based on unique state rules.

For example, while most of the holding company’s partners resided in the headquarters state, several lived in states that do not impose an individual income tax. By getting involved in the sale early, we were able to structure the transaction in a way that largely eliminated income tax for those individuals in the other states where the company operated. 

When we analyzed and calculated the potential benefit of a PTET election, we found that the client’s proposed use of the state credits generated by the election — together with additional credits for taxes paid to other states — could result in significant federal income tax for the individual partners. Our team concluded that the incremental federal tax cost outweighed the benefit of making the PTET election.

To help mitigate the impact of gain being subject to tax in the headquarters state that had high tax rates, we identified other planning opportunities across the 36 states where the company operated and leveraged favorable state tax rules to help offset the headquarters state liability.

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The Results

Significant Savings and a Fast Turnaround

  • Cost and Time Savings

    During our review, we found approximately $500,000 in tax savings for the client to offset the substantial tax impact in the headquarters state. 

    Further, understanding the time-sensitive nature of the ask, we delivered our findings to the client within a week. 

    Our work also alleviated the burden on internal teams, allowing them to continue to focus on their day-to-day responsibilities while our professionals performed the work and provided the experience needed to complete the analysis.

  • Peace of Mind

    Another key benefit to the client was establishing parameters for future tax filings. Our guidance, combined with the client’s proactive inquiry, allowed us to view the transaction from the beginning, making the process easier for them while providing peace of mind that they didn’t miss any key details by going it alone.

  • Due Diligence

    Even when a transaction seems straightforward, it’s always best to engage subject matter experts for additional review. In requesting that BDO review the state tax implications of the proposed sale, the client was able to reduce the tax it would have otherwise paid. 

When it comes to tax consequences, never make assumptions. State taxation is a complex area that depends not just on federal tax laws, but also on the interplay of various state and local jurisdictions. An ounce of prevention truly is worth a pound of cure.
John Damin
Managing Director, State & Local Tax
Timing is everything when it comes to proactive tax planning for an exit event. By engaging in strategic conversations with our clients and owners about their goals before a transaction is executed, we have the flexibility to design an effective tax savings strategy from the ground up, validate it through tax modeling, and help reduce the risk of pitfalls. Rather than reacting after a transaction closes, involving our state tax professionals early allows us to identify opportunities for significant cash savings.
Ilya Lipin
Tax Principal, State & Local Tax