Don’t Forget the SALT When Selling Your Tech Company

State tax considerations play a crucial role in the complex process of selling your technology company. While federal taxes often take center stage, state and local taxes (SALT) can significantly impact the outcome of a liquidity event. The extent and various applications of SALT require thorough due diligence in any deal to identify each party’s obligations when structuring the contractual terms. Below we discuss some of the many SALT considerations that founders should plan for prior to completing any transaction.

Asset vs Stock Sale

When deciding between an asset sale and a stock sale, both buyers and sellers ought to evaluate the tax implications of each type of sale. This process involves a careful analysis of the specific circumstances of the transaction, including the nature of the business, the types of assets involved, and the goals of both the buyer and seller.

• Tax Rates: In a stock sale, the seller typically realizes capital gains or losses on the sale of the stock. In an asset sale, however, depending on the assets being sold, the seller’s gains or losses may be subject to the higher ordinary income tax rates. Accordingly, sellers often prefer stock sales for the potential capital gains treatment, while buyers usually favor asset sales for the ability to step-up the basis of the acquired assets.
• Step-Up in Basis: For a buyer, one of the key advantages to an asset sale is that the acquired assets are stepped-up to their respective fair values on the date of acquisition. This provides the buyer a higher tax basis in the acquired assets, which the buyer can use to reduce its future tax burden when those assets are used in the business, depreciated, or sold to another party.
• Qualified Small Business Stock (QSBS): In some instances, certain gains on the sale of stock by a founding member or investor can be excluded from Federal income tax if specific conditions are met. Several states allow for this favorable tax exclusion as well, but some do not. Careful planning can result in substantial tax savings for sellers when structuring a transaction with considerations around QSBS.
• Pass Through Entity Tax (PTET): An asset sale by an S corporation or partnership may permit sellers to take advantage of state PTET regimes as a way to circumvent the individual federal cap in the SALT deduction. By electing into PTET, a seller may significantly reduce their federal tax liability by deducting state PTET paid by the company. Diligent analysis and deal structuring is critical to achieve this favorable outcome.
• Depreciation: In an asset sale, the seller may face depreciation recapture on certain depreciable assets, such as computer equipment. This means that a portion of the gain is treated as ordinary income due to previous accelerated depreciation deductions.

Apportionment

State apportionment considerations related to the sale of assets or partnership interests are crucial when buying or selling a business, especially if the business operates in multiple states. Apportionment is the process by which a business allocates its income, expenses, and assets among different jurisdictions for income tax purposes. Each state has its own rules and formulas for apportionment, and understanding and managing these considerations is essential for both buyers and sellers.

• Business Apportionment: Every state has different rules regarding how to apportion business activity and income. It is critical that management ensures the company follows SALT apportionment rules throughout the company’s lifecycle as noncompliance may negatively impact the outcome of a liquidity event if discovered during due diligence.
• Proceed Inclusion: Diligent consideration is required when determining a seller’s state apportionment. Depending on the terms of the transaction, states may require the inclusion of gross or net proceeds in the receipts or sales factor, thereby significantly increasing the tax exposure of the transaction to the respective state.
• Sourcing Receipts: States use a number of methods for sourcing receipts. How the sales proceeds are allocated among the assets sold can further impact the amount of taxes owed to a state. Planning around this consideration becomes more complex for companies with multiple revenue streams, as each stream may fall under different sourcing rules for each state.

Transfer and Sales Taxes

Key aspects to navigate in a transaction are the transfer and sales tax implications. These often are the most overlooked taxes, leaving parties incredulous when discovered during the due diligence process, or in a tax examination after the closing has occurred.

• Sales Tax: The sale of tangible personal property, such as computer or office equipment, as part of the sale of a business may be subject to sales tax. The buyer is typically responsible for paying sales tax on the purchase of these assets, but some exceptions may apply. This is especially critical for companies selling bundled hardware and software packages to customers, as hardware inventory sold to a buyer would be subject to sales tax in many states. Some states also have occasional sales tax exemptions when a significant portion of the assets are sold outside the ordinary course of business.
• Transferee Liability: In some cases, buyers may inherit a seller’s tax liabilities, including unpaid sales taxes. Software subscriptions are subject to sales tax in many states and are at times overlooked by companies in growth stages. This compliance becomes more complicated for companies bundling hardware with software packages and for companies generating transaction-based revenues. For this reason, sales tax analysis is a critical focus leading up to and during the due diligence process in identifying and addressing any existing tax liabilities before completing the transaction. “Bulk sales” certificates can help mitigate this exposure by notifying creditors and the taxing authorities of the pending transaction and creating an escrow account from the sales proceeds to address any outstanding tax liabilities.

Residency

State residency also plays a role in the taxation of business transactions. As part of planning ahead for a liquidity event, establishing or changing your state residency can impact your overall tax picture as resident-states can tax all income earned by a resident-taxpayer. State tax rates, deductions, and exemptions vary, making residency a strategic consideration to help founders and investors minimize their overall tax burden.

• Income Tax: The seller’s state of residency affects the taxation of capital gains from the sale. States have varying income tax rates, and while most states don’t have preferential capital gain tax rates, some may not tax certain types of income such as capital gains. Moreover, in some cases, the buyer may be required to withhold a percentage of the purchase price and remit it to a state if the seller is a nonresident and a portion of the purchase proceeds are allocated there.
• Residency Changes: If the seller is contemplating a change in state residency, the timing of the transaction in relation to the change of residency can have significant implications. In general, efforts should be made to change states of residency well in advance of a sale in order to establish oneself in the new jurisdiction. This is especially critical to plan if the residency change is international in nature. Taxing authorities are adverse to letting taxpayers leave their state with an anticipated windfall to be received shortly thereafter without scrutinizing them about the supposed move.

In conclusion, navigating state tax considerations through a liquidity event involves a comprehensive understanding of many tax aspects. It is important to remember that SALT rules are unique, and no two states are exactly the same. By carefully considering these factors, founders and investors can make informed decisions to optimize their tax positions, ensure compliance, and eliminate risks when planning for a liquidity event.

For more information on the SALT considerations surrounding the potential sale of your technology company, please contact Alan Goldenberg – Tax Principal and Leader of the State and Local Tax Controversy Group, Chris Noble – Partner and Leader of the Technology Group, Adam Pizzo – Partner in the Technology Group, or your Anchin Relationship Partner.