Archives for September 2023

Understanding Earnouts: The M&A Negotiating Tool with Tax Consequences

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After a lull in 2022, merger and acquisition (M&A) activity has picked up this year as expected. However, due to ongoing economic uncertainty, earnouts are likely to play a big role in many deals — which may carry significant tax consequences.

Also known as a contingent consideration, an earnout is a mechanism that promises future payments to the seller in addition to an upfront payment.

The ins and out of an earnout

Today, the gap between what sellers want and what buyers are willing to pay has widened due to several valuation variables — expected cash flows, pricing multiples and rates of return.

Earnouts can help bridge the valuation gap and facilitate deal making by offering a contingent payment that the seller only receives when specific performance targets are met by an agreed-upon date. For example, 10% of the purchase price might be contingent on whether an acquired company meets a specific revenue or earnings target over a two-year period.

Dueling tax treatments
Depending on how a deal is structured, earnout payments may be treated as either part of the purchase price or compensation to the seller for services rendered.

If an earnout is deemed part of the purchase price, it’s taxed at the capital gains rate, generally 15% or 20%. The 3.8% net investment income tax also may apply in this situation. However, if it’s considered compensation, it’s taxed at the applicable ordinary income rate, which can be as high as 37%. (Plus, it’s subject to payroll taxes.)

The characterization of an earnout affects the buyer, too. An earnout that’s treated as compensation is immediately deductible. On the other hand, the earnout must be capitalized and amortized over time if it’s considered a deferred payment on the purchase price.

Compensation vs. purchase price
Several factors can indicate whether an earnout is part of the purchase price or compensation for the seller’s services:

  • Is the seller required to perform services to receive the earnout payment?
  • Are they receiving separate reasonable compensation for those services?
  • Is the seller’s employment required for the entire earnout period?
  • Is the earnout paid even if the seller is terminated?
  • How does the earnout amount compare with reasonable compensation for the seller’s services?

Another important consideration is whether there’s any evidence of intent in documentation related to the transaction. For example, does correspondence show a difference of opinion on the target’s valuation and, in turn, the purchase price? Did the deal close after an earnout was added? Does the letter of intent connect the earnout to the seller’s continued employment?

Do your due diligence
When buying or selling a business, always consult with your tax advisor to ensure the transaction documents and structure reflect the intended tax results. The professionals at Magone & Company can help you navigate M&As to help achieve the most favorable tax position. Call us today at (973) 301-2300 for a specific evaluation of your situation.

This document is for informational purposes only and should not be considered tax or financial advice. Be sure to consult with a knowledgeable financial or legal advisor for guidance that is specific to your unique circumstances.

IRS No Longer Processing ERC Claims

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You have heard or seen on various media outlets that businesses are not taking advantage of the Employee Retention Credit (ERC). However, many companies offering assistance with filing for the credit are taking advantage of the public and making claims where none exists, all while collecting a hefty percentage of the claim.

The money that can be allegedly obtained seems too good for small business owners to pass up — and it most likely is.

In a press release, the IRS  identified several warning signs (red flags) of aggressive ERC marketing, including:

  • Unsolicited calls or advertisements mentioning an “easy application process”
  • Promoter stating they can determine ERC eligibility within minutes or claiming that a business qualifies for the ERC before any discussion of your tax situation
  • Large upfront fees to claim the credit,
  • Fees based on a percentage of the ERC refund obtained

We applaud the IRS’ recent announcement putting an immediate moratorium on processing new ERC claims through at least the end of the year. This decision comes amid rising concerns about a flood of improper claims, putting small business owners at financial risk. You could be in a much worse position if required to repay the credit (along with penalties and interest) than if you never claimed it in the first place.

Always consult a trusted tax advisor before applying for credits or filling out any paperwork that may cost you in the long run.

New Tax Scam Regarding Unclaimed Refunds

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The IRS is cautioning taxpayers of a new scam with the promise of unclaimed refunds.

This phishing scam requests sensitive information, including a photo of your driver’s license, your Social Security number and banking details, in order to steal your identity.

Here are the warning signs:

Suspicious mailer. The scam is sent via a delivery service in a cardboard envelope printed on IRS letterhead. It contains an “important notice” regarding an unclaimed refund. The letter prompts you to fill out personal details and submit it to a filing agent in order to obtain your refund.

Poor grammar, inconsistent capitalization, mixture of fonts. For example, the letter requests: “A Clear Phone of Your Driver’s License That Clearly Displays All Four (4) Angles, Taken in a Place With Good Lighting.”

Awkwardly worded phrases. Poorly written directions include: You’ll Need to Get This to Get Your Refunds After Filing. These Must Be Given to a Filing Agent Who Will Help You Submit Your Unclaimed Property Claim. Once You Send All The Information Please Try to Be Checking Your Email for Response From The Agents Thanks”

Stopping financial fraud in its tracks

If you receive a suspicious letter, do not contact the number on the letter. Instead, report the potential scam to phishing@irs.gov. You may also call the IRS’s main phone number at (800) 829-1040.

If you have questions about protecting your own or your business’ identity, reach out to the knowledgeable CPAs at Magone & Company. Our extensive fraud protection expertise can help keep your personal information under wraps. Give us a call today at (973) 301-2300.

Team “Go With Magone” Joins the Fight Against Alzheimer’s Disease

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On Saturday, September 30, Magone & Company will be raising awareness and funds for Alzheimer’s disease as Team “Go with Magone.”

Team members will participate in the Alzheimer’s Association 2023 Essex-Hudson-Union Walk to End Alzheimer’s® at South Mountain Recreation Complex, 9 Cherry Lane in West Orange, NJ.

The Alzheimer’s Association® is a worldwide voluntary health organization dedicated to Alzheimer’s care, support and research, leading the way to end Alzheimer’s and all other forms of dementia. Walk to End Alzheimer’s is the world’s largest event to support this cause.

On walk day, participants honor those affected by Alzheimer’s with the poignant Promise Garden ceremony — a mission-focused experience that signifies our solidarity in the fight against the disease. During the ceremony, walkers will carry flowers of various colors, each color representing their personal connection to the disease.

Join the fight
More than six million Americans are living with Alzheimer’s disease in the United States. Additionally, more than 11 million family members and friends provide care to people living with Alzheimer’s and other dementias. In New Jersey alone, there are over 190,000 people living with the disease and 272,000 Alzheimer’s caregivers.

To walk with team “Go With Magone” or to make a donation, please visit their team page or contact Julie Zack, Firm Manager at jzack@magonecpas.com.

Trust Taxation: It All Depends on the State

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Trusts are often established to grant legal protection for a party’s assets, ensuring they’re distributed according to the owner’s wishes. In most states, Uncle Sam will still be owed a portion — it just depends on where you live.

A trust can be taxed as a resident trust in multiple states or in no states. The individual or party that creates the trust should pay attention to these four factors for both existing and new trusts to understand how they may be impacted by their location:

  1. Where the trust was created.Several states impose a tax if the party who created the trust (known as the trustor or grantor) resided in that state when the trust was created. In other words, a person could draft a will or establish a trust while briefly residing in the state and the trust will be taxed there — even if that person died after living elsewhere for decades.
  2. Where the beneficiaries reside.A handful of states will tax a trust that has one or more beneficiaries (the trust’s recipients) residing within their borders. For example, California imposes taxes on trust income that is distributed or distributable to a state resident.
  3. Where the trustee resides. Some states will tax a trust if a trustee (the entity that manages the trust) resides in the state. States also may consider the residence of co-trustees, including trust advisors and other non-trustee fiduciaries. For example, a trustee could reside in Nevada, but if the trust also has a fiduciary living in California, California treats the trust as subject to its income tax.
  4. Where the trust is administered. A trust may be taxed by the state in which it’s administered.

Tax nexus trap

Several states don’t impose any income taxes on non-grantor trusts. These are separate taxable entities from the party who created the trust, who retains no control in it. But those states — including Florida, Nevada and Texas — are in the minority.

Moreover, trusts that ostensibly “reside” in those states may be subject to income taxes in other states. That’s because many states find ways to establish tax nexus with trusts that appear to have minimal connection to the state. The term “tax nexus” generally refers to the minimum contacts with a state that are required to subject an entity to taxation in that state.

Minimizing tax risks

It’s worthwhile to review a trust’s connections to high-tax states on an annual basis. Trustors, beneficiaries or trustees may have moved, potentially creating or eliminating tax nexus with different states.

There are also steps you can explore to help cut down the tax liability. For example, the Supreme Court acknowledged that in states that base tax on a beneficiary’s residence, the beneficiary could delay taking distributions until after relocating to a state with a more favorable tax regime. In addition, trusts may avoid taxation in states that base tax on a trustee’s residence by appointing non-resident trustees or replacing resident trustees.

A similar approach could be taken to avoid taxation based on where a trust is administered. Another alternative is removing certain nondiscretionary powers and rights from trustors or beneficiaries.

Proceed with caution

Trusts are generally created to shield assets from taxes, not to create additional tax burdens. As you can surmise from the general information above, they’re a pretty complex undertaking. Be sure to consult with trusted legal and financial professionals to help ensure the outcome you envision

If you have any questions about the tax rules involving a trust, count on Magone & Company as a knowledgeable resource. Reach out today at (973) 301-2300.

This post is for informational purposes only and should not be considered legal or financial advice. Be sure to consult with a knowledgeable tax advisor regarding your particular situation.