An organization’s legal entity structure should link its tax efficiency, business purpose, strategic direction, and operational effectiveness. An efficient structure creates value for its public or private owners, provides clarity for its employees, and reduces the overall cost structure. This is true whether an organization has two legal entities or a sprawling organizational chart.
Too often, complexity makes its way into the legal entity structure as an unintended consequence of prior tax planning, organic business expansion, or mergers and acquisitions. Over time, the legal entity structure can become redundant, complex, and a drain on resources. In this column, we explore several of the benefits of reviewing the legal entity structure, including tax planning, reducing unnecessary costs, and efficient business operations.
Although large and complex C corporation structures may be top-of-mind when considering entity optimization, a legal entity review is scalable and can have a positive impact on all types of organizations, including public and privately held businesses, partnerships, limited liability companies (LLCs), S corporations, and disregarded entities.
Please note, any reorganization that requires a change of legal form will require an attorney to handle the related filings and effectuate the changes under state law.
Optimizing Tax Posture
Jurisdictions such as Pennsylvania, Philadelphia, Delaware, Maryland, and Virginia impose corporate income taxes by separate company reporting instead of combined or unitary reporting. Organizations in areas such as these have opportunities to optimize their entity structures for tax purposes. Often, the tax benefits come from offsetting net income and losses between previously separate entities, accelerating the use of accumulated net operating losses (NOLs) and credits, or lowering overall apportionment in separate reporting jurisdictions.
These benefits often can be achieved by bringing entities together through mergers, liquidations, or the conversion of corporate entities to disregarded LLCs. This may allow an immediate offset of income and loss between the formerly separate entities and the more rapid use of NOLs. These may be enticing opportunities, but numerous tax considerations require modeling and analysis before changing the legal entity structure. Here are a few considerations:
- Income tax treatment of a restructuring – Does it qualify for tax-free treatment under IRC Sections 351 (corporate contributions), 332 (subsidiary liquidations), 355 (corporate spin-offs), 368 (corporate reorganizations), 721 (partnership contributions), etc.?
- Treatment and carryover of any tax attributes, including NOLs and credits – Does the restructuring accelerate or improve use of these tax attributes? Do the attributes carry over to any successor entities pursuant to IRC Section 381, including state conformity to this provision?
- Quantification of the annual benefits expected based on current and forecasted data.
- Post-restructuring impact, including changes to the state and local nexus profile, apportionment and effective tax rates, and calculation of deferred income taxes.
- Requirements to update entity registrations, withdrawals, issuance and collection of sales tax exemption certificates, issuance of Forms W-9, etc.
- Realty transfer tax implications if there will be a transfer of title or a change in control of entities owning real estate.
- Changes in filers for various taxes, including sales and use tax, gross receipts tax, business licenses, and employment taxes.
- Although Pennsylvania’s Capital Stock/Foreign Franchise Tax was eliminated after 2015, other states still impose franchise and net worth taxes that may be impacted by restructuring. These should be carefully considered before implementing.
- An organization with multiple LLCs subject to the California LLC tax and fee could incur duplicative and unnecessary tax and compliance costs. Does the restructuring eliminate gross-receipts-based fees, such as the California tax and fee that applies to all LLCs operating in the state and that ranges from $800 to $12,590?
Where state income tax planning is part of a business cost reduction analysis, but the desired legal entity reductions are not feasible, it is worth considering whether the tax results can be obtained without eliminating the legal entities involved. For example, can a corporation be converted to a disregarded LLC rather than being eliminated? This may yield the desired income tax result without a significant impact of other taxes or legal considerations. Further, certain states allow taxpayers to elect to file on a combined or consolidated basis, which may achieve the income tax results with no legal entity restructuring. In states such as Florida and Virginia that allow for consolidated elections, it is imperative to model the tax impacts before making an irrevocable filing election.
Tax Compliance and Other Costs
From a tax perspective, additional legal entities increase administrative demands through compliance and reporting requirements. Aside from federal and certain state income taxes that may be required on a combined or consolidated basis, most state and local tax filings are specific to each legal entity. In addition, other nonincome taxes are almost exclusively filed for each separate legal entity, including LLCs. An inefficient structure may result in duplicative filings or create substantial resource demands to comply with income, employment, sales, and property taxes. Tax compliance extends beyond the mere filing of returns: it includes other touch points such as extensions, estimated payments, tax provisions, notices, audits, and amended returns. Streamlining the structure can have a multiplier effect in reducing these compliance costs.
Maintaining each legal entity carries additional annual costs, too, and having an inefficient organizational structure can result in redundant or unnecessary expense. The amount and drivers of those costs vary, based on the level of entity activity, regulatory environment, and other compliance expenses. Estimates range from $10,000 to $50,000 or more per entity. Here are a few other cost considerations:
- Treasury/cash management – An organization’s treasury department manages liquidity, mitigates risk, and supports management and business units. These goals can be compromised by organizational complexity.
- Finance and accounting – Significant resources are associated with financial statement reporting and “closing the books.” The number of legal entities and their alignment across business units or reporting segments can exacerbate unnecessary costs.
- Shared services – Large organizations may have a shared services company that provides legal, tax, audit, accounting, procurement, or insurance services across all legal entities. The more service line agreements, the more costly maintaining extra legal entities becomes.
- Human resources – Maintaining employees across numerous legal entities requires multiple payroll reporting requirements, which may include new nexus, withholding, and other developments resulting from the COVID-19 pandemic and remote work environments.
Business Operations Alignment
Addressing an organization’s legal entity structure can lead to more efficient operations alignment. This exercise can be done any time, but may be most opportune following an acquisition or series of acquisitions, prior to a change of ownership or initial public offering, or following significant tax changes. Create a structure that provides value and aligns with its business purpose and strategic direction. A legal entity review also gives an organization an opportunity to review all aspects of its business operations, such as vendors, contracts, employment agreements, and overall operational and financial key metrics. This may be particularly timely for businesses reviewing COVID-19 impacts, such as the remote work environment, real estate needs, and centralization of operations, employees, and management teams.
Many factors must be considered when determining the number of legal entities in an organization’s structure. Through mergers, acquisitions, and organic growth, even an initially simple legal entity structure can quickly become complex and costly to maintain. The measurable tax and nontax benefits can be substantial and lead to annual cost savings. Start by determining what drives value for the organization (cost savings, operating efficiency, cash taxes, effective tax rate management, planning for future transactions, etc.). Once established, you’re ready to model the tax considerations and design the future state of the legal entity structure.
Drew VandenBrul, CPA, is a state and local tax managing director with Grant Thornton LLP in Philadelphia, leading the firm’s legal entity optimization practice. He can be reached at firstname.lastname@example.org.
Narjit S. Bhogal, CPA, is a director with Grant Thornton LLP in Philadelphia, specializing in state and local taxation. He can be reached at email@example.com.