Tax Law Income

Is your tax division ready?

March 18, 2021

Editor: Alexander J. Brosseau, CPA

The initial public offering (IPO) process is lengthy and complex, but resilient growth companies can be well positioned for an IPO despite market turbulence and economic uncertainties. The extensive planning, registration, and reporting process and its associated accounting complexities may appear daunting when an IPO is contemplated, but with proper planning and prioritization, the tax department can be prepared to navigate the tax intricacies.

To reduce the market volatility risk of traditional IPOs, companies may contemplate quicker and more cost-effective approaches, such as special-purpose acquisition company (SPAC) transactions, umbrella partnership C corporation (Up-C) structures, or spinoffs. Each comes with a unique set of challenges, though they all share the same trials of increased tax department resource needs, internal controls and financial reporting requirements, and general transaction considerations.

IPO readiness approach

Tax leadership should be actively involved as a company contemplates an IPO or alternative transaction to take the company public. Long before filing the Form S-1 registration statement with the SEC, companies should create a detailed plan and timetable and carefully assess the tax department’s readiness to operate as a public company.

Companies should prepare a comprehensive tax IPO road map that considers project oversight, financial reporting and registration statements, corporate governance, systems, process and controls, and tax technical matters.

Tax department assessment

Startups, spinoffs, and established enterprises alike require a review of the tax department to ensure the appropriate resources are in place to address the following:

  • Pre-IPO structuring;
  • Tax department participation in initial and ongoing SEC filings;
  • Availability, accuracy, and timeliness of income tax-related information used for financial reporting;
  • Accumulation of income tax-related information for required historical audited financial statements;
  • Income tax-related disclosure requirements that specifically apply to public companies;
  • Quarterly financial reporting requirements; and
  • Augmenting or revisiting current internal controls and preparation for certification related to the effectiveness of income tax-related internal controls.

Companies should consider whether their current tax resource model needs to be adjusted. The internal controls, compliance, and required documentation for a public company (versus that of a private company) will likely place additional pressure on tax department resources. Many companies rely on outside service providers for income tax financial reporting assistance. Companies should carefully design internal controls to document and demonstrate management has a sufficiently detailed understanding of their work in order to perform effective oversight and review of work performed by the third-party provider. There may also be independence restrictions to consider that require adjustments to the outsourcing model for tax.

State of internal controls

Often, tax processes for private growth companies tend to be manual and are performed with limited resources. General ledger information often requires heavy manipulation by tax department personnel to obtain legal-entity-level information or other data necessary to prepare income tax accounting on a jurisdictional basis. This increases the risk of reporting errors that could lead to control deficiencies or even financial reporting restatements. Tax departments should thoughtfully perform a risk assessment over income tax accounting cycles. Challenges to consider may include an accelerated close calendar, availability of legal-entity-level data, compliance with current tax law or accounting standards changes, and maintaining appropriate documentation sufficient for internal and external controls audits.

Tax leadership should develop a clear plan to remediate potential process and internal control weaknesses. Effective processes and internal controls should be clearly defined and emphasize regular communication across functions, describe review controls in detail, and integrate tax provision and compliance.

Financial reporting of income taxes

Depending on the IPO structure, the company may need to provide tax accruals for additional reporting periods or updates to existing financial statement disclosures. The tax department should review the sufficiency of the income tax footnote disclosures, including effective tax rate reconciliations, unrecognized tax benefits, deferred taxes, and taxation of foreign earnings. With a public company, such disclosures that typically require management judgment may be subject to increased scrutiny by external auditors and regulators.

A public registrant that is carved out or separated from a larger enterprise will be required to prepare historical, stand-alone financial statements to be reported in an SEC filing that includes a carve-out tax provision prepared on the proper basis (typically known as the separate-return method). The allocation of income taxes of a historically taxable entity is required regardless of whether the carved-out operations will be subsumed into a taxable or nontaxable entity upon consummation of the transaction. Tax leadership should determine the composition for the legal entities of the carve-out business, the availability of relevant tax information for these legal entities, and the best way to extract the data needed for the carve-out financial statements.

Current and deferred income taxes must be allocated to carve-out financial statements in accordance with FASB Accounting Standards Codification (ASC) Paragraph 740-10-30-27 and SEC Staff Accounting Bulletin (SAB) Topic 1.B.1. In determining the tax information to include in the carve-out financial statements, management should:

  • Establish an inventory of temporary differences that correspond to the carved-out assets and liabilities;
  • Perform a deferred tax asset valuation allowance assessment;
  • Determine whether it is necessary to record unrecognized tax benefits, considering the tax consequences of the separation step plan; and
  • Identify existing records and the extent of augmentation needed to support the carve-out tax provision.

Further, FASB ASC Subtopic 740-270 requires forecasted income tax expense to be allocated to interim financial reporting periods. The primary driver of the interim tax provision process is to estimate the annual effective tax rate, which needs to be updated in each interim reporting period. The company should model the prospective global tax rate and then benchmark it to similar public companies. Appropriate interim period tax footnote disclosures will also be required, and sufficient resources should be allocated to timely meet the interim accounting close cycle.

Tax attributes

Secs. 382 and 383 limit the use of net operating loss (NOL) carryforwards and other tax attributes when an ownership change occurs as a result of equity issuances, thereby limiting the company’s ability to offset its future taxable income with prior-year NOLs. State statutes have similar provisions, and the application of these limitations may vary by state. Companies typically disclose whether their attributes are subject to limitation (or will be, as a result of an IPO) in the SEC Form S-1, Registration Statement Under the Securities Act of 1933, filing. Engaging in scenario planning to understand whether a company has incurred a historical change or will trigger a change from the IPO can help increase the company’s future use of NOLs and credit carryforwards.

While alternative transactions to a traditional IPO may present certain benefits, the ownership changes may also limit the use of tax attributes in SPAC and Up-C structure transactions.

Compensation and benefits

A private company that is “going public” through a traditional IPO, a SPAC transaction, an Up-C structure, or a spinoff may seek to make a number of changes to its compensation and benefits structures. Stock-based compensation, employee stock purchase plans, accrued bonuses, prepaid commissions, expense reporting, and similar arrangements should, therefore, be analyzed for tax considerations.

The tax department should ensure existing or future deferred compensation plans comply with applicable tax rules and are efficient for both employees and the employer.

Sec. 162(m) can also have implications for transaction success awards, as well as existing and future cash- and equity-based compensation plans, including, for example, severance, incentive bonus plans, stock options, and restricted stock. Corporate tax deductions for remuneration in excess of $1 million paid to “covered employees” of publicly held corporations may be subject to a disallowance unless an exemption applies. Companies should consider whether this is relevant to any new and existing compensation arrangements.

In addition to the regular deduction ceilings of Sec. 162(m), a company considering “going public” should determine if Sec. 280G is relevant to the particular transaction and whether existing employment arrangements have a payment event that would qualify as an excess parachute payment. Such payments can be nondeductible for the company and cause significant excise taxes to be levied on the recipient. (Excise tax reimbursement to the executive under a costly tax gross-up may be contractually required in some circumstances.)

The company should also consider the potential impacts on payroll tax compliance and planning for pre- and post-IPO payroll reporting (e.g., FICA wage base restart and payroll taxes due).

Additional considerations
  • A stock basis study may be required for stock transfers leading up to the IPO. A study can be beneficial in a spinoff to avoid triggering gain under Sec. 357 when debt is pushed to the spun-off corporation.
  • An earnings and profits study can determine the corresponding withholding obligations of a corporation making a distribution and can allow for more accurate cash tax planning.
  • A transaction cost analysis can determine the tax treatment of fees paid to third-party service providers and can identify potential deductions. While costs that facilitate capital transactions are generally required to be capitalized under Sec. 263, a transaction cost analysis may present opportunities to recover certain fees, depending upon the structure of the transaction and the timing and nature of the services provided. For example, while most costs incurred in a traditional IPO are required to be capitalized, a portion of costs incurred in connection with certain SPAC transactions may be deductible.
  • A preexisting entity may be converted from a nontaxable entity to a taxable entity. Such a change may require recognition of deferred tax assets and liabilities for any resulting temporary differences and may also trigger a requirement for pro forma disclosures.
  • A thorough review of prior tax positions can identify uncertain tax positions and prompt appropriate action to address and disclose such positions ahead of the IPO.
  • A detailed plan can organize an approach for addressing other areas such as sales tax, real property tax, stock transfer taxes, transfer pricing, and intercompany agreements, as well as research and development and other tax credits.
Effective date

Once the effective date has passed, the company’s focus shifts to managing the ongoing financial reporting requirements, as well as monitoring and updating internal controls. The company should provide ongoing training to tax department personnel to ensure familiarity with the latest tax law changes and reporting requirements.

Preparedness is key

With proper planning and prioritization, the tax department can navigate the challenges discussed here. Companies interested in “going public” should organize dedicated focus teams and create an IPO road map well in advance, whether they pursue a traditional IPO, a SPAC transaction, an Up-C structure, or a spinoff. Tax plays an integral role in the pre-IPO structuring, planning, and execution stages of a successful IPO, so developing a tax IPO readiness workplan and securing knowledgeable tax resources to manage the tax implications throughout the IPO timeline is critical.

EditorNotes

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For additional information about these items, contact Mr. Brosseau at 202-661-4532 or [email protected].

Contributors are members of or associated with Deloitte Tax LLP.

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.