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    State Tax Pitfalls and Traps of Private Equity Investment in the Middle Market

    Private equity (“PE”) groups invest in middle-market companies creating numerous benefits to companies and investors alike; however, it also creates the potential for the state tax posture of the operating company or target company to unknowingly and drastically change.

    When PE groups invest in middle-market companies, new legal entities are often created for investment or debt financing purposes, etc. which results in tiered entity structures that did not exist prior to the PE ownership. These newly formed tiered structures may also involve moving people or assets from one legal entity to another. Consequently, these new structures may result in unexpected state tax filing requirements during the transaction and after the transaction.

    Pre-Acquisition Pitfalls:

    • The type of entities (i.e., partnerships or single-member limited liability companies, etc.) included in the tiered structure may change who the taxpayer or return filer is for a specific state.
    • The carryover of tax attributes such as credits or net operating losses from the purchased entity (or target) may be impacted by the transaction steps or the order of the transaction steps, resulting in the unexpected, permanent loss of those attributes.
    • Certain state tax deductions that a partnership was able to take prior to the PE ownership and tiered structure may disappear once the tiered structure is put into place, resulting in an unforeseen tax increase.
    • Indirect tax implications are often overlooked such as sales tax, payroll tax, property tax and real estate transfer taxes related to the structuring (i.e., moving of people and assets) and/or after the transaction.

    Post-Acquisition Traps:

    • Credits and incentives (both statutory and negotiated) should be given a fresh review, especially if after the PE ownership change, the operating company will be making new capital investments, creating new jobs or consolidating locations. Utility incentives, cash grants, tax abatements and refundable income tax credits may apply.
    • Net operating losses should be analyzed to determine if any opportunities exist to more efficiently utilize the losses before they expire.
    • Generally, “SALY” (“same as last year”) can no longer be followed. If a company’s tax preparer simply prepares state returns the same as it did before the PE ownership, errors are likely to be made. The new structure may not only result in new filing methodologies and new taxpayer reporting, but the nexus (taxable presence) footprint of the operating company or the newly created entities may have changed.
    • The sourcing of sales for both income tax and sales tax purposes should be reviewed. A state’s sourcing methods could result in sourcing sales to one state for sales tax purposes and another state for income tax purposes. This doesn’t only happen to companies that sell services, but also companies that sell tangible personal property. For example, sales of services can be sourced to the location of the customer or where the service is performed. A sale of the tangible property could be sourced to the ultimate destination or where the title is transferred, or possession took place. If selling software or software-as-a-service (SaaS), the sale could be sourced to more than one state. Drop shipments and dock sales also cause additional complexities.
    • Apportionment methods should be reviewed to ensure single sales factor elections haven’t been overlooked or alternative apportionment methods could result in a better representation of the company’s activity in a state.
    • If the new structure results in a new affiliated group or unitary group (i.e., group of companies operating as one), then combined returns instead of separate stand-alone state returns may be required to be filed. Additionally, not all entities in the group may be unitary, resulting in separate group returns.
    • Sales taxation of intercompany transactions, mixed and bundled transactions, digital goods and services, SaaS, etc. should be revisited, along with the confirmation that customer sales tax exemption certificates are being properly stored and maintained.


    Private equity groups and middle-market companies must be diligent in proactively addressing all state and local tax and indirect tax matters before, during and after the acquisition.

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