Key state tax issues in retail corporate restructuring

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Many retailers have undertaken legal entity restructuring for valid business reasons, including tax planning. To achieve numerous business goals (for example, supply chain management, brand protection, risk management and procurement), retailers have formed new legal entities and transferred certain business operations and related personnel into those entities. From a technical perspective, retailers must carefully review execution details to achieve operational goals and avoid successful state challenges. Traditional legal structures typically achieve and sustain their intended operational and tax results as long as state tax regimes remain static, profit remains steady, and the business operations don’t substantially change. However, even a minor change in any of those areas could trigger business or tax consequences.

Key elements of a typical multistate retail company’s overall structure often include:  
  • Geographic or functional segregation — Isolating strategic business operations or key functions in two or more legal entity structures, such as an East-West structure that manages business operations in unitary states in one legal entity and manages operations from separate return states in another  
  • Intellectual property (IP) planning — Isolating the ownership and management of IP in one legal entity and charging affiliates and/or third parties for the use or exploitation of these assets
  • Intercompany leveraging — Creating interest-bearing notes between subsidiaries to match outside third-party-interest expense paid by the parent company to benefits received by each operating affiliate

When a legal entity structure becomes ineffectual because of legislative or business changes, or creates an excessive administrative burden, business leaders often challenge finance, tax and legal advisers to solve the problem. One trend has been to convert a corporation to a limited liability company (LLC) owned within the consolidated group, because of the LLC’s tax flexibility.

Here are some practical considerations:
  • Methodology to convert to an LLC — This entity choice is used to continue a business operation in a separate legal form while obtaining the tax benefits of combining legal entities. The two ways to convert from a corporation to an LLC include (1) a formless conversion, whereby the corporation changes its state articles of incorporation to become an LLC, and (2) a statutory merger of the corporation into a newly formed LLC.  Federal and state tax implications differ for each method and should be thoroughly analyzed.
  • Retaining the Federal Employer Identification Number (FEIN) in a conversion — The IRS has determined that in a formless conversion of a corporation to an LLC, the LLC generally retains the corporation’s FEIN. It’s less certain whether the statutory merger of a corporation into a new LLC allows the new LLC to use the FEIN of the merged corporation. In addition, the IRS recently indicated it will no longer give formal letter rulings on the retention of FEINs in this type of transaction.
  • Outside debt — Many companies have historically borrowed funds from lenders with the parent company being the primary obligor and many operating affiliates being guarantors, often jointly and severally liable. The liability is often booked on the parent holding company’s balance sheet with no corresponding intercompany loan to subsidiaries. To ensure the payments are deductible at the subsidiary level, companies are converting key operating subsidiaries to an LLC of the debtor. Thus, the operating affiliate’s income flows directly into and offsets the interest expense owed by the parent company.
  • Permits and licenses — Retailers hold various permits and licenses including those related to occupancy, waste water, business, the Food and Drug Administration, and local health inspections and safety. If these licenses and permits are tied to the FEIN, the manner used to convert to an LLC could significantly affect whether the permits will transfer to the new structure. Retailers should also review any specific grandfathered items that may allow the company to operate under an older statutory provision until the entity is transferred or otherwise changed.
  • Intellectual property — Many retailers have implemented an IP management company to own and manage IP used in the business. States have passed add-back legislation, which now renders much of the intellectual property planning ineffective, and thus companies are converting these IP companies to LLCs of the operating company. When an IP company converts from a corporation to an LLC, the retail company notifies the U.S. Patent and Trademark Office of the ownership change, and the registration costs are usually not significant. However, registration costs and administrative efforts outside the United States are often overlooked and may be extremely costly and time consuming.

It’s critical to seek the input of key internal groups including legal, payroll, operations, supply chain and real estate, to reduce any unintended consequences of conversions to a LLC.

Louis Cole

Scot Grierson

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