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Businesses must navigate year-end tax planning with new tax laws potentially on the horizon

The end of the tax year is fast approaching for many businesses, but their ability to engage in traditional year-end planning may be hampered by the specter of looming tax legislation. The budget reconciliation bill, dubbed the Build Back Better Act (BBBA), is likely to include provisions affecting the taxation of businesses — although its passage is uncertain at this time.

While it appears that several of the more disadvantageous provisions targeting businesses won’t make it into the final bill, others may. In addition, some temporary provisions are coming to an end, requiring businesses to take action before year end to capitalize on them. As Congress continues to negotiate the final bill, here are some areas where you could act now to reduce your business’s 2021 tax bill.

Research and experimentation

Section 174 research and experimental (R&E) expenditures generally refer to research and development costs in the experimental or laboratory sense. They include costs related to activities intended to uncover information that would eliminate uncertainty about the development or improvement of a product.
Currently, businesses can deduct R&E expenditures in the year they’re incurred or paid. Alternatively, they can capitalize and amortize the costs over at least five years. Software development costs also can be immediately expensed, amortized over five years from the date of completion or amortized over three years from the date the software is placed in service.

However, under the Tax Cuts and Jobs Act (TCJA), that tax treatment is scheduled to expire after 2021. Beginning next year, you can’t deduct R&E costs in the year incurred. Instead, you must amortize such expenses incurred in the United States over five years and expenses incurred outside the country over 15 years. In addition, the TCJA requires that software development costs be treated as Sec. 174 expenses.

The BBBA may include a provision that delays the capitalization and amortization requirements to 2026, but it’s far from a sure thing. You might consider accelerating research expenses into 2021 to maximize your deductions and reduce the amount you may need to begin to capitalize starting next year.

Income and expense timing

Accelerating expenses into the current tax year and deferring income until the next year is a tried-and-true tax reduction strategy for businesses that use cash-basis accounting. These businesses might, for example, delay billing until later in December than they usually do, stock up on supplies and expedite bonus payments.

But the strategy is advised only for businesses that expect to be in the same or a lower tax bracket the following year — and you may expect greater profits in 2022, as the pandemic hopefully winds down. If that’s the case, your deductions could be worth more next year, so you’d want to delay expenses, while accelerating your collection of income. Moreover, under some proposed provisions in the BBBA, certain businesses may find themselves facing higher tax rates in 2022.

For example, the BBBA may expand the net investment income tax (NIIT) to include active business income from pass-through businesses. The owners of pass-through businesses — who report their business income on their individual income tax returns — also could be subject to a new 5% “surtax” on modified adjusted gross income (MAGI) that exceeds $10 million, with an additional 3% on income of more than $25 million.

Capital assets

The traditional approach of making capital purchases before year-end remains effective for reducing taxes in 2021, bearing in mind the timing issues discussed above. Businesses can deduct 100% of the cost of new and used (subject to certain conditions) qualified property in the year the property is placed in service.
You can take advantage of this bonus depreciation by purchasing computer systems, software, vehicles, machinery, equipment and office furniture, among other items. Bonus depreciation also is available for qualified improvement property (generally, interior improvements to nonresidential real property) placed in service this year. Special rules apply to property with a longer production period.

Of course, if you face higher tax rates going forward, depreciation deductions would be worth more in the future. The good news is that you can purchase qualifying property before year-end but wait until your tax filing deadline, including extensions, to determine the optimal approach.

You can also cut your taxes in 2021 with Sec. 179 expensing (deducting the entire cost). It’s available for several types of improvements to nonresidential real property, including roofs, HVAC, fire protection systems, alarm systems and security systems.

The maximum deduction for 2021 is $1.05 million (the maximum deduction also is limited to the amount of income from business activity). The deduction begins phasing out on a dollar-for-dollar basis when qualifying property placed in service this year exceeds $2.62 million. Again, you needn’t decide whether to take the immediate deduction until filing time.

Business meals

Not every tax-cutting tactic has to be dry and dull. One temporary tax provision gives you an incentive to enjoy a little fun.

For 2021 and 2022, businesses can generally deduct 100% (compared with the normal 50%) of qualifying business meals. In addition to meals incurred at and provided by restaurants, qualifying expenses include those for company events, such as holiday parties. As many employees and customers return to the workplace for the first time after extended pandemic-related absences, a company celebration could reap you both a tax break and a valuable chance to reconnect and re-engage.

Stay tuned

The TCJA was signed into law with little more than a week left in 2017. It’s possible the BBBA similarly could come down to the wire, so be prepared to take quick action in the waning days of 2021. Turn to us for the latest information.

California Small Business COVID-19 Relief Grant Deadline Extended

The State of California Small Business COVID-19 Relief Grant Program, which offers grants of $5,000 to $25,000 to eligible small businesses and nonprofits adversely affected by the pandemic, has extended the deadline for the first round of applications to January 13th, 2020.

Start a grant application here: https://careliefgrant.com/partners/county/

Basics of the COVID-19 relief grant program

The program, which allocates $500 million in financial relief to small businesses and nonprofits that have been impacted by the COVID-19 pandemic, was first announced by Gov. Newsom and the California state legislature on November 30th, 2020.

All California-based small businesses (including sole proprietors, home-based businesses, and independent contractors) and not-for-profits with a yearly gross revenue of $2.5 million or less, and have been in operation since at least June 1, 2019, may be eligible for the grant. It is worth noting that applicants with multiple business entities/franchises/locations, etc. are not eligible for multiple grants and are only allowed to apply once using their eligible small business with the highest revenue.

Grant awards by entity revenue

The grant award ranges from $5,000 to $25,000 based on your operation’s annual gross revenue as reported in the most recent federal tax return.

Gross Annual Revenue – Grant Award
$1,000 to $100,000 – $5,000
Greater than $100,000 up to $1,000,000 – $15,000
Greater than $1,000,000 up to $2,500,000 – $25,000

The award is a true grant, not a loan that has to be forgiven. The funds are intended to be used as working capital for your business’s operating expenses – payroll, rent, loan payments, COVID-protective measures, etc.

Award selection process

The grants are not issued on a “first-come, first-served” basis; rather all applications will be assessed following the close of each application round. The program prioritizes distribution based on key factors, including:

Geographic distribution based on COVID-19 health and safety restrictions;
County status and regional stay-at-home orders;
Industry sectors most impacted by the pandemic;
Underserved small business groups:
- e.g., majority-owned and run by women, persons of color, or veterans, or located in low-to-moderate income and rural communities.

The Small Business COVID-19 Relief Grant Program will be offered in two “Rounds” – with the first Round running from December 30, 2020 to January 13, 2021 at 11:59pm. Everyone who applies during a Round will be given equal consideration. Awards will be announced after each Round closes. The timing of the second and final Round is to be determined.

If you apply in the Round 1 and are not successful, your application will be carried over for consideration in Round 2 without the need to reapply. Businesses can only receive one grant even though there will be two Rounds.

For more information, visit careliefgrant.com

Forging a Path Forward: IRS Provides Guidance on Employee Payroll Tax Deferral

On August 28, 2020, the IRS issued Notice 2020-65 that provides some needed guidance for employers wondering whether and how to comply with the employee payroll tax deferral described in the August 8, 2020 Presidential memorandum (often referred to as an “executive order”). Although many questions remain unanswered, some key items are addressed.

Background on the Executive Order

In an August 8, 2020 memorandum to the Secretary of the Treasury entitled, “Deferring Payroll Tax Obligations in Light of the Ongoing COVID-19 Disaster,” President Trump directed Treasury Secretary Mnuchin to use his authority to defer the withholding, deposit and payment of employee Social Security tax on wages (i.e., 6.2% of employee wages) or Railroad Retirement tax on compensation paid to certain employees during the period September 1 through December 31, 2020. The memorandum instructed the Treasury Department to issue guidance explaining how to implement the deferral and to explore avenues, including legislation, to eliminate the obligation to pay the deferred taxes. Secretary Mnuchin made comments in an August 10 interview that employers would not be required to offer the deferral.

Drawing a line between mandatory and voluntary tax deferral

One of the most pressing questions following the President’s executive order was whether organizations were required to, or could opt-out, of the payroll tax deferral. Although the IRS Notice does not specifically state whether the employee payroll tax deferral is mandatory, the deferral appears to be voluntary, which lines up with Treasury Secretary Mnuchin’s widely reported comments.

Internal Revenue Code Section 7508A (which is the basis for the memorandum and the Notice) allows the President to postpone certain tax deadlines due to a disaster, such as COVID-19. However, Section 7508A does not give the President authority to require taxpayers to use the extended deadline. In other words, even if a deadline is postponed, a taxpayer could continue to adhere to the normal deadlines. As a result, employers can continue to withhold employee Social Security tax or Railroad Retirement tax from September 1 to December 31, 2020 if they do not wish to avail themselves of the deadline extension.

The Notice clearly places responsibility on employers for withholding and depositing the deferred taxes, and states that penalties generally would apply for any failure to comply (although the Notice states that employers can “make arrangements to otherwise collect the total Applicable Taxes from the employee”). Neither the memorandum nor the Notice eliminates the tax liability.

It appears that the employee payroll tax deferral does not apply to self-employed individuals, since it only applies to Social Security tax and Railroad Retirement tax and does not include Self-Employment Contributions Act (SECA) taxes.

Too late for many employers to benefit from deferral option

Since the guidance was released so close to the first available deferral date (i.e., September 1), employers have very little time to modify payroll procedures and payroll systems to allow employees the deferral on the first pay cycle in September.

Under the current IRS rules, it is not possible to “recover” the tax that already was withheld and remitted, but was eligible for the deferral, without causing issues with the employer tax filings and the imposition of penalties. Retroactive changes generally are not allowed simply because a taxpayer failed to use an available extension. This is consistent with the IRS’s position on employers that failed to timely defer the employer’s share of Social Security taxes (6.2%) as permitted under the CARES Act.

Key insights from the IRS guidance

The following are summaries of key points from the IRS issuance.

Dates and Eligibility

The employee payroll tax deferral applies to wages and compensation paid on a pay date during the period beginning on September 1, 2020 and ending on December 31, 2020.
The employee payroll tax deferral applies only if wages or compensation paid to an employee for a biweekly pay period are less than $4,000, or the equivalent amount with respect to other pay period frequencies. This threshold is determined on a pay period-by-period basis.

What it means:
Employees who are paid hourly or whose wages vary from pay period to pay period may not benefit from the payroll tax deferral in every pay period depending on whether the amount of wages exceeds the biweekly threshold of $4,000, or the equivalent. Employers should review with their IT departments or payroll service providers to ensure that the payroll system is configured correctly to determine who is eligible to participate in the employee payroll tax deferral on a pay period-by-pay period basis.

Deferral and Repayment Periods

The due date for the deferred withholding and payment of the employee Social Security tax and Railroad Retirement tax is postponed until the period beginning on January 1, 2021 and ending on April 30, 2021.
Employers are responsible for the deferred taxes and must withhold and pay the deferred taxes ratably from wages and compensation paid between January 1, 2021 and April 30, 2021 or interest, penalties and additions to tax will begin to accrue on May 1, 2021 with respect to any unpaid deferred taxes. If the employee’s wages are not sufficient for the withholdings, the employer can pursue payment from the employee.

What it means:
The very short-term deferral and repayment period results in a modest benefit.

For example: An employee who earns the Federal minimum wage would have an increased biweekly paycheck of $36 (or $324 for nine pay periods, from September 1 to December 31, 2020).

For employees that earn the maximum $3,999 every two weeks for nine pay periods, the benefit is $2,231. ($3,999 x 6.2% x 9 pay periods).

Unless something happens to dramatically improve the employee’s household income before January 1, 2021, the repayment of taxes ratably over the first four months of 2021 may create a greater hardship than their current cash flow shortage.

The dilemma facing employers

Many questions remain in terms of how the employee payroll tax deferral will impact employees and employers, how the deferred payroll taxes are to be reported and what changes must be made to an employer’s payroll system. Until the IRS provides further guidance regarding these outstanding questions and concerns, employers that consider implementing the employee payroll tax deferral should exercise care by putting safeguards in place to ensure that they do not fall victim to the IRS penalties.

Since the employee payroll tax deferral takes effect as early as September 1, 2020, employers that consider implementing the tax deferral likely will face a dilemma due to some of the unanswered questions unless the IRS issues additional guidance soon. For example:

Can a participating employer apply the same deferral policy to all employees, or must the employees be allowed to choose?
What are the consequences if an employee unexpectedly leaves the employer before paying the deferred tax?
If the employer cannot collect the taxes from former employees, is the employer liable for the tax or failure to withhold penalties?
What if the employee does not earn enough wages during the period between January and April of 2021 due to disability, leave of absence, etc., to pay for the deferred tax?
Does the employer report the deferred payroll tax as tax withheld on the employer’s quarterly tax returns (i.e., Form 941) and Forms W-2?
What happens if the employer did not defer the payroll tax, but the government later decides to forgive the deferred taxes? Will the employer or the employees be able to recover the tax that would have been forgiven had the tax been deferred?
Will the IRS provide a mechanism (e.g., revising the employer’s Form 941) to allow employers to “recover” the tax that was already withheld and remitted, but was eligible for the deferral, without causing issues with the employer tax filings and incurring penalties?
What if an employee receives a supplemental wage payment (e.g., bonus) outside of a normal pay period, how will that be treated for the purpose of the $4,000 eligibility threshold?

We will continue to provide updates on the Employee Payroll Tax Deferall program as more information becomes available. If you are unclear on the impact on your organization, or you would like a consultation, please reach out to our dedicated tax team: contact us now

Structuring Transactions to Maximize Value

Welcome to the Cannabis M&A Field Guide from MGO. In this series, our practice leaders and service providers provide guidance for navigating M&A deals in this new phase of the quickly expanding industries of cannabis, hemp, and related products and services. Reporting from the front-lines, our team members are structuring deals, implementing best practices, and magnifying synergies to protect investments and accrete value during post-deal integration. Our guidance on market realities takes into consideration sound accounting principles and financial responsibility to help operators and investors navigate the M&A process, facilitate successful transactions, and maximize value.

Deal structure can be viewed as the “Terms and Conditions” of an M&A deal. It lays out the rights and obligations of both parties, and provides a roadmap for completing the deal successfully. While deal structures are necessarily complex, they typically fall within three overall strategies, each with distinct advantages and disadvantages: Merger, Asset Acquisition and Stock Purchase.
In the following we will address these options, and common alternatives within each category, and provide guidance on their effectiveness in the cannabis and hemp markets.

Key considerations of an M&A structure

Before we get to the actual M&A structure options, it is worth addressing a couple essential factors that play a role in the value of an M&A deal for both sides. Each transaction structure has a unique relationship to these factors and may be advantageous or disadvantageous to both parties.

Transfer of Liabilities: Any company in the legally complex and highly-regulated cannabis and hemp industries bears a certain number of liabilities. When a company is acquired in a stock deal or is merged with, in most cases, the resulting entity takes on those liabilities. The one exception being asset deals, where a buyer purchases all or select assets instead of the equity of the target. In asset deals, liabilities are not required to be transferred.

Shareholder/Third-Party Consent: A layer of complexity for all transaction structures is presented by the need to get consent from related parties. Some degree of shareholder consent is a requirement for mergers and stock/share purchase agreements, and depending on the Target company, getting consent may be smooth, or so difficult it derails negotiations.

Beyond that initial line of consent, deals are likely to require “third party” consent from the Target company’s existing contract holders – which can include suppliers, landlords, employee unions, etc. This is a particularly important consideration in deals where a “change of control” occurs. When the Target company is dissolved as part of the transaction process, the Acquirer is typically required to re-negotiate or enter into new contracts with third parties. Non-tangible assets, including intellectual property, trademarks and patents, and operating licenses, present a further layer of complexity where the Acquirer is often required to have the ownership of those assets formally transferred to the new entity.

Tax Impact: The structure of a deal will ultimately determine which aspects are taxed and which are tax-free. For example, asset acquisitions and stock/share purchases have tax consequences for both the Acquirer and Target companies. However, some merger types can be structured so that at least a part of the sale proceeds can be tax-deferred.

As this can have a significant impact on the ROI of any deal, a deep dive into tax implications (and liabilities) is a must. In the following, we will address the tax implications of each structure in broad strokes, but for more detail please see our article on M&A Tax Implications (COMING SOON).

Asset acquisitions

In this structure, the Acquirer identifies specific or all assets held by the Target company, which can include equipment, real estate, leases, inventory, equipment and patents, and pays an agreed-upon value, in cash and/or stock, for those assets. The Target company may continue operation after the deal.
This is one of the most common transaction structures, as the Acquirer can identify the specific assets that match their business plan and avoid burdensome or undesirable aspects of the Target company. From the Target company’s perspective, they can offload under-performing/non-core assets or streamline operations, and either continue operating, pivot, or unwind their company.
For the cannabis industry, asset sales are often preferred as many companies are still working out their operational specifics and the exchange of assets can be mutually beneficial.

Advantages/Disadvantages

Transfer of Liabilities: One of the strongest advantages of an asset deal structure is that the process of negotiating the assets for sale will include discussion of related liabilities. In many cases, the Acquirer can avoid taking on certain liabilities, depending on the types of assets discussed. This gives the Acquirer an added line of defense for protecting itself against inherited liabilities.

Shareholder/Third-Party Consent: Asset acquisitions are unique among the M&A transaction structures in that they do not necessarily require a stockholder majority agreement to conduct the deal.

However, because the entire Target company entity is not transferred in the deal, consent of third-parties can be a major roadblock. Unfortunately, as stated in our M&A Strategy article, many cannabis markets licenses are inextricably linked to the organization/ownership group that applied for and received the license. This means that acquiring an asset, for example a cultivation facility, does not necessarily mean the license to operate the facility can be included in the deal, and would likely require re-application or negotiation with regulatory authorities.

Tax Impact: A major consideration is the potential tax implications of an asset deal. Both the Acquirer and Target company will face immediate tax consequences following the deal. The Acquirer has a slight advantage in that a “step-up” in basis typically occurs, allowing the acquirer to depreciate the assets following the deal. Whereas the Target company is liable for the corporate tax of the sale and will also pay taxes on dividends from the sale.

Stock/share purchase

In some ways, a stock/share purchase is a more efficient version of a merger. In this structure, the acquiring company simply purchases the ownership shares of the Target business. The companies do not necessarily merge and the Target company retains its name, structure, operations and business contracts. The Target business simply has a new ownership group.

Advantages/Disadvantages

Transfer of Liabilities: Since the entirety of the company comes under new ownership, all related liabilities are also transferred.

Shareholder/Third Party Consent: To complete a stock deal, the Acquirer needs shareholder approval, which is not problematic in many circumstances. But if the deal is for 100% of a company and/or the Target company has a plenitude of minority shareholders, getting shareholder approval can be difficult, and in some cases, make a deal impossible.

Because assets and contracts remain in the name of the Target company, third party consent is typically not required unless the relevant contracts contain specific prohibitions against assignment when there is a change of control.

Tax Impact: The primary concern for this deal is the unequal tax burdens for the Acquirer vs the Shareholders of the Target company. This structure is ideal for Target company shareholders because it avoids the double taxation that typically occurs with asset sales. Whereas Acquirers face several potentially unfavorable tax outcomes. Firstly, the Target company’s assets do not get adjusted to fair market value, and instead, continue with their historical tax basis. This denies the Acquirer any benefits from depreciation or amortization of the assets (although admittedly not as important in the cannabis industry due to 280E). Additionally, the Acquirer inherits any tax liabilities and uncertain tax positions from the Target company, raising the risk profile of the transaction.

Three types of mergers

1: Direct merger

In the most straight-forward option, the Acquiring company simply acquires the entirety of the target company, including all assets and liabilities. Target company shareholders are either bought out of their shares with cash, promissory notes, or given compensatory shares of the Acquiring company. The Target company is then considered dissolved upon completion of the deal.

2: Forward indirect merger

Also known as a forward triangular merger, the Acquiring company merges the Target company into a subsidiary of the Acquirer. The Target company is dissolved upon completion of the deal.

3: Reverse indirect merger

The third merger option is called the reverse triangular merger. In this deal the Acquirer uses a wholly-owned subsidiary to merge with the Target company. In this instance, the Target company is the surviving entity.

This is one of the most common merger types because not only is the Acquirer protected from certain liabilities due to the use of the subsidiary, but the Target company’s assets and contracts are preserved. In the cannabis industry, this is particularly advantageous because Acquirers can avoid a lot of red tape when entering a new market by simply taking up the licenses and business deals of the Target company.

Advantages/Disadvantages

Transfer of Liabilities: In option #1, the acquirer assumes all liabilities from the Target company. Options #2 and #3, provide some protection as the use of the subsidiary helps shield the Acquirer from certain liabilities.

Shareholder/Third Party Consent: Mergers can be performed without 100% shareholder approval. Typically, the Acquirer and Target company leadership will determine a mutually acceptable stockholder approval threshold.

Options #1 and #2, where the Target company is ultimately dissolved, will require re-negotiation of certain contracts and licenses. Whereas in option #3, as long as the Target company remains in operation, the contracts and licenses will likely remain intact, barring any “change of control” conditions.

Tax Impact: Ultimately, the tax implications of the merger options are complex and depend on whether cash or shares are used. Some mergers and reorganizations can be structured so that at least a part of the sale proceeds, in the form of acquirer’s stock, can receive tax-deferred treatment.

In conclusion

Each deal structure comes with its own tax advantages (or disadvantages), business continuity implications, and legal requirements. All of these factors must be considered and balanced during the negotiating process.

Catch up on previous articles in this series and see what’s coming next…

Forging a Path Forward: Impact of the CARES Act on Nonprofits

The CARES Act and the Families First Coronavirus Response Act provide significant benefits and protections for nonprofit organizations. The following provides an overview of the key aspects of each.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act

On March 27th, President Trump signed into law the CARES Act, an emergency relief bill aimed at providing much-needed relief to individuals and businesses in response to the novel coronavirus. Nonprofit organizations also received vital support through the Act. Below are overviews of key provisions that are applicable to nonprofit organizations.

SBA 7(a) CARES Act Loan aka the “Paycheck Protection Program” (PPP)

The definition of eligible businesses for the SBA 7(a) CARES Act loan program includes nonprofit organizations. Generally, only IRC Section 501(c)(3) organizations are included, however veteran organizations (IRC Section 501(c)(19)) and tribal businesses are also eligible. Generally, this program is available to nonprofit organizations with 500 or fewer employees. Organizations can borrow up to 2.5 times their monthly payroll expenses, with a cap at $10 million. Such funds can be used to cover: payroll costs, operating expenses, and rent/lease/mortgage obligations.

Organizations that do not enroll in this program may also qualify for an Employee Retention Tax Credit, whereby the CARES Act provides a payroll tax credit of up to $5,000 per employee, for Not-for-Profits adversely affected by COVID-19. This credit is available for wages paid or incurred from March 13, 2020 through December 31, 2020.
Organizations with greater than 500 employees that are not eligible for the Paycheck Protection Program loan, are eligible for funds through the Economic Stabilization Fund, where monies may be used to provide payroll and related benefits for employees. Monies provided through this fund are not eligible for the loan forgiveness provisions as outlined under the Paycheck Protection Program.

Emergency Economic Injury Disaster (EIDL) Grants

The CARES Act includes $10 billion for the federal Small Business Administration (SBA) to provide emergency grants until Dec. 31, 2020. Any nonprofit organization under IRC Section 501(c) is eligible for this loan program and can seek immediate relief through a $10,000 emergency advance within three days after applying for the EIDL grant. If the entity can substantiate the funds through payroll and operating expenses, the applicant is not required to repay the $10,000 advance and as such, the advance is turned into a grant.

Tax-Related provisions affecting nonprofits

The CARES Act also includes tax provisions that may impact nonprofits. including:

Employee retention credits
Payroll tax deferral

The CARES Act also lifts the limitations on charitable contributions deductible on future tax returns:

Individuals: Charitable contributions 100% deductible (from 60%)
Corporations: Limitation increased to 25% (from 10%)
Donor-advised funds are not impacted through these provisions.

Unemployment Benefits

The CARES Act includes a specific section allowing nonprofit organizations to be reimbursed for half of the costs incurred through the end of 2020 to pay unemployment benefits, including self-funded unemployment benefits.

Signed into law on March 18th, this relief bill mandates paid leave benefits for small business employees, generally employees of organizations with fewer than 500 employees, affected by COVID-19. It also establishes related payroll tax credits for employers.

We understand that in this time of uncertainty you may have growing concerns for the financial health of yourselves and your organizations, employees and families. Please contact us if you have any additional questions, including assistance with applying for the benefits outlined above.