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M&A on the Way? Consider a QOE Report

Whether you’re considering selling your business or acquiring another one, due diligence is a must. In many mergers and acquisitions (M&A), prospective buyers obtain a quality of earnings (QOE) report to evaluate the accuracy and sustainability of the seller’s reported earnings. Sometimes sellers get their own QOE reports to spot potential problems that might derail a transaction and identify ways to preserve or even increase the company’s value. 

Here’s what you should know about this critical document. Different from an audit QOE reports are not the same as audits. An audit yields an opinion on whether the financial statements of a business fairly present its financial position in accordance with Generally Accepted Accounting Principles (GAAP). It’s based on historical results as of the company’s fiscal year-end. In contrast, a QOE report determines whether a business’s earnings are accurate and sustainable and whether its forecasts of future performance are achievable. It typically evaluates performance over the most recent interim 12-month period. 

EBITDA effects 

Generally, the starting point for a QOE report is the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA). Many buyers and sellers believe this metric provides a better indicator of a business’s ability to generate cash flow than net income does. In addition, EBITDA helps filter out the effects of capital structure, tax status, accounting policies, and other strategic decisions that may vary depending on who’s managing the company. The next step is to “normalize” EBITDA by: Eliminating certain nonrecurring revenues and expenses, Adjusting owners’ compensation to market rates, and Adding back other discretionary expenses. Additional adjustments are sometimes needed to reflect industry-based accounting conventions. Examples include valuing inventory using the first-in, first-out (FIFO) method rather than the last-in, first-out (LIFO) method, or recognizing revenue based on the percentage-of-completion method rather than the completed-contract method. 

Continued viability 

A QOE report identifies factors that bear on the business’s continued viability as a going concern, such as operating cash flow, working capital adequacy, related-party transactions, customer concentrations, management quality, and supply chain stability. It’s also critical to scrutinize trends to determine whether they reflect improvements in earnings quality or potential red flags. For example, an upward trend in EBITDA could be caused by a positive indicator of future growth, such as increasing sales, or a sign of fiscally responsible management, such as effective cost-cutting. Alternatively, higher earnings could be the result of deferred spending on plant and equipment, a sign that the company isn’t reinvesting in its future capacity. In some cases, changes in accounting methods can give the appearance of higher earnings when no real financial improvements were made. 

A powerful tool

If an M&A transaction is on your agenda, a QOE report can be a powerful tool no matter which side of the table you’re on. When done right, it goes beyond financials to provide insights into the factors that really drive value.

Contact one of our experts to discuss more about M&A.

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Tax

Partnership and S Corporation Tax Planning

The Build Back Better Act contains various tax proposals that would affect partnerships, S corporations and their owners. Planning opportunities and other considerations for these taxpayers include the following:

  • Taxpayers with unused passive activity losses attributable to partnership or S corporation interests may want to consider disposing of the interest to utilize the loss in 2021.
  • Taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income (within certain limitations based on the taxpayer’s taxable income, whether the taxpayer is engaged in a service-type trade or business, the amount of W-2 wages paid by the business and the unadjusted basis of certain property held by the business). Planning opportunities may be available to maximize this deduction.
  • Certain requirements must be met for losses of pass-through entities to be deductible by a partner or S corporation shareholder. In addition, an individual’s excess business losses are subject to overall limitations. There may be steps that pass-through owners can take before the end of 2021 to maximize their loss deductions. The Build Back Better Act would make the excess business loss limitation permanent (the limitation is currently scheduled to expire for taxable years beginning on or after January 1, 2026) and change the manner in which the carryover of excess business losses may be used in subsequent years.
  • Under current rules, the abandonment or worthlessness of a partnership interest may generate an ordinary deduction (instead of a capital loss) in cases where no partnership liabilities are allocated to the interest. Under the Build Back Better Act, the abandonment or worthlessness of a partnership interest would generate a capital loss regardless of partnership liability allocations, effective for taxable years beginning after December 31, 2021. Taxpayers should consider an abandonment of a partnership interest in 2021 to be able to claim an ordinary deduction.
  • Following enactment of the TCJA, deductibility of expenses incurred by investment funds are treated as “investment expenses”—and therefore are limited at the individual investor level— if the fund does not operate an active trade or business (i.e., if the fund’s only activities are investment activities). To avoid the investment expense limitation, consideration should be given as to whether a particular fund’s activities are so closely connected to the operations of its portfolio companies that the fund itself should be viewed as operating an active trade or business.
  • Under current rules, gains allocated to carried interests in investment funds are treated as long-term capital gains only if the investment property has been held for more than three years. Investment funds should consider holding the property for more than three years prior to sale to qualify for reduced long-term capital gains rates. Although the Build Back Better Act currently does not propose changes to the carried interest rules, an earlier draft of the bill would have extended the current three-year property holding period to five years. Additionally, there are multiple bills in the Senate that, if enacted, would seek to tax all carry allocations at ordinary income rates.
  • Under the Build Back Better Act, essentially all pass-through income of high-income owners that is not subject to self-employment tax would be subject to the 3.8% Net Investment Income Tax (NIIT). This means that pass-through income and gains on sales of assets allocable to partnership and S corporation owners would incur NIIT, even if the owner actively participates in the business. Additionally, taxpayers that currently utilize a state law limited partnership to avoid self-employment taxes on the distributive shares of active “limited partners” would instead be subject to the 3.8% NIIT. If enacted, this proposal would be effective for taxable years beginning after December 31, 2021. Taxpayers should consider accelerating income and planned dispositions of business assets into 2021 to avoid the possible additional tax.
  • The Build Back Better Act proposes to modify the rules with respect to business interest expense incurred by partnerships and S corporations effective for taxable years beginning after December 31, 2022. Under the proposed bill, the Section 163(j) limitation with respect to business interest expense would be applied at the partner and S corporation shareholder level. Currently, the business interest expense limitation is applied at the entity level (also see Maximize interest expense deductions, above).
  • Various states have enacted PTE tax elections that seek a workaround to the federal personal income tax limitation on the deduction of state taxes for individual owners of pass-through entities.

For more guidance on tax planning for your S corp or partnership, contact one of our tax experts.

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News

Guidance on Tennessee Corporate Income Tax and Taxability of payments from the Tennessee Business Relief Program.

The state of Tennessee announces information regarding federal taxation of certain funding for businesses.  Payments received under the Tennessee Business Relief Program (BRP) or the Supplemental Employer Recovery Grant (SERG) Program are subject to franchise and excise tax. However, the funding from these programs is not subject to Tennessee business tax (also known as a business license), which is based on gross receipts of the business.

Tennessee established the Tennessee Business Relief Program (BRP) and the Supplemental Employer Recovery Grant  (SERG) program utilizing federal CARES Act funds.  The IRS has announced that if a state government establishes an economic relief program, such as BRP and SERG, to support businesses using CARES Act funds, the funding received by a business from such a program is included in federal taxable income.

Because the starting point for determining a Tennessee franchise and excise tax liability is federal taxable income, these payments will be subject to franchise and excise tax. These payments are not included in gross receipts for Tennessee business tax purposes and are not subject to the business tax.

For further guidance, please contact your ATA representative for more information.

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Helpful Articles

2020 Q4 tax calendar: Key deadlines for businesses and other employers

Here are some of the key tax-related deadlines affecting businesses and other employers during the fourth quarter of 2020. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements. 

  • Thursday, October 15 If a calendar-year C corporation that filed an automatic six-month extension: File a 2019 income tax return (Form 1120) and pay any tax, interest and penalties due. Make contributions for 2019 to certain employer-sponsored retirement plans. 
  • Monday, November 2 Report income tax withholding and FICA taxes for third quarter 2020 (Form 941) and pay any tax due. (See exception below under “November 10.”) 
  • Tuesday, November 10 Report income tax withholding and FICA taxes for third quarter 2020 (Form 941), if you deposited on time (and in full) all of the associated taxes due. 
  • Tuesday, December 15 If a calendar-year C corporation, pay the fourth installment of 2020 estimated income taxes. 
  • Thursday, December 31 Establish a retirement plan for 2020 (generally other than a SIMPLE, a Safe-Harbor 401(k) or a SEP). 

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