Business tax considerations amid economic headwinds

An operating business that takes time now to understand the tax ramifications of a debt restructuring could improve outcomes for partners or shareholders if such action becomes necessary amid intensifying economic challenges.

A restructuring or workout often involves a cancellation of debt income. Understanding what triggers a cancellation of debt income event, the exclusions that may apply and differences in how they affect corporations and partnerships could strengthen organizational decision-making, said Nick Gruidl, partner and leader of the M&A practice in RSM’s Washington National Tax group.

Indeed, entity type is a crucial distinction. For a transaction involving a partnership, for example, the impact is generally felt at the partner level. If the distressed business is a C corporation, the transaction is generally limited to the corporation.

One common source of a cancellation of debt, regardless of a company’s health, is the modification of a debt instrument. While the definition of modification can be quite broad, such an event is more likely to occur during challenging economic conditions like there are currently. They can include the deferral of interest payments and the extension of a maturity date, changes in interest rates and reduced collateral on debt.

If a cancellation of debt income event occurs, exclusions and deferral opportunities might exist. It’s important to understand, however, that when the COD event occurs at a partnership, the rules around insolvency and bankruptcy provide the exclusion at the individual partner level instead of the partnership level.

“This is often a surprise for companies that go through debt workouts without talking to their tax advisors,” said Patrick Phillips, principal in RSM’s Washington National Tax M&A practice. “Partners can get stuck with COD income without any cash to pay the taxes, and there’s no exclusion because the partners themselves are not in bankruptcy or are not insolvent.”

Middle market companies are pivoting their operations to mitigate shrinking profit margins amid high inflation and the economic downturn.

“Margins are eroding—it’s not one thing, it’s many things,” said Casey Chapman, RSM principal and leader of the firm’s supply chain consulting practice. He cited extended lead times, higher trade and tariff costs and fluctuations in foreign currency among many supply constraints.

Fast-changing compliance regulations and indirect expenses such as value-added taxes and excise taxes are adding to cost pressures, along with workforce staffing and jurisdiction considerations, said Justin Silva, RSM tax partner and leader of the firm’s tax accounting methods and periods group. Now, more than ever, companies must have a clear sight line into their entire cost framework, he said.

Silva stressed that volatility in cost variables makes a strong case for reliable internal systems to analyze data from across an organization. “If your costs change month over month, and you were accustomed to quarter over quarter or year over year, how quickly is that data being reflected so you can analyze it and make a good business decision?

To hedge against global instability, some companies are drafting plans to move their supply operations out of China to other areas within Asia, as well as to diversify their supply chain, while others are divesting non-core assets, Chapman said. Silva said some businesses he serves are eliminating low-profit or high-cost products or services from their lineup.

Mike Fletcher, an RSM tax partner who specializes in supply chain issues, said he has seen a real emphasis and focus around pricing details built into supply contracts.

More robust costing models are now essential, the group said, noting that businesses with inventories are developing more complex inventory management strategies. In some instances, accounting methodologies are changing to relieve the tax burden, Silva said. At some clients, he observes a move toward equipment leasing rather than outright purchases, and a shift to the first-in first-out (FIFO) method of valuing inventories from last-in first-out (LIFO).

INSIGHT FOR THE CEO: If there is a silver lining to the unstable economic environment, it might be how it has been a catalyst for digital transformation, such as predictive modeling.

Silva said that while he sees companies finding alternative ways to incentivize investments in people through environmental, social and governance initiatives, he is seeing them accelerate digital transformation and adoption of technology that increases efficiency and improves data access points, regardless of costs.

Chapman noted that businesses are looking at demand planning and more artificial intelligence and machine learning solutions. There are data consolidation tools like enterprise performance management (EPM) systems and business intelligence systems that pull data from multiple sources and can be used to allocate costs systematically. Doing so will enable visibility to key factors such as cost changes and margin profiles. Managers can make quicker decisions around pricing, cost reduction initiatives and rationalization of products and potentially customers.

Businesses competing for talented employees seek to differentiate themselves by offering compensation packages that feature more than just salary. Whether those benefits include educational assistance, health and wellness support or shares of equity, or other incentives such as career development and ESG initiatives, understanding the tax implications can help an organization make decisions that support its business objectives and avoid surprise costs.

“Tax shouldn’t drive the conversations; your workforce strategies really are tied into your overall business strategy,” said Anne Bushman, partner in RSM’s Washington National Tax group and leader of the firm’s compensation and benefits practice. “But tax can’t be ignored, either.”

Tax implications of cash compensation usually are straightforward compared to those of other benefits. But even so, as Bushman noted, the trend toward hybrid and remote work has introduced additional questions, such as in which jurisdictions an employer might have reporting obligations.

Then, in addition to cash, a so-called total rewards package might include various benefits with tax treatment that is more complex.

“Some can be taxable, some can be nontaxable, some are deductible, some are nondeductible—it’s a crazy mix of all of that,” said Pete Berard, RSM senior director and leader of the firm’s employment tax practice.

Remote work, itself, as a recruitment and retention tool comes with a litany of tax considerations. From state and local income tax withholding requirements, to determining the so-called tax home of remote and hybrid employees, to applying the so-called convenience of the employer rule, the potential for unexpected tax obligations is higher for employers that don’t understand how laws apply.

INSIGHT FOR THE CEO: Tight labor market conditions represent an opportunity for businesses to keep their employees, said Marni Rozen, RSM director in the firm’s human capital management practice.

To that end, companies can engage in so-called stay interviews with content employees, as opposed to exit interviews with workers on the way out the door.

“They can tell you what’s in the secret sauce that’s working well, and you can do more of what’s working,” Rozen said.