How Unemployment Taxes Can Drive Up Merger Costs

If job cuts follow an m&a deal, the acquirer faces hefty increases in unemployment compensation taxes that will stick for several years. Over the past few years, the corporate climate has, in general, shown signs of stabilization after the “downsizing and merger mania” of the 1980s and early to mid-1990s. One of the most telling signs of this calming has been the overall decrease in the national unemployment rate toward its lowest point in decades. This, in turn, led to action by the states to alleviate some of the rising state unemployment tax costs (see Table 1). However, all is not rosy in the state unemployment tax world and acquirers have to be careful to avoid problems that have the potential to increase their rates. Even with the decreasing state unemployment tax costs, payroll taxes are still among the largest category of taxes paid by employers. And the recent wave of mergers, acquisitions, restructurings, buyouts, and downsizings is certain to result in some increased state unemployment taxes for companies whose strategic initiatives include cuts in their work forces. Although the era of massive job cuts appears to be over, layoffs, albeit on a smaller scale, still have been prominent in the news lately. Many companies are not aware of the “hidden costs” that can arise from these reductions. This article focuses on the impact that downsizing, mergers, and acquisitions can have on a company’s employment tax liabilities and suggest steps for alleviating them. Downsizing – Will You Really Save Money? There are many reasons that a company may decide to downsize, whether it be the closing of a plant, shutting down of an unprofitable division, elimination of duplicate responsibilities, laying-off of people across the board, or rationalization after a merger or acquisition. In any of those instances, one of the major goals of the downsizing is cost reduction, i.e., reduction of payroll, streamlining functions, etc. Often overlooked in the decisionmaking process is the impact that the headcount reduction has on state unemployment tax costs. A major reason for this oversight is the fact that the employment tax function is generally separate from the company’s general tax and finance operations – and may even be handled by an outside vendor. While this segregation is common and generally makes the most sense from an operational standpoint, coordination between the payroll or human resources functions and the tax and finance functions can find some of the major employment tax issues that may escape detection if either department weighs the financial effects of the downsizing on its own. For starters, a company’s state unemployment tax rate is a direct reflection of its unemployment activity and experience in the state levying the payroll. The tax applies only to the portion of a larger company located in that state. As layoffs from that unit increase, so does the amount of unemployment benefits collected. These benefits are charged to the former employer’s unemployment account, and are considered when the state calculates the company’s tax rate. Since the amount of benefits that an individual is eligible to collect can approach $8,000 in aggregate, a layoff of as few as 50 employees can have a significant impact on your unemployment account. Often, this can increase your state unemployment tax rate by 2% to 3% annually. This tax rate increase is applied to the wages paid to all remaining employees and can cost the company hundreds of thousands of dollars annually in each state where the downsizing occurs. Even worse, these increased costs can impact the company for a three- to 10-year period. Through proper planning and anticipation, some of these costs can be controlled. Additionally, state unemployment tax savings may be derived through proactive planning strategies to mitigate the effects of corporate restructuring. Are You Forfeiting Tax Savings? Corporate changes of any kind, but especially mergers and acquisitions, can have a significant impact on employment tax liability. Some states require the transfer of experience rates, based on a company’s work force and layoff history, from seller to buyer. Others make such a transfer optional; that is, successor employers, such as acquirers, must apply for the experience transfer. Additionally, the timing of a merger or acquisition (e.g., December 31 or January 1) can significantly impact unemployment tax costs. This is because the transaction date mandates whether a successor employer must utilize a commingled tax rate or its own rate in the year immediately following the transaction. Many employers do not realize, and consequently do not take advantage of, the measures required to ensure that the favorable payroll tax attributes of an acquired or merged entity are preserved. As a result, millions of dollars of unemployment reserve balances revert annually to state taxing authorities, favorable unemployment experience ratings are forfeited, and duplicate payroll taxes are paid. To Transfer or Not to Transfer? As noted above, the option of transferring unemployment experience from a predecessor entity to a successor entity may be determined by law. However, many states differentiate between a total transfer of experience and a partial transfer of experience. A state’s basis for differentiating between a complete transfer and a partial transfer is determined only by the portion of an acquirer’s or target’s business that is within its borders. If substantially all or only part of a target’s business is transferred to a successor, certain states (e.g., Massachusetts) require that the unemployment experience, good or bad, remain with the predecessor entity. Alternatively, some states (e.g., New York) mandate that the successor assume the target’s unemployment experience in that state. Other states (e.g., New Jersey) require the acquirer/successor to apply for the transfer of the predecessor’s unemployment experience. Most states mandate an unemployment experience transfer if all or substantially all of a predecessor’s business in the state is transferred to the successor. However, certain states (e.g., Florida) provide that such an experience transfer is optional. Other factors the states consider with respect to experience transfers, both total and partial, include whether the predecessor and successor are commonly owned and whether the successor was an employer in the state prior to the transaction. In general, if the successor has the option of securing an experience transfer and turns down the opportunity, it likely would maintain its previously assigned tax rate or the state would assign it a standard “new employer” tax rate. This standard rate usually remains in effect for a two-to-four-year period and can range from 1% to approximately 4.5% of the payroll, depending on the state. Most states mandate an unemployment tax experience transfer after a “total transfer” of business or operations from one company to another, such as in m&a, or a transfer of any assets or operations from one commonly controlled entity to another. However, certain states have changed their laws to accommodate employers that have traditionally experienced high turnover and were assessed at the higher end of the UC tax scale. Table 2 shows three states that have made significant strides in giving employers a “second chance” at favorable unemployment tax rates. In addition, all states have provisions regarding the carryover of the transferred employees’ unemployment taxable wage base limits from the target to the successor entity. The Internal Revenue Service has similar provisions for FICA and FUTA accounts. In all states, a successor employer is able to utilize the taxable wage base limits of the transferred employees when the unemployment experience is transferred, thereby avoiding duplicate state unemployment tax costs. However, many state laws provide that if the unemployment experience is not transferred, the successor employer cannot carry over the taxable wages base limits of the transferred employees. Simply put, if there is no experience transfer, both the predecessor and successor employers would remit state unemployment taxes on wages paid to the transferred employees during the year of the transaction. Therefore, it may be cost-beneficial for an acquirer to transfer a relatively high predecessor rate in order to qualify to utilize the transferred employees’ pre-transaction wages in calculating those employees’ wage base limits. That would avoid duplicate payment of state unemployment taxes. As can be seen, the often-overlooked employment tax arena can have a significant impact on a company’s bottom line. With proper planning, much of the increased costs that arise from mergers and acquisitions and attendant downsizings can be controlled, if not eliminated. One key is to address employment tax issues at an early point in the planning of downsizings, mergers, acquisitions, reorganizations, and other types of corporate activity that impact jobs to make sure increased UC tax costs don’t offset expected savings. Table 1: State Moves to Reduce Unemployment Compensation TaxesState Action on Unemployment TaxesCalifornia Decrease in tax rate schedule for 1998, reducing rates by 0.1% to 0.3% and allowing voluntary contributions for the first time since 1992. Further tax rate schedule reduction in 1999 resulting in additional tax rate reduction of 0.1% to 0.3%.Kansas Positive balance employers are assigned a zero tax rate for 1995 to 1999.Louisiana Taxable wage base limit decreased from $8,500 per employee during 1995 to $7,700 per employee during 1996. Further reduction to $7,000 per employee for 1998 and 1999.Massachusetts Tax rate schedule decrease for 1998 and 1999. This resulted in a cut in unemployment taxes by approximately 20% per year.New Jersey Tax rate schedule decrease for 1997/98 and 1998/99 tax years. This would decrease unemployment taxes by 15% to 20% per year.New York 1997 tax rates decreased by approximately 0.2%. This is the first tax rate reduction in New York during the 1990s. Further reduction of 0.9% for 1998. Overhaul of unemployment tax law effective 1999 to become more “employer-friendly” and reduce state unemployment tax rates.Source: Arthur Andersen<\TBL> Table 2: Major State Law Changes on Unemployment Compensation Taxes EffectiveState Old Law New Law Date Georgia A successor employer (total successor A successor employer (total successor in July 1995 in interest) who was not already subject interest) who was not already subject to Georgia unemployment tax will be to Georgia unemployment tax may be assigned the predecessor’s rate for the assigned the lower of the state’s new remainder of the calendar year. employer tax rate or the predecessor’s rateMaryland A successor employer (partial successor in A successor employer who was not already October 1996 interest) that was not already subject to subject to Maryland unemployment tax has Maryland unemployment tax will be the option to take the state’s new employer assigned the state’s new employer tax rate. tax rate or the predecessor’s rate.Virginia A successor employer (partial successor in A successor employer who was not already July 1997 interest) who was not already subject to subject to Virginia unemployment tax has the Virginia unemployment tax will be assigned option to take the state’s new employer tax the predecessor’s rate for the remainder rate or the predecessor’s rate. of the calendar year.Source: Arthur Andersen<\TBL>