Transfer Pricing and Employee Leasing for Private Equity | Podcast

In this episode of Weaver: Beyond the Numbers, Josh Finfrock explains the necessity of establishing arm’s length service fees for employment companies to avoid tax exposure, which is a common issue in due diligence.

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Detailed Description of Transfer Pricing and Employee Leasing for Private Equity

00:00:00
Josh: Hi. I’m Josh Finfrock, and I lead the transfer pricing practice here at Weaver.

We’re going to start a regular video podcast and put out topics on transfer pricing that affect your business.

00:00:10
Josh: One of those topics we want to talk about today affects many private equity companies we work with.

It’s not a typical issue in that it doesn’t have a cross-border element necessarily of international taxation, which is where most people commonly think of transfer pricing.

00:00:25
Josh: But when private equity groups make acquisitions, it’s fairly common that they will want to set up a partnership to own that operating company going forward.

Now a couple of things they end up needing to think about in this is if they’re going to have some of the management teams stay on as both employees, but with some interest in the partnership going forward, those management personnel have to be separated from the partnership because they can’t be both partners in the partnership and employees.

00:00:56
Josh: So that’s one reason for an employee company. So, we might incorporate an entity for the purpose of housing W-2 status employees. Other benefits of this are things like limited liability for employment related matters.

00:01:15
Josh: A partnership doesn’t shield the ultimate shareholders from that liability whereas a corporation can. Also, there’s an economy of scale sometimes when there’s multiple groups of employees being put together in one employment entity.

There’s HR compliance type efficiencies and synergies. There may also be economies of scale to negotiate for better rates for benefits and things that can be offered to employees to retain them.

00:01:40
Josh: So, these are some of the reasons we end up with these employment companies in the structures. But this is where transfer pricing comes into play. So, kind of back to the basics here.

00:01:49
Josh: We now have two entities at least, right, in this structure under common control. And Internal Revenue Code Section 482 gives the IRS the ability to adjust income for taxpayers to reflect arm’s length behavior effectively.

00:02:05
Josh: And what they do in that context is look at the functions, assets and risks of each party to assess what that should be.

00:02:14
Josh: So, the issue is we commonly will see either whether we’re doing a diligence on a company that may be getting acquired that already has an employment company, or we’re going to need to set one up post-acquisition.

00:02:27
Josh: If that entity just has the payroll running through on a breakeven basis, which is the natural incentive because that employment corporation will commonly have a second layer of tax due, right, at the entity level before another layer of tax on the shareholders.

So, the incentive is to have that pass through at a breakeven for tax efficiency purposes, but that’s leaving us with a tax exposure, right, because it’s not arm’s length behavior.

00:02:51
Josh: So, our solution here is really to take what transfer pricing rules give us and say, we need to have one of the prescribed IRS methods and do the analytics on what are the economics of this service fee so that we can support an arm’s length service fee to that employment company.

00:03:08
Josh: And if we have an arm’s length service fee, then we don’t have a tax exposure. So that’s a really important issue to flag on due diligence.

It’s common that attorneys are looking for that in the structuring for different legal reasons, and we also have different tax efficiency things that are being considered in the structuring of a deal.

00:03:26
Josh: So that’s our topic for today, and we hope you’ll want us to come back. So, follow me on LinkedIn and watch for more topics like this. Thanks.