Why Income Tax and Nonresident Withholding Calculations Get Complicated in a Transaction-Driven VDA

jamesmkelleher

Sep 21

6 min read

hen a Voluntary Disclosure Agreement surfaces in connection with an M&A transaction, particularly one where the target's final state income tax and nonresident withholding filings need to be prepared as part of the deal, the calculation is rarely as simple as filing a normal year's return one last time. Several layers of complexity are unique to this situation: prior-year state depreciation and Section 179 differences that were never conformed to federal treatment, the need to reconstruct apportionment across multiple historic years rather than just the current one, and, where the transaction is structured as a deemed asset sale, such as a Section 338(h)(10) election or an F reorganization, state-specific basis adjustments that federal treatment does not automatically resolve. This post walks through why each of these pieces adds complexity to a VDA prepared in a transaction context.

Why the Final Return Isn't Just "One More Year"

In a typical VDA, the goal is to reconstruct historic exposure and get the entity compliant on a go-forward basis. In a transaction context, there often is no go-forward basis, at least not for the entity in its current form. The final return needs to correctly reflect years of unaddressed state-level adjustments, all at once, often under deal timeline pressure, and often while the underlying entity is being sold, converted, or liquidated as part of the same transaction. That combination, historic gaps plus a terminal filing plus a transaction structure with its own tax consequences, is what makes these final-year calculations meaningfully harder than a standard VDA filing.

State Depreciation and Section 179 Adjustments

One of the most common, and most easily overlooked, sources of complexity is the divergence between federal and state depreciation and Section 179 rules.

Not all states conform to federal bonus depreciation. A number of states decouple from federal bonus depreciation entirely, or conform only partially, meaning a business that claimed full federal bonus depreciation has been carrying a different, larger state depreciable basis and different state accumulated depreciation all along. If the entity has not been filing in a state at all, as is often the case in a VDA, this divergence has never been tracked or calculated for that state, and it needs to be reconstructed retroactively for every year in the lookback period.
Section 179 limits and phase-outs vary by state. States that decouple from federal Section 179 limits, or impose their own lower dollar caps or phase-out thresholds, require a separate addback and recovery calculation. A business that expensed equipment federally under Section 179 may need to spread that same deduction over the asset's useful life for state purposes instead, creating a different depreciation schedule that has to be built from scratch if it was never previously maintained.
These adjustments compound year over year. Because depreciation is cumulative, an unaddressed decoupling adjustment in year one of the lookback period does not just affect that year. It changes the state tax basis of the asset for every subsequent year, which in turn affects the gain or loss calculation when the asset is ultimately sold or the business itself is sold. Reconstructing this correctly generally requires rebuilding a state-specific fixed asset schedule for the entire lookback period, not just estimating a single adjustment.
This directly affects the final return. Because the transaction may involve a sale of assets, whether actual or deemed, the accumulated difference between federal and state depreciable basis becomes directly relevant to calculating state-source gain on the final return, making it impossible to sidestep the historic reconstruction even if the years themselves were never going to be separately audited.

Preparing Multistate Apportionment for Multiple Historic Years

Because a VDA is inherently retroactive, and because the underlying entity is being sold or restructured, the apportionment calculation cannot simply reflect the current year. It generally needs to be built out for every year within the negotiated lookback period, which introduces its own layers of difficulty.

Apportionment formulas and factor weighting change over time. States periodically shift between three-factor, single-sales-factor, or other weighted apportionment formulas, and a state's formula in an earlier year of the lookback period may be different from its current formula. Each year has to be apportioned using the rules in effect for that specific year, not the current rules applied retroactively.
Sourcing rules for sales, particularly of services and intangibles, have evolved. Many states have moved from cost-of-performance sourcing to market-based sourcing for services and intangible income over the past decade or so. An entity being brought current across a multi-year lookback period may need to apply different sourcing methodologies to different years within the same disclosure.
The underlying data supporting apportionment often does not exist in the same form for every year. Just as with the broader data gaps discussed in connection with sales tax VDAs, payroll, property, and sales data supporting apportionment factors may be incomplete, especially for earlier years in the lookback period, requiring the same kind of reconstruction and documented methodology used elsewhere in the VDA process.
The final year's apportionment feeds directly into the transaction. Because the final return needs to reflect apportioned income up through the transaction date, and because the transaction itself may generate state-source gain that needs to be apportioned using that same year's factors, getting the historic apportionment calculations right is a prerequisite to getting the final year right, not a separate exercise.

State Basis Adjustments on Sale: 338(h)(10) and F Reorganizations

When the transaction is structured as a deemed asset sale under a Section 338(h)(10) election, or as an F reorganization, the federal tax consequences are well established, but state treatment does not automatically follow the same path, which adds another layer of complexity to the final-year calculation.

Not all states conform to the federal deemed asset sale treatment. A Section 338(h)(10) election treats the transaction as an asset sale for federal tax purposes even though it is legally a stock sale. Some states conform to this treatment automatically, others require a separate state-level election or conformity statute, and a few do not recognize the deemed asset sale at all for state tax purposes, treating the transaction as a stock sale regardless of the federal election. This means the entity's final state return may need to reflect an entirely different sale characterization than its federal return, depending on the state.
State basis in the assets may differ from federal basis going into the deemed sale. Because of the depreciation and Section 179 divergence discussed earlier, the assets deemed sold under a 338(h)(10) election may have a different state tax basis than their federal basis at the time of the transaction. The state-source gain or loss on the deemed sale needs to be calculated using that state-specific basis, not simply carried over from the federal gain calculation.
F reorganizations raise their own state conformity questions. An F reorganization is generally treated as a tax-free reorganization for federal purposes, with the surviving entity treated as a continuation of the prior entity. States generally, though not universally, follow this treatment, but the analysis needs to be confirmed state by state, particularly in states where the entity has not previously filed and where there is no established precedent for how that state's tax authority will treat the reorganization for state law purposes.
The interaction with the VDA lookback period requires careful sequencing. If the deemed asset sale or reorganization occurs at the end of the lookback period being addressed in the VDA, the state-specific basis reconstruction described above needs to be complete before the final year's gain calculation can be finalized, meaning the historic depreciation and apportionment work and the transaction-year gain calculation are not independent tasks. They depend on each other.

Why This All Has to Come Together on One Timeline

In a standalone VDA, historic reconstruction work can proceed at a measured pace, and the entity typically has flexibility on when to finalize and submit the disclosure. In a transaction context, all of the above, state depreciation reconstruction, multi-year apportionment rebuilding, and state-specific basis and gain calculations tied to a 338(h)(10) election or F reorganization, generally needs to be resolved on the deal timeline, not a timeline of the entity's choosing. This is often the single biggest practical difference between a standalone VDA and one prepared as part of a transaction: the analytical work is the same in kind, but it is significantly compressed, and it needs to produce a number that both the buyer and seller can rely on for purposes of closing, indemnification, and escrow, not just a number that resolves the state's inquiry.

The Bottom Line

Preparing final-year state income tax and nonresident withholding filings as part of a transaction-driven VDA is considerably more involved than a standard voluntary disclosure. Depreciation and Section 179 differences between federal and state treatment need to be reconstructed across the full lookback period, not estimated for a single year. Apportionment has to be built out year by year, using the rules in effect for each specific year, because it feeds directly into the final year's transaction-related income. And where the deal is structured as a 338(h)(10) election or an F reorganization, state conformity to the federal deemed sale or reorganization treatment has to be confirmed jurisdiction by jurisdiction, since state basis in the assets may not match federal basis by the time of the sale. Getting all of this right, on a deal timeline, is why these calculations require early attention rather than being treated as a closing-week formality.

This article is for general informational purposes and does not constitute legal or tax advice. Companies involved in a transaction with unresolved state tax exposure should consult qualified state tax and transaction advisors well in advance of closing.