1010-00002 · Client 1010 · Tax

tax-memo-state-nexus.docx DOCUMENT Capital Markets

74 / 83 ← → ✕

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE ATTORNEY WORK PRODUCT

This memorandum is a privileged and confidential communication protected by the attorney-client privilege and the work product doctrine. It is intended solely for the use of the addressees identified below. Any unauthorized review, use, disclosure, or distribution is prohibited.

MEMORANDUM

February 1, 2024

Right-click to update Table of Contents

I. EXECUTIVE SUMMARY

This memorandum analyzes the state income and franchise tax implications for Arbor Health Technologies Inc. ("AHT" or the "Company") across the Company's ten nexus states in connection with its proposed initial public offering (the "IPO") of shares of its common stock on the New York Stock Exchange (proposed ticker symbol: ARHT), SEC File Number 333-276841. The analysis addresses both the existing state tax posture of the Company and the specific state tax consequences and obligations arising from the IPO transaction itself and the Company's post-IPO status as a publicly traded corporation.

AHT is a Delaware C-corporation headquartered in Cambridge, Massachusetts. The Company operates a cloud-based clinical decision support, population health management, and revenue cycle management software-as-a-service ("SaaS") platform that currently serves over 1,200 hospital systems and physician groups across 42 states. As of the date of this memorandum, AHT files income and/or franchise tax returns in ten states: Massachusetts, New York, California, Texas, Illinois, Florida, Pennsylvania, Ohio, New Jersey, and Georgia.

For the fiscal year ended December 31, 2023 ("FY2023"), AHT reported total revenue of $612.4 million, representing a 28% year-over-year increase from $478.4 million in FY2022. The Company reported Adjusted EBITDA of $138.7 million and net income of $41.3 million for FY2023. As of December 31, 2023, AHT employed approximately 3,400 individuals across its various locations and remote working arrangements.

The proposed IPO involves the sale of 20,000,000 newly issued shares of common stock at an anticipated price of $18.00 to $20.00 per share (revised range per the Company's Registration Statement on Form S-1/A, filed February 5, 2024), generating estimated base gross proceeds of $360,000,000 to $400,000,000. The underwriters have been granted a 3,000,000-share overallotment option (representing 15% of the base offering), which, if exercised in full, would increase total gross proceeds to $414,000,000 to $460,000,000. The IPO is structured as an entirely primary offering, with no secondary sales by existing stockholders.

This memorandum addresses the following key areas:

1. Nexus analysis and filing obligations — A state-by-state review of the Company's basis for nexus in each of its ten filing states, including both traditional physical presence nexus and post-South Dakota v. Wayfair economic nexus standards as applied by each state for income and franchise tax purposes.

2. State-level treatment of IPO equity issuance proceeds — An analysis confirming that proceeds from the issuance of the Company's own stock are not includable in taxable income for state income tax purposes, with attention to specific state variations, including the impact on the New York business capital base.

3. Income apportionment considerations — A review of the Company's apportionment methodology across its nexus states, with particular attention to market-based sourcing of SaaS revenue and the potential effects of revenue growth on state-by-state apportionment percentages.

4. Withholding obligations on equity compensation exercises and settlements post-IPO — An analysis of the Company's state income tax withholding obligations arising from post-IPO exercises of stock options under the 2014 Stock Incentive Plan, vesting and settlement of restricted stock units under the 2024 Equity Incentive Plan, purchases under the 2024 Employee Stock Purchase Plan, and the impact of Section 83(b) elections.

5. Franchise tax implications — An analysis of the Delaware franchise tax, New York capital base tax, Texas franchise (margin) tax, and Pennsylvania capital stock/franchise tax implications of the IPO and the resulting changes in the Company's capital structure.

6. Potential additional nexus exposures arising from the IPO — Identification of risk areas where the Company's post-IPO growth, hiring, and acquisition activities may create nexus in additional states.

7. Recommendations — Specific action items for the Company to address prior to and following the closing of the IPO.

This memorandum does not address sales and use tax, property tax, unclaimed property or escheat obligations, or payroll tax matters other than state income tax withholding on equity compensation income. A separate memorandum, dated January 22, 2024, addresses the federal Section 382 ownership change analysis in connection with the IPO.

II. BACKGROUND AND FACTUAL ASSUMPTIONS

The analysis in this memorandum is based on the following factual background and assumptions, which have been derived from information provided by AHT management, review of the Company's draft Registration Statement on Form S-1 and the amendment thereto, review of the Company's organizational documents, and discussions with the Company's Chief Financial Officer, David Halderman, and General Counsel, Rachel Moynihan.

A. Corporate Structure and Tax Status

AHT was incorporated in the State of Delaware on March 17, 2014 under the name "Arbor Health Technologies Inc." and has been treated as a C-corporation for federal and state income tax purposes since its formation. The Company has not at any time elected S-corporation status under Subchapter S of the Internal Revenue Code of 1986, as amended (the "Code"), nor has it been treated as a partnership or disregarded entity for federal or state tax purposes.

The Company's Federal Employer Identification Number is 47-3891205. The Company's registered agent in the State of Delaware is National Registered Agents of Delaware, Inc., located at 160 Greentree Drive, Suite 101, Dover, Delaware 19904. The Company maintains its principal executive offices and headquarters at 275 Kendall Avenue, Suite 1400, Cambridge, Massachusetts 02142. The Company's Standard Industrial Classification (SIC) Code is 7372 (Prepackaged Software).

AHT operates as a single legal entity. As of the date of this memorandum, the Company has no subsidiaries, whether wholly owned or otherwise, and no disregarded entities for federal or state income tax purposes. The Company has not entered into any tax sharing or tax indemnification agreements with any affiliated entities. We have assumed for purposes of this memorandum that the Company's single-entity structure will remain in effect through the closing of the IPO and for the foreseeable future, absent any post-IPO acquisitions or restructuring transactions.

B. Pre-IPO Capitalization and Ownership

As of the date immediately prior to the expected closing of the IPO, the Company's authorized capital stock consists of 120,000,000 shares of common stock, par value $0.001 per share. Of the authorized shares, 80,000,000 shares are issued and outstanding. The Company has no authorized preferred stock outstanding as of this date.

The following table summarizes the principal pre-IPO stockholders and their respective ownership interests:

Following the IPO, assuming the issuance of all 20,000,000 base offering shares and the full exercise of the 3,000,000-share overallotment option, the total number of shares of common stock outstanding will be 103,000,000.

C. IPO Structure

The IPO is structured as an entirely primary offering. AHT will issue and sell 20,000,000 new shares of common stock (plus up to 3,000,000 additional shares pursuant to the overallotment option). No existing stockholders are selling shares in the offering.

The underwriting discount is 6.0% of the public offering price, equal to $1.20 per share (assuming a midpoint offering price of $19.00 per share, for illustrative purposes). The total underwriting discount, assuming a full offering including the overallotment, would be approximately $27,600,000 (23,000,000 shares × $1.20 per share). The Company has estimated that total offering expenses, exclusive of the underwriting discount, will be approximately $4,200,000, which includes SEC registration fees, FINRA fees, NYSE listing fees, legal fees, accounting fees, printing costs, transfer agent fees, and miscellaneous expenses.

The Company has disclosed that it intends to use a portion of the net proceeds from the IPO to repay approximately $65,000,000 of outstanding borrowings under its $150,000,000 senior secured revolving credit facility with Keypoint National Bank, N.A. (the "Credit Facility"). The Credit Facility bears interest at SOFR plus 200 basis points, has a maturity date of March 15, 2027, and is secured by substantially all of the Company's assets. The Company intends to retain the Credit Facility following the repayment for ongoing working capital and general corporate purposes.

In connection with the IPO, AHT will file an Amended and Restated Certificate of Incorporation with the Delaware Secretary of State on the expected closing date of February 13, 2024. The Amended and Restated Certificate of Incorporation will authorize 400,000,000 shares of common stock, par value $0.001 per share, and 50,000,000 shares of preferred stock, par value $0.001 per share.

D. Equity Compensation Plans

AHT maintains, or will maintain effective upon the closing of the IPO, the following equity compensation arrangements:

2014 Stock Incentive Plan. The Company adopted the 2014 Stock Incentive Plan (the "2014 Plan") in connection with its formation. The 2014 Plan authorizes the grant of incentive stock options ("ISOs") and nonqualified stock options ("NQSOs") covering up to 12,000,000 shares of common stock. As of the date of this memorandum, options covering 11,200,000 shares have been granted under the 2014 Plan, of which options covering 8,400,000 shares are vested and exercisable. The weighted average exercise price of all outstanding options under the 2014 Plan is $3.25 per share. No additional grants will be made under the 2014 Plan following the IPO, though all outstanding options will remain exercisable in accordance with their terms. The options granted under the 2014 Plan include both ISOs and NQSOs; the specific classification of each grant should be confirmed with the Company's equity plan administrator in connection with the withholding analysis.

2024 Equity Incentive Plan. The Company's board of directors adopted, and the Company's stockholders approved, the 2024 Equity Incentive Plan (the "2024 Plan") on January 15, 2024. The 2024 Plan will become effective upon the closing of the IPO. The 2024 Plan reserves 10,300,000 shares of common stock (equal to 10% of the anticipated post-IPO shares outstanding of 103,000,000) for issuance pursuant to awards granted thereunder. The 2024 Plan includes an annual "evergreen" provision that automatically increases the share reserve on January 1 of each calendar year by 3% of the total number of shares of common stock outstanding on the preceding December 31. The 2024 Plan authorizes the grant of ISOs, NQSOs, restricted stock units ("RSUs"), stock appreciation rights ("SARs"), and performance-based awards.

2024 Employee Stock Purchase Plan. The Company's board of directors also adopted the 2024 Employee Stock Purchase Plan (the "ESPP") on January 15, 2024, which will become effective upon the closing of the IPO. The ESPP reserves 2,060,000 shares of common stock (equal to 2% of the anticipated post-IPO shares outstanding) for issuance. The ESPP provides for a 15% discount from the lower of the fair market value of the Company's common stock on the first or last day of each semi-annual offering period. The ESPP is intended to qualify as an "employee stock purchase plan" under Section 423 of the Code.

Section 83(b) Elections. Fourteen current employees of the Company received restricted stock grants during the period from 2021 through 2022 and timely filed elections under Section 83(b) of the Code with the Internal Revenue Service within 30 days of the date of each respective grant. As a result, these employees recognized ordinary income equal to the fair market value of the restricted stock at the time of grant, rather than at the time of vesting. The aggregate ordinary income recognized by these 14 employees in connection with their 83(b) elections, and the state tax withholding reported thereon, has not been independently verified for purposes of this memorandum but has been represented by AHT management to be properly reported.

Federal R&D Tax Credits. AHT generated $8.7 million of federal research and development tax credits under Section 41 of the Code for FY2023. As of December 31, 2023, the Company has a cumulative R&D credit carryforward of $12.4 million. The utilization of these credits may be subject to limitation under Section 383 of the Code in the event of an ownership change under Section 382; however, as addressed in our separate memorandum dated January 22, 2024, the IPO is not expected to trigger such an ownership change.

E. Employee Distribution and Physical Presence

As of December 31, 2023, AHT employed approximately 3,400 individuals. The Company maintains its principal offices and primary engineering center at its Cambridge, Massachusetts headquarters. The Company also maintains offices and/or has significant employee concentrations in New York, California, Texas, Illinois, and Georgia. The Company has remote employees located in Pennsylvania, Ohio, New Jersey, Florida, and various other states.

The Company's cloud-based SaaS platform is hosted by third-party data center providers and is not operated from Company-owned or Company-leased data center facilities. The Company's customers are located in 42 states. The distribution of employees across specific states, including employee headcounts and payroll amounts, has been provided by AHT management in the supplemental data package delivered to our office on January 18, 2024, and we have relied on that data for purposes of this analysis.

III. STATE-BY-STATE NEXUS ANALYSIS AND FILING STATUS

Introductory Note

AHT currently files income and/or franchise tax returns in ten states based on physical presence, economic nexus, and/or factor presence thresholds established under each state's applicable law. This section provides a state-by-state analysis of the basis for the Company's nexus in each of these ten filing states, the applicable tax type and rate, the apportionment methodology employed by each state, the Company's current filing status, and the IPO-related considerations specific to each jurisdiction.

The analysis considers both traditional nexus standards — predicated on physical presence, including employees, offices, and tangible property — and the post-South Dakota v. Wayfair, Inc., 585 U.S. 162 (2018), economic nexus standards that have been adopted by an increasing number of states for income and franchise tax purposes. It is important to note that the Wayfair decision addressed sales and use tax nexus, not income tax nexus, and the extent to which states may apply economic nexus standards for income and franchise tax purposes remains a developing area of law. However, a number of the states in which AHT files have adopted factor presence standards or other economic nexus thresholds for their income and franchise taxes, as discussed below.

This section does not address sales and use tax nexus, which is subject to a separate analysis and is outside the scope of this memorandum.

A. Massachusetts

Nexus Basis. AHT has substantial nexus with the Commonwealth of Massachusetts by virtue of its headquarters location at 275 Kendall Avenue, Suite 1400, Cambridge, MA 02142, where the Company maintains its principal executive offices and its primary engineering and product development center. AHT has a significant number of employees in Massachusetts, including senior executives, engineers, and administrative staff. The Company's commercial domicile is in Massachusetts. Accordingly, AHT has clear nexus with Massachusetts under both traditional physical presence standards and the Commonwealth's domiciliary/commercial domicile nexus principles.

Tax Type. Massachusetts imposes a corporate excise tax on corporations doing business in the Commonwealth. The excise consists of two components: (i) an income measure, which is the greater of (a) net income apportioned to Massachusetts multiplied by the applicable tax rate (currently 8.0% for corporations with taxable income over $1 million), or (b) a minimum tax of $456; and (ii) a non-income measure (tangible property measure), computed at $2.60 per $1,000 of the corporation's tangible personal property or net worth allocable to Massachusetts. The total excise is the sum of the income measure and the non-income measure, subject to a minimum tax.

Apportionment. Massachusetts employs a single sales factor apportionment formula for corporations whose income is derived primarily from the sale of services or intangible property. This standard has been effective for tax years beginning on or after January 1, 2014, pursuant to M.G.L. c. 63, § 38(l). Under this formula, AHT's Massachusetts taxable income is determined by multiplying its total apportionable income by the ratio of its Massachusetts-sourced receipts to its total receipts. Massachusetts applies market-based sourcing for service revenue, sourcing receipts to the location where the benefit of the service is received.

Filing Status. AHT currently files Massachusetts corporate excise tax returns and has done so since the Company's inception. Massachusetts is expected to continue to be a significant apportionment state for the Company given the location of the Company's commercial domicile and the concentration of employees in the Commonwealth.

IPO Considerations. There is no special Massachusetts tax treatment applicable to equity issuance proceeds; consistent with the general analysis in Section IV of this memorandum, proceeds from the issuance of the Company's own stock are not includable in income for Massachusetts corporate excise tax purposes. AHT will have withholding obligations on equity compensation income for Massachusetts-resident employees and for non-resident employees earning Massachusetts-source income, as discussed in Section V.

B. New York

Nexus Basis. AHT has nexus with the State of New York based on its maintenance of a physical office in the state, the presence of employees performing services in New York, the solicitation of business in New York, and the Company's satisfaction of economic nexus standards under Article 9-A, Section 209 of the New York Tax Law. Under New York's bright-line nexus provisions, a corporation is deemed to be "doing business" in New York and is subject to the franchise tax if, among other things, it derives $1,000,000 or more of receipts from New York sources, has property in New York with a value exceeding $54,000, or has payroll in New York exceeding $54,000.

Tax Type. New York imposes a corporate franchise tax under Article 9-A of the Tax Law. The tax is computed as the highest of: (i) the business income base (taxable business income apportioned to New York, taxed at 6.5% for most corporations; 7.25% for corporations with a business income base over $5,000,000); (ii) the business capital base (0.04% of total business capital allocated to New York, capped at $5,000,000 per year); or (iii) a fixed-dollar minimum tax based on New York receipts (ranging from $25 to $200,000 depending on receipts level).

Apportionment. New York uses a single receipts factor for apportionment purposes, with customer-based (market-based) sourcing for service revenue. This methodology has been in effect for tax years beginning on or after January 1, 2015. Service receipts are sourced to New York to the extent the service is delivered to or benefits a customer in New York.

Filing Status. AHT currently files New York franchise tax returns under Article 9-A.

IPO Considerations. Proceeds from the equity issuance are excluded from the business income base, consistent with the general analysis in Section IV below. However, the post-IPO influx of capital will increase the Company's reported business capital, which is relevant for the capital base component of the franchise tax. This is discussed in detail in Sections IV.C and VII.B. AHT will have withholding obligations on equity compensation for New York-resident and New York-source-income employees. Of particular importance, New York's "convenience of the employer" rule may apply to remote employees whose assigned office is in New York but who perform some or all of their services from locations outside New York. Under this doctrine, compensation is sourced to New York unless the employee's out-of-state work location is established as a bona fide office of the employer maintained for the employer's necessity rather than the employee's convenience. AHT should carefully evaluate the application of this rule to its workforce, as discussed further in Section V.

C. California

Nexus Basis. AHT has nexus with the State of California based on its maintenance of a physical office and the presence of employees in the state. In addition, AHT satisfies California's economic nexus standards under California Revenue and Taxation Code Section 23101(b), which deems a corporation to be "doing business" in California if it has, among other things, (i) California-source sales exceeding $500,000 (adjusted annually), (ii) real or tangible personal property in California exceeding $50,000, (iii) California payroll exceeding $50,000, or (iv) 25% or more of its total sales, property, or payroll in California.

Tax Type. California imposes a corporate income tax at a rate of 8.84% of net income apportioned to California. In addition, all corporations organized in or qualified to do business in California are subject to a minimum franchise tax of $800, which is payable regardless of whether the corporation has net income.

Apportionment. California has employed a single sales factor apportionment formula for tax years beginning on or after January 1, 2013, applicable to corporations that derive more than 50% of their income from business activities. California applies market-based sourcing for service revenue, sourcing receipts to the location where the customer receives the benefit of the service.

Filing Status. AHT currently files California corporate income tax returns (Form 100).

IPO Considerations. California conforms to Code Section 1032, and accordingly, proceeds from the issuance of the Company's own stock are excluded from California taxable income. California's market-based sourcing rules may significantly affect AHT's California apportionment factor depending on the geographic distribution of customers receiving the Company's SaaS and analytics services. AHT will have withholding obligations on equity compensation for California-resident employees and for non-resident employees with California-source income. California's Franchise Tax Board applies particularly aggressive allocation rules for stock option income earned by non-residents and former residents, as discussed in detail in Section V. Under FTB Publication 1005 and related guidance, stock option income is allocated to California based on the ratio of California workdays to total workdays during the period from the grant date to the exercise date. ESPP purchases may also trigger California withholding for California-based participants in the event of a disqualifying disposition.

D. Texas

Nexus Basis. AHT has nexus with the State of Texas based on the presence of employees and the maintenance of a physical office in the state. In addition, AHT's gross receipts from Texas sources exceed the $500,000 threshold that establishes nexus for Texas franchise tax purposes.

Tax Type. Texas imposes a franchise (margin) tax on each taxable entity that does business in the state or is chartered or organized in Texas. The franchise tax is not a traditional income tax; rather, it is computed on "total revenue" less the greater of (i) cost of goods sold, (ii) compensation, or (iii) a 30% standard deduction. The applicable tax rate is 0.375% for entities qualifying as wholesale or retail and 0.75% for all other entities. Based on AHT's SaaS business model, the 0.75% rate is expected to apply.

Apportionment. Texas employs a single gross receipts factor for purposes of apportioning the franchise tax margin to Texas. Receipts from services are generally sourced to Texas based on the location of the performance of the service or the location of the customer, depending on the nature of the service.

Filing Status. AHT currently files Texas franchise tax reports.

IPO Considerations. IPO proceeds from the equity issuance should be excluded from "total revenue" for Texas franchise tax purposes, as such proceeds represent a capital transaction and are not revenue within the meaning of Texas Tax Code Section 171.1011. Texas does not impose an individual state income tax; accordingly, there are no state-level withholding obligations on equity compensation income for Texas-based employees.

E. Illinois

Nexus Basis. AHT has nexus with the State of Illinois based on the presence of employees and the maintenance of a physical office in the state. AHT also satisfies Illinois's economic nexus standards applicable to corporations.

Tax Type. Illinois imposes a corporate income tax at a rate of 7.0% on income apportioned to the state. In addition, Illinois imposes a personal property replacement income tax ("PPRIT") at a rate of 2.5% on the same tax base, for a combined effective rate of 9.5%.

Apportionment. Illinois employs a single sales factor apportionment formula with market-based sourcing for service revenue, sourcing receipts to the state where the customer receives the benefit of the service. This methodology applies for tax years ending on or after December 31, 2009.

Filing Status. AHT currently files Illinois corporate income and replacement tax returns (Form IL-1120).

IPO Considerations. IPO equity issuance proceeds are excluded from Illinois taxable income, consistent with Illinois's conformity with the Code. AHT will have withholding obligations on equity compensation for Illinois-resident employees, as discussed in Section V. Illinois applies supplemental income tax withholding rules that may affect the calculation of withholding amounts on equity compensation income.

F. Florida

Nexus Basis. AHT has nexus with the State of Florida based on the presence of employees, including remote workers, in the state. AHT also satisfies Florida's economic nexus standards for corporations doing business in the state.

Tax Type. Florida imposes a corporate income/franchise tax at a rate of 5.5% on income apportioned to the state. Florida provides a $50,000 exemption from the corporate income tax base.

Apportionment. Florida applies a three-factor apportionment formula, weighting sales, property, and payroll equally, although qualifying taxpayers may elect single-sales-factor apportionment. Florida applies market-based sourcing for service revenue.

Filing Status. AHT currently files Florida corporate income/franchise tax returns (Form F-1120).

IPO Considerations. Florida does not impose an individual state income tax. Accordingly, there are no state-level withholding obligations on equity compensation income for Florida-based employees. IPO equity issuance proceeds are excluded from Florida taxable income, as Florida begins its income tax computation with federal taxable income, and proceeds from stock issuance are not included in federal taxable income under Code Section 1032.

G. Pennsylvania

Nexus Basis. AHT has nexus with the Commonwealth of Pennsylvania based on the presence of employees in the state. AHT may also satisfy Pennsylvania's economic nexus standards, which apply to corporations with $500,000 or more of Pennsylvania-source receipts.

Tax Type. Pennsylvania imposes a corporate net income tax on net income apportioned to the Commonwealth. The corporate net income tax rate for 2024 is 8.99%, which is scheduled to phase down annually, reaching 4.99% by tax year 2031. Pennsylvania also historically imposed a capital stock/franchise tax; however, that tax has been fully eliminated as of January 1, 2024.

Apportionment. Pennsylvania applies a three-factor apportionment formula that is in the process of transitioning toward a single sales factor. For tax year 2023, the sales factor is weighted at 90% and the property and payroll factors are each weighted at 5%. Pennsylvania applies market-based sourcing for service revenue.

Filing Status. AHT currently files Pennsylvania corporate net income tax returns (Form RCT-101). With the elimination of the capital stock/franchise tax, no further capital stock tax filings will be required for tax years beginning on or after January 1, 2024.

IPO Considerations. The elimination of the Pennsylvania capital stock/franchise tax as of January 1, 2024 removes any franchise tax consequences associated with the post-IPO increase in the Company's capital structure. IPO equity issuance proceeds are excluded from Pennsylvania corporate net income. AHT will have withholding obligations on equity compensation for Pennsylvania-resident employees at the Pennsylvania flat individual income tax rate of 3.07%.

H. Ohio

Nexus Basis. AHT has nexus with the State of Ohio based on the presence of employees in the state. AHT may also satisfy Ohio's bright-line nexus standards, which impose the commercial activity tax on corporations with $500,000 or more of Ohio-sitused receipts or $50,000 or more of Ohio-based property or payroll.

Tax Type. Ohio does not impose a traditional corporate income tax. Instead, Ohio imposes a Commercial Activity Tax (the "CAT"), which is a gross receipts tax on "taxable gross receipts" exceeding $150,000. The CAT is imposed at tiered rates, with the principal rate being 0.26% on taxable gross receipts in excess of $1,000,000.

Apportionment. Ohio situses receipts from services based on the location where the customer receives the benefit of the service, consistent with a market-based sourcing approach.

Filing Status. AHT currently files Ohio CAT returns.

IPO Considerations. IPO equity issuance proceeds do not constitute "taxable gross receipts" under the Ohio CAT. Ohio Revenue Code Section 5751.01(F)(2) excludes from the definition of taxable gross receipts amounts received from the issuance of the taxpayer's own stock or other equity instruments. There are no individual income tax withholding obligations at the state level relevant to the CAT; however, Ohio municipal income tax withholding may apply in specific municipalities where AHT has employees, as discussed in Section V.

I. New Jersey

Nexus Basis. AHT has nexus with the State of New Jersey based on the presence of employees, including remote workers, in the state. In addition, AHT satisfies New Jersey's bright-line economic nexus standards, which establish nexus for corporations with either (i) $100,000 or more of New Jersey-source receipts, or (ii) 200 or more separate transactions delivered into New Jersey during the tax year.

Tax Type. New Jersey imposes the Corporation Business Tax ("CBT") on the adjusted entire net income of corporations apportioned to New Jersey. The CBT rate is 9.0% for corporations with allocated taxable net income in excess of $1,000,000. An additional surtax of 2.5% has been imposed on corporations with allocated taxable income over $1,000,000 for certain tax years; this surtax has been extended by recent legislation and may remain in effect for AHT's 2024 tax year. In addition to the net income base, the CBT is also computed on an Alternative Minimum Assessment ("AMA") basis, which is determined based on gross receipts or gross profits, with the higher of the net income base tax or the AMA being owed.

Apportionment. New Jersey applies a single sales factor apportionment formula with market-based sourcing for service revenue.

Filing Status. AHT currently files New Jersey CBT returns (Form CBT-100).

IPO Considerations. New Jersey has adopted relatively aggressive combined reporting provisions that may affect the computation of AHT's CBT liability, though as a single-entity taxpayer, AHT does not currently file on a combined basis. IPO equity issuance proceeds are excluded from CBT net income. However, AHT should evaluate the impact of the IPO on the AMA computation, as the AMA is based on gross receipts or gross profits and the influx of capital and potential interest income from invested IPO proceeds could affect the AMA calculation. AHT will have withholding obligations on equity compensation for New Jersey-resident employees, as discussed in Section V.

J. Georgia

Nexus Basis. AHT has nexus with the State of Georgia based on the presence of employees and the maintenance of a physical office in the state. AHT also satisfies Georgia's economic nexus standards for corporations doing business in the state.

Tax Type. Georgia imposes a corporate income tax on net income apportioned to the state. The corporate income tax rate has been 5.75%; however, pursuant to recent legislation (HB 1437, signed April 26, 2022), the rate began reducing to 5.39% effective January 1, 2024.

Apportionment. Georgia employs a single sales factor apportionment formula with market-based sourcing for service revenue.

Filing Status. AHT currently files Georgia corporate income tax returns (Form 600).

IPO Considerations. IPO equity issuance proceeds are excluded from Georgia corporate income. AHT will have withholding obligations on equity compensation for Georgia-resident employees at the applicable Georgia graduated individual income tax rates. AHT should be aware that Georgia applies a relatively broad definition of "business income," which could potentially affect the characterization of certain ancillary items of income; however, the equity issuance proceeds themselves are not income at all and are not subject to this analysis.

IV. STATE-LEVEL TREATMENT OF IPO EQUITY ISSUANCE PROCEEDS

A. General Principles

The fundamental question addressed in this section is whether the proceeds received by AHT from the issuance and sale of its common stock in the IPO will be subject to state income or franchise taxes in any of the Company's ten nexus states. The analysis is straightforward in most respects, but several nuances and state-specific considerations warrant detailed discussion.

For federal income tax purposes, Section 1032 of the Code provides that "[n]o gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation." Accordingly, the gross proceeds of $360,000,000 to $460,000,000 (depending on the offering price and exercise of the overallotment option) received by AHT in exchange for the issuance of 20,000,000 to 23,000,000 shares of newly issued common stock will not be included in AHT's gross income for federal income tax purposes. This principle applies regardless of the offering price or the relationship between the offering price and the par value of the stock.

For state income tax purposes, the treatment of IPO equity issuance proceeds depends on each state's conformity with the Code and its own statutory definitions of "business income," "non-business income," "allocable income," and "apportionable income." However, in practice, all ten of AHT's nexus states either conform to Section 1032 of the Code directly, use federal taxable income as the starting point for computing state taxable income (thereby incorporating the Section 1032 exclusion by reference), or otherwise do not treat the receipt of capital from the issuance of a corporation's own stock as a taxable event. The equity issuance proceeds are capital contributions to the corporation — they increase the Company's paid-in capital and stockholders' equity but do not generate income.

The underwriting discount, which will total approximately $27,600,000 based on the full offering of 23,000,000 shares at $1.20 per share, and the estimated offering expenses of approximately $4,200,000, represent capital costs incurred in connection with the issuance of stock. These costs reduce the amount of additional paid-in capital recorded on the Company's balance sheet. They are not deductible for federal or state income tax purposes, as they are capital costs associated with the issuance of stock, not ordinary and necessary business expenses within the meaning of Code Section 162.

B. State-by-State Treatment

The following summarizes our analysis for each of the ten nexus states, confirming that the IPO equity issuance proceeds are not includable in the taxable income or franchise tax base in any of these jurisdictions:

Massachusetts. Excluded from Massachusetts corporate excise tax. The Commonwealth starts with federal gross income as the starting point for the income measure of the corporate excise tax. Because the IPO proceeds are not included in federal gross income under Section 1032, they are likewise excluded from the Massachusetts tax base. No adjustment is required.

New York. Excluded from the New York business income base. New York begins its franchise tax computation with "entire net income," which is based on federal taxable income with certain modifications. Because IPO proceeds are not included in federal taxable income, they are excluded from the New York business income base. However, we note the important impact on the business capital base component of the franchise tax, discussed in Section IV.C below. The post-IPO increase in total stockholders' equity (reflecting the net proceeds of the offering credited to additional paid-in capital) will increase AHT's reported business capital for purposes of the capital base tax.

California. Excluded from California taxable income. California starts with federal taxable income in computing net income subject to the corporate income tax. California conforms to Section 1032 of the Code, and accordingly, IPO proceeds are not included in California taxable income. No adjustment is required.

Texas. Excluded from total revenue for Texas franchise (margin) tax purposes. Texas Tax Code Section 171.1011 defines "total revenue" by reference to certain Internal Revenue Code provisions and specifically excludes non-revenue items, including proceeds from the issuance of the taxpayer's own stock. The IPO equity issuance constitutes a capital transaction, not a revenue-generating transaction.

Illinois. Excluded from Illinois taxable income. Illinois begins its corporate income tax computation with federal taxable income, and accordingly, the Section 1032 exclusion is incorporated by reference. No modification is required.

Florida. Excluded from Florida taxable income. Florida starts with federal taxable income (as adjusted) as the basis for computing corporate income. Because IPO proceeds are not included in federal taxable income, they are excluded from the Florida tax base.

Pennsylvania. Excluded from Pennsylvania corporate net income. Pennsylvania begins its computation of taxable income with federal taxable income and makes certain modifications; however, no modification results in the inclusion of stock issuance proceeds. The Section 1032 exclusion applies.

Ohio. Excluded from Ohio CAT taxable gross receipts. Ohio Revenue Code Section 5751.01(F)(2) specifically excludes from the definition of "taxable gross receipts" proceeds received from the issuance of the taxpayer's own stock or other equity instruments. This exclusion is consistent with the general principle that capital contributions are not receipts from business operations.

New Jersey. Excluded from CBT net income. New Jersey begins its CBT computation with entire net income based on federal taxable income, and accordingly, IPO proceeds are excluded. However, AHT should evaluate the impact of the IPO on the Alternative Minimum Assessment ("AMA") base. The AMA is computed based on either New Jersey gross receipts or New Jersey gross profits (whichever produces a higher AMA), and it is possible that interest income earned on invested IPO proceeds could affect the gross receipts or gross profits calculation. This consideration is discussed further in Section IV.D.

Georgia. Excluded from Georgia corporate income. Georgia begins with federal taxable income as the starting point for computing state net income, and accordingly, IPO proceeds are excluded by operation of the Section 1032 exclusion.

C. Special Consideration — New York Business Capital Base

While the IPO equity issuance proceeds are excluded from the New York business income base, the post-IPO increase in the Company's total equity will have a direct and potentially material impact on the business capital base component of the New York franchise tax.

Under Article 9-A of the New York Tax Law, the franchise tax is computed as the highest of the business income base, the business capital base, or the fixed-dollar minimum tax. The business capital base tax is imposed at a rate of 0.04% (four basis points) of total business capital allocated to New York, subject to an annual cap of $5,000,000. "Business capital" generally means the total assets of the corporation minus liabilities not deducted elsewhere.

The IPO is expected to generate net proceeds of approximately $328,200,000 to $428,200,000 (after deducting the underwriting discount and offering expenses), which will be credited to AHT's additional paid-in capital and will increase total stockholders' equity and total assets on the Company's balance sheet. After the repayment of approximately $65,000,000 of outstanding indebtedness under the Credit Facility, the net increase to the Company's balance sheet will be somewhat reduced, but it will still represent a significant increase in the Company's total business capital.

AHT should model the post-IPO New York capital base tax liability under various scenarios, taking into account (i) the amount of net IPO proceeds retained on the balance sheet, (ii) the New York receipts apportionment factor (which is used to allocate business capital to New York), and (iii) the $5,000,000 annual cap. Depending on the magnitude of the capital base allocated to New York, the capital base tax may exceed the business income base tax, potentially making the capital base component the binding constraint for the franchise tax computation in one or more post-IPO tax years.

D. Impact on Apportionment Factors

Equity issuance proceeds from the IPO are non-operational receipts and should be excluded from both the numerator and the denominator of the sales/receipts apportionment factor in all applicable states. Because the IPO proceeds do not represent receipts from the sale of goods, the performance of services, or other operational activities, their inclusion in the apportionment factor would distort the formula and misrepresent the geographic distribution of AHT's business activities.

Similarly, the underwriting discount and offering expenses are capital costs, not operating expenses or receipts, and should not be included in the receipts factor or otherwise affect the apportionment calculation.

However, AHT should exercise care in tracking interest income earned on IPO proceeds that are deposited in operating accounts or invested in short-term instruments following the closing of the offering. Such interest income, including any amounts earned on balances maintained at Keypoint National Bank, N.A. or elsewhere, may constitute apportionable business income for state tax purposes, particularly in states that apply a broad, functional definition of "business income" (i.e., income arising from the regular course of the taxpayer's trade or business operations, or income from assets that are an integral part of the taxpayer's regular trade or business operations). AHT should track the amount and characterization of any investment income generated from IPO proceeds and evaluate the appropriate treatment for each nexus state, including the sourcing of such income for apportionment purposes.

V. WITHHOLDING OBLIGATIONS ON EQUITY COMPENSATION POST-IPO

A. Overview of Issue

The closing of the IPO will create a liquid public market for AHT's common stock (NYSE: ARHT), enabling holders of vested stock options to exercise their options and immediately sell shares (a "same-day sale" or "exercise and sell" transaction). The IPO will also establish a publicly quoted fair market value for the Company's common stock, which will be used to determine the compensation income recognized upon the vesting and settlement of RSUs and other equity awards.

As of the date of the IPO, AHT will have outstanding options to purchase 8,400,000 shares of common stock that are vested and exercisable under the 2014 Stock Incentive Plan, with a weighted average exercise price of $3.25 per share. At the midpoint of the anticipated offering price range ($19.00 per share), the aggregate intrinsic value of these vested options would be approximately $132,300,000 (8,400,000 shares × ($19.00 - $3.25)). The exercise of some or all of these options will generate significant compensation income subject to state (and federal) income tax withholding, depending on the classification of the options as ISOs or NQSOs.

In addition, future grants of RSUs, options, and other awards under the 2024 Equity Incentive Plan will generate compensation income upon vesting and settlement, and purchases under the 2024 ESPP may generate compensation income upon disqualifying dispositions of ESPP shares. AHT, as the employer, will be obligated to withhold applicable federal and state income taxes, as well as employment taxes, on the compensation income recognized by its employees in connection with these equity transactions.

The following discussion addresses the state income tax withholding obligations in each of AHT's nexus states that impose an individual income tax.

B. State Withholding — General Rules

AHT is required to withhold state income taxes on compensation income arising from the exercise of NQSOs, the vesting and settlement of RSUs, and other equity compensation events for employees located in, or earning income sourced to, states that impose an individual income tax and require employer withholding. The amount of the withholding is generally determined by the applicable state's withholding rate (whether flat or graduated) and its rules for sourcing equity compensation income.

Two of AHT's ten nexus states — Texas and Florida — do not impose an individual state income tax and therefore do not require withholding on equity compensation income. The remaining eight nexus states each impose individual income taxes and have their own rules for withholding on equity compensation, as discussed in detail below.

For ISOs that satisfy the holding period requirements of Code Section 422 (i.e., the shares acquired upon exercise are held for at least two years from the grant date and one year from the exercise date), no ordinary income is recognized at the time of exercise, and no withholding is required. However, if the shares are disposed of in a "disqualifying disposition" (i.e., the holding period requirements are not satisfied), the excess of the fair market value at exercise over the exercise price is treated as ordinary compensation income, and the employer's withholding obligations are triggered retroactively. AHT should implement procedures to track ISO share dispositions and identify disqualifying dispositions.

C. State-by-State Withholding Analysis

1. Massachusetts. Massachusetts requires withholding at the Commonwealth's flat individual income tax rate of 5.0% on the "spread" at exercise (for NQSOs, the excess of fair market value over the exercise price at the time of exercise) and on the fair market value at vesting (for RSUs, the fair market value of the shares delivered upon settlement). Withholding applies to Massachusetts-resident employees on their worldwide equity compensation income and to non-resident employees to the extent the equity compensation income constitutes Massachusetts-source income.

For employees who performed services in Massachusetts during all or a portion of the stock option vesting period (the period from the grant date to the vesting date, or from the grant date to the exercise date, depending on the state's allocation methodology), the equity compensation income must be sourced to Massachusetts based on the ratio of the employee's Massachusetts workdays to total workdays during the applicable vesting or service period. This allocation must be performed on a grant-by-grant basis, as the relevant service period may differ for each grant.

For the 14 employees who filed Section 83(b) elections in connection with restricted stock grants received in 2021 and 2022, ordinary income was recognized and taxed at the time of the grant. No additional ordinary income is recognized at the time the restrictions lapse (i.e., at vesting), and accordingly, no additional state withholding obligations arise for these individuals at vesting. Any subsequent gain upon the disposition of the shares will be treated as capital gain, which is not subject to employer withholding.

2. New York

New York requires withholding at the applicable New York State graduated withholding rates on equity compensation income. For employees who are residents of New York City, the combined state and city withholding rate can reach approximately 10.9% for the highest earners, reflecting both the New York State rate (up to 10.9% for taxable income over $25,000,000) and the New York City rate (up to 3.876%).

New York applies a service-period allocation method for sourcing stock option income to New York for non-resident employees. Under this method, the portion of the gain attributable to New York is determined by the ratio of the employee's New York workdays to total workdays during the period from the grant date to the exercise date.

Of critical importance is New York's "convenience of the employer" doctrine. Under 20 NYCRR § 132.18, compensation paid to a non-resident employee is deemed to be entirely New York-source income if the employee's assigned primary office or base of employment is in New York, unless the employee's work at an out-of-state location is performed at a bona fide employer office established for the employer's necessity (not the employee's convenience). This doctrine has been the subject of significant controversy and litigation but remains in force. For AHT employees whose assigned office is in New York but who work remotely from other states, the convenience doctrine could result in the entirety of their equity compensation income being sourced to New York, potentially resulting in double taxation (mitigated by credits in some states). AHT should identify all employees subject to this rule and assess the impact on withholding obligations.

3. California. California requires withholding on equity compensation income at the applicable California supplemental withholding rate of 10.23% for supplemental wages, or at the rate determined under the aggregate method if that method is applied. California is widely regarded as having among the most aggressive sourcing rules for stock option and equity compensation income of any state.

Under California Franchise Tax Board Publication 1005 and related administrative guidance, stock option income earned by non-resident employees is sourced to California based on the ratio of the employee's California workdays to total workdays during the period from the option grant date to the option exercise date. This allocation applies regardless of the employee's state of residence at the time of exercise. Accordingly, if an employee performed services in California during any portion of the grant-to-exercise period — even if the employee has since relocated to another state — a portion of the gain recognized upon exercise is California-source income and is subject to California withholding.

This rule has significant implications for AHT, which has employees who may have worked in California during various periods of the 2014 Stock Incentive Plan's existence. For mobile employees who have performed services in multiple states during the vesting period, California's allocation rule will require a detailed workday analysis for each option grant.

For RSUs, a similar allocation applies based on the ratio of California workdays to total workdays during the vesting period.

With respect to the ESPP, any compensation income recognized upon a disqualifying disposition of ESPP shares (i.e., the spread at the purchase date) is treated as compensation and is subject to California withholding for California-resident employees and non-resident employees with California-source income.

4. Illinois. Illinois requires withholding at the state's flat individual income tax rate of 4.95% on equity compensation income recognized by Illinois-resident employees. For non-resident employees, Illinois generally does not tax compensation earned for services performed outside the state. Accordingly, non-resident employees who did not perform services in Illinois during the relevant vesting or service period should not be subject to Illinois withholding on their equity compensation income.

AHT should be aware of Illinois's supplemental income tax withholding rules, which may affect the calculation of withholding amounts when equity compensation income is paid in addition to regular wages.

5. Pennsylvania. Pennsylvania requires withholding at the Commonwealth's flat individual income tax rate of 3.07% on equity compensation income, including the spread at exercise (for NQSOs) and the fair market value at vesting (for RSUs). Pennsylvania treats stock option income as compensation subject to the personal income tax.

Pennsylvania's flat rate and relatively straightforward sourcing rules make the withholding calculation less complex than in certain other states. For non-resident employees, Pennsylvania sources compensation income based on the location where the services were performed.

6. Ohio. Ohio does not impose a traditional state-level individual income tax withholding requirement on employers in the same manner as most other income tax states. However, Ohio municipalities impose local income taxes (administered by Regional Income Tax Agency ("RITA"), Central Collection Agency ("CCA"), and individual municipal tax departments), and employers with employees located in Ohio municipalities may have municipal withholding obligations. The municipal income tax rates vary by municipality and can range from 1.0% to 3.0% in major cities such as Columbus (2.5%), Cleveland (2.5%), and Cincinnati (1.8%).

AHT should confirm which Ohio municipalities its employees are located in and determine the applicable municipal withholding obligations for equity compensation income. This analysis is beyond the scope of this memorandum but is flagged as an action item.

7. New Jersey

New Jersey requires withholding at the state's graduated individual income tax rates, which range up to 10.75% for the highest income earners (taxable income over $1,000,000). Equity compensation income is treated as wages subject to New Jersey withholding.

For non-resident employees, New Jersey sources stock option income based on the proportion of services performed in New Jersey during the applicable vesting or service period, consistent with the multi-state allocation methodology described in Section V.D below.

8. Georgia. Georgia requires withholding at the state's graduated individual income tax rates, which range up to 5.75% (reducing to 5.39% for tax year 2024). Georgia applies a standard service-period allocation method for sourcing equity compensation income to Georgia for non-resident employees, based on the ratio of Georgia workdays to total workdays during the applicable vesting or service period.

D. Multi-State Allocation Issues for Mobile Employees

AHT employs a workforce that includes individuals who have worked in, or relocated between, multiple states during their tenure with the Company. For options granted under the 2014 Stock Incentive Plan, which were granted beginning in 2014, the applicable vesting periods may span many years during which an employee may have performed services in two or more states. Upon exercise, the gain must be allocated among the states in which the employee performed services during the vesting period, based on each state's workday allocation rules.

This multi-state allocation requirement applies not only to stock options but also to RSUs granted under the 2024 Plan and to any other equity awards with multi-year vesting schedules. The complexity of the allocation increases as the number of states in which an employee has performed services during the relevant period increases.

AHT should implement a robust tracking mechanism to (i) identify employees who have performed services in multiple states during the applicable vesting or service periods, (ii) calculate the workday allocation ratios for each state for each grant, and (iii) compute the correct withholding amounts for each state. We recommend that AHT engage Hargrove Prindaux Advisory Group LLC (compensation consultant, 1600 Market Street, Suite 3400, Philadelphia, PA 19103) or a qualified payroll tax specialist to develop and implement multi-state allocation procedures for equity compensation. This engagement should be commenced prior to the first post-IPO option exercises or RSU settlements to ensure compliance from the outset.

E. Impact of Section 83(b) Elections

As noted above, 14 current employees of the Company filed elections under Section 83(b) of the Code in connection with restricted stock grants received during 2021 and 2022. By filing these elections, each employee elected to include in gross income the fair market value of the restricted stock (less any amount paid for the stock) at the time of the grant, rather than at the time the restrictions lapsed. This had the effect of accelerating the recognition of ordinary income to the grant date and converting any subsequent appreciation in the stock's value from ordinary income to capital gain.

For state income tax purposes, the consequence of the 83(b) election is that state withholding was due at the time of the grant-date income recognition, and no additional state withholding obligation arises upon the lapse of the restrictions (i.e., at vesting). The amount of ordinary income recognized at the grant date was the fair market value of the stock at that time, which, for a pre-IPO private company, would have been based on an independent 409A valuation. Any gain realized upon the subsequent sale of the stock (after the restrictions lapse and the stock becomes freely tradable post-IPO) will be treated as capital gain, which is not subject to employer withholding.

AHT should confirm that the 83(b) election filings were properly reported to each applicable state taxing authority at the time of the grants and that the corresponding state income tax withholding was correctly computed and remitted. If any deficiencies are identified, corrective filings should be made.

F. Section 423 ESPP Considerations

The 2024 ESPP is intended to qualify as an "employee stock purchase plan" under Section 423 of the Code. Under a Section 423 qualified plan, no income is recognized by the employee at the time of enrollment or at the time of purchase (the end of each offering period). The income tax consequences depend on whether the employee makes a "qualifying disposition" or a "disqualifying disposition" of the shares acquired

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE ATTORNEY WORK PRODUCT
This memorandum is a privileged and confidential communication protected by the attorney-client privilege and the work product doctrine. It is intended solely for the use of the addressees identified below. Any unauthorized review, use, disclosure, or distribution is prohibited.
MEMORANDUM
February 1, 2024
Right-click to update Table of Contents
I. EXECUTIVE SUMMARY
This memorandum analyzes the state income and franchise tax implications for Arbor Health Technologies Inc. ("AHT" or the "Company") across the Company's ten nexus states in connection with its proposed initial public offering (the "IPO") of shares of its common stock on the New York Stock Exchange (proposed ticker symbol: ARHT), SEC File Number 333-276841. The analysis addresses both the existing state tax posture of the Company and the specific state tax consequences and obligations arising from the IPO transaction itself and the Company's post-IPO status as a publicly traded corporation.
AHT is a Delaware C-corporation headquartered in Cambridge, Massachusetts. The Company operates a cloud-based clinical decision support, population health management, and revenue cycle management software-as-a-service ("SaaS") platform that currently serves over 1,200 hospital systems and physician groups across 42 states. As of the date of this memorandum, AHT files income and/or franchise tax returns in ten states: Massachusetts, New York, California, Texas, Illinois, Florida, Pennsylvania, Ohio, New Jersey, and Georgia.
For the fiscal year ended December 31, 2023 ("FY2023"), AHT reported total revenue of $612.4 million, representing a 28% year-over-year increase from $478.4 million in FY2022. The Company reported Adjusted EBITDA of $138.7 million and net income of $41.3 million for FY2023. As of December 31, 2023, AHT employed approximately 3,400 individuals across its various locations and remote working arrangements.
The proposed IPO involves the sale of 20,000,000 newly issued shares of common stock at an anticipated price of $18.00 to $20.00 per share (revised range per the Company's Registration Statement on Form S-1/A, filed February 5, 2024), generating estimated base gross proceeds of $360,000,000 to $400,000,000. The underwriters have been granted a 3,000,000-share overallotment option (representing 15% of the base offering), which, if exercised in full, would increase total gross proceeds to $414,000,000 to $460,000,000. The IPO is structured as an entirely primary offering, with no secondary sales by existing stockholders.
This memorandum addresses the following key areas:
1. Nexus analysis and filing obligations — A state-by-state review of the Company's basis for nexus in each of its ten filing states, including both traditional physical presence nexus and post-South Dakota v. Wayfair economic nexus standards as applied by each state for income and franchise tax purposes.
2. State-level treatment of IPO equity issuance proceeds — An analysis confirming that proceeds from the issuance of the Company's own stock are not includable in taxable income for state income tax purposes, with attention to specific state variations, including the impact on the New York business capital base.
3. Income apportionment considerations — A review of the Company's apportionment methodology across its nexus states, with particular attention to market-based sourcing of SaaS revenue and the potential effects of revenue growth on state-by-state apportionment percentages.
4. Withholding obligations on equity compensation exercises and settlements post-IPO — An analysis of the Company's state income tax withholding obligations arising from post-IPO exercises of stock options under the 2014 Stock Incentive Plan, vesting and settlement of restricted stock units under the 2024 Equity Incentive Plan, purchases under the 2024 Employee Stock Purchase Plan, and the impact of Section 83(b) elections.
5. Franchise tax implications — An analysis of the Delaware franchise tax, New York capital base tax, Texas franchise (margin) tax, and Pennsylvania capital stock/franchise tax implications of the IPO and the resulting changes in the Company's capital structure.
6. Potential additional nexus exposures arising from the IPO — Identification of risk areas where the Company's post-IPO growth, hiring, and acquisition activities may create nexus in additional states.
7. Recommendations — Specific action items for the Company to address prior to and following the closing of the IPO.
This memorandum does not address sales and use tax, property tax, unclaimed property or escheat obligations, or payroll tax matters other than state income tax withholding on equity compensation income. A separate memorandum, dated January 22, 2024, addresses the federal Section 382 ownership change analysis in connection with the IPO.
II. BACKGROUND AND FACTUAL ASSUMPTIONS
The analysis in this memorandum is based on the following factual background and assumptions, which have been derived from information provided by AHT management, review of the Company's draft Registration Statement on Form S-1 and the amendment thereto, review of the Company's organizational documents, and discussions with the Company's Chief Financial Officer, David Halderman, and General Counsel, Rachel Moynihan.
A. Corporate Structure and Tax Status
AHT was incorporated in the State of Delaware on March 17, 2014 under the name "Arbor Health Technologies Inc." and has been treated as a C-corporation for federal and state income tax purposes since its formation. The Company has not at any time elected S-corporation status under Subchapter S of the Internal Revenue Code of 1986, as amended (the "Code"), nor has it been treated as a partnership or disregarded entity for federal or state tax purposes.
The Company's Federal Employer Identification Number is 47-3891205. The Company's registered agent in the State of Delaware is National Registered Agents of Delaware, Inc., located at 160 Greentree Drive, Suite 101, Dover, Delaware 19904. The Company maintains its principal executive offices and headquarters at 275 Kendall Avenue, Suite 1400, Cambridge, Massachusetts 02142. The Company's Standard Industrial Classification (SIC) Code is 7372 (Prepackaged Software).
AHT operates as a single legal entity. As of the date of this memorandum, the Company has no subsidiaries, whether wholly owned or otherwise, and no disregarded entities for federal or state income tax purposes. The Company has not entered into any tax sharing or tax indemnification agreements with any affiliated entities. We have assumed for purposes of this memorandum that the Company's single-entity structure will remain in effect through the closing of the IPO and for the foreseeable future, absent any post-IPO acquisitions or restructuring transactions.
B. Pre-IPO Capitalization and Ownership
As of the date immediately prior to the expected closing of the IPO, the Company's authorized capital stock consists of 120,000,000 shares of common stock, par value $0.001 per share. Of the authorized shares, 80,000,000 shares are issued and outstanding. The Company has no authorized preferred stock outstanding as of this date.
The following table summarizes the principal pre-IPO stockholders and their respective ownership interests:
Following the IPO, assuming the issuance of all 20,000,000 base offering shares and the full exercise of the 3,000,000-share overallotment option, the total number of shares of common stock outstanding will be 103,000,000.
C. IPO Structure
The IPO is structured as an entirely primary offering. AHT will issue and sell 20,000,000 new shares of common stock (plus up to 3,000,000 additional shares pursuant to the overallotment option). No existing stockholders are selling shares in the offering.
The underwriting discount is 6.0% of the public offering price, equal to $1.20 per share (assuming a midpoint offering price of $19.00 per share, for illustrative purposes). The total underwriting discount, assuming a full offering including the overallotment, would be approximately $27,600,000 (23,000,000 shares × $1.20 per share). The Company has estimated that total offering expenses, exclusive of the underwriting discount, will be approximately $4,200,000, which includes SEC registration fees, FINRA fees, NYSE listing fees, legal fees, accounting fees, printing costs, transfer agent fees, and miscellaneous expenses.
The Company has disclosed that it intends to use a portion of the net proceeds from the IPO to repay approximately $65,000,000 of outstanding borrowings under its $150,000,000 senior secured revolving credit facility with Keypoint National Bank, N.A. (the "Credit Facility"). The Credit Facility bears interest at SOFR plus 200 basis points, has a maturity date of March 15, 2027, and is secured by substantially all of the Company's assets. The Company intends to retain the Credit Facility following the repayment for ongoing working capital and general corporate purposes.
In connection with the IPO, AHT will file an Amended and Restated Certificate of Incorporation with the Delaware Secretary of State on the expected closing date of February 13, 2024. The Amended and Restated Certificate of Incorporation will authorize 400,000,000 shares of common stock, par value $0.001 per share, and 50,000,000 shares of preferred stock, par value $0.001 per share.
D. Equity Compensation Plans
AHT maintains, or will maintain effective upon the closing of the IPO, the following equity compensation arrangements:
2014 Stock Incentive Plan. The Company adopted the 2014 Stock Incentive Plan (the "2014 Plan") in connection with its formation. The 2014 Plan authorizes the grant of incentive stock options ("ISOs") and nonqualified stock options ("NQSOs") covering up to 12,000,000 shares of common stock. As of the date of this memorandum, options covering 11,200,000 shares have been granted under the 2014 Plan, of which options covering 8,400,000 shares are vested and exercisable. The weighted average exercise price of all outstanding options under the 2014 Plan is $3.25 per share. No additional grants will be made under the 2014 Plan following the IPO, though all outstanding options will remain exercisable in accordance with their terms. The options granted under the 2014 Plan include both ISOs and NQSOs; the specific classification of each grant should be confirmed with the Company's equity plan administrator in connection with the withholding analysis.
2024 Equity Incentive Plan. The Company's board of directors adopted, and the Company's stockholders approved, the 2024 Equity Incentive Plan (the "2024 Plan") on January 15, 2024. The 2024 Plan will become effective upon the closing of the IPO. The 2024 Plan reserves 10,300,000 shares of common stock (equal to 10% of the anticipated post-IPO shares outstanding of 103,000,000) for issuance pursuant to awards granted thereunder. The 2024 Plan includes an annual "evergreen" provision that automatically increases the share reserve on January 1 of each calendar year by 3% of the total number of shares of common stock outstanding on the preceding December 31. The 2024 Plan authorizes the grant of ISOs, NQSOs, restricted stock units ("RSUs"), stock appreciation rights ("SARs"), and performance-based awards.
2024 Employee Stock Purchase Plan. The Company's board of directors also adopted the 2024 Employee Stock Purchase Plan (the "ESPP") on January 15, 2024, which will become effective upon the closing of the IPO. The ESPP reserves 2,060,000 shares of common stock (equal to 2% of the anticipated post-IPO shares outstanding) for issuance. The ESPP provides for a 15% discount from the lower of the fair market value of the Company's common stock on the first or last day of each semi-annual offering period. The ESPP is intended to qualify as an "employee stock purchase plan" under Section 423 of the Code.
Section 83(b) Elections. Fourteen current employees of the Company received restricted stock grants during the period from 2021 through 2022 and timely filed elections under Section 83(b) of the Code with the Internal Revenue Service within 30 days of the date of each respective grant. As a result, these employees recognized ordinary income equal to the fair market value of the restricted stock at the time of grant, rather than at the time of vesting. The aggregate ordinary income recognized by these 14 employees in connection with their 83(b) elections, and the state tax withholding reported thereon, has not been independently verified for purposes of this memorandum but has been represented by AHT management to be properly reported.
Federal R&D Tax Credits. AHT generated $8.7 million of federal research and development tax credits under Section 41 of the Code for FY2023. As of December 31, 2023, the Company has a cumulative R&D credit carryforward of $12.4 million. The utilization of these credits may be subject to limitation under Section 383 of the Code in the event of an ownership change under Section 382; however, as addressed in our separate memorandum dated January 22, 2024, the IPO is not expected to trigger such an ownership change.
E. Employee Distribution and Physical Presence
As of December 31, 2023, AHT employed approximately 3,400 individuals. The Company maintains its principal offices and primary engineering center at its Cambridge, Massachusetts headquarters. The Company also maintains offices and/or has significant employee concentrations in New York, California, Texas, Illinois, and Georgia. The Company has remote employees located in Pennsylvania, Ohio, New Jersey, Florida, and various other states.
The Company's cloud-based SaaS platform is hosted by third-party data center providers and is not operated from Company-owned or Company-leased data center facilities. The Company's customers are located in 42 states. The distribution of employees across specific states, including employee headcounts and payroll amounts, has been provided by AHT management in the supplemental data package delivered to our office on January 18, 2024, and we have relied on that data for purposes of this analysis.
III. STATE-BY-STATE NEXUS ANALYSIS AND FILING STATUS
Introductory Note
AHT currently files income and/or franchise tax returns in ten states based on physical presence, economic nexus, and/or factor presence thresholds established under each state's applicable law. This section provides a state-by-state analysis of the basis for the Company's nexus in each of these ten filing states, the applicable tax type and rate, the apportionment methodology employed by each state, the Company's current filing status, and the IPO-related considerations specific to each jurisdiction.
The analysis considers both traditional nexus standards — predicated on physical presence, including employees, offices, and tangible property — and the post-South Dakota v. Wayfair, Inc., 585 U.S. 162 (2018), economic nexus standards that have been adopted by an increasing number of states for income and franchise tax purposes. It is important to note that the Wayfair decision addressed sales and use tax nexus, not income tax nexus, and the extent to which states may apply economic nexus standards for income and franchise tax purposes remains a developing area of law. However, a number of the states in which AHT files have adopted factor presence standards or other economic nexus thresholds for their income and franchise taxes, as discussed below.
This section does not address sales and use tax nexus, which is subject to a separate analysis and is outside the scope of this memorandum.
A. Massachusetts
Nexus Basis. AHT has substantial nexus with the Commonwealth of Massachusetts by virtue of its headquarters location at 275 Kendall Avenue, Suite 1400, Cambridge, MA 02142, where the Company maintains its principal executive offices and its primary engineering and product development center. AHT has a significant number of employees in Massachusetts, including senior executives, engineers, and administrative staff. The Company's commercial domicile is in Massachusetts. Accordingly, AHT has clear nexus with Massachusetts under both traditional physical presence standards and the Commonwealth's domiciliary/commercial domicile nexus principles.
Tax Type. Massachusetts imposes a corporate excise tax on corporations doing business in the Commonwealth. The excise consists of two components: (i) an income measure, which is the greater of (a) net income apportioned to Massachusetts multiplied by the applicable tax rate (currently 8.0% for corporations with taxable income over $1 million), or (b) a minimum tax of $456; and (ii) a non-income measure (tangible property measure), computed at $2.60 per $1,000 of the corporation's tangible personal property or net worth allocable to Massachusetts. The total excise is the sum of the income measure and the non-income measure, subject to a minimum tax.
Apportionment. Massachusetts employs a single sales factor apportionment formula for corporations whose income is derived primarily from the sale of services or intangible property. This standard has been effective for tax years beginning on or after January 1, 2014, pursuant to M.G.L. c. 63, § 38(l). Under this formula, AHT's Massachusetts taxable income is determined by multiplying its total apportionable income by the ratio of its Massachusetts-sourced receipts to its total receipts. Massachusetts applies market-based sourcing for service revenue, sourcing receipts to the location where the benefit of the service is received.
Filing Status. AHT currently files Massachusetts corporate excise tax returns and has done so since the Company's inception. Massachusetts is expected to continue to be a significant apportionment state for the Company given the location of the Company's commercial domicile and the concentration of employees in the Commonwealth.
IPO Considerations. There is no special Massachusetts tax treatment applicable to equity issuance proceeds; consistent with the general analysis in Section IV of this memorandum, proceeds from the issuance of the Company's own stock are not includable in income for Massachusetts corporate excise tax purposes. AHT will have withholding obligations on equity compensation income for Massachusetts-resident employees and for non-resident employees earning Massachusetts-source income, as discussed in Section V.
B. New York
Nexus Basis. AHT has nexus with the State of New York based on its maintenance of a physical office in the state, the presence of employees performing services in New York, the solicitation of business in New York, and the Company's satisfaction of economic nexus standards under Article 9-A, Section 209 of the New York Tax Law. Under New York's bright-line nexus provisions, a corporation is deemed to be "doing business" in New York and is subject to the franchise tax if, among other things, it derives $1,000,000 or more of receipts from New York sources, has property in New York with a value exceeding $54,000, or has payroll in New York exceeding $54,000.
Tax Type. New York imposes a corporate franchise tax under Article 9-A of the Tax Law. The tax is computed as the highest of: (i) the business income base (taxable business income apportioned to New York, taxed at 6.5% for most corporations; 7.25% for corporations with a business income base over $5,000,000); (ii) the business capital base (0.04% of total business capital allocated to New York, capped at $5,000,000 per year); or (iii) a fixed-dollar minimum tax based on New York receipts (ranging from $25 to $200,000 depending on receipts level).
Apportionment. New York uses a single receipts factor for apportionment purposes, with customer-based (market-based) sourcing for service revenue. This methodology has been in effect for tax years beginning on or after January 1, 2015. Service receipts are sourced to New York to the extent the service is delivered to or benefits a customer in New York.
Filing Status. AHT currently files New York franchise tax returns under Article 9-A.
IPO Considerations. Proceeds from the equity issuance are excluded from the business income base, consistent with the general analysis in Section IV below. However, the post-IPO influx of capital will increase the Company's reported business capital, which is relevant for the capital base component of the franchise tax. This is discussed in detail in Sections IV.C and VII.B. AHT will have withholding obligations on equity compensation for New York-resident and New York-source-income employees. Of particular importance, New York's "convenience of the employer" rule may apply to remote employees whose assigned office is in New York but who perform some or all of their services from locations outside New York. Under this doctrine, compensation is sourced to New York unless the employee's out-of-state work location is established as a bona fide office of the employer maintained for the employer's necessity rather than the employee's convenience. AHT should carefully evaluate the application of this rule to its workforce, as discussed further in Section V.
C. California
Nexus Basis. AHT has nexus with the State of California based on its maintenance of a physical office and the presence of employees in the state. In addition, AHT satisfies California's economic nexus standards under California Revenue and Taxation Code Section 23101(b), which deems a corporation to be "doing business" in California if it has, among other things, (i) California-source sales exceeding $500,000 (adjusted annually), (ii) real or tangible personal property in California exceeding $50,000, (iii) California payroll exceeding $50,000, or (iv) 25% or more of its total sales, property, or payroll in California.
Tax Type. California imposes a corporate income tax at a rate of 8.84% of net income apportioned to California. In addition, all corporations organized in or qualified to do business in California are subject to a minimum franchise tax of $800, which is payable regardless of whether the corporation has net income.
Apportionment. California has employed a single sales factor apportionment formula for tax years beginning on or after January 1, 2013, applicable to corporations that derive more than 50% of their income from business activities. California applies market-based sourcing for service revenue, sourcing receipts to the location where the customer receives the benefit of the service.
Filing Status. AHT currently files California corporate income tax returns (Form 100).
IPO Considerations. California conforms to Code Section 1032, and accordingly, proceeds from the issuance of the Company's own stock are excluded from California taxable income. California's market-based sourcing rules may significantly affect AHT's California apportionment factor depending on the geographic distribution of customers receiving the Company's SaaS and analytics services. AHT will have withholding obligations on equity compensation for California-resident employees and for non-resident employees with California-source income. California's Franchise Tax Board applies particularly aggressive allocation rules for stock option income earned by non-residents and former residents, as discussed in detail in Section V. Under FTB Publication 1005 and related guidance, stock option income is allocated to California based on the ratio of California workdays to total workdays during the period from the grant date to the exercise date. ESPP purchases may also trigger California withholding for California-based participants in the event of a disqualifying disposition.
D. Texas
Nexus Basis. AHT has nexus with the State of Texas based on the presence of employees and the maintenance of a physical office in the state. In addition, AHT's gross receipts from Texas sources exceed the $500,000 threshold that establishes nexus for Texas franchise tax purposes.
Tax Type. Texas imposes a franchise (margin) tax on each taxable entity that does business in the state or is chartered or organized in Texas. The franchise tax is not a traditional income tax; rather, it is computed on "total revenue" less the greater of (i) cost of goods sold, (ii) compensation, or (iii) a 30% standard deduction. The applicable tax rate is 0.375% for entities qualifying as wholesale or retail and 0.75% for all other entities. Based on AHT's SaaS business model, the 0.75% rate is expected to apply.
Apportionment. Texas employs a single gross receipts factor for purposes of apportioning the franchise tax margin to Texas. Receipts from services are generally sourced to Texas based on the location of the performance of the service or the location of the customer, depending on the nature of the service.
Filing Status. AHT currently files Texas franchise tax reports.
IPO Considerations. IPO proceeds from the equity issuance should be excluded from "total revenue" for Texas franchise tax purposes, as such proceeds represent a capital transaction and are not revenue within the meaning of Texas Tax Code Section 171.1011. Texas does not impose an individual state income tax; accordingly, there are no state-level withholding obligations on equity compensation income for Texas-based employees.
E. Illinois
Nexus Basis. AHT has nexus with the State of Illinois based on the presence of employees and the maintenance of a physical office in the state. AHT also satisfies Illinois's economic nexus standards applicable to corporations.
Tax Type. Illinois imposes a corporate income tax at a rate of 7.0% on income apportioned to the state. In addition, Illinois imposes a personal property replacement income tax ("PPRIT") at a rate of 2.5% on the same tax base, for a combined effective rate of 9.5%.
Apportionment. Illinois employs a single sales factor apportionment formula with market-based sourcing for service revenue, sourcing receipts to the state where the customer receives the benefit of the service. This methodology applies for tax years ending on or after December 31, 2009.
Filing Status. AHT currently files Illinois corporate income and replacement tax returns (Form IL-1120).
IPO Considerations. IPO equity issuance proceeds are excluded from Illinois taxable income, consistent with Illinois's conformity with the Code. AHT will have withholding obligations on equity compensation for Illinois-resident employees, as discussed in Section V. Illinois applies supplemental income tax withholding rules that may affect the calculation of withholding amounts on equity compensation income.
F. Florida
Nexus Basis. AHT has nexus with the State of Florida based on the presence of employees, including remote workers, in the state. AHT also satisfies Florida's economic nexus standards for corporations doing business in the state.
Tax Type. Florida imposes a corporate income/franchise tax at a rate of 5.5% on income apportioned to the state. Florida provides a $50,000 exemption from the corporate income tax base.
Apportionment. Florida applies a three-factor apportionment formula, weighting sales, property, and payroll equally, although qualifying taxpayers may elect single-sales-factor apportionment. Florida applies market-based sourcing for service revenue.
Filing Status. AHT currently files Florida corporate income/franchise tax returns (Form F-1120).
IPO Considerations. Florida does not impose an individual state income tax. Accordingly, there are no state-level withholding obligations on equity compensation income for Florida-based employees. IPO equity issuance proceeds are excluded from Florida taxable income, as Florida begins its income tax computation with federal taxable income, and proceeds from stock issuance are not included in federal taxable income under Code Section 1032.
G. Pennsylvania
Nexus Basis. AHT has nexus with the Commonwealth of Pennsylvania based on the presence of employees in the state. AHT may also satisfy Pennsylvania's economic nexus standards, which apply to corporations with $500,000 or more of Pennsylvania-source receipts.
Tax Type. Pennsylvania imposes a corporate net income tax on net income apportioned to the Commonwealth. The corporate net income tax rate for 2024 is 8.99%, which is scheduled to phase down annually, reaching 4.99% by tax year 2031. Pennsylvania also historically imposed a capital stock/franchise tax; however, that tax has been fully eliminated as of January 1, 2024.
Apportionment. Pennsylvania applies a three-factor apportionment formula that is in the process of transitioning toward a single sales factor. For tax year 2023, the sales factor is weighted at 90% and the property and payroll factors are each weighted at 5%. Pennsylvania applies market-based sourcing for service revenue.
Filing Status. AHT currently files Pennsylvania corporate net income tax returns (Form RCT-101). With the elimination of the capital stock/franchise tax, no further capital stock tax filings will be required for tax years beginning on or after January 1, 2024.
IPO Considerations. The elimination of the Pennsylvania capital stock/franchise tax as of January 1, 2024 removes any franchise tax consequences associated with the post-IPO increase in the Company's capital structure. IPO equity issuance proceeds are excluded from Pennsylvania corporate net income. AHT will have withholding obligations on equity compensation for Pennsylvania-resident employees at the Pennsylvania flat individual income tax rate of 3.07%.
H. Ohio
Nexus Basis. AHT has nexus with the State of Ohio based on the presence of employees in the state. AHT may also satisfy Ohio's bright-line nexus standards, which impose the commercial activity tax on corporations with $500,000 or more of Ohio-sitused receipts or $50,000 or more of Ohio-based property or payroll.
Tax Type. Ohio does not impose a traditional corporate income tax. Instead, Ohio imposes a Commercial Activity Tax (the "CAT"), which is a gross receipts tax on "taxable gross receipts" exceeding $150,000. The CAT is imposed at tiered rates, with the principal rate being 0.26% on taxable gross receipts in excess of $1,000,000.
Apportionment. Ohio situses receipts from services based on the location where the customer receives the benefit of the service, consistent with a market-based sourcing approach.
Filing Status. AHT currently files Ohio CAT returns.
IPO Considerations. IPO equity issuance proceeds do not constitute "taxable gross receipts" under the Ohio CAT. Ohio Revenue Code Section 5751.01(F)(2) excludes from the definition of taxable gross receipts amounts received from the issuance of the taxpayer's own stock or other equity instruments. There are no individual income tax withholding obligations at the state level relevant to the CAT; however, Ohio municipal income tax withholding may apply in specific municipalities where AHT has employees, as discussed in Section V.
I. New Jersey
Nexus Basis. AHT has nexus with the State of New Jersey based on the presence of employees, including remote workers, in the state. In addition, AHT satisfies New Jersey's bright-line economic nexus standards, which establish nexus for corporations with either (i) $100,000 or more of New Jersey-source receipts, or (ii) 200 or more separate transactions delivered into New Jersey during the tax year.
Tax Type. New Jersey imposes the Corporation Business Tax ("CBT") on the adjusted entire net income of corporations apportioned to New Jersey. The CBT rate is 9.0% for corporations with allocated taxable net income in excess of $1,000,000. An additional surtax of 2.5% has been imposed on corporations with allocated taxable income over $1,000,000 for certain tax years; this surtax has been extended by recent legislation and may remain in effect for AHT's 2024 tax year. In addition to the net income base, the CBT is also computed on an Alternative Minimum Assessment ("AMA") basis, which is determined based on gross receipts or gross profits, with the higher of the net income base tax or the AMA being owed.
Apportionment. New Jersey applies a single sales factor apportionment formula with market-based sourcing for service revenue.
Filing Status. AHT currently files New Jersey CBT returns (Form CBT-100).
IPO Considerations. New Jersey has adopted relatively aggressive combined reporting provisions that may affect the computation of AHT's CBT liability, though as a single-entity taxpayer, AHT does not currently file on a combined basis. IPO equity issuance proceeds are excluded from CBT net income. However, AHT should evaluate the impact of the IPO on the AMA computation, as the AMA is based on gross receipts or gross profits and the influx of capital and potential interest income from invested IPO proceeds could affect the AMA calculation. AHT will have withholding obligations on equity compensation for New Jersey-resident employees, as discussed in Section V.
J. Georgia
Nexus Basis. AHT has nexus with the State of Georgia based on the presence of employees and the maintenance of a physical office in the state. AHT also satisfies Georgia's economic nexus standards for corporations doing business in the state.
Tax Type. Georgia imposes a corporate income tax on net income apportioned to the state. The corporate income tax rate has been 5.75%; however, pursuant to recent legislation (HB 1437, signed April 26, 2022), the rate began reducing to 5.39% effective January 1, 2024.
Apportionment. Georgia employs a single sales factor apportionment formula with market-based sourcing for service revenue.
Filing Status. AHT currently files Georgia corporate income tax returns (Form 600).
IPO Considerations. IPO equity issuance proceeds are excluded from Georgia corporate income. AHT will have withholding obligations on equity compensation for Georgia-resident employees at the applicable Georgia graduated individual income tax rates. AHT should be aware that Georgia applies a relatively broad definition of "business income," which could potentially affect the characterization of certain ancillary items of income; however, the equity issuance proceeds themselves are not income at all and are not subject to this analysis.
IV. STATE-LEVEL TREATMENT OF IPO EQUITY ISSUANCE PROCEEDS
A. General Principles
The fundamental question addressed in this section is whether the proceeds received by AHT from the issuance and sale of its common stock in the IPO will be subject to state income or franchise taxes in any of the Company's ten nexus states. The analysis is straightforward in most respects, but several nuances and state-specific considerations warrant detailed discussion.
For federal income tax purposes, Section 1032 of the Code provides that "[n]o gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation." Accordingly, the gross proceeds of $360,000,000 to $460,000,000 (depending on the offering price and exercise of the overallotment option) received by AHT in exchange for the issuance of 20,000,000 to 23,000,000 shares of newly issued common stock will not be included in AHT's gross income for federal income tax purposes. This principle applies regardless of the offering price or the relationship between the offering price and the par value of the stock.
For state income tax purposes, the treatment of IPO equity issuance proceeds depends on each state's conformity with the Code and its own statutory definitions of "business income," "non-business income," "allocable income," and "apportionable income." However, in practice, all ten of AHT's nexus states either conform to Section 1032 of the Code directly, use federal taxable income as the starting point for computing state taxable income (thereby incorporating the Section 1032 exclusion by reference), or otherwise do not treat the receipt of capital from the issuance of a corporation's own stock as a taxable event. The equity issuance proceeds are capital contributions to the corporation — they increase the Company's paid-in capital and stockholders' equity but do not generate income.
The underwriting discount, which will total approximately $27,600,000 based on the full offering of 23,000,000 shares at $1.20 per share, and the estimated offering expenses of approximately $4,200,000, represent capital costs incurred in connection with the issuance of stock. These costs reduce the amount of additional paid-in capital recorded on the Company's balance sheet. They are not deductible for federal or state income tax purposes, as they are capital costs associated with the issuance of stock, not ordinary and necessary business expenses within the meaning of Code Section 162.
B. State-by-State Treatment
The following summarizes our analysis for each of the ten nexus states, confirming that the IPO equity issuance proceeds are not includable in the taxable income or franchise tax base in any of these jurisdictions:
Massachusetts. Excluded from Massachusetts corporate excise tax. The Commonwealth starts with federal gross income as the starting point for the income measure of the corporate excise tax. Because the IPO proceeds are not included in federal gross income under Section 1032, they are likewise excluded from the Massachusetts tax base. No adjustment is required.
New York. Excluded from the New York business income base. New York begins its franchise tax computation with "entire net income," which is based on federal taxable income with certain modifications. Because IPO proceeds are not included in federal taxable income, they are excluded from the New York business income base. However, we note the important impact on the business capital base component of the franchise tax, discussed in Section IV.C below. The post-IPO increase in total stockholders' equity (reflecting the net proceeds of the offering credited to additional paid-in capital) will increase AHT's reported business capital for purposes of the capital base tax.
California. Excluded from California taxable income. California starts with federal taxable income in computing net income subject to the corporate income tax. California conforms to Section 1032 of the Code, and accordingly, IPO proceeds are not included in California taxable income. No adjustment is required.
Texas. Excluded from total revenue for Texas franchise (margin) tax purposes. Texas Tax Code Section 171.1011 defines "total revenue" by reference to certain Internal Revenue Code provisions and specifically excludes non-revenue items, including proceeds from the issuance of the taxpayer's own stock. The IPO equity issuance constitutes a capital transaction, not a revenue-generating transaction.
Illinois. Excluded from Illinois taxable income. Illinois begins its corporate income tax computation with federal taxable income, and accordingly, the Section 1032 exclusion is incorporated by reference. No modification is required.
Florida. Excluded from Florida taxable income. Florida starts with federal taxable income (as adjusted) as the basis for computing corporate income. Because IPO proceeds are not included in federal taxable income, they are excluded from the Florida tax base.
Pennsylvania. Excluded from Pennsylvania corporate net income. Pennsylvania begins its computation of taxable income with federal taxable income and makes certain modifications; however, no modification results in the inclusion of stock issuance proceeds. The Section 1032 exclusion applies.
Ohio. Excluded from Ohio CAT taxable gross receipts. Ohio Revenue Code Section 5751.01(F)(2) specifically excludes from the definition of "taxable gross receipts" proceeds received from the issuance of the taxpayer's own stock or other equity instruments. This exclusion is consistent with the general principle that capital contributions are not receipts from business operations.
New Jersey. Excluded from CBT net income. New Jersey begins its CBT computation with entire net income based on federal taxable income, and accordingly, IPO proceeds are excluded. However, AHT should evaluate the impact of the IPO on the Alternative Minimum Assessment ("AMA") base. The AMA is computed based on either New Jersey gross receipts or New Jersey gross profits (whichever produces a higher AMA), and it is possible that interest income earned on invested IPO proceeds could affect the gross receipts or gross profits calculation. This consideration is discussed further in Section IV.D.
Georgia. Excluded from Georgia corporate income. Georgia begins with federal taxable income as the starting point for computing state net income, and accordingly, IPO proceeds are excluded by operation of the Section 1032 exclusion.
C. Special Consideration — New York Business Capital Base
While the IPO equity issuance proceeds are excluded from the New York business income base, the post-IPO increase in the Company's total equity will have a direct and potentially material impact on the business capital base component of the New York franchise tax.
Under Article 9-A of the New York Tax Law, the franchise tax is computed as the highest of the business income base, the business capital base, or the fixed-dollar minimum tax. The business capital base tax is imposed at a rate of 0.04% (four basis points) of total business capital allocated to New York, subject to an annual cap of $5,000,000. "Business capital" generally means the total assets of the corporation minus liabilities not deducted elsewhere.
The IPO is expected to generate net proceeds of approximately $328,200,000 to $428,200,000 (after deducting the underwriting discount and offering expenses), which will be credited to AHT's additional paid-in capital and will increase total stockholders' equity and total assets on the Company's balance sheet. After the repayment of approximately $65,000,000 of outstanding indebtedness under the Credit Facility, the net increase to the Company's balance sheet will be somewhat reduced, but it will still represent a significant increase in the Company's total business capital.
AHT should model the post-IPO New York capital base tax liability under various scenarios, taking into account (i) the amount of net IPO proceeds retained on the balance sheet, (ii) the New York receipts apportionment factor (which is used to allocate business capital to New York), and (iii) the $5,000,000 annual cap. Depending on the magnitude of the capital base allocated to New York, the capital base tax may exceed the business income base tax, potentially making the capital base component the binding constraint for the franchise tax computation in one or more post-IPO tax years.
D. Impact on Apportionment Factors
Equity issuance proceeds from the IPO are non-operational receipts and should be excluded from both the numerator and the denominator of the sales/receipts apportionment factor in all applicable states. Because the IPO proceeds do not represent receipts from the sale of goods, the performance of services, or other operational activities, their inclusion in the apportionment factor would distort the formula and misrepresent the geographic distribution of AHT's business activities.
Similarly, the underwriting discount and offering expenses are capital costs, not operating expenses or receipts, and should not be included in the receipts factor or otherwise affect the apportionment calculation.
However, AHT should exercise care in tracking interest income earned on IPO proceeds that are deposited in operating accounts or invested in short-term instruments following the closing of the offering. Such interest income, including any amounts earned on balances maintained at Keypoint National Bank, N.A. or elsewhere, may constitute apportionable business income for state tax purposes, particularly in states that apply a broad, functional definition of "business income" (i.e., income arising from the regular course of the taxpayer's trade or business operations, or income from assets that are an integral part of the taxpayer's regular trade or business operations). AHT should track the amount and characterization of any investment income generated from IPO proceeds and evaluate the appropriate treatment for each nexus state, including the sourcing of such income for apportionment purposes.
V. WITHHOLDING OBLIGATIONS ON EQUITY COMPENSATION POST-IPO
A. Overview of Issue
The closing of the IPO will create a liquid public market for AHT's common stock (NYSE: ARHT), enabling holders of vested stock options to exercise their options and immediately sell shares (a "same-day sale" or "exercise and sell" transaction). The IPO will also establish a publicly quoted fair market value for the Company's common stock, which will be used to determine the compensation income recognized upon the vesting and settlement of RSUs and other equity awards.
As of the date of the IPO, AHT will have outstanding options to purchase 8,400,000 shares of common stock that are vested and exercisable under the 2014 Stock Incentive Plan, with a weighted average exercise price of $3.25 per share. At the midpoint of the anticipated offering price range ($19.00 per share), the aggregate intrinsic value of these vested options would be approximately $132,300,000 (8,400,000 shares × ($19.00 - $3.25)). The exercise of some or all of these options will generate significant compensation income subject to state (and federal) income tax withholding, depending on the classification of the options as ISOs or NQSOs.
In addition, future grants of RSUs, options, and other awards under the 2024 Equity Incentive Plan will generate compensation income upon vesting and settlement, and purchases under the 2024 ESPP may generate compensation income upon disqualifying dispositions of ESPP shares. AHT, as the employer, will be obligated to withhold applicable federal and state income taxes, as well as employment taxes, on the compensation income recognized by its employees in connection with these equity transactions.
The following discussion addresses the state income tax withholding obligations in each of AHT's nexus states that impose an individual income tax.
B. State Withholding — General Rules
AHT is required to withhold state income taxes on compensation income arising from the exercise of NQSOs, the vesting and settlement of RSUs, and other equity compensation events for employees located in, or earning income sourced to, states that impose an individual income tax and require employer withholding. The amount of the withholding is generally determined by the applicable state's withholding rate (whether flat or graduated) and its rules for sourcing equity compensation income.
Two of AHT's ten nexus states — Texas and Florida — do not impose an individual state income tax and therefore do not require withholding on equity compensation income. The remaining eight nexus states each impose individual income taxes and have their own rules for withholding on equity compensation, as discussed in detail below.
For ISOs that satisfy the holding period requirements of Code Section 422 (i.e., the shares acquired upon exercise are held for at least two years from the grant date and one year from the exercise date), no ordinary income is recognized at the time of exercise, and no withholding is required. However, if the shares are disposed of in a "disqualifying disposition" (i.e., the holding period requirements are not satisfied), the excess of the fair market value at exercise over the exercise price is treated as ordinary compensation income, and the employer's withholding obligations are triggered retroactively. AHT should implement procedures to track ISO share dispositions and identify disqualifying dispositions.
C. State-by-State Withholding Analysis
1. Massachusetts. Massachusetts requires withholding at the Commonwealth's flat individual income tax rate of 5.0% on the "spread" at exercise (for NQSOs, the excess of fair market value over the exercise price at the time of exercise) and on the fair market value at vesting (for RSUs, the fair market value of the shares delivered upon settlement). Withholding applies to Massachusetts-resident employees on their worldwide equity compensation income and to non-resident employees to the extent the equity compensation income constitutes Massachusetts-source income.
For employees who performed services in Massachusetts during all or a portion of the stock option vesting period (the period from the grant date to the vesting date, or from the grant date to the exercise date, depending on the state's allocation methodology), the equity compensation income must be sourced to Massachusetts based on the ratio of the employee's Massachusetts workdays to total workdays during the applicable vesting or service period. This allocation must be performed on a grant-by-grant basis, as the relevant service period may differ for each grant.
For the 14 employees who filed Section 83(b) elections in connection with restricted stock grants received in 2021 and 2022, ordinary income was recognized and taxed at the time of the grant. No additional ordinary income is recognized at the time the restrictions lapse (i.e., at vesting), and accordingly, no additional state withholding obligations arise for these individuals at vesting. Any subsequent gain upon the disposition of the shares will be treated as capital gain, which is not subject to employer withholding.
2. New York
New York requires withholding at the applicable New York State graduated withholding rates on equity compensation income. For employees who are residents of New York City, the combined state and city withholding rate can reach approximately 10.9% for the highest earners, reflecting both the New York State rate (up to 10.9% for taxable income over $25,000,000) and the New York City rate (up to 3.876%).
New York applies a service-period allocation method for sourcing stock option income to New York for non-resident employees. Under this method, the portion of the gain attributable to New York is determined by the ratio of the employee's New York workdays to total workdays during the period from the grant date to the exercise date.
Of critical importance is New York's "convenience of the employer" doctrine. Under 20 NYCRR § 132.18, compensation paid to a non-resident employee is deemed to be entirely New York-source income if the employee's assigned primary office or base of employment is in New York, unless the employee's work at an out-of-state location is performed at a bona fide employer office established for the employer's necessity (not the employee's convenience). This doctrine has been the subject of significant controversy and litigation but remains in force. For AHT employees whose assigned office is in New York but who work remotely from other states, the convenience doctrine could result in the entirety of their equity compensation income being sourced to New York, potentially resulting in double taxation (mitigated by credits in some states). AHT should identify all employees subject to this rule and assess the impact on withholding obligations.
3. California. California requires withholding on equity compensation income at the applicable California supplemental withholding rate of 10.23% for supplemental wages, or at the rate determined under the aggregate method if that method is applied. California is widely regarded as having among the most aggressive sourcing rules for stock option and equity compensation income of any state.
Under California Franchise Tax Board Publication 1005 and related administrative guidance, stock option income earned by non-resident employees is sourced to California based on the ratio of the employee's California workdays to total workdays during the period from the option grant date to the option exercise date. This allocation applies regardless of the employee's state of residence at the time of exercise. Accordingly, if an employee performed services in California during any portion of the grant-to-exercise period — even if the employee has since relocated to another state — a portion of the gain recognized upon exercise is California-source income and is subject to California withholding.
This rule has significant implications for AHT, which has employees who may have worked in California during various periods of the 2014 Stock Incentive Plan's existence. For mobile employees who have performed services in multiple states during the vesting period, California's allocation rule will require a detailed workday analysis for each option grant.
For RSUs, a similar allocation applies based on the ratio of California workdays to total workdays during the vesting period.
With respect to the ESPP, any compensation income recognized upon a disqualifying disposition of ESPP shares (i.e., the spread at the purchase date) is treated as compensation and is subject to California withholding for California-resident employees and non-resident employees with California-source income.
4. Illinois. Illinois requires withholding at the state's flat individual income tax rate of 4.95% on equity compensation income recognized by Illinois-resident employees. For non-resident employees, Illinois generally does not tax compensation earned for services performed outside the state. Accordingly, non-resident employees who did not perform services in Illinois during the relevant vesting or service period should not be subject to Illinois withholding on their equity compensation income.
AHT should be aware of Illinois's supplemental income tax withholding rules, which may affect the calculation of withholding amounts when equity compensation income is paid in addition to regular wages.
5. Pennsylvania. Pennsylvania requires withholding at the Commonwealth's flat individual income tax rate of 3.07% on equity compensation income, including the spread at exercise (for NQSOs) and the fair market value at vesting (for RSUs). Pennsylvania treats stock option income as compensation subject to the personal income tax.
Pennsylvania's flat rate and relatively straightforward sourcing rules make the withholding calculation less complex than in certain other states. For non-resident employees, Pennsylvania sources compensation income based on the location where the services were performed.
6. Ohio. Ohio does not impose a traditional state-level individual income tax withholding requirement on employers in the same manner as most other income tax states. However, Ohio municipalities impose local income taxes (administered by Regional Income Tax Agency ("RITA"), Central Collection Agency ("CCA"), and individual municipal tax departments), and employers with employees located in Ohio municipalities may have municipal withholding obligations. The municipal income tax rates vary by municipality and can range from 1.0% to 3.0% in major cities such as Columbus (2.5%), Cleveland (2.5%), and Cincinnati (1.8%).
AHT should confirm which Ohio municipalities its employees are located in and determine the applicable municipal withholding obligations for equity compensation income. This analysis is beyond the scope of this memorandum but is flagged as an action item.
7. New Jersey
New Jersey requires withholding at the state's graduated individual income tax rates, which range up to 10.75% for the highest income earners (taxable income over $1,000,000). Equity compensation income is treated as wages subject to New Jersey withholding.
For non-resident employees, New Jersey sources stock option income based on the proportion of services performed in New Jersey during the applicable vesting or service period, consistent with the multi-state allocation methodology described in Section V.D below.
8. Georgia. Georgia requires withholding at the state's graduated individual income tax rates, which range up to 5.75% (reducing to 5.39% for tax year 2024). Georgia applies a standard service-period allocation method for sourcing equity compensation income to Georgia for non-resident employees, based on the ratio of Georgia workdays to total workdays during the applicable vesting or service period.
D. Multi-State Allocation Issues for Mobile Employees
AHT employs a workforce that includes individuals who have worked in, or relocated between, multiple states during their tenure with the Company. For options granted under the 2014 Stock Incentive Plan, which were granted beginning in 2014, the applicable vesting periods may span many years during which an employee may have performed services in two or more states. Upon exercise, the gain must be allocated among the states in which the employee performed services during the vesting period, based on each state's workday allocation rules.
This multi-state allocation requirement applies not only to stock options but also to RSUs granted under the 2024 Plan and to any other equity awards with multi-year vesting schedules. The complexity of the allocation increases as the number of states in which an employee has performed services during the relevant period increases.
AHT should implement a robust tracking mechanism to (i) identify employees who have performed services in multiple states during the applicable vesting or service periods, (ii) calculate the workday allocation ratios for each state for each grant, and (iii) compute the correct withholding amounts for each state. We recommend that AHT engage Hargrove Prindaux Advisory Group LLC (compensation consultant, 1600 Market Street, Suite 3400, Philadelphia, PA 19103) or a qualified payroll tax specialist to develop and implement multi-state allocation procedures for equity compensation. This engagement should be commenced prior to the first post-IPO option exercises or RSU settlements to ensure compliance from the outset.
E. Impact of Section 83(b) Elections
As noted above, 14 current employees of the Company filed elections under Section 83(b) of the Code in connection with restricted stock grants received during 2021 and 2022. By filing these elections, each employee elected to include in gross income the fair market value of the restricted stock (less any amount paid for the stock) at the time of the grant, rather than at the time the restrictions lapsed. This had the effect of accelerating the recognition of ordinary income to the grant date and converting any subsequent appreciation in the stock's value from ordinary income to capital gain.
For state income tax purposes, the consequence of the 83(b) election is that state withholding was due at the time of the grant-date income recognition, and no additional state withholding obligation arises upon the lapse of the restrictions (i.e., at vesting). The amount of ordinary income recognized at the grant date was the fair market value of the stock at that time, which, for a pre-IPO private company, would have been based on an independent 409A valuation. Any gain realized upon the subsequent sale of the stock (after the restrictions lapse and the stock becomes freely tradable post-IPO) will be treated as capital gain, which is not subject to employer withholding.
AHT should confirm that the 83(b) election filings were properly reported to each applicable state taxing authority at the time of the grants and that the corresponding state income tax withholding was correctly computed and remitted. If any deficiencies are identified, corrective filings should be made.
F. Section 423 ESPP Considerations
The 2024 ESPP is intended to qualify as an "employee stock purchase plan" under Section 423 of the Code. Under a Section 423 qualified plan, no income is recognized by the employee at the time of enrollment or at the time of purchase (the end of each offering period). The income tax consequences depend on whether the employee makes a "qualifying disposition" or a "disqualifying disposition" of the shares acquired

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE ATTORNEY WORK PRODUCT

MEMORANDUM

I. EXECUTIVE SUMMARY

II. BACKGROUND AND FACTUAL ASSUMPTIONS

III. STATE-BY-STATE NEXUS ANALYSIS AND FILING STATUS

IV. STATE-LEVEL TREATMENT OF IPO EQUITY ISSUANCE PROCEEDS

V. WITHHOLDING OBLIGATIONS ON EQUITY COMPENSATION POST-IPO

Record

Parties

Dates

Amounts