Tax Receivable Agreement and Income Taxes |
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Sep. 30, 2023 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Tax Receivable Agreement and Income Taxes | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Tax Receivable Agreement and Income Taxes |
Note 13 — Tax Receivable Agreement and Income Taxes Tax Receivable Agreement In connection with the initial public offering in February 2022, the Company entered into a tax receivable agreement (“TRA”) with DDH LLC and DDM (together, the “TRA Holders”) which provides for payment by the Company to the TRA Holders of 85% of the net cash savings, if any, in U.S. federal, state and local income tax and franchise tax that the Company actually realizes or is deemed to realize in certain circumstances. Direct Digital Holdings, Inc. will retain the benefit of the remaining 15% of these net cash savings, and as a result, the Company recorded $823,481 during 2022 as additional paid-in capital. The TRA liability is calculated by determining the tax basis subject to the TRA (“tax basis”) and applying a blended tax rate to the basis differences and calculating the resulting impact. The blended tax rate consists of the U.S. federal income tax rate and assumed combined state and local income tax rate driven by the apportionment factors applicable to each state. Any taxable income or loss generated by the Company will be allocated to TRA Holders in accordance with the TRA, and distributions to the owners of LLC Units in an amount sufficient to fund their tax obligations will be made. Pursuant to the Company’s election under Section 754 of the Code, the Company expects to obtain an increase in its share of the tax basis in the net assets of DDH, LLC when LLC interests are redeemed or exchanged by the members of DDH, LLC. The Company plans to make an election under Section 754 if the Code for each taxable year in which a redemption or exchange of LLC interest occurs. During the year ended December 31, 2022, a member of DDM exchanged 100,000 Class B shares into Class A shares. As of September 30, 2023, the Company has recorded a deferred tax asset primarily from the outside basis difference in the partnership interest of $5,082,424, and a total TRA liability of $4,286,375, of which $41,141 is reflected as a current liability in which $45,815 was paid during the nine months ended September 30, 2023. The payments under the TRA will not be conditional on holder of rights under the TRA having a continued ownership interest in either DDH LLC or the Company. The Company may elect to defer payments due under the TRA if the Company does not have available cash to satisfy its payment obligations under the TRA. Any such deferred payments under the TRA generally will accrue interest from the due date for such payment until the payment date. The Company accounts for any amounts payable under the TRA in accordance with ASC Topic 450, Contingencies, and will recognize subsequent period changes to the measurement of the liability from the TRA in the statement of operations as a component of income before taxes. The term of the TRA commenced upon completion of the IPO and will continue until all tax benefits that are subject to the TRA have been utilized or expired, unless the Company exercises its right to terminate the TRA. If the Company elects to terminate the TRA early (or it is terminated early due to changes in control), the obligations under the TRA would accelerate and the Company would be required to make an immediate payment equal to the present value of the anticipated future payments to be made by the Company under the TRA. Income Taxes Through the Organizational Transactions completed in February 2022, the Company formed an Up-C structure which allows DDM to continue to realize tax benefits associated with owning interests in an entity that is treated as a partnership for U.S. federal income tax purposes. Under the Up-C structure, the Company is subject to corporation income tax on the variable ownership changes of 19.7% and 20.45% that occurred in the first and third quarters of 2022, respectively. As a result, the Company recorded a tax provision for federal and state income tax for the three months ended September 30, 2023 and 2022 of $165,994 and $128,436, respectively, and for the nine months ended September 30, 2023 and 2022 of $165,658 and $215,112, respectively. Income tax expense is based on the estimated annual effective rate for the year, which includes estimated federal and state income taxes on the Company’s projected pre-tax income. The expense for income taxes and the effective income tax rates were as follows:
The effective tax rates were lower than the statutory tax rates for the three and nine months ended September 30, 2023 primarily due to the Company’s partnership income that is not subject to federal and state taxes.
The Company files income tax returns in the United States federal jurisdiction and various state jurisdictions. In the normal course of business, the Company can be examined by various tax authorities, including the Internal Revenue Service in the United States. There are currently no federal or state audits in process. |