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VideoBuy-Side Tax Due Diligence: The Hidden Fraud Risk That Could Extend Tax Exposure for Years | Podcast
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Private Equity in Motion
In this episode of Weaver: Beyond the Numbers, Private Equity in Motion, Sean Muller discusses how alleged fraud can create significant tax exposure for buyers during buy-side tax due diligence. While tax add-backs, personal expenses, and improperly documented transactions are often identified during diligence, recent tax court cases highlight how these issues may lead to IRS fraud allegations that extend the statute of limitations well beyond the typical three- or six-year periods. Sean also explores the implications for stock acquisitions and C-corporation transactions, where historical tax liabilities and other exposures may transfer with the business.
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Detailed Description of Buy-Side Tax Due Diligence: The Hidden Fraud Risk That Could Extend Tax Exposure for Years
00:00:00
Sean: We’re talking about buy-side due diligence right now, and there have been some recent cases that have come out that may make buy-side due diligence from a tax perspective a little more complicated.
It’s very common for owner-operators of businesses to have some, let’s say, questionable expenses running through their businesses that generally get treated as add-backs for purchase price.
00:00:19
Sean: We always talk about the country club dues, the cars, whatever it may be. There are some probably questionable expenses that run through there.
And traditionally, the statute for those items is three years. If these items exceed 25% of gross income, they can extend the statute for six years.
00:00:36
Sean: But there’s been a couple of cases here recently that have alleged fraud and actually been successful in arguing that the taxpayer has participated in fraud.
When there is fraud, there is absolutely no statute that closes, so you can go back 20 years.
00:00:56
Sean: There’s one case where this is the . The taxpayer allegedly had no idea what was going on.
00:01:05
Sean: Their tax adviser was actually taking fraudulent deductions for them for 20 years, and the IRS came in and alleged fraud. The taxpayer came in and said, “I had no idea about this.”
The IRS said, “We don’t care. You signed the tax return,” and actually assessed 20 years of penalties and interest on them for that.
00:01:23
Sean: There’s a recent case that’s also come out where a business owner owned 100% of the company, had his wife on payroll, had his kids on payroll, was getting weekly massages for health reasons, taking all sorts of trips, paying college tuition, et cetera, and he was coding all these things as valid business expenses.
00:01:45
Sean: He even had some shareholder loans because a CPA firm came in and said, “You need to have some shareholder loans.” Well, they didn’t have proper documentation for the shareholder loans, so they weren’t respected as loans.
00:01:56
Sean: And then because of the 20-year history of doing all these expenses, and it was every single year, they asserted fraud and were successful.
They assigned fraud penalties to the taxpayer, and because this entity was actually a C-Corp, they asserted fraud penalties at the C-Corp as well for these deductions that shouldn’t have been allowed.
00:02:16
Sean: When you’re looking at due diligence, you really have to be concerned: is this every year? These add-backs, how egregious are they? And especially if you’re buying a C-Corp, you’re stepping into the shoes there.
Are you now looking at 20 years of statute versus a three-year statute, and what this exposure looks like?
00:02:34
Sean: One important thing: Fraud is determined by the IRS. The IRS has to successfully argue that fraud occurred. There’s a number of factors they look to.
00:02:44
Sean: But the IRS, if they do assert fraud, they’ve got to prove it. This has to be a continuous piece, but it’s just something for due diligence.
It’s not just a three-year statute. It could be a forever statute on these things.
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