What’s Hiding Under the Hood: The Need for Tax Due Diligence

Sales of businesses are an exciting and hopeful time. Buyers eagerly anticipate owning the business and expanding operations as profits dance through their heads. As sellers contemplate their next venture or ponder which blended cocktail to order while lounging on a white sand beach.

The visions may be shattered unexpectedly when a tax authority asserts that the business is subject to a substantial tax assessment that the seller should have paid before the sale was finalized. This discovery can lead to negotiations with insurance companies, drawn out legal battles, and strained relationships with key members on both sides of the transaction.

To mitigate the risk of this scenario, both buyers and sellers should conduct tax due diligence early on in the process to identify potential tax issues before finalizing the transaction. Buyers gain comfort that the purchase does not come with unexpected tax surprises and, if tax exposures are identified, sellers have an opportunity to remedy issues prior to discovery during the buyer’s due diligence process.

The goal of tax due diligence is to uncover any historical, current, or immediate tax issues associated with the historical operations of a target business. It encompasses not only direct income-based taxes levied by the Internal Revenue Service or state income tax authorities, but also other taxes that may be due, such as business activity, sales and use, payroll or property taxes.

One common misconception is that tax liabilities are addressed by 1) the definitive agreement(s) or 2) the transaction structure itself.

1. While a typical agreement may contain verbiage to indemnify a buyer for all pre-transaction taxes, the ability to collect the funds after proving a breach is difficult and may result in substantial legal fees – all while the tax authority insists on immediate payment (many times including a significant interest and penalty assessment) and does not wait until after the resolution of the legal process.
2. Further, while particular transaction structures exist that may limit certain historical tax liability, there are no known transaction structures that entirely absolve such liability. For many types of taxes, transferee liability applies and may shift liability unexpectedly to the buyer. For example, in an asset acquisition, a buyer does not expect to be liable for historical US federal income tax liability but may still be liable for state income or franchise, sales and use, payroll, property, and various other historical tax deficiencies.

Components of Tax Due Diligence

The methodology for conducting tax due diligence is similar for both buy-side or sell-side tax due diligence, i.e., whether the workstream is performed on behalf of a buyer or seller. The components vary slightly depending on the transaction structure and what is being bought or sold (most frequently, equity or assets). A tax due diligence workstream generally results in a tax due diligence report. The article summarizes and details certain tax-related exposures or risk concerning a transaction.

Company Background and Transaction Overview

The tax due diligence workstream outlines the contemplated transaction and history of the “Target” – i.e., the business planned to be acquired or sold. It is critical to understand the transaction perimeter and any parent or subsidiary (including foreign entities) companies in the structure that may impact the tax analysis.  The workstream may also focus on historical acquisitions or dispositions, and tax controversy matters such as tax audits or notices (whether historical, ongoing, or anticipated), or other areas.

Federal and State Income Tax

Federal and state income taxes not only have the potential for audits related to complex calculations and aggressive positions; they also may lead to unintended consequences that impact cash flows for buyers and sellers. For example, unfiled state income tax returns in states that a company’s business has expanded to can create a large potential tax liability. A buyer may be unhappy to realize that a significant deferred tax item was recorded as an off-balance sheet liability and reverses post-transaction, leaving the seller with the cash and the buyer with the tax bill. On the other hand, a seller may be surprised to learn that a transaction may trigger a significant tax acceleration that reduces post-transaction proceeds.

Specifically on the state income tax side, small and seemingly innocuous changes in how a business operates over time, combined with everchanging state-specific laws, may create a perfect storm in which an unknown state tax filing obligation has ballooned into a significant issue.

Sales and Use Tax

Many states have unique and complex regimes governing sales tax. The determination of filing obligations and nexus, revenue stream taxability, and customer profiles create an intricate web that is easy to get caught in as a business scales and laws change.  The other side of the coin is use tax – a tax assessed by a state when an otherwise taxable purchase was not subjected to sales tax. Use tax is generally missed on purchases made in one state and then transferred to another state. Use tax compliance is frequently ignored during normal operations and can result in significant tax cost.

Payroll Tax

Federal and state payroll taxes are an area of tax where small mistakes can occur frequently and compound over time. Even though the payroll taxes should have been withheld from employee paychecks, the company or its executives are ultimately liable for the unpaid taxes. In addition to the payroll tax responsibilities for the employees of the Target, tax authorities have been keen to analyze a business’ classification of its independent contractors. To make matters worse, tax authorities are generally especially punitive when it comes assessing penalties related to these taxes.

Property Tax

There are two types of property taxes that are generally covered during tax due diligence. Real property tax is assessed on land and buildings by the locality, typically the county, where the property is physically located. Business property tax, or tangible personal property tax, is another property tax that is generally assessed on the remaining property of the Target – typically on fixed assets and leasehold improvements.

Unclaimed Property Reporting

While not technically a tax, tax due diligence workstreams often cover unclaimed and abandoned property compliance. For example, if an employee doesn’t cash a bi-weekly payroll check, a state may require that the funds be remitted to hold in trust rather than “reversed” into the target company’s income.  In recent years, as states seek to strengthen their revenue streams, unclaimed and abandoned property reporting has become an increasing area of tax authority focus.

Informed Decisions Mean Mitigated Risk

Ultimately, tax due diligence informs investors, acquirers, and stakeholders of the target’s tax risks and exposures. By understanding the key areas of tax risk, stakeholders make well-informed decisions and take appropriate measures to mitigate tax-related risk. Remember: this is a primer to M&A tax due diligence practice. Engaging tax and legal professionals to assist in the review process provides expert insights and ensures a comprehensive understanding of the tax implications of a transaction.

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