Never underestimate the role of tax due diligence in independent sponsor transactions

While independent sponsors routinely focus on financial diligence (quality of earnings) and tax structuring, they often leave out a critical component of the diligence equation: tax due diligence.

In managing costs through the diligence process, independent sponsors understand that they are “on the hook” for these costs until they secure a capital provider. Once this happens, the capital provider will fill their shoes until the deal closes while also taking on the risk of a broken deal. Tax diligence provides an independent sponsor with an understanding of the potential tax risks and exposures a buyer may inherit through a transaction. This knowledge could impact negotiations, trigger a reassessment of the purchase price, and impact the reps and warranties, as well as the indemnification provisions, of the purchase agreement.

We often hear this argument: We are structuring as an “asset deal,” so taxes are not an issue. While this may hold true as it pertains to federal and state income taxes, it does not apply to non-income taxes where successor liability exists. 

Tax diligence provides tax advisors with a more holistic view of the target, enabling them to better understand the implications of different structuring options. Identifying a target’s tax attributes (including net operating losses (NOLs), tax credits, etc.) through diligence may impact the structure of the transaction and also inform the buyer of additional value post-closing.

Key findings from a tax due diligence process can impact the target’s quality of earnings (EBITDA) and quality of assets (working capital), directly affecting its overall valuation.  Other findings that may come during tax due diligence include:

• Sales and use tax liability. There are two issues to consider here: (i) Sales taxes incorrectly charged to customers have, in some instances, led to a reduction in product selling prices that ensure the target company remains competitive, and (ii) Any use taxes not disclosed and paid by the target may result in additional expenses.
• Failure of the target to correctly classify sub-contractors as employees. This may result in an understatement of the employer portion of payroll taxes. Further, in some instances, employers will need to increase amounts paid to 1099s to compensate them for additional taxes they have to pay as W-2 employees.
• Issues related to recognizing customer overpayments or credits as income and not considering escheat laws in different states.
• Tax risks that require remedial action to be completed pre-closing, or at the very least the process started. For example, state nexus issues requiring voluntary disclosure applications (VDAs) take time. Buyers will gain far more comfort knowing that the process is underway and, in some instances, completed before closing. Also, the costs associated with remediation, if identified early, will be for the seller’s account.

Rep and Warranty insurance requires comprehensive tax diligence to limit the number of exclusions that underwriters will ask for. This will result in greater coverage for any potential exposures that may arise post-closing. The VDAs mentioned above are a good example of limiting exclusions.  

Finally, institutional capital providers are becoming a more common equity source for independent sponsors, overtaking family offices as the “first port of call” for capital. As sophisticated investors, capital providers are requiring tax diligence. Leaving this as a final step in the diligence process may result in unexpected valuation and material-related issues that can delay closings. Sellers who may already be fatigued by the transaction process may feel let down when faced with significant diligence items late in the process. This could lead to broader “trust” issues. 

We cannot overstate the importance of the role tax diligence plays in the overall due diligence process. It can pre-empt potential complications while preserving the value of the transaction.

_{Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.}