Tax Due Diligence: Because What You Don’t Know Can Hurt You
The need for tax due diligence is sometimes overlooked by buyers focused on quality of earnings analyses or other non-financial diligence reviews, but has never been greater than it is today. The growing complexity of Federal, state, and local tax laws, the myriad taxes imposed on businesses, aggressive (and sometimes, evasive) tax reducing or deferring strategies employed by taxpayers, vigorous enforcement by taxing authorities and expansion by state legislatures of bases for state tax nexus all combine to add risk to an investment made in the absence of a proper tax review.
WHAT IS TAX DUE DILIGENCE?
Tax due diligence is a comprehensive examination of the different types of taxes that may be imposed upon a particular business, as well as the various taxing jurisdictions in which it may have sufficient connection to be subject to such taxes. Most frequently employed on the buy side of a transaction, the goal of tax due diligence is to uncover significant potential tax exposures. Unlike annual income tax return preparation, tax due diligence is less concerned with relatively small missed items or miscalculations (for example, should a disallowed meals and entertainment deduction have been $10,000 instead of $5,000). While the threshold for significance can change with the value of the deal (or the target, if the deal is for less than 100% of the equity), an amount that would affect a buyer's negotiations or decision to proceed with a transaction is typically higher than that which would concern a tax return preparer.
WHAT DOES TAX DUE DILIGENCE ENTAIL?
Tax diligence covers not only income taxes, but also sales and use taxes, payroll and employment taxes, property taxes, unclaimed and abandoned property (escheatment), and independent contractor vs. employee classification. Where target companies have either foreign subsidiaries or foreign parents, tax due diligence may include a review of transfer pricing and foreign tax credit issues. The process includes reading tax returns (for all types of taxes) and non-tax documents, and making inquiries of management and the target's tax advisors. Reading non-tax documents, such as minutes of corporate board meetings or LLC member meetings, financial statements and related footnotes, equity compensation plans, and employment contracts can lead to discovery of a variety of potential tax issues, including prior ownership changes that affect a corporation's ability to utilize net operating loss carry forwards against future income, aggressive or uncertain tax positions taken, and deferred compensation and golden parachute issues.
WHAT IF THE TARGET IS A PARTNERSHIP OR AN "S" CORPORATION, DO I STILL NEED INCOME TAX DUE DILIGENCE?
Corporations taxed under subchapter C of the Internal Revenue Code pay corporate level income taxes on net income. Accordingly, tax due diligence of such entities requires examining whether there exists the potential for assessment by the IRS (or a state or local tax authority) of additional corporate income tax liabilities (and, in turn, interest and penalties) resulting from errors or incorrect tax positions discovered on audit. Unlike "C" corporations, partnerships and "S" corporations are "flow-through" entities, meaning that they do not pay entity level income taxes on their net income. Instead, net income is passed out to the partners, LLC members, or S corporation shareholders and taxed to such owners (or at higher levels in a tiered structure). While theoretically, any tax audit adjustments made to pre-transaction periods should not accrue to the buyer, the need for income tax diligence is not completely obviated.
The rules governing S corporations place strict limitations on ownership, permissible equity interests, and, in some circumstances, the permissible amount of certain types of income. Violations of these rules can lead to an inadvertent termination of the S election, the consequence of which is that the target is held to be a C corporation subject to corporate level income tax from the date of the termination. Tax, interest and penalty can then be assessed with respect to all open tax years. Moreover, if a 338(h)(10) or 336(e) election is made (to treat the purchase of S corporation stock as a purchase of assets for tax purposes), the election will be invalid and the buyer will lose the step up in tax basis of the target's assets that was expected.
If there are no remaining or insufficient escrows or installment payments to be made, recovery for violations of representations and warranties must be sought from selling shareholders, which may require litigation. Frequently, seemingly innocuous events within an S corporation, such as paying personal expenses for only one shareholder, can cause an inadvertent termination of a target's S election.
Acquisition of a partnership interest poses no risk of historical tax liabilities for pre-transaction periods to the buyer. However, a buyer may still be adversely affected by errors or other events that pre-date the acquisition. Improper acceleration of depreciation may leave the buyer with less tax basis in assets attributable to the purchased interest than was expected. Even if the buyer obtains an asset basis step up (by the partnership making or having made a section "754 election"), the recovery period for the step up may be slower than would have been received had the assets been properly depreciated in the first place. Also, the buyer may inherit special allocations of taxable income attributable to the seller's interest. Again, the absolute effect of these allocations may be offset by a basis step up achieved through a section 754 election, but the timing of the special allocation and the recovery through the basis step up may be detrimental to the buyer.
WHAT IF THE TRANSACTION IS STRUCTURED AS AN ASSET PURCHASE?
As long as the buyer and seller are unrelated parties dealing at arm's length and the assets are purchased at fair market value, there should not be any significant risk of historical tax liability accruing to the buyer. However, structuring a transaction as an asset purchase does not insulate from potential tax liabilities for sales and use taxes, payroll and employment taxes, property taxes, and unclaimed property assessments. These taxes are subject to transferee liability and cause the buyer to remain at risk for historical tax liabilities. In a carve out, this risk may be mitigated by the continued existence of the seller (with primary liability attaching to the seller and only secondary liability following the assets). But where the transaction involves 100% of the seller's assets, a taxing jurisdiction may simply follow the assets and look to the buyer to satisfy any assessments or outstanding liabilities. Knowing where and how much potential exposure exists enables the buyer to deal with it effectively in negotiations with the seller before they materialize.
IF THE TARGET IS LOCATED IN ONLY ONE STATE, DO I ONLY HAVE TO DO TAX DUE DILIGENCE IN THAT STATE?
While Federal tax law has gained considerable complexity over the years, targets and their tax advisors are more likely to be cognizant of Federal tax changes and significant issues affecting their businesses, partly because Federal income tax is imposed at a higher rate than state income tax and other taxes and, therefore, garners more attention. Furthermore, no matter where a target business operates or how large its footprint is, a Federal return (and only one Federal return) must be filed.
As much as Federal tax law has changed, state tax law, proportionately, has evolved to a much higher degree. Shrinking state coffers and expanding budget deficits have pushed states to increase tax revenues. With raising tax rates on your own residents (or taxing more things) being politically inexpedient, the only way to increase tax revenues is to broaden the tax base. Historically, businesses were not taxable in any state where they had no physical presence, and even physical presence did not result in state income tax nexus if the presence was limited to mere solicitation of sales of tangible personal property. Now, many states are adding gross receipts taxes, commercial activity taxes, and "economic nexus" to subject out-of-state businesses to taxation that does not depend on physical presence, but only on generating a threshold level of sales within the state or benefiting from some economic relationship to customers within the state. Having a link on an otherwise unrelated website can now result in state income and sales tax nexus if a customer is directed to a target's website and a sale results. All too frequently, a growing company increasing revenues by expanding its customer base in new markets is blissfully unaware of these changes and the new filing requirements imposed as a result of their operational success.
Many companies also make the mistake of thinking that if an activity is taxable (or not taxable) in one state, the answer will be the same in other states in which it files a return. But quantum changes in technology have caused a paradigm shift in how business is conducted, customers and clients are served, and how products are delivered. E-commerce, electronic communication, and electronic delivery have also changed the state tax landscape. Every state has the power to tax or exempt different activities or variants of similar activities. Companies focused on product delivery, client service, and attracting new customers do not have as high on their list of priorities checking the taxing rules of a state on the other side of the country. Local or even regional tax advisors often are not aware of differing tax rules in states with which they do not regularly file returns for other clients.
WHAT ARE THE BENEFITS OF TAX DUE DILIGENCE?
The benefits of tax due diligence can far exceed the costs. Overstated NOLs, underreported tax liabilities, non-filing exposures, failure to charge sales tax or pay use tax, and payroll tax errors can all result in potentially significant exposures. If a buyer is not aware of, and protected from, these risks, potential exposures that come to fruition can negatively impact the expected return or profit on a transaction predicted in financial models.
Once discovered, potential risks can be mitigated or eliminated in a variety of ways. Virtually all transactions include representations and warranties by the seller pertaining to the propriety and completeness of tax matters, which can be modified or supplemented to address specific identified exposures. Escrows are another common feature of transaction documents, both the amount and duration of which can be increased as necessary to provide protection.
Sometimes potential exposures can be so significant or clear as to the outcome if the target is audited that escrows will not provide a sufficient remedy. In these circumstances, alternate transaction structures, purchase price reductions, installment sales, and earn-outs can all provide effective protection to a buyer. When a potential exposure is due to non-filing of a return, there is no time limit on the life of the exposure, since tax statutes of limitations do not run where a return has never been filed. Recommending the target to file amended returns or entering into voluntary disclosure agreements with relevant tax authorities to remedy non-filing issues can cure these ills.
Alternatively, when none of these remedies are sufficient, desirable, or obtainable (due to seller objections), buyers can consider purchasing tax risk insurance. Tax risk insurance can be very cost effective and efficient. The policies are very flexible; they can be tailored to cover as much or as little as desired, based on business judgment and cost/benefit analysis. Policies can cover all tax exposures or be limited to specifically identified exposures such as "S" election validity or sales tax exposure for a particular year. If the buyer is the insured party or beneficiary, claims are paid without the involvement of the seller, allowing the seller to walk away after the close of the transaction and removing potential controversy or litigation from the realm of possibility. Sellers may be willing to accept a reasonable policy cost as an adjustment to the deal consideration in exchange for finality.
WHAT DOES COHNREZNICK THINK?
Buyers need to be protected from downside risks to a deal on which they have invested significant time and capital. Even where a buyer does not avail itself of any remedies to identified potential exposures, tax due diligence enables a buyer to make an informed decision and whether to accept them. An efficient process will not interfere with overall transaction progress and can pay for itself in removing potential negative impacts to financial models on which transaction consideration is based.
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 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.
InsightInflation Reduction Act: Prevailing wage and apprenticeship guidance issuedLee PetersonGuidance under the Inflation Reduction Act has been released addressing prevailing wage and apprenticeship guidance. Learn more.
InsightNew York small businesses: Apply quickly for COVID-19 Capital Costs tax creditArvinder Kaur, Jamie Kelly, and Corey L. RosenthalCertain small businesses in New York State may qualify for up to $25,000 of credit for expenses related to the COVID-19 pandemic. Check your eligibility.
InsightNew York State announces Digital Game Development Tax Credit ProgramArvinder Kaur and Corey L. RosenthalA new credit was announced in New York focused on advancing technology, creative arts, and entertainment in the state through the New York State Digital Game Development Program. Learn more.
InsightTax planning: Accounting methods to help preserve cash in unsure timesRichard Shevak, Travis Butler, Scott Hamilton
InsightYear-end tax planning opportunities for the consumer industryJoel Boff, Corey RosenthalTax laws are constantly changing, and this means the consumer products industry needs to be aware of certain opportunities and concerns as they close out the year. Learn more.
InsightNavigating the state tax landscape: Three areas growing tech companies should focus onShaune ScutellaroAs technology companies grow they not only have to navigate seed rounds, angel investors, public offerings, and more. They also have to navigate state tax laws. Learn more