Performing Tax Due Diligence: How to Prepare for Your Business Transactions
When it comes to making business transactions, it is imperative to understand any tax implications that could be connected to the proposed deal prior to decision-making. When faced with a lucrative opportunity, you should ask yourself: have I looked into all aspects of the transaction, what are the future tax liabilities I maybe inheriting and will I be able to utilize any of the Target’s tax attributes in the future? Inherited tax liabilities can have a material impact on the expected rate of return in the proposed transaction, and the failure to quantify and account for the liabilities can result in buyer’s remorse. In many instances, a Target company’s future tax liability is not accurately presented on the company’s balance sheet. An understanding as to how and where the company conducts business along with an examination of prior returns, elections and correspondence with taxing authorities will help identify and quantify both stated and unstated tax liabilities. This process is known as tax due diligence.
Tax due diligence is an essential step in making educated, well-informed decisions. Typically conducted during the buying process of an acquisition or merger transaction, the core goal of due diligence is to reveal and investigate any significant tax liabilities that the buyer could potentially be exposed to. In addition to helping buyers mitigate risk, conducting thorough due diligence offers many other benefits, including better negotiation leverage and the ability to potentially structure and plan for the utilization of acquired tax attributes.
Below is a brief description of the items typically reviewed during a tax due diligence engagement:
- Corporate Structure – This allows you to identify how the target company’s corporate structure fits with your (the buyer’s) structure? What, if any, structure changes should be made before or after the transaction. In addition, it allows you to identify what jurisdictions the target company is conducting business.
- Federal and State Tax Returns & Workpapers – These should be reviewed for all open tax years; you’ll want to determine any substantial positions taken on the target company’s tax return(s). This review should not be limited to income tax returns and should include payroll tax returns, sales and use tax returns, and excise tax returns, if applicable.
- Asset / Stock Acquisition – In an asset acquisition, you’ll need to discuss the allocation of the purchase price, potential Section 338(h)(10) election, and structure the transaction to minimize any transfer taxes that may be incurred on the sale. With a stock acquisition, you are far more likely to inherit the tax liabilities and acquire the tax attributes discussed above. Typically a stock acquisition requires a much higher level of tax due diligence.
- International Operations – If the target company operates internationally, it’s important to obtain an understanding of the corporate structure for its foreign operations. This includes considerations such as restructurings, stock and asset basis information, earnings and profits analysis as well as local tax requirements in the foreign jurisdiction.
- Accounting Period & Tax Elections – You should make note of any changes in the target company’s tax accounting period in prior years. This often includes the potential consequences of a shortened tax year due to the acquisition itself. In connection with review of tax returns, any elections made should also be reviewed.
- Audits – All prior-year audit results should be reviewed, in addition to any existing IRS or state audits if applicable. You should also inquire about any extension of the statute of limitations.
Controlling Potential Risks & Exposure
When conducting the tax due diligence process, it is essential for the buyer to ensure that the selling entity paid all its tax liabilities on a current basis and that the seller has anticipated any and all adjustments that could arise in current and future audits by all tax authorities and jurisdictions. While tax due diligence allows the buyer to become fully aware of any additional liabilities that are of concern, it also makes the buyer aware of any tax assets that could present planning opportunities for the buyer.
Once the tax due diligence process is carried out, the buyer should bring forward and address any concerns related to the potential tax exposures that have been identified during the examination. These and other concerns—both negative and positive—will continue to be discussed throughout the purchase agreement drafting process. Simply put, if you as the buyer do not become educated on these potential risks through the application of tax due diligence, you will not be able to fully protect yourself from excessive exposure, and it could have a negative impact on your expected return of profit.
At FF&F, our practiced team of experts is well-versed in conducting tax due diligence on all levels, and it is our goal to provide our clients with the step-by-step guidance needed to carry out a thorough investigation for each transaction. For more information on the tax due diligence process or our services, please contact us at firstname.lastname@example.org or (212) 245-5900.
Kimberly Roque, CPA, MST is a Tax Manager at FF&F with over 9 years of accounting experience, with 6 in private and 3 in public accounting. Her focus is consolidated corporate tax returns and income tax provisions.