Whether selling or buying a business, tax due diligence is critical and can benefit each party. Transaction structure, tax accounting methods, state and local tax considerations, and, ultimately, tax planning are just a few factors that should be analyzed before following through with a purchase. On the other side, minimizing tax while optimizing benefits is the prime concern for sellers. Regardless, the transaction services team at FORVIS can help buyers and sellers navigate potential risks by performing tax due diligence.
Why is tax due diligence so important? Ultimately, this is one of the best ways to get to know the target company. The purchaser may be inheriting tax exposures or attributes (such as net operating losses (NOLs) or credits) that should be considered in settling on terms or a purchase price. Opportunities may be found for tax planning following the transaction itself (such as research and development (R&D) credits or tax accounting method changes). All of this helps to effectively structure a transaction and inform the decision makers evaluating whether to pursue the purchase.
The first thing to consider is how to structure the deal itself—is this an asset sale or an equity transaction? Generally, purchasers prefer asset sales while sellers prefer equity transactions. While asset sales generally result in greater depreciation or amortization for the purchaser, they result in a higher tax bill to sellers given the presence of ordinary tax rates in these transactions. Therefore, equity transactions can result in a lower tax impact and cash outlay for the seller. Accordingly, the sale structure could factor into the selling price as well. For example, if it is an asset sale, the seller could require a higher price to make them “whole” from a cash flow perspective.
Depending on the structure of the transaction, the scope of due diligence may be different. While asset sales generally require less analysis, equity transactions typically require a deeper dive into the business. In addition, assets can be more easily identified and valued, and there is a multitude of factors (both tangible and intangible) that go into the ultimate worth of the company’s equity. Generally, there are a few “hot spots” that often are the focus of a tax due diligence engagement on the buyer side. That being said, sellers should also know what items diligence may focus on in the event pre-diligence remediation may be needed. These “hot spots” include, but are not limited to:
- Presence of NOLs: Section 382 limits the ability of the purchaser to use NOLs following a transaction in certain situations and thus can factor into the attractiveness of the target company.
- Tax positions: For equity transactions, the risk of an audit for previous tax years typically transfers to the purchaser. Therefore, the potential for additional tax liabilities, interest, and penalties could be a concern following a transaction. A good indication of this may be the company’s audit history.
- Unexpected income: For forecasting purposes, both favorable and unfavorable timing differences should be considered. Deferred revenue acceleration could be an unwelcome surprise if not previously identified.
- Accuracy of tax accounting methods: From revenue recognition to Section 263A calculations, analysis of both the current and potential changes to tax accounting methods could influence the future worth of the company to the buyer. Overall, the buyer will want to feel comfortable that the tax methods in place are appropriate, and if not, what impact changing the methods would have on future profits.
- State and local tax considerations: To estimate the potential compliance and tax burden, it is important to know which states and localities require filings. Not keeping up with these filing requirements could lead to a failure to file and a failure to pay interest and penalties. In addition, future state nexus requirement changes could result in unexpected income tax and sales and use tax issues. With the ever-evolving landscape of this portion of tax law, it is certainly worth investing time into state and local tax considerations.
The list of topics goes on—everything from CARES Act opportunities to the presence of independent contractors. Undoubtedly, there is much to be considered when buying or selling a business. Therefore, thorough tax due diligence allows for decision makers to be good stewards of a company’s resources and future. Having a professional to help you navigate the transaction can help avoid pitfalls and missed opportunities.
Reach out to a tax professional at FORVIS or submit the Contact Us form below if you have any questions.