In the leadup to mergers and acquisitions (M&A), buyers often focus on the financial performance of the target company. But in all the excitement, they often overlook a key component of a deal that can come back to haunt them: tax positions.
Just as a family wouldn’t buy a house without having a professional inspect the foundation, companies involved in M&A need to be sure that they’re protected from the tax position of the company they’re acquiring. Otherwise, they risk inheriting a seller’s potentially expensive financial gambles and oversights in addition to the business itself.
From multi-state tax liabilities to payroll compliance, tax exposures can impact the success of a deal in very real ways. Here are a few tips for understanding a business’ tax positions in order to save time and ensure a smooth transition.
A company’s tax exposure
One of the primary concerns in any M&A deal is income tax exposure, which comes in all shapes and sizes.
Oftentimes, and particularly with smaller businesses, owners decided to take a calculated risk by neglecting to pay a tax in the hopes that the IRS won’t notice. Other times, it’s a matter of owners simply not knowing the tax requirements and winging it.
Either way, a history of ignoring tax issues can have dire consequences on both sides of an M&A deal. For buyers, uncovering tax liabilities can lead to renegotiation or termination of the deal in order to avoid paying the seller’s tax penalties once they’re discovered by the IRS. For sellers, the revelation of hidden tax exposures can result in a price reduction or a long-term escrow scenario where part of the purchase price is held back until the issues are resolved.
Another issue is a history of misclassifying workers. For example, when full-time workers are classified as 1099-based contractors, it can lead to substantial payroll tax liabilities that become the burden of an unaware buyer.
Additionally, if a company has dealings in foreign countries, they often encounter complex foreign tax-compliance issues. Non-disclosure of foreign bank accounts or failure to file required forms, such as the Foreign Bank Account Report (FBAR), can result in severe penalties in perpetuity until they’re paid. And if the company does business in more than one state, there’s a whole extra layer of diligence that must be done.
Interstate business and tax filings
One term that can’t be overlooked during M&A is nexus: put simply, the tax liabilities that result in doing business in multiple states.
Each state has different tax requirements based on the company’s activities there. If the target company has an office in New Jersey, warehouses in Connecticut, and sales reps in New York, the company could have nexus in each of those states, meaning it needs to comply with the tax laws of those respective states.
During the due diligence process, it’s crucial to identify where the company has established a nexus. This involves looking at their physical presence, economic presence, and activities like marketing. Understanding these factors helps the buyer identify any potential tax liabilities that might come with the acquisition.
Diligence should include a thorough review of the company’s varying tax returns and filings. That includes investigating whether there have been any past audits or disputes in all places the business has nexus. This can help the buyer negotiate better terms, like indemnifications or adjustments to the purchase price, to cover any potential tax liabilities.
Identifying tax exposures as the seller
Ensuring a successful M&A deal starts with a prepared seller, who should be willing and ready to identify potential tax exposures before the potential buyer even asks.
By conducting a thorough internal review and addressing compliance issues, sellers can present a more attractive and transparent position to potential buyers. Additionally, it can help them anticipate and work toward remedying potential situations before they become heated points of contention.
Sellers should also be prepared to negotiate tax-related terms in the sale agreement. This might include agreeing to escrows, indemnities, or even adjusting the sale structure. For instance, while buyers typically prefer asset purchases for their tax advantages, sellers might negotiate compensations for any additional tax burden this structure imposes on them, resulting in a lower price of sale because the buyer is essentially absorbing oversights and liabilities.
Like many business practices, the key to a smooth M&A process is diligence. For a buyer, this includes examining income tax filings, payroll tax compliance, and any potential foreign tax obligations. And for a seller, it means being ready to answer meticulous questions and provide tax information in a timely manner.
In business, the only truly welcome surprises are unexpected windfalls. Diligent planning and transparency on tax positions are key to keeping an M&A deal on track and surprise-free all the way to the finish line.
