On Tax Due Diligence, 5 Details You Shouldn’t Overlook

Heading into an M&A transaction, prospective buyers should pay close attention to common tax issues.

Here’s a primer in what to do before you engage in a merger or acquisition deal to help prevent financial surprises and setbacks down the road.

Do examine the necessary details regarding your target company’s tax structure in advance.

Don’t leave any stone unturned, if you want to maximize the value of your transaction.

Here are five tips to incorporate commonly-reviewed issues of tax due diligence into your process.

1. Changes in Methods of Accounting

Determine whether there have been, or will be, any accounting method changes that will impact your organization post-acquisition. If the target company makes such a change during an acquisition, you could be hit with an unforeseen tax bill after this process is complete.

By conducting necessary due diligence in advance, you can ensure that all parties have obtained the proper consent and modified the necessary adjustment periods accordingly.

2. Deferred Revenue

In preparation for the transaction process, check for any revenue that may not be immediately recognized. For example, imagine that your target company sells an annual software subscription service: While customers may pay upfront for the whole year, the company might not record receiving the money until services are provided.

Before you acquire a company, determine whether this target is properly recognizing deferred revenue under U.S. tax law. If not, it could affect you post-acquisition.

3. Invalid S Corporation Election

S corporations can bypass corporate income tax and simply report corporate income on the personal tax returns of their shareholders. So, many companies want to earn this distinction.

But the IRS has put forth specific filing requirements that must be met to qualify. If a corporation’s S election is not valid or has been inadvertently terminated, substantial federal and state income tax liabilities may arise at the corporate level. It’s crucial that you investigate the validity of an S corporation before engaging in a transaction.

4. Sales and Use Tax

Many states charge sales and use taxes on the transfer of property, including business assets. But some states have exceptions related to M&A transactions. Further, a target’s sales tax liabilities can succeed to the new ownership in both stock and asset transactions. Depending on industry, these sales and use taxes can range from being a minor annoyance to a multimillion-dollar exposure.

Don’t fall victim to a huge, unexpected tax bill. During due diligence, investigate the sales and use tax laws in the states where your target company operates.

5. Worker Misclassification

The misclassification of employees as independent contractors is widespread in the United States. If your target company has not properly classified its workers, you could be responsible for unpaid taxes post-deal. To avoid such complications, verify each employee’s status before engaging in an M&A transaction.

By going beyond the routine due diligence examinations, you will maximize the value of your transaction. A complete understanding of your target’s tax liabilities will allow you to make more informed decisions and lower your transaction risks.