Tax Due Diligence in M&A Transactions

The necessity of tax due diligence is not always on the top of minds for buyers focused on quality of earnings analyses and other non-tax reviews. However, completing the tax review could prevent substantial historical risks and contingencies from developing that could affect the expected profit or return of an acquisition, as predicted in financial models.

Tax due diligence is crucial regardless of whether a company is C or S, a partnership, an LLC or a C corporation. They generally don’t pay entity level income taxes on their net income; instead, net income is passed out to partners or members or S shareholders (or at higher levels in a tiered structure) to be taxed on individual ownership. This means that the tax due diligence process should include examining whether there is a possibility for a determination by the IRS or state or local tax authorities of an additional corporate income tax liabilities (and associated penalties and interest) due to mistakes or incorrect positions that are discovered on audit.

Due diligence is more essential than ever. The IRS is stepping up its scrutiny of accounts that are not disclosed to foreign banks and financial institutions, the expansion of the state base for the nexus between sales and tax, and the growing amount of jurisdictions that enforce unclaimed property laws are some of the issues to be considered when completing any M&A deal. Based on the circumstances, failing to meet the IRS’ due diligence requirements could result in penalties being assessed against both the signer and non-signing preparer under Circular 230.

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