Tax Due Diligence in M&A Transactions

The need for tax due diligence is not always top of mind for buyers who are concerned about the quality of earnings analysis and other non-tax reviews. But completing a tax review can prevent significant historical risks and contingencies being discovered that could impact the expected return or profit of an acquisition, as predicted in financial models.

If a company is an C or S corporation, or a partnership or an LLC, the need to conduct tax due diligence is essential. These types of entities do not pay taxes at the level of their entity on their income. Instead, the net income is distributed to members, partners or S shareholders for the purpose of individual ownership taxation. As a result, the tax due diligence focus needs to include reviewing whether there is a potential for a determination by the IRS or local or state tax authorities of additional corporate income tax liabilities (and associated interest and penalties) due to mistakes or inaccurate positions found during an audit.

Due diligence is more critical than ever. Increased scrutiny by the IRS of unreported foreign bank and other financial accounts, the growth of state-based bases for sales tax nexus, changes in accounting practices, and an increasing number jurisdictions that have laws against unclaimed property, are just a few of numerous issues that must be taken into consideration in any M&A transaction. Circular 230 may impose penalties on both the signer of the agreement as well as the non-signing preparation company if they fail to meet the IRS’s due diligence requirements.

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