Tax Risks in M&A Transactions

Recent studies indicate that the most common claims buyers make against sellers for violations of sellers' representations and warranties in M&A purchase agreements relate to tax matters. In reality, there is never just a buyer and a seller in an M&A transaction. Both sides share a silent partner, the taxman. Actually, they both have a "taxman" because Uncle Sam is not the only "silent partner" owed a cut of the target company's profits. State and local authorities, often multiple of each, have a seat at that table.

And in most cases, they have been truly "silent" partners, taking their cuts when they are provided and otherwise sitting on the sidelines. Then suddenly the buyer shows up and puts on the hat of a proxy for those silent partners and opines: "Well, you may have flown under the radar on these issues for all those years, but we are big and draw more attention and, when this deal gets announced, it will bring out the wolves."

Key Highlights

• Tax matters are among the most common issues identified during M&A due diligence.
• Historical tax mistakes can accumulate years of liability, interest, and penalties, significantly impacting deal outcomes.
• Proactive tax preparation before entering the market can help protect valuation and support smoother transactions.

The Compounding Effect of Time

And it does tend to be "all those years" when a tax issue is spotted. It's almost always a repetitive issue. As a rule of thumb, federal, state, and local authorities have the right to look back as far as 6 years in some cases, and therefore any mistake can carry a penalty of up to 6 times the annual liability it created. With that comes the additional interest and potential penalties.

Many corporate tax mistakes occur when businesses are smaller and then get repeated as the company grows. The interest, though, again as a rule of thumb, grosses up those older, smaller mistakes to the point where they may attract even greater liability than the newer iterations of that same mistake.

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Common Tax Mistakes Identified in M&A Diligence

Many tax mistakes occur when companies grow over time, and the issues can become even larger than the original liability.

What kind of mistakes are we talking about?

• Filing under an incorrect subsection of the Internal Revenue Code (e.g., C-corp, S-corp, partnership) but are not properly authorized to do so.
• Calculating taxable income under the wrong subchapter of the Internal Revenue Code, such as deducting personal income tax as a business expense when the company is set up as a tax pass-through entity.
• Failing to properly GAAP financials to the tax reporting standards.
• Being taxed as an S corporation at the federal level, but not applying for that treatment at the state level.
• Misunderstanding physical nexus rules that create income, sales, or use tax responsibilities across multiple states.
• Overlooking the implications of the 2018 South Dakota verses Wayfair case, which expanded states' authority to impose sales tax obligations on businesses without a physical presence.
• Incorrectly calculating and paying more local sales taxes.
• Continuing to pay taxes on a cash-basis accounting after exceeding eligibility thresholds.
• Maintaining accounting records is insufficient to support tax filings.
• Restating financial statements without amending corresponding tax returns.
• Comingling business and personal expenses.
• Misclassifying employees as independent contractors to avoid payroll tax.
• Underpaying their quarterly estimated tax payments.
• Failing to file required Form 5500s for retirement, health, and welfare plans.
• Overlooking required disclosures for foreign assets.

And what's oddly conforming about these mistakes is that they rarely result in the taxpayer having overpaid their taxes.

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How Tax Issues Can Impact Deal Outcomes

In an M&A transaction, the buyer will bring in tax experts to look for each of these potential risks (and many others). Once found, the consequences to the seller typically include one or more of the following:

• A reduction in purchase price.
• Increased escrowed funds that must be held for a year or two after closing.
• Refusal to close the purchase until the issues are cleared to the buyers' satisfaction (and given the urgency of the deal process once it hits this stage, this may mean not whittling down the liabilities to their smallest possible dollar value).
• Heightened scrutiny on the other aspects of the seller's business.
• Increased legal costs to negotiate tax-related provisions.
• Additional closing conditions while continuing to run operations
• In some cases, diligence becomes so exhaustive that buyers may interpret minor or technical matters as material risks that are not there.

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Preparing for a Successful Transaction

Tax exposure can materially affect deal value, timing, and certainty of closing. Proactive tax planning, clean accounting practices, and periodic professional review in the years leading up to a sale can significantly reduce transaction risk and preserve enterprise value.

At Benchmark International, our team works closely with business owners and their professional advisors to identify potential risks before a company is brought to market. This preparation helps ensure sellers enter the process from a position of strength.

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