“Considerations in Conducting Tax Due Diligence in Business Acquisitions,” The Legal Intelligencer

Mark Lubin's article "Considerations in Conducting Tax Due Diligence in Business Acquisitions,” in The Legal Intelligencer

Reprinted with permission from the April 30, 2024, edition of The Legal Intelligencer © 2024 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.

Considerations in Conducting Tax Due Diligence in Business Acquisitions

By Mark L. Lubin

Attorneys are sometimes asked to assist with tax due diligence in business acquisitions, which involves investigating a target business to assess potential tax exposure that could affect a purchaser. Details of diligence engagements vary depending on the size and complexity of the target business, transaction budget, and the sophistication of accountants and other advisers, but they are usually intricate and time-sensitive. Errors can result in substantial tax liability and exposure. This article focuses on federal income tax aspects of tax due diligence from the perspective of purchasers’ attorneys.

Diligence Objectives

Tax diligence priorities and approaches differ considerably, just as acquisition structures vary. Attorneys must understand clients’ objectives and tailor diligence procedures to meet those objectives, taking into account deal-specific factors.

A fundamental diligence objective is understanding the potential liabilities of the target business for pre-acquisition periods that may affect the buyer after the acquisition. These can include unreported or underreported taxes imposed on the target, liabilities of affiliated entities that at any time were included in consolidated tax returns or tax-sharing agreements with the target, and liabilities of entities previously acquired by the target. Buyer exposure to such liabilities can sometimes be mitigated through adjustments to the transaction structure.

Prior target actions can constrain post-acquisition buyer action. Diligence objectives should include determining the existence of such constraints. Where they are uncovered, their impact can sometimes be mitigated.

Taxable entity targets often possess tax attributes that are valuable to the purchaser, such as basis in target assets and loss and credit carryovers. Especially where the buyer relies on (and pays for) those attributes, their existence and value should be corroborated.

Scope and Process Considerations

Targets vary in shape and size, affecting diligence scope and details. Entity acquisitions generally involve greater potential exposure than asset deals, with taxable target entities (i.e., C corporations) presenting the greatest exposure. Corporations other than the target may need to be examined where the target has been included in consolidated federal income tax returns (participating corporations are subject to joint and several liability for taxes of every corporation in the group), or was a party to a tax sharing or similar agreement. Additional exposure can also apply to targets that hold or previously held interests in “pass-through” entities such as partnerships.

S corporations and LLCs are generally taxed on a pass-through basis, with income taxes reported at the owner level. That may reduce the scope of diligence, but exposure for employment and other taxes should not be overlooked. Attorneys conducting diligence should also corroborate that a purported S corporation target made an S election and qualifies for such treatment. S corporations that were previously C corporations may be subject to excess passive income and built-in gains taxes.

Asset acquisitions typically involve less exposure than entity-level deals. Where target assets include interests in subsidiaries, entity diligence considerations apply to those subsidiaries. Also, while some stock acquisitions may be treated as asset acquisitions for certain tax purposes (such as by reason of Section 338(h)(10) elections), entity-level exposures typically remain with the target in those transactions.

Partnerships (including LLCs taxable as such) are generally not subject to entity-level income taxes but can be subject to other entity-level taxes. Also, LLCs taxable on a pass-through basis may be subject to entity-level exposure as the successor to other entities in acquisitions or due to status as a former taxable entity.

While state and local taxes are beyond the scope of this article, sales and use taxes (and associated procedural requirements) often present material exposure in entity and asset acquisitions.

Making the Most of Diligence Opportunities

While scope and procedures of diligence can differ, time and access to seller resources are usually limited. Sellers will typically make documentary materials available to the buyer and its advisers and allow them to speak with key seller tax personnel. Buyer’s counsel needs to make the most of those opportunities.

First, early in the engagement, buyer’s counsel should determine the target’s ownership structure, the types of businesses it conducts, significant transactions it has engaged in, tax planning it has done, and the identity of its relevant personnel. Recent target tax returns and financial reports can be helpful in obtaining this information. A preliminary issues checklist should be prepared based on that review, and it can be updated throughout the process to track documents reviewed and other efforts made. Sample diligence checklists available online can represent a good starting point, but the checklist should be tailored to the target and transaction structure. Buyer’s counsel should also agree with the seller on a process and timetable (which should be subject to adjustment to reflect items that arise during diligence). Buyer accountants or other advisers can help in developing the checklist and timetable.

As diligence progresses, buyer’s counsel should coordinate with other parties regarding requests for documents and other information. The diligence process should also include at least one meeting with target tax leadership and nontax personnel with knowledge of matters that could affect tax exposures. An agenda for any such meeting should be prepared, and sufficient time should be allocated to all topics that may involve material exposure. As documents are obtained and reviewed, buyer’s counsel should continually consider potential exposures and the possible need for further investigation based on newly discovered issues. Buyer’s counsel should coordinate and leverage the abilities of other buyer advisers, if involved.

Upon the conclusion of diligence, the buyer or other interested parties will often require written due diligence reports. A fulsome tax diligence checklist can provide a good framework for such a report. Due diligence checklists and reports should be regarded as sensitive documents; those documents are unlikely to remain confidential. Also, exposures isolated in the diligence process and discussed in diligence reports are generally excluded from representations and warranties coverage (where obtained).

Conclusion

Tax diligence presents a good opportunity for attorneys to provide value to buyers, through mitigation of target or seller-related exposures, and development of integration and other planning alternatives for the acquired business. Advance planning, careful organization, and coordination with other advisers are critical to the effective conduct of tax diligence engagements.