The Importance of Tax Diligence In A Purchase

Since the financial crisis, there has been increased focus on tax diligence. Nick Gruidl, Partner in the Tax and M&A arm of McGladrey, cites investor wariness, increased state and local audit activity, and growing awareness of international tax jurisdictions as some of the biggest reasons for more time spent on pre-sale tax analyses.

Best practices for tax diligence

1. Research non-income based taxes.

If the tax due diligence on a deal only relates to income-related taxes, your results will be incomplete and leave you open to potentially fatal oversights. As an example, the government has scrutinized employee versus independent contractor characterizations made by companies. If the target company has misclassified employees as independent contractors, you may inherit that tax liability. In the past that has been enough to put more than a few companies out of business.

2. Ensure a wide enough scope for diligence.

Look beyond the easy questions to expose all tax risks. For instance, it may be tempting to neglect tax questions around a small international operation, but it is necessary to do the legwork. Particularly if the business operates internationally, examining the differences between tax jurisdictions and separate tax systems is an important step.

3. Be aware of current trends in federal taxes.

Changes in taxes have significant impact on deal activity, either spurring or dampening efforts. At the end of 2012, for example, uncertainty surrounding anticipated tax changes created a spike in deal activity. Stay apprised of changing tax regulations so you can act on these types of developments. Relevant future issues are likely to include individual tax rates, corporate tax rates, and taxation of carried interest. In 2013, the highest tax rates for individuals ticked up to 39.6% plus the additional 3.8% Medicare tax. Corporate tax rates stayed at 35% and there is talk of lowering the corporate rate as part of broader tax reform.

This is significant because it’s the first time in over a decade that corporate and individual tax rates have not matched closely. Now that corporate rates are lower than individual rates, appeal of flow through entities might change.

4. Consider the ideal transaction structure.

Proper tax diligence allows you to create the most favorable structure for your transaction. Many buyers make the mistake of making an acquisition without properly considering the post-transaction structure. Consider the merits of corporations versus flow through entities, and the integration into your existing business if the acquisition is an add-on.

5. Explore potential opportunities and credits.

Not all tax due diligence is for the purpose of avoiding risk. You can also uncover opportunities for unrealized growth and savings. The lowest hanging fruit is usually found in various tax credits: R&D, state employment, federal energy efficiency credits and so on. There are so many credits available, it’s likely that the CPA of the target company hasn’t exhausted all opportunities.

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Grimes, McGovern & Associates provides expert advice during all phases of a transaction. Contact us today for a confidential consultation: John McGovern, CEO, [email protected], (917) 881-6563.