Best Practices in Tax Due Diligence

In an effort to help you conduct better due diligence, Axial is launching a six-part series on the Best Practices in Due Diligence. The first installment will discuss the importance of tax due diligence and the best strategies to properly vet a target company. Future articles will discuss legal, operational, cultural, and other due diligence.

While due diligence has always been a vital part of the deal process — especially financial, legal, and cultural — firms have become more sophisticated about it in recent years. Since the financial crisis, it seems that dealmakers are more deeply examining their opportunities with an eye for non-traditional risks that can make a deal unprofitable.

Nick Gruidl, a Partner in McGladrey’s Corporate Tax and M&A arm, has noticed that one of the burgeoning areas is tax due diligence. “The rising focus on tax due diligence, and all diligence for that matter, is probably the result of a series of bad experiences during the financial crisis of 2008 and 2009,” explained Gruidl. “Dealmakers have learned not to make the same mistakes twice.” Combine investor wariness with increased state and local audit activity, growing awareness of international tax jurisdictions, and tax due diligence has become a vital part of any successful deal.

To help lay the groundwork for proper tax due diligence, here are several key requisites to consider before moving forward with a deal.

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. Gruidl explained “When it comes to exposure risks that have the potential to derail otherwise stable acquisitions, non-income based taxes are critical. While most people think of income-related taxes, there are still plenty of non-income related concerns like sales tax, employment tax, property tax, etc.”

He continued, “For example, the government has recently been scrutinizing the employee versus independent contractor characterization 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.”

Ensure a wide enough scope for diligence:

Even if you are looking for the right exposure risks, Gruidl explained that you may need to look beyond the easy questions in some situations. “One of the larger mistakes is having too narrow a scope in the process. For example, while it might be tempting to neglect tax questions surrounding a small international operation, it is necessary to look into it,” says Gruidl. “Without a review, you never know if you may be walking into exposure in the millions of dollars.”

As a matter of fact, international questions have been one of the contributing factors for the increasing importance of tax due diligence in the last few years. Gruidl explained, “As businesses look internationally, either for growth or acquisitions, buyers are becoming more aware of both domestic and international tax issues. The number of jurisdictions and separate tax systems is a concern for many.”

Be aware of current trends in federal taxes:

Taxes can have serious impacts on deal activity, either by spurring or damping efforts. As we saw at the end of 2012, the uncertainty surrounding the anticipated tax changes created a spike in deal activity. Being able to stay appraised of changing tax regulations, can help ensure you can successfully act on these types of developments.

“I think the next issue will be around individual tax rates and corporate tax rates and taxation of carried interest,” explained Gruidl. “At the start of 2013, the highest tax rates for individuals ticked back up to 39.6% plus the additional 3.8% Medicare tax. Meanwhile, corporate rates stayed at 35% and there is talk of lowering the corporate rate as part of broader tax reform.”

This difference in individual and corporate taxes is significant because it is the first time in over a decade since the two have not matched closely. Gruidl explained, “Now that corporate rates are lower than individual rates, it will be interesting to see how deals are structured in response. Namely, the appeal of flow through entities might change.”

Consider the ideal transaction structure:

Proper tax due diligence also allows you to identify the most favorable structure for your transaction. While the basic questions of asset versus stock sales are vital, there are longer, post-sale structures that need to be considered.

Gruidl recommended explicitly asking the question: “How can I best structure this deal going forward from a tax perspective?”

With this question in mind, you can work to restructure your deal to the best situation. He explained,”Many buyers make the mistake of making an acquisition without properly considering the post-transaction structure. You need to consider the merits of corporations versus flow through entities, and the integration into your existing business if the acquisition is an add on.”

Explore potential opportunities and credits:

Not all tax due diligence needs to be for the purposes of risk-aversion. Conducting thorough tax due diligence can also reveal significant opportunities for unrealized growth.

“A proper review of the company’s tax position can allow you to identify previously unrealized tax savings,” explained Gruidl. “The lowest hanging fruit is usually the various tax credits: R&D credits, state employment credits, and federal energy efficiency credits, etc. There are so many credits out there that often the CPA of the target company has not properly identified all the opportunities.”