The Basics
- Tax due diligence is a deal-focused review of historical tax filings, positions, and exposures designed to uncover issues before they become purchase price problems.
- Successor liability and nexus exposure are often the biggest pressure points, because buyers can inherit unpaid state and local tax liabilities—even in certain asset deals—if those risks are not identified early.
- Tax attributes such as NOLs, credits, and other carryforwards should be validated upfront, since deal structure and ownership changes can limit or eliminate their post-close value.
______________________________________________________________________________________________
Why Tax Due Diligence is Crucial for Buying or Selling a Business
In the fast-paced world of mergers and acquisitions (M&As), the “sticker price” of a deal is rarely the final cost. Beneath the surface of a target company’s financial statements lies a complex web of historical tax positions, nexus footprints, and potential liabilities.
Whether you’re looking to acquire a competitor or preparing your own business for an exit, tax due diligence is not just a box to check; it’s a critical risk-management tool that can make or break the value of your transaction.
What is Tax Due Diligence?
Tax due diligence is a comprehensive review of a company’s historical tax compliance and the validity of its tax positions. Unlike a standard audit, which focuses on financial statement accuracy, tax due diligence looks for “skeletons in the closet” — unrecorded liabilities that could follow the buyer or significantly reduce the seller’s proceeds.
In today’s regulatory environment, this review covers more than just federal income tax. It increasingly focuses on state and local taxes (SALT), international reporting, and payroll compliance.
The Buyer’s Perspective: How Tax Due Diligence Protects Your Investment
For a buyer, the goal of tax due diligence is simple: No surprises. When you acquire a company, you could also be acquiring its past tax mistakes. Key focus areas for buyers include:
- Successor Liability: In many jurisdictions, the buyer can be held responsible for the seller’s unpaid taxes, even in an asset sale.
- Historical Nexus: Many businesses don’t know what they don’t know about their state-tax filing obligations. Due diligence identifies if a target has been operating in states where it failed to file, potentially triggering years of back taxes, interest, and penalties.
- Validation of Tax Attributes: If the deal value depends on the target’s net operating losses (NOLs) or R&D tax credits, the buyer must ensure those attributes will survive the change in ownership and are calculated correctly.
The Seller’s Perspective: Maximizing Exit Value
Sell-side due diligence is a proactive strategy sellers use to “clean house” before going to market. By identifying and addressing tax issues with their business early, sellers can:
- Prevent Price Chips: If a buyer discovers a tax issue during their review, they will often use it to negotiate a lower purchase price or demand a larger escrow.
- Accelerate the Timeline: Identifying issues early allows you to remediate them (such as through Voluntary Disclosure Agreements) before they stall the closing process.
- Strengthen Credibility: Presenting a clean tax history backed by professional due diligence builds trust with potential suitors and their lenders.
Critical Areas of Focus in Tax Due Diligence
As tax laws continue to evolve, three areas have become particularly high-risk in recent M&A transactions:
- State and Local Tax (SALT): With the shift toward remote work and economic nexus (Wayfair) rules, many companies have filing obligations in states they have never physically visited.
- Sales Tax Compliance: This is often the largest unrecorded liability in a deal. A failure to collect sales tax on software, services, or physical goods can lead to massive exposure.
- Worker Classification: The IRS and state agencies are cracking down on companies that misclassify employees as independent contractors. The resulting payroll tax and penalty exposure can be a significant deal-point.
How Due Diligence Impacts the Purchase Agreement
The findings of the tax due diligence report directly influence the legal structure of the deal. They often lead to:
- Specific Indemnifications: Requiring the seller to protect the buyer from specific identified risks.
- Escrow Holdbacks: Setting aside a portion of the purchase price to cover potential tax assessments.
- Tax Insurance: In some cases, parties may purchase Representation and Warranty insurance (RWI) to cover unknown tax liabilities.
Your Takeaway
In the M&A arena, what you don’t know can hurt you. Tax due diligence provides the clarity needed to value a deal accurately and protect the interests of all parties involved. Whether you’re buying or selling a business, a proactive approach to tax risk is the best way to ensure a smooth closing and a successful post-deal transition.
Rehmann’s transaction advisory team specializes in identifying hidden risks and opportunities in M&A deals. To ensure your next transaction is built on a solid tax foundation, click here to connect with our specialists.
Frequently Asked Questions
Q: If we’re doing an asset deal, do we still need tax due diligence?
A: Yes. While asset deals generally provide more protection than stock deals, many states have “successor liability” laws for sales tax and payroll tax that can transfer to the buyer regardless of the deal structure.
Q: When should we start the tax due diligence process?
A: Ideally, as soon as a Letter of Intent (LOI) is signed. For sellers, we recommend starting a pre-sale review 6–12 months before going to market to allow adequate time for remediation.
Q: Is due diligence necessary for small M&A transactions?
A: Risk is not always proportional to deal size. A small software company with a global customer base can easily have sales tax exposure that exceeds its total annual revenue.