Sell-Side M&A Transactions and Tax Due Diligence

At a Glance

Main Takeaway

The buying party often conducts in-depth tax due diligence when closing a merger or acquisition transaction. Tax due diligence includes thoroughly reviewing the target company’s tax profile, from contractual obligations and liabilities to regulatory adherence and operational risks.

Usually, buyers perform most of the due diligence in a deal; however, it is becoming more imperative for sellers to also perform due diligence. Applying sell-side due diligence practices can expedite mergers and acquisitions (M&A) transactions, minimize sell-side risks, and guarantee that sellers secure the best purchase price in negotiations.

With rising inflation, an unstable banking environment, and high interest rates, buyers are being especially cautious and more likely to walk away from a deal if they think the purchase is too risky. So, for sellers, making sure all tax positions are correct prior to the finalization of a deal has become even more critical.

Next Step

For a smoother and less lengthy transaction, you should know the differences in tax due diligence responsibilities between both parties and explore the benefits of thorough sell-side due diligence.

Importance of Timing in Sell-Side Tax Due Diligence

As a selling party in a merger or acquisition deal, choosing the right time to do your due diligence before selling the company can affect your chances of closing the deal.

• Identify potential risks early. Conducting tax due diligence as early as possible lets you paint a complete picture of the company’s valuation. Knowing all potential tax liabilities early in the process reduces the risk of delaying negotiations, saving time and money. It also gives you time to address potential compliance issues instead of focusing on the mechanics of the deal.
• Prepare for the buyer’s questions. A critical part of the due diligence process is answering the buy-side’s questions regarding your company’s tax compliance. For instance, they may ask whether the company’s tax filings are up-to-date, whether any audits or investigations are ongoing, or if it complies with all applicable state laws and federal regulations. Proper timing and self-analysis will provide the information needed to answer these questions confidently. It helps reduce delays and ensure a smoother transaction process.

• Control the company’s tax narrative. Performing sell-side due diligence lets you proactively communicate your company’s tax position, identifying risks to permanent losses. It gives you the leverage to set the tone during negotiations, eliminate surprises, and build a credible and trustworthy image.

• Reduce sell-side fatigue. The M&A process is typically lengthy and arduous. Early and timely sell-side due diligence can make the process smoother, reducing the time it takes to complete the transaction and making it more manageable for both parties. By reducing the risk of deal fatigue, leading to poor decision-making, you will have better leverage in negotiating terms with the buyer.

• Close the deal more efficiently. Timely sell-side due diligence is not just about identifying risks ahead of time; it can also help you address them before closing the deal as they come to fruition.

For example, if you find overdue taxes or signs of operational inefficiencies, you can issue corrective filings or restructure the company accordingly. It can help you increase the company’s valuation and shorten the time the buy-side spends on due diligence.

Comparing Buy-Side and Sell-Side Tax Due Diligence

While both the buy-side and the sell-side can conduct tax due diligence during an M&A deal, they have opposite objectives. Each side has questions, concerns, and risks to address prior to the close of the deal.

Buy-Side Objectives

The primary objective of buy-side due diligence is to identify the company’s risks and tax liabilities as comprehensively as possible. The process begins after the buyers issue a Letter of Intent (LOI). The buy-side’s focus within due diligence is primarily retrospective, meaning buyers look at the company’s past to issue a decision on the deal.

The buy-side’s due diligence results will determine whether the buyers proceed with the deal, request changes and modifications, or abandon the transaction altogether.

Some key M&A buyer questions include:

• What is the company’s liability status with the IRS and other tax authorities?
• Does the company have a history of receiving tax credits?
• How are staff classified for tax purposes? (e.g., employees vs. contractors)
• Did past tax audits reveal unresolved or recurring issues?
• What is the current tax position of the target, and does it complement the buyer’s net tax position?

Sell-Side Objectives

While sellers also conduct tax due diligence to identify risks and liabilities, the sell-side due diligence process generally starts months, if not years, before receiving an offer. The main objective is to resolve or mitigate any discovered risks and liabilities before negotiations to increase the business’s value.

Key M&A seller questions include:

• What issues might the buy-side find objectionable, and how can we address them?
• What are our company’s competitive advantages, and how can we highlight them?
• How do our company’s effective tax rates compare to others in our industry or sector?
• Can we structure the deal in a more tax-efficient way for buyers?

Common Tax Risks in M&A Transactions

The due diligence process can reveal risks and liabilities at the local, state, and federal levels. Below are some of the most common tax issues that may arise.

State and Local Tax Risks

• Local and state sales taxes. Your company may be subject to local and state taxes in California, depending on its city and county of residence. Unpaid sales tax or failure to collect sales tax from customers is a common liability for retailers and restaurants. In addition, real estate taxes and liens can remain a hidden liability undisclosed within a transaction.

• Franchise taxes. Businesses in California must pay an annual franchise tax to the California Franchise Tax Board (FTB). These taxes are levied in addition to standard income taxes. Due diligence may reveal unpaid or late-filed franchise taxes.

• Tax nexus issues. The M&A deal can change a company’s tax nexus and affect the tax types, rates, and filing requirements the buyer will be subjected to, making the deal structure more complex. This could mean additional compliance requirements, resulting in a change in the company’s valuation. For example, your company’s California tax liability may change or fall under one or multiple other states’ jurisdictions if you change the headquarters of the target company from within California to another state while continuing business within California.

• Tax withholding requirements. Your company must accurately withhold taxes for its employees and contractors under California withholding laws. Failing to properly withhold taxes or a history of late and incorrect filings can pass on the costs to the buyer, affecting company valuation and buyer confidence.

Federal Tax Risks

• Asset sale vs. stock sale. Choosing whether to sell the company’s assets or stocks during the M&A transaction is a critical decision for sellers. Each option has different tax implications and challenges for both parties. Making an unfavorable choice can impact the chances of success, alter the company’s valuation, or increase your tax liabilities after closing the deal.

• Income and capital gains taxes. How the deal is structured will impact your tax obligations. For instance, selling depreciable assets may incur federal income taxes as it is considered “ordinary income,” whereas selling stocks or investment assets may result in capital gains taxes.

• Net operating losses (NOLs). If your business’s tax deductions exceed its taxable income, it registers net operating losses (NOLs). Due diligence can reveal whether these NOLs are transferable to the new owner after the transaction and their impact on the company’s valuation. NOLs are considered deferred tax assets and are usually hidden assets not accrued for within most small business financial statements.

Depending on the transaction’s structure, the buyer may also be subjected to Section 382 limitations on using NOLs after an ownership change.

How Sell-Side Tax Due Diligence Can Mitigate Risks

Proper, timely sell-side tax diligence can help manage any risks you discover, ensuring the M&A process is completed more smoothly.

• Address unpaid taxes. Identifying unpaid or under-collected local, state, and federal taxes through due diligence is the first step in addressing unpaid taxes. As a result, owners can create a remediation plan to ensure all due taxes are paid before the sale.

• Compliance with local jurisdictions. Due diligence allows you to determine which jurisdictions the company has tax obligations before and after the sale. It provides the information needed to ensure compliance with all applicable tax rules.

• Evaluating sale type. Proper tax due diligence can provide the information needed to determine whether an asset or stock sale is more advantageous for the seller. It can also help give you a stronger negotiating position with the buyers in influencing the perspective of either option.

• Tax liability minimization. The due diligence process can provide detailed information regarding your company’s tax liabilities, such as income and capital gains taxes. The information can help you develop plans to minimize these taxes and obtain a higher sale value by matching them with global losses and gains of a similar nature.

• NOL management. If the tax diligence process reveals the company has registered NOLs, it can help you determine their transferability to the buyer. You can also determine whether any Section 382 limitations apply post-transaction and communicate them to the buyer before receiving the letter of intent.

Role of Sell-Side Advisors in the M&A Process

Consider hiring an experienced advisor at Windes before initiating an M&A transaction with a buyer. Our advisors can provide you with sell-side M&A advisory services, helping you facilitate the M&A process in many ways:

• Company valuation. Windes’ M&A advisors can evaluate the company’s assets, market position, tax liabilities, and other financial details to determine its valuation. We can also produce a Quality of Earnings (QOE) report to detail your company’s financial health and operational performance. Our advisors can help you estimate a realistic sale price and strengthen your negotiation position.

• Negotiating assistance. Windes can assist you during the negotiation process, help you understand the deal’s terms and conditions, and provide actionable advice.

• Due diligence services. Our M&A advisory team can help you at every stage of the tax due diligence process, from gathering documentation to assessing liabilities. We can also advise on the options on how to structure the deal and expedite the transaction process.

• Avoid common mistakes. Windes’ M&A advisors have the experience to help you identify and avoid common mistakes, especially for first-time sellers. For example, they can help you assess your tax nexus thresholds and file sales tax returns in all applicable jurisdictions. Windes can also ensure you avoid scams regarding qualification for tax credits, such as those involving the Employee Retention Credit (ERC).

• Deal closing: If you are about to close the deal with buyers, our M&A advisors can help you navigate the final steps. Changes to corporate structures and entity dissolution require additional filings unknown by most owners.

Complete Your M&A Transaction With Windes

Completing a mergers and acquisition deal as a seller requires careful planning and proper tax due diligence. Windes’ M&A Strategy Team will ensure the due diligence process is as thorough as possible.

Our services can help you move the transaction toward a speedy close, identify and mitigate risks ahead of time, and ensure buyers offer the best purchase price. Contact us today for advice and guidance regarding the tax due diligence process and how we can help you close the deal smoothly and efficiently.