Tax risks to watch out for when buying your target company

Whenever you’re going into a business deal, there’s an asymmetry of information. The sellers know certain things; the buyers know other things, and both sides are trying to get up to par.

If you’re on the buy side of the equation, you have to understand how the target company will integrate with your operations and how it’s going to impact you. One of the risks of managing and completing an acquisition relates to potential successor liability — you don’t want to end up with unforeseen taxes from the purchase.

Conducting tax due diligence not only helps you identify and manage potential risks, it’s also very important for structuring and planning purposes going forward. A rigorous diligence process may give you and your advisers the ability to leverage your knowledge and understanding of certain risks to unearth new value in the deal, such as stepping up the basis of the assets.

“As a buyer, when you’re done with the diligence process, you might understand certain aspects of that company, especially from a tax perspective, better than the company that is selling,” says Dave Godenswager, senior manager of Transaction Advisory Services at BDO.

Smart Business spoke with Godenswager about the risks of a merger or acquisition, from a tax perspective.

What risks do buyers need to watch out for?

Some areas that create problems are sales and use taxes, payroll taxes and worker classification.

Before you sign the deal, you want to understand what you’re buying, including the deal structure. If you do an equity deal, you’re buying historic liabilities. Often prospective buyers think if they do an asset deal, there’s no successor liability. While that’s generally true for most federal income taxes, it’s not true for other types of taxes like payroll and sales and use taxes.

Make sure you know where the product or service is being delivered, where it is being manufactured and where the service is being performed. With indirect taxes you have to understand where exactly the target is operating and who is performing the service, because rules vary greatly by state and state legislatures keep expanding the sales tax base.

Do they have employees, or independent contractors? Do they have a ‘share economy’ that includes contractors, temporary workers, self-employed, part-timers, freelancers and free agents? A share economy can create state and local tax income problems, because an enterprise might be in more jurisdictions than was originally envisioned, which means a higher compliance hurdle for the buyer.

It’s more challenging to navigate state regulatory filings now. State and local governments are starved for revenue; the tax rules have become incredibly complex and favorable to the states, since state legislatures are the ones who draft the rules. For example, in New York if you don’t do certain bulk sale notifications in an asset deal, you may still be potentially liable for those sales and use taxes.

The business world also is increasingly international, which brings up issues that might not be readily apparent at first. For example, if you’re buying something that’s owned by a foreign company, you may have withholding obligations and must consider the potential impact of the Foreign Investment in Real Property Tax Act of 1980, Foreign Account Tax Compliance Act and other provisions.

How should buyers best mitigate these risks?

Engage your advisers early in the process — even though that comes with a certain cost. That means getting expert help sometimes before the letter of intent (LOI).

After the LOI is signed, your advisers can help digest the information gathered through due diligence and integrate it with the reps and warranties and indemnification provisions of the purchase agreement. Also, the advisers should consider whether to include certain carve-outs, like taxes because you’ve identified a tax issue, from a basket in the purchase agreement. Similar to a deductible in an insurance policy, a basket defines the dollar amount of post closing claims a buyer must exceed before pursuing a refund for the claim from the seller.

It’s all about communicating, talking early in the process and not relegating it to after the LOI.

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