Maximizing Business Sale Value: The Critical Role of Pre-sale Tax Due Diligence
Introduction: The Importance of Pre-sale Tax Due Diligence
In the complex arena of mergers and acquisitions, the focus often lies on the buyer’s due diligence. However, the significance of sellers conducting tax diligence is increasingly recognized for its role in streamlining sales and maximizing value. This post explores how sell-side tax diligence, often overlooked, can be a game-changer for businesses in the M&A process, especially in a market facing economic challenges like lingering inflation and high interest rates.
The Necessity of Early Sell-Side Tax Diligence
Timing is Key
Deciding to sell a business is a monumental step. Balancing this with ongoing operations can be overwhelming. Engaging a sell-side tax advisor early—months before entering the market—will pay off in higher after-tax proceeds, a more tax-efficient structure for the deal, and a smoother deal process. This proactive approach allows for addressing potential tax risks and setting the stage for a smoother transaction.
Role of the Sell-Side Tax Advisor
The sell-side tax advisor’s role is twofold: preparing the business for buyer scrutiny and identifying and mitigating tax risks. This preparation involves a thorough review of the business’s tax obligations and strategies for resolving any issues. The goal is to clean up any tax-related matters before they become stumbling blocks in the eyes of potential buyers.
The Process of Pre-Sale Sell-Side Tax Diligence
Mirroring Buy-Side Due Diligence
Sell-side tax diligence mirrors the buy-side process but with a different objective. While buy-side focuses on identifying risks, sell-side aims at mitigation. This involves a comprehensive review of the company’s tax affairs, including state and local taxes, sales taxes, missed tax filings, imperfect tax elections, federal tax issues, and potential compliance pitfalls.
Common Tax Risks and Mitigation
Risks in areas like sales tax nexus, state income tax obligations, and federal tax compliance are common.
The aftermath from the Wayfair Supreme Court decision on sales tax nexus is still reverberating throughout the states, and many closely held companies are not in compliance. The stark reality is that the statute of limitations never closes if tax returns haven’t been filed. Sales tax obligations are imposed on gross revenue, so delinquent sales tax obligations can quickly derail a transaction.
Many businesses haven’t kept up with the implications of economic nexus on the explosion of the number of states they’re now deemed to be doing business in. Some business owners are still under the misperception that if they don’t have an office or employees in a jurisdiction, then there is no tax return filing requirement. This old thinking has led to draconian holdbacks and downward purchase price adjustments in many recent deals.
The pandemic brought new risks including excess Paycheck Protection Program loans and inappropriate Employee Retention Credits. Businesses were forced to accommodate work from home, which often meant employees in new states, resulting in new state tax filing requirements.
For selling companies structured as S corporations, one of the key risks is that somewhere along the way, the S election has been invalidated. S corporations only allow certain types of shareholders, mainly U.S. individuals and specific types of trusts. S corporations can only have one class of stock, calling into question every distribution that is not pro-rata. For many S corporations, an F Reorganization is one way to mitigate risks for the Buyer. It’s critical for S corporation owners to understand F Reorganizations. For more, see What Is An F Reorganization and Why Are They So Popular?
Prospective buyers will typically request all of a target’s Forms 1099s to hunt for instances of workers misclassified as independent contractors who should have been employees. The cost of non-compliance in this area can be staggering. Fines and penalties by the U.S Department of Labor, IRS, and state agencies; unpaid employment taxes; unemployment insurance deficiencies; unpaid workers’ compensation premiums; blown employee benefit plans, just to name a few.
Identifying and addressing these issues in advance can prevent them from becoming deal-breakers.
Advantages of Conducting Pre-Sale Tax Diligence
Smoother Transactions
By addressing tax issues beforehand, businesses can avoid delays and complications during the M&A process. This not only expedites the transaction but also presents the company in a better light to potential buyers.
Enhanced Company Valuation
Proactively dealing with tax matters can positively impact the company’s valuation. With reduced risks and clear tax compliance, businesses can command a higher price and minimize purchase price adjustments or holdbacks.
Building Buyer Confidence
Pre-sale tax due diligence demonstrates to potential buyers that the company is well-managed and transparent. This increases buyer confidence and can lead to more favorable terms in the sale agreement.
Conclusion: The Strategic Edge of Pre-Sale Tax Due Diligence
Pre-sale tax due diligence is a strategic tool that can significantly impact the success of a business sale. By undertaking this process early and thoroughly, companies can navigate the M&A landscape more effectively, ensuring a smoother transaction and maximizing after-tax proceeds for the sellers. For business owners contemplating a sale, engaging a skilled sell-side tax advisor should be a priority in their exit strategy.