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October 26, 2016 Article 3 min read
If you’re considering acquiring another business, be sure to perform thorough financial and tax due diligence. If there are “skeletons in the closet,” you want to know prior to an acquisition.

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The main goal of financial and tax due diligence is to mitigate the risks associated with a transaction.

It provides the buyer an opportunity to discover potential “skeletons in the closet” prior to an acquisition.

As a starting point for any investment analysis, you must assess and verify the seller’s financial performance and tax compliance history. While the concept is basic, the processes involved are anything but straightforward and require careful analysis.

Financial due diligence

Financial due diligence is typically the most thoroughly examined aspect of the due diligence process, but don’t let familiarity obscure the task at hand. A thoughtful and holistic approach is required to truly understand the potential risk areas and their corresponding implications on the transaction.

  • Access capabilities
    As a starting point, your target must be able to produce timely and consistent financial statements. It’s vitally important to analyze the numbers with an eye toward inconsistencies and deviations from generally accepted accounting principles. Compare expenses against those of known competitors: Do they fall outside acceptable averages? If so, determine the reasons for the performance swings
  • Examine position
    Examine the target company’s position in the marketplace, noting trends that could impact recent performance. For instance, take a transaction involving a petroleum retailer. Financial performance could appear exceptional, though a closer inspection could reveal inflated industry-wide margins due to uncharacteristic oil pricing activity. A return to average pricing could significantly deflate performance metrics, and thus valuation, commensurately.
  • Determine future impactors
    Finally, look carefully for any obscured events or decisions that can influence future post-integration earnings:
    • An owner that hasn’t taken a salary
    • Compensation levels for staff and management
    • Healthcare and other benefit costs
    • Legal issues, including settlements, that directly impact expenses
    • Unpaid tax liabilities, including IRS liens and other issues caused by poor cash management controls
    • Dated ERP applications that don’t provide sufficient or even accurate financial metrics, such as inventory and WIP

Four additional considerations

While each company and transaction is different, some consistent traps to avoid include:

  1. Poor cash management controls
  2. Inventory costing and valuation
  3. Collectability of accounts receiveable
  4. Ineffective systems and processes

Tax structuring, due diligence, and planning

You should view the tax implications of a proposed transaction holistically. Tax structuring and tax due diligence are necessary to ensure your long-term tax objectives are achieved.

  • Tax structuring
    Tax structuring seeks to identify the optimal tax structure for a transaction, preferable one that achieves a step-up in the tax basis of assets. Possible ways to achieve a step-up may include a:
    • Direct asset purchase
    • Deemed asset purchase (e.g., Section 338(h)(10) or Section 336(e) elections, purchase of a disregarded entity)
    • Purchase of an ownership interest in a partnership or limited liability company that’s classified as a partnership for tax purposes
    • Unilateral Section 338(g) election to treat a stock purchase as an asset purchase
  • Tax due diligence
    Tax due diligence should be tailored to your target entity’s tax classification (C corporation, S corporation, limited liability company, or partnership) as well as the structure of the transaction from a tax perspective.

    In certain instances, tax exposures may be so significant that they cause the tax structure of the proposed acquisition to be altered. You may be subject to state and local successor liabilities laws even in transactions structured as direct asset purchases.

    Common areas of focus during due diligence may include:
    • Failure to file required tax returns
    • Missing elections or forms (e.g., reporting of a transaction, accounting method changes, safe-harbor elections, transactions between related parties)
    • The validity of the S corporation status of the target company
    • Related party transactions (arm’s length)
    • Previous acquisitions, dispositions, or legal reorganizations
    • Timing of deductions and revenue recognition policies
    • Payroll withholding taxes and the misclassification of employees as contractors
    • Executive compensation, golden parachutes, and bonus structure/incentive plan
    • State sales and use tax issues
  • Tax planning
    Your deal team should recognize the interplay between tax structuring and tax due diligence when planning a transaction. In doing so, historical tax exposures may be mitigated, and costly future tax compliance mistakes will be avoided. Additionally, the potential impact upon ROI may be minimized, and deal proceeds will be maximized upon future exit.
To the extent that you’ll assume historical tax exposures given the legal form of the transaction, potential tax exposures should be addressed in the transaction documents as well as post-close.