Tax diligence and planning: Don’t leave money on the table or risk a deal collapse
Tax readiness is an often-overlooked aspect of preparing for an exit, yet the consequences can be significant. Why leave money on the table or risk the deal’s collapse?
Sell-side tax due diligence identifies outstanding issues proactively, so companies can proactively remediate or quantify exposure. It should begin long before you’re considering a sale, since remediation with tax authorities can be a lengthy process.
Like sell-side diligence, tax diligence also needs to begin long before you’re considering a sale, since remediation with tax authorities can be a lengthy process.
When readying a company for sale, PE firms should focus on two areas of tax: first, uncovering any existing issues that could cause a buyer to hesitate or push for a lower price and, second, setting up a tax-efficient structure that maximizes after-tax proceeds on exit.
Common tax issues discovered during diligence
Based on our experience working with PE firms to prepare companies for sale, issues that surface during sell-side tax due diligence tend to fall into the following four areas:
- Tax elections - Since companies can make myriad tax elections — filing consolidated returns to treat a foreign entity as a disregarded entity or Section 338 elections to treat stock deals as asset deals for tax purposes are just two examples — you’ll need to provide evidence prior to the sale that you filed on time for all elections. In some cases, you may need to show election acceptance letters from the IRS. If the diligence process uncovers a problem, you may be able to take steps to remediate. These may include filing for automatic late election relief or requesting a private letter ruling from the IRS.
- Form filing - The forms a company is required to file tend to increase in number and complexity as the entity grows, and failure to file is a common problem, especially in the international arena. This can lead to some significant penalties — often upward of $10,000 and sometimes even as much as $25,000 per form per year.
- Compliance with state and local tax laws - As companies expand their geographic footprint, they establish nexus in a growing number of states. Unfortunately, the business’ state and local tax filings don’t always keep pace. If diligence uncovers a failure to file in a particular state, companies in some cases may file a voluntary disclosure agreement and remit past-due taxes without penalty. Otherwise, companies will need to quantify the exposure to demonstrate it isn’t material, thereby supporting the company’s conclusion not to file.
- An aggressive tax position - Every company’s tax strategy is different. The important thing when selling is to make sure you have documentation and talking points to support the company’s position so you can clearly articulate it to a potential buyer.
Tax areas to consider when planning an exit
- Qualified small business stock - The Section 1202 gain exclusion allows noncorporate sellers of qualifying C corporation stock investments to exclude all or a portion of the gain on the sale of their stock from their taxable income. The gain exclusion can give a significant boost to the after-tax return on qualifying investments.
- After-tax proceeds - It’s important to go into negotiations with an understanding of your proposed exit structure and any tax-planning opportunities identified that will affect your after-tax proceeds. Modeling the after-tax proceeds based on the structure you’ve selected will help you achieve this.
- Tax reform - You and your tax advisor will want to perform a thorough analysis to determine how tax reform will affect your structure and after-tax proceeds.
- Structure - Your optimal structure will maximize after-tax proceeds on exit. Examine all available tax structures and weigh the pros and cons of each before settling on your best option.
- Transaction cost analysis - Identifying opportunities to accelerate deductions can increase cash flow and return on investment.
- Deductions - Another important consideration is who benefits from the timing of certain company deductions — you or the buyer? As the seller, if you’re unable to deduct your transaction costs, you may want to negotiate a higher purchase price — for an amount equal to the tax benefit the buyer will receive from these costs.
Maximizing after-tax proceeds upon exit
In any transaction, your ideal tax structure and the buyer’s may not align. Finding a balance will be central to the negotiation, which is why it’s important to understand the degree to which your tax structure will impact the buyer — and how the buyer’s ideal structure will impact you. For example, it might cost you more to set up the tax structure the buyer prefers, but doing so could support a higher sale price to make you whole.
In any transaction, your ideal tax structure and the buyer’s may not align.
Designing the right tax structure requires a holistic view that brings together a host of considerations, from tax reform and deduction timing to an analysis of transaction costs. With a solid understanding of how all the pieces fit together, you can significantly increase the after-tax proceeds from the sale.
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